Prepared by Dr Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 14: Game Theory and the Economics of Information By Edgar K Browning & Mark A Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives     Understand the basics of game theory: a mathematical technique to study choice under conditions of strategic interaction Describe the prisoner’s dilemma and its applicability to oligopoly theory as well as many other situations Explore how the outcome in the case of a prisoner’s dilemma differs in a repeated-game versus a single-period setting Analyze asymmetric information and market outcomes in the case where consumers have less information than sellers (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives (continued)  Explain how insurance markets may function when information is imperfect and there is the possibility of either adverse selection or moral hazard  Show how limited price information affects price dispersion for a product  Investigate advertising and the extent to which it serves to artificially differentiate products versus provide information to consumers about the availability of products and their prices and qualities Copyright © 2015 John Wiley & Sons, Inc All rights reserved Understand the basics of game theory: a mathematical technique to study choice under conditions of strategic interaction 14.1 GAME THEORY Copyright © 2015 John Wiley & Sons, Inc All rights reserved Game Theory  Game theory – a method of analyzing situation in which the outcomes of your choices depend on others’ choices, and vice versa  Elements common to all game theory:    Players – decision makers whose behavior we are trying to predict and/or explain Strategies – the possible choices of the players Payoffs – the outcomes or consequences of the strategies chosen Copyright © 2015 John Wiley & Sons, Inc All rights reserved Determination of Equilibrium  Payoff matrix – a simple way of representing how each combination of choices affects players’ payoffs in a game theory setting  Dominant strategy – a case where a player is better off adopting a particular strategy regardless of the strategy adopted by the other player  Dominant-strategy equilibrium – the simplest game theory outcome, resulting from both players having dominant strategies Copyright © 2015 John Wiley & Sons, Inc All rights reserved Table 14.1 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Nash Equilibrium  Definition: a set of strategies such that each player’s choice is the best one possible given the strategy chosen by the other player(s)  All dominant-strategy equilibria are Nash equilibria  Not all Nash equilibria are dominant-strategy equilibria  Not all games have a Nash equilibria  Nash equilibrium is closely related to the analysis of the Cournot oligopoly model Copyright © 2015 John Wiley & Sons, Inc All rights reserved Table 14.2 - Nash Equilibrium Copyright © 2015 John Wiley & Sons, Inc All rights reserved Describe the prisoner’s dilemma and its applicability to oligopoly theory as well as many other situations 14.2 THE PRISONER’S DILEMMA GAME Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 Game Theory and Oligopoly: A Summary  Game theory – provides a technique that is suited to investigate strategic interactions between oligopolies  No general theory of oligopoly exists Copyright © 2015 John Wiley & Sons, Inc All rights reserved 20 Analyze asymmetric information and market outcomes in the case where consumers have less information than sellers 14.4 ASYMMETRIC INFORMATION Copyright © 2015 John Wiley & Sons, Inc All rights reserved 21 Asymmetric Information  Imperfect information – the case when market participants lack some information relevant to their decisions  Asymmetric information – a case in which participants on one side of the market know more about a good’s quality than participants on the other side  The “Lemons” Model Copyright © 2015 John Wiley & Sons, Inc All rights reserved 22 The “Lemons” Model  Market application: pre-owned cars  Long-run outcome: low-quality cars tend to drive out high-quality cars in the presence of asymmetric information  Market responses:    availability of information can increase market efficiency information is scarce and, consequently, costly  Benefit from information will not always be worth the cost it might be efficient for consumers to be less than fully informed Copyright © 2015 John Wiley & Sons, Inc All rights reserved 23 Explain how insurance markets may function when information is imperfect and there is the possibility of either adverse selection or moral hazard 14.5 ADVERSE SELECTION AND MORAL HAZARD Copyright © 2015 John Wiley & Sons, Inc All rights reserved 24 Adverse Selection  Adverse selection – a situation in which asymmetric information causes higher-risk customers to be more likely to purchase or sellers to be more likely to supply low-quality goods  Application – insurance markets in which the assumption of full information (both firms and customers know the risks) is modified  Possible outcome – higher-risk customers tend to be insured and lowerrisk customers choose to remain uninsured Copyright © 2015 John Wiley & Sons, Inc All rights reserved 25 Market Responses to Adverse Selection  Outcome is mitigated: there are potential gains to market participants from adjusting their behavior to account for the adverse selection problem  Lower benefits, reduce costs, spread risk  Examples:    Upper limit on insurance coverage Requirement of physical exams and/or a waiting period Group plans covering all employees Copyright © 2015 John Wiley & Sons, Inc All rights reserved 26 Moral Hazard  Moral hazard – a situation that occurs when, as a result of having insurance, an individual becomes more likely to engage in risky behavior   The problem arises when insurance companies lack knowledge of the actions people take that may affect the occurrence of unfavorable events Another problem: lower cost to the insured individual increases the demand for services which raises the cost of health care and insurance premiums Copyright © 2015 John Wiley & Sons, Inc All rights reserved 27 Market Responses to Moral Hazard Application: medical insurance market    Limitation on the services covered by insurance Requirement of the insured person to pay part of the costs:  Coinsurance rate – the share of the cost borne by the patient Deductibles – the amount that the patient must pay before insurance coverage is effective Copyright © 2015 John Wiley & Sons, Inc All rights reserved 28 Show how limited price information affects price dispersion for a product 14.6 LIMITED PRICE INFORMATION Copyright © 2015 John Wiley & Sons, Inc All rights reserved 29 Limited Price Information  Price dispersion – a range of prices for the same product, usually as a result of customers’ lacking price information  Search costs – the costs that customers incur in acquiring information  Price dispersion will fall when the benefit from search is higher than the cost Copyright © 2015 John Wiley & Sons, Inc All rights reserved 30 Investigate advertising and the extent to which it serves to artificially differentiate products versus provide information to consumers about the availability of products and their prices and qualities 14.7 ADVERTISING Copyright © 2015 John Wiley & Sons, Inc All rights reserved 31 Advertising   Firms advertise to attempt to increase the demand for their product:  Advertising as information about availability, price, and quality  Artificial product differentiation: the use of advertising to differentiate products that are essentially the same  Demand curve might also become less price elastic Effects of advertising:  Reduce price dispersion and lower the average price  Solve the lemons problems by giving high-quality sellers an advantage over low-quality sellers  Introduce consumers to new products Copyright © 2015 John Wiley & Sons, Inc All rights reserved 32 Figure 14.1 – Advertising and a Firm’s Demand Curve Copyright © 2015 John Wiley & Sons, Inc All rights reserved 33 Advertising, the Full Price of a Product, and Market Efficiency  Full price – the sum of the money price and the search costs that consumers incur  Advertising is a substitute for the consumer’s own search efforts, and thereby reduce search costs  Advertising is a low-cost way of conveying information, and thereby increases market efficiency Copyright © 2015 John Wiley & Sons, Inc All rights reserved 34 ... Understand the basics of game theory: a mathematical technique to study choice under conditions of strategic interaction Describe the prisoner’s dilemma and its applicability to oligopoly theory. .. Investigate advertising and the extent to which it serves to artificially differentiate products versus provide information to consumers about the availability of products and their prices and qualities... reserved Game Theory  Game theory – a method of analyzing situation in which the outcomes of your choices depend on others’ choices, and vice versa  Elements common to all game theory:   