1 MICROECONOMICS Notes for LECTURE 5 I STRATEGY AND GAME THEORY There are two notions of strategy that come to the fore in business schools: 1. Strategy as the study of the sources of competitive advantage for firms 2. Strategy as the art or skill of using stratagems The first of these is a business school discipline in its own right and will be introduced in the session. The second is the subject of game theory, a part of microeconomics, but which also forms an important part of strategy in the first sense. Here we concentrate on game theory. Game theory analyses situations of strategic interaction, where the outcomes of people's actions depend on the actions of other people. Situations of this kind arise routinely in the business world. Where so, it is necessary for the people or 'players' involved to anticipate what other players will do, taking into account that everyone is doing the same thing. The purpose of these notes is to give an overview of some of the tools of game theory, which will help you do this. The key components of a game are i) players, ii) payoffs and iii) strategies. These may be illustrated with the classic Prisoners Dilemma: Player 2 Deny Confess Player 1 Deny 2, 2 0, 3 Confess 3, 0 1, 1 Fig. 1. Prisoners' dilemma (Normal Form) Here and in what follows payoffs are written (Player 1, Player 2). Player 1 will be taken to be a 'he' and Player 2 a 'she'. This game is an idealised representation of a particular kind of situation that arises in various social contexts. Particular examples, some of which we will consider later on, include the instability of collusive behaviour, work-motivation problems in co- operatives, voting behaviour, littering, demand revelation problems in context of public goods, etc. The way to read the matrix is as follows. Both players face a choice between "Deny" and "Confess". They are assumed to be highly rational, only interested in themselves, and to prefer higher payoffs to lower payoffs. It is also assumed that they can see
2 everything depicted in Fig. 1. above, except what the other player chooses, and that the game is played only once. The goal is then to deduce what they would do under these conditions, where the payoffs each of them receive depends on their respective choices. For example, if both players choose "Deny" both of them receive 2; if Player 1 chooses "deny" and Player 2 chooses "Confess", Player 1 receives 0 and Player 2 receives 3; and so on. See if you can work out the right answer. II STATIC GAMES WITH COMPLETE INFORMATION In games of complete information, the timing, feasible moves and payoffs of the game are all common knowledge. A proposition or event is common knowledge if everyone knows it, everyone knows that everyone knows it, everyone knows that everyone knows that everyone knows it, and so on. The timing of static games of complete information is as