Game Theory in Oligopoly
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Jacy VykeGame Theory in Oligopoly
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Jacy VykeLESSON NINE
ELEMENTS OF GAME THEORY IN OLIGOPOLY
Oligopolies exist where there are a few interdependent firms in the industry. Each firm
has to take account of its rivals’ likely responses to its actions.
Game theory is used to analyse conflicts of interest among rival firms.
Oligopolists engage in various strategic behaviour like price – cutting or advertising.
Terms
a) Strategy - these are the players’ plans of actions, moves or countermoves. A
player’s strategy has not only to set out the preferred course of action but also
to anticipate the possible reaction of opponents.
b) Pay – offs – These are the possible outcomes of each strategy or combination of
strategies for a player given the rivals’ counter- strategies. Examples of pay -
offs include wages, profits, utilities, market shares, jail terms, losses etc. The
pay – offs do not have to be pleasant.
c) Pay – off matrix – this is a table which illustrates the pay – offs for every
possible action by each player for every possible reaction by the other players.
d) Dominant strategy – this refers to each player’s best strategy given the rival’s
counter – strategies.
Associated with each type of game is a solution concept.
Game theory provides tools for use in decision – making.
Examples in economics are duopolies, families, trading processes like auctions,
situations within firms like promotions, and between countries in international
trade.
Example
Consider two rival firms, A and B. Suppose that A wishes to increase its share for its
products. It might have two strategies; a price cut or an increase in advertising. Firm A
anticipates that B will react to either of these strategies in like manner; i.e either with
a price cut or with an increase in advertising. We can thus construct a pay-off matrix
showing two strategies for each four possible outcomes ( in terms of market shares )
Firm B
Price cut Extra Advertising
A B A B
60 40 75 25
Firm A
Price cut
A B A B
Extra Advertising
50 50 65 35
Row 1 shows the two possible outcomes when A adopts the price-cutting strategy; A
will achieve a market share of 60% if B also goes for a price cutting strategy, and a
market share of 75% if B responds with extra advertising.
Row 2 shows the two possible outcomes when A adopts the extra advertising strategy;
in this case, A will achieve 50% market share if B responds with a price-cut, and 65%
market share if B also goes for extra adverting.
We assume that A will proceed in the belief that B is also aware of the pay-off matrix;
hence B responds to either of A’s strategies by cutting price as this gives B a higher
market share than could be achieved by extra advertising. ‘A’ will also opt for the
price-cutting strategy and so achieve a market share of 60%. Price-cutting is the
dominant strategy for both A and B.
In this example, the market is shared between A and B only, so one firm’s gain is
necessarily the other firm’s loss. This is known as a zero-sum game.
The Prisoner’s Dilemma
This is a special type of game which shows that sometimes cooperation is beneficial to
participants.
In oligopolies where producers behave selfishly, their strategies may lead to a greater
loss to themselves and to their rivals than if they had cooperated. The idea behind
Prisoner’s dilemma is the mistrust of other participants which creates an incentive to
cheat. The behaviour of firms is likened to that of Prisoner’s faced with the dilemma of
whether or not to confess to a crime.
Consider the pay-off matrix table below
Prisoner B
Confess Don’t confess
A B A B
2 yrs 2 yrs 3 mon 3 mon
Prisoner A A B A B
Confess 3 yrs 3 mon 9 mon 9 mon
Don’t confess
By inspecting the matrix, if A and B trust each other and cooperate the each can get a
9 month sentence by not cooperating. But both individuals feel unable to trust the
other not to confess. Each fears that the other might confess in order to get a short 3
month sentence; so resulting in a 3 year sentence for the one who doesn’t confess.
Consequently in this position of mistrust, each prisoner will attempt to adopt a
strategy of confessing to the crime. Thus, the final outcome is given by the top-left cell
where each confesses and gets a 2 year sentence
This is a Nash equilibrium as both A and B act in their own self – interest. This
outcome displays competitive behaviour. The pursuit of self – interest therefore, does
not produce the optimal outcome form this example.
Note that many negative externalities especially environmental pollution exhibit the
characteristics of the Prisoner’s dilemma. Mistrust and the competitive behaviour of
producers tend to accelerate the harmful effects of externalities while cooperation
might lead to reduced levels of damage.
