Game Theory

Game study is the study of strategic interaction where one player’s decision depends on what
the other player does. What the opponent does also depends upon what he thinks the first
player will do.

PayOff Matrix

A payoff matrix is a tool that is used to simplify all of the possible outcomes of a strategic
decision. It is a visual representation of all the possible strategies and all of the possible
outcomes.

Prisoner’s Dilemma

The prisoner's dilemma is a standard example of a game analyzed in game theory that shows
why two completely rational individuals might not cooperate, even if it appears that it is in their
best interests to do so.

Game:

In the traditional version of the game, the police have arrested two suspects Tom and Gerry
and are interrogating them in separate rooms. Each can either confess, thereby implicating the
other, or keep silent. No matter what the other suspect does, each can improve his own
position by confessing. If the other confesses, then one had better do the same to avoid the
especially harsh sentence that awaits a recalcitrant holdout. If the other keeps silent, then one
can obtain the favorable treatment accorded a state’s witness by confessing. Thus, confession is
the dominant strategy for each. But when both confess, the outcome is worse for both than
when both keep silent.

Gerry
Confess Not Confess
Confess 10, 10 0, 20
Tom Not confess 20, 0 5, 5

Tom’s strategies are listed in rows and his payoffs are listed first. Gerry’s payoffs are listed
second in columns. Both players do not know other party’s decisions and move simultaneously.

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 Dominant Strategy

A DOMINANT strategy occurs when there is an optimal choice of strategy for each player no
matter what the other does.

 If Gerry chooses confess, Tom will choose confess

 If Gerry chooses not confess, Tom will choose confess
 Therefore Confess is a dominant strategy for Tom

 If Tom chooses confess, Confess will choose confess

 If Tom chooses not confess, Gerry will choose confess
 Therefore Confess is a dominant strategy for Gerry

Thus both will choose confess not matter what the other does and get 10 years in prison.

Gerry
Confess Not Confess
Confess 10, 10 0, 20
Tom Not confess 20, 0 5, 5

Nash Equilibrium

Definition: The Nash equilibrium is the solution to a game in which two or more players have a
strategy, and with each participant considering an opponent’s choice, he has no incentive,
nothing to gain, by switching his strategy.

Here Confess, Confess in the Nash Equilibrium.

Note: Although Not Confess, Not Confess is a better option but that is not reached.

Application in oligopoly:

Consider this example of a simple pricing game:

The values in the table refer to the profits that flow from making a particular output decision. In
this simple game, the firm can choose to produce a high or a low output. The profit payoff
matrix is shown below.

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 Firm B's output
High output Low output
Firm A's output High output £5m, £5m £12m, £4m

Low output £4m, £12m £10m, £10m

 Display of payoffs: row first, column second e.g. if Firm A chooses a high output and
Firm B opts for a low output, Firm A wins £12m and Firm B wins £4m.
 In this game the reward to both firms choosing to limit supply and thereby keep the
price relatively high is that they each earn £10m. But choosing to defect from this
strategy and increase output can cause a rise in market supply, lower prices and lower
profits - £5m each if both choose to do so.

 A dominant strategy is one that is best irrespective of the other player's choice. In this
case the dominant strategy is competition between the firms. (High output, High
Output). This is also the Nash equilibrium.

 The Prisoners' Dilemma can help to explain the breakdown of price-fixing agreements
between producers which can lead to the out-break of price wars among suppliers, the
break-down of other joint ventures between producers and also the collapse of free-
trade agreements between countries when one or more countries decides that
protectionist strategies are in their own best interest.

 The key point is that game theory provides an insight into the interdependent decision-
making that lies at the heart of the interaction between businesses in a competitive
market.

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Collusion and game theory

Dominant Strategy for Firm A is :

Dominant Strategy for B is :

Nash Equilibrium:

Collusive Outcome:

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 Merger and Integration
A merger involves two firms combining to form one larger company; it can occur due to a
takeover or mutual agreement.

There are three types of mergers: Horizontal, Vertical and Conglomerate.

Horizontal Integration Definition

Horizontal integration occurs when there is a merger between two firms in the same industry
operating at the same stage of production.

For example, if two newspapers like the Independent and the Guardian merged, this would be a
horizontal integration.

Vertical Integration
Vertical integration occurs when a firm controls different stages of production.

For example, in the brewing industry, you have

1. Production – Brewing of beer.

2. Distribution – beer transported to local markets.
3. Retail – Beer sold in pubs and shops.

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 To remember vertical integration – think of going up the supply chain.
 Horizontal integration, by contrast, is at the same stage of production think of other business at
the same stage of production, e.g. different pub companies, different brewers.

A large brewer could also own transport and the pub in which it is sold. In this case, the brewer
has vertical integration. When a brewer owns a pub, it is known as a ‘tied pub’.

A ‘free pub’ occurs when the pub is not owned by a brewer but is free to sell whatever beers it
wants to. In other words in a free pub, the ownership of retail is different to the ownership of
production.

Backward Integration

This occurs when a firm buys another firm who supplies raw materials. E.g. A petrol station
buys the company producing oil from the ground

Forward Integration

This occurs when a firm merges with another firm at the next stage of production. For example,
a company producing coffee beans could buy a chain of coffee shops. e.g. if Nescafe produce
coffee beans, they could buy more coffee shops to sell their own beans in

Pros and Cons of Mergers

The pros and cons in summary:

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 Advantages of mergers

 Economies of scale – bigger firms more efficient

 More profit enables more research and development.
 Struggling firms can benefit from new management.

Disadvantages of mergers

 Increased market share can lead to monopoly power and higher prices for consumers
 A larger firm may experience diseconomies of scale – e.g. harder to communicate and
coordinate.

When looking at mergers it is important to look at the subject on a case by case basis as each
merger has different possible benefits and costs – depending on the industry and firms in
question.

Pros of mergers

1. Network Economies. In some industries, firms need to provide a national network. This
means there are very significant economies of scale. A national network may imply the most
efficient number of firms in the industry is one. For example, when T-Mobile merged with
Orange in the UK, they justified the merger on the grounds that:

“The ambition is to combine both the Orange and T-Mobile networks, cut out duplication, and
create a single super-network. For customers, it will mean bigger network and better coverage,
while reducing the number of stations and sites – which is good for cost reduction as well as
being good for the environment.”

2. Research and development. In some industries, it is important to invest in research and

development to discover new products/technology. A merger enables the firm to be more
profitable and have greater funds for research and development. This is important in industries
such as drug research, where a firm needs to be able to afford many failures.

3. Other economies of scale

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 Two smaller firms producing Q2 would have average costs of AC2. A merger which led to a firm
producing at Q1 would have lower average costs of AC 1.

The potential economies of scale that can arise include:

 Bulk buying – buying raw materials in bulk enables lower average costs
 Technical economies – large machines and investment is more efficient spread over a larger
output.
 Marketing economies – A tech firm bought by Google may benefit from Google’s expertise and
brand name.
 Examples of economies of scale.

In a horizontal merger, economies of scale can be quite extensive, especially if there are high
fixed costs in the industry. For example, aeroplane manufacture is now dominated by two large
firms after a series of mergers.

If the merger was a vertical merger (two firms at different stages of production)
or conglomerate merger, the scope for economies of scale would be lower.

4. Avoid duplication

In some industries, it makes sense to have a merger to avoid duplication. For example, two bus
companies may be competing over the same stretch of roads. Consumers could benefit from a
single firm with lower costs. Avoiding duplication would have environmental benefits and help
reduce congestion.
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 5. Regulation of Monopoly

Even if a firm gains monopoly power from a merger, it doesn’t have to lead to higher prices if it
is sufficiently regulated by the government. For example, in some industries, the government
have price controls to limit price increases. That enables firms to benefit from economies of
scale, but consumers don’t face monopoly prices.

Cons of Mergers

1. Higher Prices

A merger can reduce competition and give the new firm monopoly power. With less
competition and greater market share, the new firm can usually increase prices for consumers.
For example, there is opposition to the merger between British Airways (parent group IAG) and
BMI. (link Guardian) This merger would give British Airways an even higher percentage of
flights leaving Heathrow and therefore much scope for setting higher prices. Richard Branson
(of Virgin) states:

“This takeover would take British flying back to the dark ages. BA has a track record of
dominating routes, forcing less flying and higher prices. This move is clearly about knocking out
the competition. The regulators cannot allow British Airways to sew up UK flying and squeeze
the life out of the travelling public. It is vital that regulatory authorities, in the UK as well as in
Europe, give this merger the fullest possible scrutiny and ensure it is stopped.”

2. Less choice. A merger can lead to less choice for consumers.

A merger can lead to less choice for consumers. This is important for industries such as
retail/clothing/food where choice is as important as price

3. Job Losses.

A merger can lead to job losses. This is a particular cause for concern if it is an aggressive
takeover by an ‘asset stripping’ company – A firm which seeks to merge and get rid of under-
performing sectors of the target firm.

 On the other hand, other economists may argue this ‘creative destruction’ of job losses will
only lead to temporary job losses and the unemployed will find new jobs in more efficient firms.

4. Diseconomies of Scale.

The new larger firm may experience dis-economies of scale from the increased size. After a
merger, the new bigger firm may lack the same degree of control and struggle to motivate
workers. If workers feel they are just part of a big multinational they may be less motivated to
try hard. Also, if the two firms had little in common then it may be difficult to gain the synergy
between the two companies

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 Evaluation – The desirability of a merger depends upon:

1. How much is competition reduced by? E.g. A merger between Tesco and Sainsburys would lead
to a significant fall in competition amongst UK supermarkets. This would lead to higher prices
for basic necessities.
2. How significant are economies of scale in the industry? A merger between Tesco and
Sainsburys may enable some economies of scale, but it would be relatively low compared to
two oil drilling companies. The fixed costs in oil exploration are much higher. Therefore, there is
more justification for a merger in oil exploration than in supermarkets.
3. How Contestable is the market? After the merger can new firms still enter or are barriers to
entry sufficiently high to deter new firms?
4. What are the objectives of mergers? – Are the firms seeking to gain efficiency or are the
managers hoping for higher salaries and more prestige in new firms?

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