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GAME THEORY

• Game Theory
Ray Powell Definition: It is a mathematical approach to the study of
conflict and decision-making which treats conflict as games with
tactics and strategies and rational players.

• Prisoner’s Dilemma is an example of the Game Theory which


provides insight into both the interdependence of
competitive Oligopolies and incentive to collude.

• Although it can be used to predict or explain other situations.


•PRISONER’S DILEMMA

The scenario can be explained using two prisoners accused of the same crime. In
it the two prisoners are put in separate cells unable to communicate. Assuming
that there isn’t concrete evidence to imprison them, the prosecutors will try to
persuade them to implicate one another.

-If neither goes along with the guards they will get a sentence of a year.

-If one accepts the deal with the prosecutor and the second prisoner keeps
quiet, the turncoat (snitch) goes free and the patsy gets ten years.

-If they both denounce one another, they both


get five years.

Now Prisoner’s dilemma attempts to predict the


most likely situation.
Outcome/Dominant Strategy

• Given the situation each prisoner has the incentive to denounce the
other. Although one of the prisoners might decide to keep quiet, a
rational self-interested person would always betray his fellow prisoner.

• This leaves them moldering in jail for five years when they could cut their
sentence to one year each if they both kept quiet. Hence their Dominant
strategy was to denounce one another.

• Dominant Strategy is the strategy to be pursued whatever the rival or


opponent decides to do.
Animated Example
Application to Oligopoly

• In Oligopoly there is a small number of firms in the market.


Each firm will want to make the highest profit possible, but
there is uncertainty (no perfect knowledge) as each firm cannot
be sure what the rival’s response to its actions may be.

• In this case they may decide to collude/cooperate, but a


collusive agreement can never eliminate uncertainty
completely as firms can cheat on the agreement.

• However if they do not cooperate they will have to compete


and on competing the dominant strategy for the firms does not
deliver the best outcome.
Simplified Example Using A Duopoly

PAY-OFF MATRIX

COCA-COLA
INCREASE PRICE NO CHANGE

PEPSI CO. £700M/£800M £100M/£1100M


INCREASE PRICE

NO CHANGE £600M/£300M £400M/£600M


FROM THE PAY-OFF MATRIX

• Pepsi Co. and Coca-Cola may want to increase the price of


drinks but they will have consider the reaction of one another.
They have three available market strategies.
-One firm increases its price an the other firm does not
resulting in loss of sale for the former.
-Both leave their prices unchanged.
-They both increase the price of their
drinks.
• As there is no perfect knowledge
in the market, each firm would try to
make the most rational decision.
Outcome/Dominant Strategy
• Pepsi Co. knows that if it increases its price and Coca-Cola
does not it risks losing sales, and the same applies to Coca-
Cola.
• This would result in both firms leaving price unchanged as
they risk losing sales if the rival firm does not increase their
price too.
• From the pay-off matrix the best outcome for both firms
would be to both increase their price, but as there is no
knowledge of what the opposing firm might do the dominant
strategy would be to leave priced unchanged.
• Coca-Cola may choose to use retain its current price whatever
Pepsi Co. does. Thus Coca-Cola would be using Pure Strategy.
The problem with this is that Pepsi Co. would not know of
Coca-Cola’s strategy.
An Alternative

• Both firms can choose to collude. Therefore they would be a joint


decision on what action to take.

• But on collusion Coca-Cola might cheat on the agreement and sell


at the unchanged price, as it stands to gain more when it sells at
the normal price.

• This is the problem with collusion


and a reason firms might not want
to cooperate.
Criticisms Of The Game Theory

• It is a GAME. This is a theory of what


firms might do when presented with a
certain situation.

• There is no complete certainty.

• The game is based on probability


which is not a 100% accurate.
REAL-LIFE APPLICATION
The End

By Abdul & Ira

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