PG Semester I Micro Economics Shika Ramesh

Module – 3: Oligopoly and Economic Behaviour of the Firm

Oligopoly: The term ‘oligo’ means a few and ‘poly’ means selling. So oligopoly is a market
structure having a few seller (more than two but less than ten firms) selling differentiated
products. There are two forms of oligopoly:

1. Pure oligopoly: When few sellers sell homogenous products, that is, without product
differentiation, it is said to be a pure oligopoly. These are very rare.
2. Differentiated oligopoly: When few sellers engage in the sale of products with close
substitutes, that is, heterogeneous products, it is called a differentiated oligopoly. This
form is said to prevail in the real world.

There are two types of oligopoly – collusive and non-collusive oligopoly.

 Collusive oligopoly is a form of market in which few firms form a mutual agreement
to avoid competition. They form a cartel and fix the output quotas and the market
price. Leading firm in the market is accepted by the cartel as a price leader. All the
firms in the cartel accept the price as fixed by the price leader.
 Non-collusive oligopoly is a form of market in which each firm has its price and
output policy and is independent of the rival firms in the market. The entire firms
enable to increase its market share through competition in the market. The main
theories under non-collusive oligopoly are of Cournot, Bertrand, Chamberlin, Sweezy
and Stackelberg models.

Collusive Oligopoly – Cartels and Price Leadership

1. Cartel: A cartel is defined as a group of firms that gets together to make output and price
decisions. When numerous oligopolist enter into a formal agreement, they are said to form a
‘cartel’ or ‘collusion’. A cartel restrains competition among the member firms and its
formation has been declared illegal in many countries. Oligopolistic firms join a cartel to
increase their market power and members work together to determine jointly the level of
output that each member will produce and/or the price that each member will charge. By
working together, the cartel members are able to behave like a monopolist. The organization
of petroleum‐exporting countries (OPEC) is perhaps the best‐known example of an
international cartel; OPEC members meet regularly to decide how much oil each member of
the cartel will be allowed to produce.

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The most common form of collusive oligopoly is the formation of a central agency. All firms
are a part of central agency. All decisions regarding price and output are taken by this agency.
This type of collusion is called ‘perfect collusion or perfect cartel’. The price and the output
are determined in such a way that maximum joint profits are assumed for all its members.
The output produced by each firm is decided by the agency and profits are distributed among
the firms on a pre-determined agreement. The below figure explains price determination
under collusive oligopoly.

Assume two firms have formed a collusion which estimates aggregate demand under pure
oligopoly. From the horizontal summation of the MC curves of the individual firms, the
market MC curve is derived. The central agency will fix the price at the point where MC =
MR for the industry. Given the market demand curve, the monopoly situation is determined
by the intersection of MC and MR curves at point E0. The total output is Q and it will be sold
at price P. The central agency allocates the production among the two firms by equating the
MR to the individual MC curves. Thus, first firm will produce Qa and the second firm will
produce Qb. The firm with the lower cost produces larger amount of output. The total
industry profit is the sum of the profits from the output of the two firms, denoted by the
shaded area.

2. Price Leadership: Another form of collusion is price leadership. In this form, one firm
sets the price and the others follow it because it is advantageous to them or because they
prefer to avoid uncertainty about their competitor’s reactions. There are three types of price
leadership – price leadership by a low-cost firm, dominant firm and barometric price
leadership.

1. Price leadership by a low-cost firm: In this form, it is assumed that there are two
firms which produce identical products at different costs, which clearly must be sold

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at the same price. The most important condition for this form is that the firms have
unequal costs. The firm with the lowest cost will charge a lower price and this price
will be followed by the high-cost firm, although at this price, the high-cost firm does
not maximize its profits.
2. Price leadership by a dominant firm: In this form, it is assumed that the dominant
firm has a considerable share of the total market and there are some smaller firms
with small market share. It is assumed that the dominant firm knows the market
demand. The dominant firm maximizes his profits at the point where MC = MR while
the small firms are price-takers and may or may not maximize their profits, depending
on their cost structure. If the leader is to maximize the profits, he must make sure that
the small firms will not only follow his price, but that they will also produce the right
quantity.
3. Barometric price leadership: In this form, it is argued that all firms will follow
(exactly or approximately) the changes of the price of a firm who is considered to
have good knowledge of the prevailing market conditions and can forecast better than
the others and the future market developments. In short, the firm chosen as the leader
is considered as a barometer reflecting the changes in economic environment. The
barometric firm may neither be a low-cost or a dominant firm. Usually, it is a firm
which, from past behaviour, has established the reputation of a good forecaster of
economic changes. Barometric price leadership may be established for various
reasons:
 Rivalry between several large firms in an industry may make it impossible to accept
one among them as the leader.
 Followers avoid the continuous re-calculation of costs as economic conditions
change.
 The barometric firm has proved itself as a ‘reasonably’ good forecaster of changes in
cost and demand conditions and by following it, the other firms can be ‘reasonably’
sure that they chose the correct price policy.

These forms of price leadership was developed by Fellner and others, the traditional theorists
of price leadership. The feature of a traditional price leader is that he sets his price on
marginalistic rules, that is, MC = MR. For the leader, the behavioural rule is MC = MR. the
other firms are price-takers who will not maximize their profits by adopting the price of the
leader.

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Non-Collusive Oligopoly Models

1. Cournot’s Model: The model was developed by Augustin Cournot in 1838. He illustrated
his model with the example of two firms, each owning a spring of mineral water well, which
is produced at zero costs. Each firm acts on the assumption that its rival/competitors will not
change its output and decides its own output so as to maximize profits.

Assume that firm A starts producing and selling

mineral water. He will produce quantity A at
price P where profits are at a maximum because
at this point, MC = MR = 0 and the demand curve
of the firm will be DC (½ of the total market).
Now, firm B assumes that firm A will keep its
output constant (at quantity OA) and hence,
considers that his own demand curve is CD’.
Clearly, firm B will produce half the quantity of
AD’ (or CD’ demand curve) because at this level of output (AB), the firm’s revenue and
profits is at its maximum. Thus, firm B produces half of the market which has not been
1 1 1 1 1
supplied by firm A, that is, B’s output is ½ of the total market { [1 − 2] = 2 × 2 = 4 }.
2

Firm A then assumes that firm B will retain is output constant in the next period. So, he will
produce half of the market which is not supplied by firm B. Thus, firm A in the next period
1 1 1 3 3
will produce { [1 − 4] = 2 × 4 = 8 }. Firm B reacts on this and will produce half of the
2
1 3 1 3 5
unsupplied output in the market, that is, {2 [1 − 8] = 2 × 8 = 16 }. This pattern continues

since firms have the naive behaviour of never learning from their past patterns of reaction.

However, eventually an equilibrium is reached in which each firm produces 1/3rd of the total
market. Together, they cover 2/3rd of the total market. Each firm maximises its profit in each
period but the industry profits are not maximised, that is, the firm s would have higher joint
profits if they recognized their interdependence. This would lead them to act ‘a monopolist’
producing ½ of the total market outptut. Thus, Cournot’s model leads to a stable equilibrium.
If more firms are assumed to exist in the industry, the higher the total quantity of output
supplied in the market. Hence, the price will be lower.

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Criticisms of the model

1. The behavioural pattern of the firms is naïve. They do not learn from past
experiences.
2. This mode can be extended to any number of firms.
3. It is a closed model, that is, entry is not allowed.
4. The mode does not say how long the adjustment period will be.
5. The assumption of costless production is unrealistic. This is based on reaction curves
approach.

Isoprofit curve: An isoprofit curve for

firm A is the locus of points defined by
different levels of output of A and his
rival B, which yield A the same level of
profits. An isoprofit curve for firm B is
the locus of points defined by different
levels of output of B and his rival A, which yield B the same level of profits.

Properties

1. Isoprofit curves for substitute goods are concave to the axes along which the output of
firms are measured.
2. The farther the isoprofit curves lie from the axes, the lower is the profit and vice
versa.
3. For firm A, the highest points of the successive isoprofit curves lie to the left of each
other. If these highest points of the isoprofit curves are joined, firm A’s reaction curve
is obtained. It is called a reaction curve because it shows how firm A will determine
its output as a reaction to firm B’s decision to produce a certain level of output.

Cournot’s equilibrium is
determined by the intersection
of the two reaction curves. It is a
stable equilibrium, provided that
A’s reaction curve is steeper
than B’s reaction curve. When
examining this situation arising

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from A’s decision to produce quantity A1 lower than the equilibrium quantity Ae. Firm B will
react by producing B1 assuming firm A will keep its output constant at OA1. However, firm A
reacts by producing a higher quantity A2 assuming firm B will remain fixed at output B1.
Then, firm B reacts by reducing its output to B2. This continue till point ‘e’ is reached which
is the stable equilibrium point. At point e, each firm maximizes its own profit, but the
industrial profit is not maximized.

This is seen by a curve similar to

Edgeworth’s contract curve which traces
points of tangency of the two firms’
isoprofit curves. Points on the contract curve
are optimal. But point e is a sub-optimal
point and total industry profits would be
higher if the firms moved away from it on
any point between ‘a’ and ‘b’ on the
contract curve. At point a, firm A have same
profit πA3 while firm B has a higher profit (πB2 > πB3). At point b, firm B have same profit
πB3 while firm A have a higher profit (πA2 > πA3). Finally, at an intermediate point between
a and b, that is, c, both firms have high profits.

2. Bertrand’s Model: Bertrand developed his duopoly model in 1883. He assumes that each
firm acts independently on the assumption that hs rival will keep its price constant,
irrespective of its own decision about pricing. Thus, each firm is faced by the same market
demand and aims at the maximization of its own profit, on the assumption that the price of
the competitor will remain constant.

In Bertrand’s model, the reaction curves are derived

from isoprofit maps, which are convex to the axes,
on which the prices of the duopolists are measured.
Each isoprofit curve for firm A shows the same level
of profits from different price levels charged by the
firm and its rival. The isoprofit curve for firm A is
convex to its price-axis. This shape shows the fact
that firm A must lower its price upto a certain level
(point e) to meet the cutting price of its competitor,

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in order to maintain the level of its profits at πA2. However, after that price level has been
reached and if firm B continues to cut its price, firm A will be unable to retain its price, even
if it keeps its own price unchanged. The lower the isoprofit curves, the lower the level of
profits.

In summary, for any price charged by firm B, there

will be a unique price charged by firm A which
maximizes the latter’s profits. This unique profit-
maximizing price is determined at the lowest point
on the highest attainable isoprofit curve of firm A.
If all the lowest points of the successive isoprofit
curves are joined, the reaction curve of firm A is
obtained. The reaction curve of firm A here is the
locus of points of maximum profits that firm A can
attain by charging a certain price, given the price of its rival. Bertrand’s model leads to a
stable equilibrium defined by the point of intersection of the two reaction curves. Point e
denotes a stable equilibrium at which the price charged by firm A and B are PAe and PBe
respectively. If firm A charges a lower price PA1, firm B will charge PB1 because on
Bertrand’s assumption, this price will maximise B’s profit. Firm A will react to this decision
of its rival by charging a higher price P A2. Firm B will react by increasing its price and so on
until point e is reached, when the market will be in equilibrium. The same equilibrium will be
reached if firms started by charging a price higher than PAe or PBe: a competitive price cut
would take place which would drive both
prices down to their equilibrium level PAe
and PBe.

Bertrand’s model does not lead to

maximization of the industry profit due to
the fact that firms behave naively, by
always assuming that their rival will keep
its price fixed. If the firms moved on a
point between ‘c’ and ‘d’ on the
Edgeworth contract curve, one or both
firms would have higher profits and
hence, industry profits would be higher.

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3. Chamberlin’s Model: According to Chamberlin, a stable equilibrium can be reached with

the monopoly price being charged by all the firms, if the firms recognize their
interdependence and act so as to maximize the industry profits (monopoly profits). He
accepts that if the firms do not recognize their interdependence, the industry will either reach
Cournot equilibrium (each firm acts independently on the assumption that its rivals will keep
its output constant) or Bertrand’s equilibrium (each firm acts independently on the
assumption that its rivals will keep its price constant). However, Chamberlin rejects the
assumption of independent action by the competitors. He says that the firms do, infact,
recognize their interdependence. Firms are not as naïve as in Cournot’s and Bertrand’s
model. Firms, when charging their price or output, recognize their direct and indirect effects
of their decisions. The recogniton of the full effects (direct and indirect) of a change in the
firm’s output or price results in a stable industry equilibrium with the monopoly price and
output. Chamberlin assumes that the monpoly solution can be achieved without collusion: the
firms are assumed to be intelligent enough to quickly recognize their interdependence, learn
from their past mistakes and adopt the best position, which is charging the monoopoly price.

In his model, the market demand is a straight line

with negative slope and production is assumed
costless for simplicity. If firm A is the first start to
production, it will produce the profit-maximising
output OXm and sell it at the monopoly price Pm
(DC demand curve). Firm B considers that its
demand is CD’ and will attempt to maximise its
profits by producing ½ of this demand, that is, XmB
quantity at which B’s MR = MC = 0. As a
consequence, the total industry output is OB and the price falls to P. Now, firm A realises that
its rival do react to its actions and thus, decides to reduce its output to OA, which is ½ of
OXm and equal to B’s output. The industry output is thus OXm and price rises to the
monopoly level OPm. Firm B realises that this is the best for both of them and so will keep its
output the same at XmB = AXm. Thus, the markets will be equally shared between firms A
and B (OA = AXm). Thus, they define the monopoly price as the best for the group.

4. Sweezy’s Model: Paul M. Sweezy in 1939 published an article in which he introduced the
kinked demand curve as an operational tool for the determination of the equilibrium in
oligopolistic markets. The demand curve of the oligopolist has a kink at point E reflecting the

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following behavioural pattern. All firms are

interdependent and decides important issues like
price determination jointly. Once this price is set,
all firms tend to follow this pricing pattern. If one
firm decides to increase the price, no other firms
will follow that pricing pattern which will result in
the shift of customers to other firms of the same
products with low price. Hence, the firm who
raised the price would be forced to lower the price
back to the previous level fixed by the group. Conversely, if the firm introduces a price-cut,
all other firms would follow it and reduce the price to the same extent. hence, the firm who
reduced the price will not get the advatage of the price-cut and thus will raise the price back
up to the previous level. Thus, price tends to remain sticky which is the reason for the kink in
the demand curve. The kinked demand curve has two segments – the upper section of the
demand curve has high elasticity while the lower segment is inelastic. The equilibrium of the
firm is defined by the point of the kink because at any point to the left of the kink, MC curve
is below MR while to the right of the kink, MC is greater than MR. Thus, the total profit is
maximised at the kink.

In this model, the kinked demand curve can explain the stickiness of the price in situation of
changing costs and of rivalry. It does not define the level at which price will be set in order to
maximise profits. Thus, this is not a theory of pricing rather a tool for explaining price
stickiness.

5. Stackelberg’s Model: This model was developed by Heinrich Von Stackelberg and is an
extension of Cournot’s model. It is assumed that one duopolist is sufficiently sophisticated
(capable of becoming a leader) to recognise that his competitor acts on the Cournot
assumption. This allows the sophisticated duopolist to determine the reaction curve of his
rival and incorporate it in his own profit function to maximise his profits. Assume that the
isoprofit curves and reaction functions of the duopolists are given. If firm A is the
sophisticated oligopolist, it will assume that its rival will act on the basis of its own reaction
curve. This will permit firm A to choose to set its own output at the level which maximises
its own profit. This is point ‘a’ which lies on the lowest possible isoprofit curve of firm A
denoting the maximum profit firm A can achieve, given B’s reaction curve. Firm A thus, will
produce XA and firm B will react by producing XB, according to its reaction curve. The

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sophisticated oligopolist becomes in

effect the leader while the naïve rival
who acted on the cournot equilibrium
becomes the follower. Clearly,
sophistication is rewarding for firm A
because he reaches an isoprofit curve
closer to his axis than if he behaved
with the same naïve behaviour as his
rival.

If firm B is the sophisticated oligopolist, he will choose to produce X’B output corresponding
to point ‘b’ on A’s reaction curve because this is the largest profit firm B can achieve, given
his isoprofit map and A’s reaction curve. Firm B will now be the leader and firm A becomes
the follower. Now, firm B has a higher profit and firm A has a lower profit as compared with
cournot equilibrium.

In short, if only one firm is sophisticated, it will emerge as the leader and a stable equilibrium
will emerge, since the naïve firm will act as a follower. However, if both firms are
sophisticated, then, both firms will want to act as leaders because this action yields a greater
profit to them. In this case, the market situation becomes unstable and is known as
Stackelberg’s Disequilibrium. The effect of this is either price war or collusion. The model
basically shows that a bargaining procedure and a collusive agreement becomes
advantageous to both duopolists. With such an agreement, the duopolists may reach on the
Edgeworth contract curve and thus, attains joint profit maximisation.

Contestable Market Theory – William J. Baumol

The theory of contestable markets is associated with the American economist William J.
Baumol. Contestable market theory is an economic concept stating that companies with few
rivals behave in a competitive manner when the market they operate in has weak barriers to
entry. Contestable in economics means that a company can be challenged or contested by
rival companies looking to enter the industry or market. In other words, a contestable market
is a market whereby companies can enter and leave freely with low sunk costs. Sunk costs are
major irrecoverable costs to enter an industry such as the purchase of a manufacturing plant
or equipment. Higher sunk costs indicates lower contestability as exit costs will be high when
high investment is made at the time of entry into business. The contestable market theory

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assumes that even in a monopoly or oligopoly, dominant companies will act competitively
when there is a lack of barriers for competitors. Dominant players in an industry will do
everything to reduce the contestability of their industry by preventing new entrants from
driving them out of business. According to contestable market theory, when access to
technology is equal, and barriers to entry are weak, low, or non-existent, a constant threat
exists that new competitors will enter the marketplace. Examples of barriers to entry include
government regulation or high entry costs. Without these barriers, competitors can enter the
market and challenge the existing, well-established companies.

In short, the main features of a contestable market are:

 There are no entry or exit barriers.
 There are no sunk costs.
 Access to the same level of technology (to existing firms and new entrants).

Firms are forced to keep excess profits to a minimum, and move towards sales maximisation
rather than profit maximisation. In a perfectly contestable market with an unlimited number
of potential entrants, initially, a firm gets
supernormal profits at point A with price P1 and
output Q1. With the threat of new entrants
entering the market, the existing firms will reduce
the price to P2 and increases output to Q2 (sales
maximization) thereby, profits are pushed down to
normal profits at point B (where AC = AR). Thus,
supernormal profits at point A will become
normal profits at point B.

Theory of Games

Game theory is the process of modelling the strategic interaction between two or more
players in a situation containing set rules and outcomes. Game theory gets its name from
actual games. Games like checkers and chess are strategic games where two players interact
and the outcome of the game is determined by the actions of both players. The focus of game
theory is the game, which serves as a model of an interactive situation among rational
players. Game theory is the science of strategy. It attempts to determine mathematically and
logically the actions that “players” should take to secure the best outcomes for themselves in

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a wide array of “games.” While used in a number of disciplines, game theory is most notably
used as a tool within the study of economics. The economic application of game theory can
be a valuable tool to aide in the fundamental analysis of industries, sectors and any strategic
interaction between two or more firms. Game theory was pioneered by Princeton
mathematician John Von Neumann and Morgenstern in their classic work “Theory of Games
and Economic Behaviour” published in 1944.

Concepts in Game Theory

1. Game: Any set of circumstances that has a result dependent on the actions of two or
more decision-makers (players).
2. Players: A strategic decision-maker within the context of the game.
3. Strategy: A complete plan of action a player will take given the set of circumstances
that might arise within the game.
4. Payoff: The pay-out a player receives from arriving at a particular outcome. The pay-
out can be in any quantifiable form, from dollars to utility. Any complete description
of a game must include these three elements, that is, players, strategy and payoff.
5. Payoff Matrix: In a game, the gains and losses, resulting from different moves and
counter moves, when represented in the form of a matrix are known as payoff matrix.
6. Information set: The information available at a given point in the game. The term
information set is most usually applied when the game has a sequential component.
7. Equilibrium: The point in a game where both players have made their decisions and
an outcome is reached.

Oligopoly presents a problem in which the firms must select strategies by taking into account
the responses of their rivals, which they cannot know for sure in advance. A choice wherein
the actions of others will affect the outcome of that choice is called a strategic choice. Game
theory is an analytical approach through which strategic choices can be assessed. The
strategic choices available to an oligopoly firm are pricing choices, marketing strategies and
product-development efforts.

For example, an airline’s decision to raise or lower its fares, or to leave them unchanged is a
strategic choice. The rival airlines’ decision to match or ignore their rival’s price decision is
also a strategic choice. Once a firm implements a strategic decision, there will be an outcome.
The outcome of a strategic decision is called a payoff. In general, the payoff in an oligopoly

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game is the change in economic profit to each firm. The firm’s payoff depends partly on the
strategic choice it makes and partly on the strategic choices of its rivals.

Types of Games

Games are divided into two types – cooperative and non-cooperative games.

 Cooperative Game: Two poker players agree to share winnings no matter who
actually wins, as a result their strategies are based on how best to maximize the joint
expected payoff, not individual payoffs. Hence, in a cooperative game, players try to
maximize the joint expected payoff. It is a game in which participants can negotiate
binding contracts that allow them to plan joint strategies.
 Non-cooperative game: Games where the players are not able to negotiate and make
binding agreements within the game.

Games are again of two types: simultaneous games and sequential games.

 Simultaneous games are games in which players take strategic actions at the same
time, without knowing what move the other has chosen. A good example of this type
of game is the matching coins game where two players each have a coin and choose
which side to face up. They then reveal their choices simultaneously and if they match
one player gets to keep both coins and if they don’t match the other player keeps both
coins.
 Sequential games are games where players take turns and move consecutively. Chess
and go are all good examples of sequential games. One player observes the move of
the other player, then makes their play and so on.

Games can also be single-shot or repeated.

 Single-shot games are played once and then the game is over. A single-shot game
might be a game of rock, paper, scissors played once to determine who gets to sit in
the front seat of a car.
 Repeated games are simultaneous move games played repeatedly by the same
players. A repeated game might be repeated plays of rock, paper and scissors with the
first player to win five times getting the right to sit in the front seat of a car.

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As with any concept in economics, there is the assumption of rationality and maximization. It
is assumed that players within the game are rational and will strive to maximize their payoffs
in the game. The number of players in a game can theoretically be infinite, but most games
will be put into the context of two players. One of the simplest games is a sequential game
involving two players. The games all share the common feature of interdependence. That is,
the outcome for each participant depends on the choices (strategies) of all.

Strategies in Game Theory

In the game theory, different players adopt different types of strategies on the basis of the
outcome. For instance, the player may adopt a single strategy every time as it provides
him/her maximum outcome or he/she can adopt multiple strategies. Apart from this, a player
may also adopt a strategy that provides him/her minimum loss. Therefore, on the basis of
outcome, the strategies of the game theory are classified as pure and mixed strategies,
dominant and dominated strategies, minimax strategy, and maximin strategy.

1. Pure and Mixed Strategies: In a pure strategy, players adopt a strategy that provides
the best payoffs. In other words, a pure strategy is the one that provides maximum
profit or the best outcome to players. Therefore, it is regarded as the best strategy for
every player of the game. For example, the increase in the prices of the products of
two firms is the best strategy for both of them. This is because if both of them
increase the prices of their products, they would earn maximum profits. However, if
only one of the firms increase the prices of its products, then it would incur losses. In
such a case, an increase in price is regarded as a pure strategy for both the firms.

In a mixed strategy, players adopt different strategies to get the possible outcome. For
example, in cricket, a bowler cannot throw the same type of ball every time because it
makes the batsman aware about the type of ball thrown. In such a case, the batsman
may make more runs. However, if the bowler throws the ball differently every time
(spin and throw ball), then, it may make the batsman puzzled about the type of ball, he
would be getting the next time. Therefore, it is preferred that bowler or batsman
should adopt a mixed strategy in this case. For example, the bowler throws a spin ball
and fastball with a 50-50 combination and the batsman predicts the 50-50
combination of the spin and fast ball. The outcome does not depend on the
combination of fastball and spin ball rather it depends on the prediction of the
batsman that he can get any type of ball from the bowler.

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2. Dominant and dominated strategies: A dominant strategy is the one that is best for
an organization (player) and is not influenced by the strategies of other organizations
(players). It is a strategy that results in the highest payoff to a player regardless of the
opponent’s action. A dominated strategy is the one that provides players the least
payoff (outcome) as compared to other strategies in a game. In the analysis of the
game theory, dominated strategies are identified so that they can be eliminated from
the game. Consider a situation where two companies, called Startupo and Megacorp,
are competing in a new market. This market has one product which is sold in two
different versions: the simple consumer version and the complex professional version.
Both versions of the products are equally profitable for the company selling them.
Most people in the market (80%) are interested in the consumer version, and only a
few (20%) are interested in the professional version. Each company can decide
whether it wants to sell the consumer version or the professional version of the
product. If both companies decide to sell the same type of product, then the two
companies have to split the market for that product. Otherwise, each company has the
full consumer or professional market for itself.

As such, each company has two possible strategies to choose from and there are four
possible outcomes to the scenario:

 Both companies enter the consumer market: This means that the companies split
the consumer market (which accounts for 80% of the total market share), and that
each company therefore gets 40% of the total market share.
 Both companies enter the professional market: This means that the companies split
the professional market (which accounts for 20% of the total market share), and
that each company therefore gets 10% of the total market share.
 Startupo enters the consumer market and Megacorp enters the professional
market: This means that Startupo gets the full consumer market (80% of the total
market share), and Megacorp gets the full professional market (20% of the total
market share).
 Megacorp enters the consumer market, and Startupo enters the professional
market: This means that Megacorp gets the full consumer market (80% of the total
market share), and Startupo gets the full professional market (20% of the total
market share).

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PG Semester I Micro Economics Shika Ramesh

Based on this, if a company chooses to enter the consumer market, they know that they
will get either 40% or 80% of the total market share. Conversely, if a company chooses
to enter the professional market, they know that they will get either 10% or 20% of the
total market share. Accordingly, for both companies, the dominant strategy in this
scenario is to enter the consumer market, since regardless of which move the other
company makes, they will end up getting a bigger portion of the market share this way.
Conversely, for both companies, the dominated strategy is to enter the professional
market, since regardless of which move the other company makes, they will end up
getting a smaller portion of the market share this way.

3. Minimax strategy: A minimax strategy is a strategy in game theory where a player

makes a decision that yields the ‘best of the best’ outcome. Minimax strategy is the one
in which a player or organization maximizes the probability of minimum profit so that
the degree of risk can be reduced (minimizing one’s own maximum loss).
4. Maximin strategy: A maximin strategy is a strategy in game theory where a player
makes a decision that yields the ‘best of the worst’ outcome. All decisions will have costs
and benefits and a maximin strategy is one that seeks out the decision that yields the
smallest loss (maximize one’s own minimum gain). A strategy that allows players to
avoid the largest losses is the maximin strategy.

Column
Player 2

2, −2 0, 0 1, −1
Row
Player 1
4, −4 −3, 3 2, −2
1, −1 −2, 2 2, −2

Since the payoffs of the column player are just the negative of the payoffs of the row player,
the matrix showing only the payoffs of the row player (on the right) can be written as
2 0 1
follows: 4 −3 2
1 −2 2

Maximin strategy for player 1: maximize their own minimum gain. If player 1 plays the
first strategy (strategy A) then their minimum gain is 0. If player 1 plays strategy B then their
minimum gain is -3. If player 1 plays strategy C then their minimum gain is -2. Minimax
strategy for player 2: minimize their own maximum loss. If player 2 plays strategy A then
their maximum loss is 4 (their max loss is player 1’s max gain). If player 2 plays strategy B

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PG Semester I Micro Economics Shika Ramesh

then their maximum loss is 0. If player 2 plays strategy C then their maximum loss is 2. This
can be written as:

Column
Saddle Point
Player 2

𝐴 𝐵 𝐶 Minimum Gain

𝐴 2 𝟎 1 0
Row 𝐵 4 −3 2 −3 Maximin
Player 1
𝐶 1 −2 2 −2
Maximum Loss 4 0 2
Minimax
Take the maximum of the minimum gains, i.e. the maximum of row minima (maximin) and
the minimum of the maximum losses, i.e. the minimum of column maxima (minimax). If they
are equal, it is called a saddle point. If a saddle point exists, it should always be played. Here,
player 1 plays strategy A and player 2 plays strategy B. A saddle point is a Nash equilibrium.

Zero-Sum and Non-Zero Sum Game

Zero-sum is a situation in game theory in which one person’s gain is equivalent to another’s
loss, so the net change in wealth or benefit is zero. More typical are games with the potential
for either mutual gain (positive sum) or mutual harm (negative sum) as well as some conflict.
A zero-sum game may have as few as two players or as many as millions of participants. In
financial markets, options and futures are examples of zero-sum games, excluding transaction
costs. For every person who gains on a contract, there is a counter-party who loses. In theory,
a zero-sum game is solved via three solutions, perhaps the most notable of which is the Nash
Equilibrium put forth by John Nash in a 1951 paper titled “Non-Cooperative Games.”

Nash Equilibrium: The Nash Equilibrium states that two or more opponents in the game -
given knowledge of each other’s’ choices and that they will not receive any benefit from
changing their choice - will therefore not deviate from their choice. Nash equilibrium is a
concept within game theory where the optimal outcome of a game is where there is no
incentive to deviate from their initial strategy. More specifically, the Nash equilibrium is a
concept of game theory where the optimal outcome of a game is one where no player has an
incentive to deviate from his chosen strategy after considering an opponent's choice. Overall,
an individual can receive no incremental benefit from changing actions, assuming other
players remain constant in their strategies. A game may have multiple Nash equilibria or
none at all.

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PG Semester I Micro Economics Shika Ramesh

Example: Imagine a game between Tom and Sam. In this simple game, both players can
choose strategy A, to receive $1, or strategy B, to lose $1. Logically, both players choose
strategy A and receive a payoff of $1. If you revealed Sam's strategy to Tom and vice versa,
you see that no player deviates from the original choice. Knowing the other player's move
means little and doesn't change either player's behaviour. The outcome A represents a Nash
equilibrium. It is an outcome reached that, once achieved, means no player can increase
payoff by changing decisions unilaterally. It can also be thought of as "no regrets," in the
sense that once a decision is made, the player will have no regrets concerning decisions
considering the consequences.

Non-zero-sum games differ from zero-sum games in that there is no universally accepted
solution. That is, there is no single optimal strategy that is preferable to all others, nor is there
a predictable outcome. Non-zero-sum games are also non-strictly competitive, as opposed to
the completely competitive zero-sum games, because such games generally have both
competitive and cooperative elements. Players engaged in a non-zero sum conflict have some
complementary interests and some interests that are completely opposed.

Example: ‘The Battle of the Sexes’ is a simple example of a typical non-zero-sum game. In
this example, a man and his wife want to go out for the evening. They have decided to go
either to a shopping or to a boxing match. Both prefer to go together rather than going alone.
While the man prefers to go to the boxing match, he would prefer to go with his wife to
shopping rather than go to the fight alone. Similarly, the wife would prefer to go to shopping,
but she too would rather go to the fight with her husband than go to shopping alone. The
matrix representing the game and their utility is given below:
Husband
Battle of the Sexes
Boxing Match Shopping
Boxing Match 2, 3 0, 0
Wife
Shopping 0, 0 3, 2

The wife's payoff matrix is represented by the first element of the ordered pair while the
husband's payoff matrix is represented by the second of the ordered pair. From the matrix
above, it can be seen that the situation represents a non-zero-sum, non-strictly competitive
conflict. The common interest between the husband and wife is that they would both prefer to
be together than to go to the events separately. However, the opposing interests is that the
wife prefers to go to the ballet while her husband prefers to go to the boxing match. Most

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PG Semester I Micro Economics Shika Ramesh

other popular game theory strategies like the prisoner’s dilemma, Cournot competition are
non-zero sum.

The Prisoners’ Dilemma: The Prisoner's Dilemma is the most well-known example of game
theory. Consider the example of two criminals arrested for a crime. Prosecutors have no hard
evidence to convict them. However, to gain a confession, officials remove the prisoners from
their solitary cells and question each one in separate chambers. Neither prisoner has the
means to communicate with each other. Officials present four deals, often displayed as a 2 x
2 box.

1. If both confess, they will each receive a five-year prison sentence.

2. If Prisoner 1 confesses, but Prisoner 2 does not, Prisoner 1 will get two years and Prisoner
2 will get ten years.
3. If Prisoner 2 confesses, but Prisoner 1 does not, Prisoner 1 will get ten years, and Prisoner
2 will get two years.
4. If both do not confess, each will serve two years in prison.
Prisoner 2
Prisoner’s Dilemma
Confess Not Confess
Confess 5, 5 2, 10
Prisoner 1
Not Confess 10, 2 2, 2

The most favorable strategy is to not confess. However, neither prisoner is aware of the
other's strategy and without certainty that one will not confess, both will likely confess and
receive a five-year prison sentence. The Nash equilibrium suggests that in a prisoner's
dilemma, both players will make the move that is best for them individually, but worse for
them collectively.

Applications of Game Theory

Game theory is not just theory, it is also applied in many areas. The use of game theory has
expanded and applied to economics, business, biology, computer science, political science,
psychology and philosophy. Game theory can describe a number of specific phenomena:
interpersonal relations, competition, war and political affairs. From historical aspects, game
theory can be identified in the works of ancient philosophers. It is applied to develop theories
of ethical or normative behaviour. Economists and philosophers have applied game theory to
understand rational behaviour. The main advantages of this theory are:

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PG Semester I Micro Economics Shika Ramesh

 Game theory provides a systematic quantitative approach for deciding the best
strategy in competitive situations.
 It provides a framework for competitor’s reactions to the firm actions.
 It is helpful in handling the situation of independence of firms.
 Game theory is a management device which helps rational decision-making.
 Game theory is an important tactics applied in mathematical economics and business
for modelling the patterns of behaviour of interacting agents. Economists use ‘Game
Theory’ as a tool to analyze economic competition, economic phenomena such as
bargaining, auctions, voting theory, political economy, behavioural economics etc.
 Game theory is applied for determining different strategies in the business world. It
offers valuable tools for solving strategy problems. Many business strategies are short
or long-term plans to achieve sustainable profitability. A business can often
successfully position in the market with right strategy and a business will suffer in the
long run with wrong strategy.
 Strategic behaviour occurs regularly among executives, manager and investors in
business world. They must decide to enter into new markets, launch new products,
invest now or lose the opportunity to invest and make pricing and purchasing
decisions.
 Game-theoretic models are very potential tools for analyzing firm decisions. Game
theory models forces each player to consider the actions of others when picking their
strategy, in which one player may respond to the moves of his competitor. It provides
significant benefit to a decision maker.
 Game theory is widely used in political affairs, which is focused on the areas of
international politics, war strategy, war bargaining, social choice theory, Strategic
voting, political economy etc.
 Game theory is an effective tool in the hands of diplomats and politicians to analysis
any situation of conflict between individuals, companies, states, political parties.
Rationality of actors and the choice of strategies are one of the basic assumptions of
game theory.
 Game theory seems to be useful tool for research on terrorism because it captures the
interaction between attacked subject and terrorist organization, when the steps are
interdependent and therefore cannot be analyzed separately.

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PG Semester I Micro Economics Shika Ramesh

Important Issues in Game Theory

The biggest issue with game theory is that, like most other economic models, it relies on the
assumption that people are rational actors that are self-interested and utility-maximizing. Of
course, we are social beings who do cooperate and do care about the welfare of others, often
at our own expense. Game theory cannot account for the fact that in some situations we may
fall into a Nash equilibrium, and other times not, depending on the social context and who the
players are. Some other limitations are:
 As the number of players increases in the actual business, the game theory becomes
more difficult.
 Game theory simply provides a general rule of logic, not the winning strategy.
 There is much uncertainty in actual field of business which cannot be considered in
game theory.
 Businessmen do not have adequate knowledge for the game theory.

Game theory assumes that each firm has knowledge of the strategies of the other as against its
own strategies and is able to construct the pay-off matrix for a possible solution. This is a
highly unrealistic assumption and has little practicability. An entrepreneur is not fully aware
of the strategies available to him, much less those available to his rival. He can only have a
guess of his and his rival’s strategies.

The theory of games assumes that both the duopolists in an oligopoly market are practical
men. Each rival moves on this presumption that his opponent will always make a wise move
and then he adopts a countermove. This is an unrealistic assumption because entrepreneurs do
not always act rationally. But if an entrepreneur is not practical, he cannot play either the
maximin or minimax strategy. Thus, the problem cannot be solved.

In game theory, it is easy to understand a two-person game. But as the analysis is elaborated
to three or four person games, it becomes complex and difficult. However, the theory of
games has not been developed for games with more than four players. Most economic
problems involve many players. For instance, the number of sellers and buyers is quite large
in monopolistic competition and the game theory does not provide any solution to it.

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