Unit 8: Exercise 8-1 - Defining Oligopoly and Game Theory

Considering the information in the video and Chapter 11 (pages 387-394), write a few study notes to answer the following questions:

·         What are the main ideas behind game theory?

·         How did it develop?

·         Is there evidence of game theory in the current economy? Explain.

·         How does the payoff matrix work?

·         Describe the principles behind collusive and cartel actions.

Game Theory is a mathematical algorithm used by players to analyze strategic situations, interactions and behaviours. Based on a player’s analysis of a situation he hopes to enhance success of his/her choices based on the strategic choices made by his opponent(s). In other words, the outcome is dependent on your actions as well as the action of others. What does this mean in economics? Well, in a competitive environment firms are constantly analyzing each other to gain corporate intelligence and strategize what the market player’s next move will be. A firm or an individual is always concerned about their own self interest.

There are many people in history that have been involved in some form of development or study of the game theory. In the ECON-250 10 minute video on game theory at http://www.youtube.com/watch?v=54Dk3x4osik John Nash’s contributions are primarily cited. However, another major contributor in the study of this theory is John von Neumann, amongst others. A chronology of Game Theory, for those interested, can be found at http://www.econ.canterbury.ac.nz/personal_pages/paul_walker/gt/hist.htm#nobel2 .

If we look at the various types of markets I believe game theory does not play a significant role in perfect competition, monopolistic or monopoly environments. The reason being one group is price takers (perfect competition, monopolistic) and the other is price is set by market demand (monopoly). Game theory would have benefit in an oligopoly environment where decision making and market share are based more on strategic thinking such as automobile or petroleum gas competitors.

The payoff matrix is a grid showing the best, mediocre and worst outcomes to profit, price or what ever other value one is trying to determine when employing game theory. Below is an example of a payoff matrix showing profits based on a dollar value against a quantity sold. If both firms are in equilibrium the profits earned are the same (top left). When one or the other firm gets hungry for business we see a shift in balance of fairness for one or the other (top right and bottom left). If both firms get extremely competitive against each other, such as a price war, then both will suffer (bottom right).

Collusion: an agreement among suppliers to set the price of a product or the quantities each will produce.

Cartel: an association of sellers acting in unison.

The definitions of collusive and cartel are noted above from Sayre/Morris 6e, Microeconomics. Both of these types of agreements if actioned in a legal manner provide benefit to both the firm and consumer. Both of these methodologies have a tendency to breakdown when illegal activity such as price fixing becomes involved with illegal collusion where firms attempt to control supply. The detriment of cartels is enforcement of production levels or again price fixing.