Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1 Chapter 11 Game Theory and Asymmetric Information

Chapter Eleven Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

1

Chapter 11

Game Theory and

Asymmetric Information


2

OverviewGame theoryGame theory and auctionsStrategy and game theory

Asymmetric informationReputationStandardizationMarket signaling


3

Game theory Economic optimization has two

shortcomings when applied to actual business situations

assumes factors such as reaction of competitors or tastes and preferences of consumers remain constant

managers sometimes make decisions when other parties have more information about market conditions


4

Game theory

Game theory: is concerned with “how individuals make decisions when they are aware that their actions affect each other and when each individual takes this into account”


5

Game theory Fundamental aspects of game theory

players are interdependent uncertainty: other players’ actions are

not entirely predictable

Types of games zero-sum or non-zero-sum cooperative or non-cooperative two-person or n-person


6

Games in economics Prisoners’ Dilemma

two-person, non-zero-sum, non-cooperative

always has a dominant strategy

equilibrium is stable

confessing is dominant strategy for each player, no matter what other player chooses

each player has no incentive to unilaterally change his strategy


7

Games in economicsOligopoly pricing usingprisoners’ dilemma

• (Low/Low) is a stable equilibrium … no incentive for either firm to deviate

• better off at (High/High) but it is not stable … each firm has an incentive to deviate

• (High/High) would be an equilibrium … if the firms were allowed to cooperate


8

Games in economics Example: Beach Kiosk Game: a two-

person, zero-sum, non-cooperative game

Suppose two companies provide snacks and sunscreen on a beach

beachgoers will spread themselves out evenly along the beach

both companies ultimately locate at the midpoint of the beach, otherwise the other company has an advantage (closer to more beachgoers

Real life example: location of gas stations


9

Games in economics Repeated Game: game is played

repeatedly over a period of time

• in a perpetual repeated game, equilibria that are not stable may become stable due to the threat of retaliation

• however, if number of periods is fixed, players will have incentive to ‘cheat’ in the last period due to lack of threat of retaliation, which will then allow them to cheat in all periods


10

Games in economicsExample: assume (High, High) equilibrium reached

and both firms start off charging the high price in the next period, if one firm cheats (charges low

price), it receives 600 in that period

other firm will change to low prices in the next period to ‘retaliate’ and both will end up at (Low, Low) equilibrium

thus, incentive exists not to cheat in a perpetual repeated game and (High, High) is a viable equilibrium (unlike in the short game)


11

Games in economics Simultaneous games are games in

which players make their strategy choices at the same time

Sequential games are games in which players make their decisions sequentially

In sequential games, the first mover may

have an advantage


12

Games in economics Consider the following payoff matrix in which firms

choose their capacity, either high or low. Suppose firm C has the ability to move first

C would choose Low, then D would choose High


13

Game theory and auctions Dutch auction (a non-cooperative, non-zero-sum

game): each buyer describes the quantity demanded

and price to pay starting at highest price, sum quantity

demanded up to the supply available all product is sold at the highest price that

clears the market Seller wants to sell at highest price, buyer wants

to buy at lowest price Solution: every player’s dominant strategy is to

bid as late as possible


14

Strategy and game theory Problem: in Prisoners’ Dilemma, players

have a dominant strategy that leads to suboptimal results

Commitment, explicit or implicit, can be used to achieve preferred outcomes. It must be credible: burn bridges behind you establish and use a reputation write contracts


15

Strategy and game theory

Incentives also can be used to change the game to achieve preferred outcomes

Illustration: GM card. GM came up with a strategy where customers could apply 5% of their purchases to a GM vehicle

Illustration: Health insurance. Firms provide a menu of care levels.


16

Strategy and game theory

PARTS: paradigm for studying a situation, predicting players’ actions, making strategic decisions Players: Who are players and what are their

goals? Added Value: What do the different players

contribute to the pie? Rules: What is the form of competition? Time

structure of the game? Tactics: What options are open to the players?

Commitments? Incentives? Scope: What are the boundaries of the game?


17

Asymmetric information Asymmetric information: market

situation in which one party in a transaction has more information than the other party. Leads to many problems in markets: too much or too little production difficult contracting possible fraud market may disappear


18

Asymmetric information Adverse selection: prior to transaction,

one party may know more about the value of a good than the other

Example: ‘lemons’ (bad used cars)… seller knows the vehicle well, but buyer does not, yet market does not divide in two


19

Asymmetric information Moral Hazard: transaction changes the

incentives of a party because it cannot be monitored after the transaction

Example: insurance industry ... poor information takes place after the sale, not before


20

Asymmetric Information Market responses:

• obtaining information from third parties• relying on reputation of the seller• standardization of products• market signaling: demonstrated success in

one activity provides information about success/quality in another


21


Example: education as a signal

attending college demonstrates certain traits

employers see this a screening device


22


Example: warranties

more costly on low quality goods than high quality goods

consumers see them as a screening device


23


Example: banking systems

banks know less about the borrower’s ability to repay than the customer

arms length banking: US relationship banking: Japan

Documents

Chapter ElevenCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1 Chapter 11 Game Theory and Asymmetric Information