Understanding Firms Interaction Through Game Theories - Essay Example

?UNDERSTANDING FIRM’S INTERACTION THROUGH GAME THEORIES INTRODUCTION Game theory is a study of how companies, industries or individuals behave or actin strategic situations. Strategic situations in this scenario imply those positions whereby every individual or industry, in settling on what actions or steps to take, must put into consideration how other individuals, firms or industries might counter that action. This game theory is of vitality in oligopolistic markets. In industrial economics, the profits of an industry or firm are highly dependent on not only how much it produces but also how much the other industry produces. This means that the payoffs of an industry for its production depend not only on their decisions but also on their rival’s decisions (Durlauf, 2010). A game theory is composed of a series of elements including: players or partners, rules which imply the possible decisions that one is capable of making given another party’s decisions, and the facts that a player could have knowledge of before moving or making a decision. Other elements include the consequences or outcomes of certain moves and the payoffs of each possible outcome. Payoffs imply the money got from a given decision (Durlauf, 2010). Game theories In arriving at the solutions given the game theories, it is important that industries understand certain tools. These tools include dominated and dominant strategies and the Nash equilibrium. A dominant strategy is a tactic that gives higher payoffs no matter what the opponent does, while a dominated strategy is an approach that is lower than another strategy; this implies that for a dominated strategy, there is a dominant strategy that is in existence over it. On the other hand, in Nash equilibrium, no industry or individual is in preference of a different choice. This means that each player chooses the best strategy given the approaches taken by the other players in the market (Durlauf, 2010). In an effort to understanding how firms and industries react, it is vital that the different types of game theories are understood. Firms’ interactions are mainly guided by certain game theories. There is a myriad of game theories. Simultaneous game is one of the game theories. As the name suggests, the players in the market make decisions independent of the other player’s decisions. This means that no party is aware of the other party’s choices or decisions. This kind of scenario forms what is known as a Cournot model. In such a case, each firm or industry tries to make a forecast of what the other player in the market will be so as to arrive at a reasonable decision itself (Durlauf, 2010). In Cournot models, firms predicts the other industry’s output choice and then based on the forecasts, each firm goes ahead to choosing a profit maximizing output for itself. In cournot, prices as at Nash equilibrium are above the perfect competitive prices. In this case it is clear that the Cournot game model influence the market price as firms try to control their levels of production. Thus, through Cournot model, it is possible for firms to come up with best reaction functions in their production in cases where the industries have completely no clue on what the other players in the market are up to achieving (Mukherjee, 2004). Sequential game is another game theory whereby an industry or firm makes a decision on price or quantity, when it already has knowledge on what another player or partner has decided on. The kind of strategic interaction depicted in such a scenario gives rise to a Stackleberg’s model. In this model, one industry makes a choice before another. It is frequently used to depict industries in which there is a dominant firm. In the Stackleberg’s model, an industry that is a leader chooses output to maximize profits depending on how a follower will react to its choice. Given the choices by a leader, a follower will try as much as possible to make profits given the quantity the leader produces. A leader makes decisions on its own production considering the follower’s profit maximization problem. For example, if an industry happens to set its quantity first, it is known as a quantity leader and the other a quantity follower. The same case applies with the price (Durlauf, 2010). Bertrand model is another game theory that explains the how firms or industries interact in the market. It is a model whereby firms decide on the price to set for its products in the market. This affects the quantity supplied in the market which, in other words, influence the quantities industries produce. For a leader to make a reasonable decision on how to set its prices, it must first forecast how the behavior of the follower afterwards. Nash equilibrium in Bertrand model directs prices to the same case as in perfect competition where price equals marginal cost (P=MC). Industries that are followers must always set a price that equals the leader’s so as to maintain the equilibrium in the market. Otherwise, consumers would choose cheaper commodities resulting in no equilibrium. Industries that are price takers decide on how much to produce so as to realize profits since the price as set in the market is what they have and have to take as given (Durlauf, 2010). Zero-sum game is another game whereby the benefits of one player equal the losses of the other. This means that the total benefits of all players or partners in the industry or market, given particular strategies, equal to zero. This was the first game theory model to be used to explain industries interactions. However with time, industries noted that the benefits equal to zero, hence, it was paramount that strategies taken result to a positive benefit. Thus, industries opt for strategies that result in positive and efficient outcomes (Mukherjee, 2004). Thus, from the above game theories, it is evident that firm’s interactions are a result of those game theories. Firms act given another firm’s decisions. Therefore, the quantity that a firm produces and the prices set by firms is arrived at through the game theories. It is not possible for a firm to decide on a choice without relying on other firms’ decisions (Kelly, 2003). Difference between quantity competition and price competition Quantity competition is rivalry whose basis is on quantity determining strategies. It refers to the Cournot competition where industries regulate their levels of produce. In doing so, the market price is influenced. With the quantity competition, the leader has already set the Cournot Nash. Thus, it is rather hard for any industry to influence the quantity produced in order to make profits. All industries take the quantity as set; this has a serious impact on the market prices as industries will view it as necessary to make changes so as to recover profits. In quantity competition, prices are decided on the market’s tolerance (Mukherjee, 2004). Price competition on the other hand is a rivalry in the market whose foundation is on price setting strategies. It stands for the Bertrand competition. Leaders in the market set a price that the followers take. The followers are price takers; they have no influence on the price. They take it as given and cannot influence it to make profits. All the followers can do is influence the quantities they produce so as to make profits. In such a case, the best response function is called the Bertrand Nash (Mukherjee, 2004). REFERENCES Durlauf, S. N., 2010. Game theory. Basingstoke: Palgrave Macmillan. Kelly, A., 2003. Decision making using game theory an introduction for managers. Cambridge, UK: Cambridge University Press. Mukherjee, A., 2004. Price and quantity competition under free entry. Nottingham: University of Nottingham. Read More