Game theory and Oligopoly

B.Chatterjee
NMIMS
ASMSOC
Game theory and Oligopoly
Game theory, a branch of applied mathematics, provides tools for analyzing situations in which
parties, called players, make decisions that are interdependent. This interdependence causes each
player to consider the other player’s possible decisions, or strategies, in formulating strategy. A
solution to a game describes the optimal decisions of the players, and the outcomes that may result
from these decisions. Game theory is the science of strategy. It attempts to determine a framework
that will determine the actions that players should take to secure the best outcomes for
themselves. The essence of a game is the interdependence of player strategies.
Game theory has been applied to a wide variety of situations in which the choices of players
interact to affect the outcome. The classic example of game theory in the business world arises
when analyzing an economic environment characterized by an oligopoly. In oligopoly, since
decisions of firms such as pricing, production, investment, advertising are strategically
interdependent, game theory is applied to understand those decision making process.
There are various forms of games depending upon the type of strategic interaction between the
players. The simplest form of game is two-person/player non-cooperative simultaneous game. A
classic example of this type of game is “Prisoner’s dilemma”. The logic of this game can also be
applied in business context.
Prisoner’s Dilemma (simultaneous non- Prisoner B
cooperative game)
Two prisoners, A and B, suspected of committing Strategy Confess Don’t
a robbery together, are isolated and interrogated. confess
Prisoner A
Each is concerned only with getting the shortest Confess 5,5 1,10
possible prison sentence for himself; each must
decide whether to confess without knowing his
partner’s decision. Both prisoners, however, know Don’t 10, 1 2, 2
the consequences of their decisions: (1) if both confess
confess, both go to jail for five years; (2) if neither
confesses, both go to jail for 2 years and (3) if one What will be the decision of Prisoner A?
confesses while the other does not, the confessor If Prisoner B confesses, then the best response for prisoner A is to confess (5
goes to jail for 1 year and the silent one goes to years of jail<10 years of jail). If prisoner B doesn’t confess, then the best
response for prisoner A is to confess (1 year of jail<2years of jail)
jail for 10 years. The normal form of this game is
shown in the table. What will be the decision of Prisoner B?
If Prisoner A confesses, then the best response for prisoner B is to confess (5
years of jail<10 years of jail). If prisoner A doesn’t confess, then the best
The numbers in the above table represents jail terms. response for prisoner A is to confess (1 year of jail<2years of jail)
The jail term of prisoner A is the first number read
For both prisoner, “Confess” is what we call the
vertically(column wise) dominant strategy.
The jail term of prisoner B is the second number read
horizontally(row wise) Dominant strategy: A strategy is dominant if that
strategy is the best response of the player regardless the
strategy chosen by the other player.
“Confess, Confess” is the Nash Equilibrium.
 Prisoner’s Dilemma (simultaneous non-
cooperative game) Prisoner B
For both prisoner, “Confess” is the
dominant strategy Strategy Confess Don’t confess
Dominant strategy: A strategy is Prisoner A
dominant if that strategy is the best Confess 5,5 1,10
response of the player regardless the
strategy chosen by the other player. Don’t confess 10, 1 2, 2
“Confess, Confess” is what we call is the
Nash Equilibrium.
Prisoners dilemma (PD) kind of situation in real-life with similar
Paradoxically, however, the two robbers would do better characteristics have often been observed. For example, two
if they both adopted the apparently irrational strategy of shopkeepers engaged in a price war may well be caught up in a
remaining silent; each would then serve only one year in PD. Each shopkeeper knows that if he has lower prices than his
jail. The irony of PD is that when each of two (or more) rival, he will attract his rival’s customers and thereby increase his
parties acts selfishly and does not cooperate with the own profits. Each therefore decides to lower his prices, with the
other (that is, when he confesses), they do worse than result that neither gains any customers and both earn smaller
when they act unselfishly and cooperate together (that profits.
is, when they remain silent).
 Oligopoly
Firm A and Firm B are two major players in an oligopolistic market. What is the outcome of the game?
Both of them has to decide simultaneously on the strategy whether to
charge a low price or a high price.
Each strategy will give them a return, called “pay offs”. Payoffs may be profit, Firm B
revenue, sales etc.
The objective of each firm is to decide its best strategy, given the strategy of
the other firm. Strategy Low Price High price
The payoff of Firm A is the first number read vertically(column wise) Firm A
The pay off of Firm B is the second number read horizontally(row wise) Low price 10,10 100,-50

What strategy will each firm choose?

High Price -50, 100 50, 50
Firm A: If firm B chooses Low price then firm A chooses low price (10>-50). If
firm B chooses High price, then firm A chooses Low price (100>50). Therefore
Firm A will choose “Low price”
Firm B: If firm A chooses Low price then firm B chooses low price (10>-50). If
firm A chooses High price, then firm B chooses Low price (100>50). Therefore
Firm B will choose “Low price” The outcome of the game is called “Nash Equilibrium”
Therefore each firm will choose “Low price as their optimal strategy”
IN THESE TYPE OF GAMES, PLAYERS HAVE DOMINANT STRATEGY
BECAUSE WHATEVER STRATEGY FIRM B IS CHOOSING, FIRM A WILL ALWAYS
CHOOSE LOW PRICE
SIMILALRY, WHATEVER STRATEGY FIRM A IS CHOOSING, FIRM B WILL
ALWAYS CHOOSE LOW PRICE
Pay off matrix for advertising game

Firm B

Strategy Advertise Doesn’t

Advertise
Firm A
Advertise 10,5 15,0

Don’t Advertise 6,8 10, 2

Advertise, advertise
Pay off matrix for investment game

Firm B

Strategy Don’t Invest Invest

Firm A
Don’t Invest 0,0 10,10

Invest 100,0 20, 10