MICROECONOMICS: Theory & Applications
Chapter 14: Game Theory and the Economics of
Information
By
Edgar K. Browning & Mark A. Zupan
John Wiley & Sons, Inc.
11th Edition, Copyright 2012
PowerPoint prepared by Della L. Sue, Marist College
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 singleperiod setting.
 Analyze asymmetric information and market
outcomes in the case where consumers have less
information than sellers.
(continued)
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Learning Objectives
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(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.
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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:
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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
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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

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Table 14.1
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Nash Equilibrium

A set of strategies such that each player’s choice is the best
one possible given the strategy chosen by the other player(s)
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All dominant-strategy equilibria are Nash equilibria.
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Not all Nash equilibria are dominant-strategy equilibria.
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Not all games have a Nash equilibria.
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Nash equilibrium is closely related to the analysis of the
Cournot oligopoly model.
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Table 14.2 - Nash Equilibrium
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The Prisoner’s Dilemma Game
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The most famous game theory model in which
self-interest on the part of each player leads to a
result in which all players are worse off than
they could be if different choices were made.
Dominant-strategy equilibrium
Nash equilibrium
Wide-applicability
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Table 14.3
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The Prisoner’s Dilemma and Cheating
by Cartel Members
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Outcome: each party acts in their own self-interest,
resulting in all parties being worse off
Alternative plan: all parties agree to collude
Two strategies for each party:
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Comply – maximizes combined profit for parties
Cheat – stronger incentive for each party with potential for
larger individual profit but lower combined profit
Success of collusive agreement depends on:
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Enforceability
Number of parties
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Table 14.4
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Table 14.5
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Repeated Games
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Repeated Game Model – a game theory model in
which the “game” is played more than once
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“Tit-for-tat” – a strategy in which each player mimics
the action taken by the other player in the preceding
period; 2 alternatives: comply, cheat
Out come:
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Cheating in current period can result in losses in
subsequent period
Disincentive to cheat
Strengthens incentive to collude
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Table 14.6
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Asymmetric Information
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Imperfect information – the case when market
participants lack some information relevant to
their decisions
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Asymmetric information – a case in which
participants on one side of the market know
more about a good’s quality than do
participants on the other side
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The “Lemons” Model
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The “Lemons” Model
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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 response:
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increase and improve information
information is scarce and, consequently, costly
availability of information can increase market
efficiency
it might be efficient for consumers to be less than
fully informed.
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Adverse Selection
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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
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Application – insurance markets in which the
assumption of full information (both firms and
customers know the risks) is modified
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Possible outcome – higher-risk customers tend to be
insured and lower-risk customers choose to remain
uninsured
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Market Responses to Adverse
Selection
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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:
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Upper limit on insurance coverage
Requirement of physical exams and/or a waiting
period
Group plans covering all employees
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Moral Hazard
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Moral hazard – a situation that occurs
when, as a result of having insurance, an
individual becomes more likely to engage
in risky behavior
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The problem arises when insurance
companies lack knowledge of the actions
people take that may affect the occurrence
of unfavorable events.
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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:
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Coinsurance rate – the share of the cost borne by
the patient
Deductibles – the amount that the patient
must pay before insurance coverage is
effective
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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.
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Advertising

Firms advertise to attempt to increase the
demand for their product:
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Advertising as information about availability, price, and
quality
Artificial product differentiation: the use of advertising to
differentiate products that are essentially the same
Effects of advertising:
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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
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Figure 14.1 – Advertising and
a Firm’s Demand Curve
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Advertising, the Full Price of a
Product, and Market Efficiency
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Full price – the sum of the money price and the
search costs that consumers incur
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Advertising is a substitute for the consumer’s own
search efforts, and thereby reduce search costs.
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Advertising is a low-cost way of conveying
information, and thereby increases market
efficiency.
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