Oligopoly and game theory

Oligopoly

An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). Oligopolies can result from various forms of collusion which reduce competition and lead to higher costs for consumers. Alternatively, oligopolies can see fierce competition because competitors can realize large gains and losses at each other’s expense. In such oligopolies, outcomes for consumers can often be favourable.

Firms operating in oligopoly industries tend to keep prices stable. They know that the actions of one firm will impact on the other firms in the industry, in other words they are interdependent. If one firm were to raise its prices then others would not follow and because the goods traded are similar, customers will move to the lower cost option. If a firm were to lower prices then other firms would follow suit and a price war would result, with no real gain for any of the firms in the industry. Instead, oligopoly firms will tend to work together through collusive agreements, whether they are tacit or overt or engage in non-price competition. Non-price competition can take the form of advertising, issuing of loyalty cards, branding, packaging and other measures to reduce the closeness of substitutes.

Game theory

Game Theory can be used by economists to predict how firms will react in a number of given scenarios. It is used mainly when dealing with oligopoly to explain why firms may collude and furthermore why they may later decide to abandon any agreement to collude. The prisoner’s dilemma can explain the way that game theory can be used by firms.

Prisoner’s dilemma

Assumptions
• The model assumes a zero sum game — there will be a winner and loser.
• The prisoners have been kept separate and so do not know what each is doing, but they do know the outcome of each action.

prisonners-dilemma

What should they do?

Confess — If one of them was to confess then they should get a 3 month prison sentence, but as they cannot trust each other, and cannot be sure that the other party has not also confessed (which would result in a 10 year sentence for the prisoner who did not confess), they will act selfishly therefore both confessing to get the best solution for themselves. Thus they will tend to D, where both confess.

Not Confess — if they could trust each other and be sure of each other’s response this would be the best option. By not confessing both prisoners would get one year each — ie option A.

Maximax — maximising the maximum benefit for the individual, ie B and C which would mean that Rixy should confess and would get 3 months, but only if Franky could be trusted not to confess, otherwise both will get 3 years.

Maximin — minimum benefit, ie D, which is where the prisoners will tend to because they cannot trust each other.

Game theory suggests that firms don’t trust each other and although they know that it is mutually beneficial for them to collude to set the price at £2, they will tend to an option where they will both set price at £1.80 as neither firm can be trusted to keep to any agreement.

Dominant strategy — in this case the same policy is suggested by different strategies. This is a dominant strategy game because both strategies encourage a cut in price, ie Maximax (where each firm in isolation would set the price at £1.80 hoping that the other firm has gone for £2) and Maximin (where both firms will eventually end up at because they have set price at £1.80).

nash-equilibrium

Both strategies suggest a Nash Equilibrium.

Nash Equilibrium — is the position resulting from everyone making their optimal decision, ie setting
price at £1.80, by attempting, independently, to choose the best strategy for whatever the other is likely to do, ending up in a worse position than if they had colluded to set price at £2.

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