The Theory of Games: Game Theory - Term Paper Example

XXXXXX Number: XXXXXXX XXXXXXX XXXXXX XXXXXXX XX – XX – 2009 Microeconomics – The Theory of Games: Game Theory Introduction: There are several different types of markets structures that are present. The main structures include, Perfect competition, Monopolistic Competition, Oligopoly and Monopoly. This paper will deal with the concept of Oligopoly and an attempt has been made to explain the term oligopoly and the key features of an Oligopoly market. A deep analysis of Collusion and competition faced in the markets due to Oligopoly has also been conducted. Before moving into the details of the topic, it is essential to understand the definition of Oligopoly. Definition of Oligopoly: ‘A Market Structure where there are a few enough firms to enable barriers to be erected against entry of new firms’ (Sloman and Sutcliffe). This form of market structure has a few firms that are present, and the freedom to entry here is restricted. These firms mostly deal in undifferentiated or differentiated products and some of the best examples include cars, cement, and electronic appliances. The demand curve for this kind of market is mostly downward sloping and the slope is relatively inelastic in nature (Riley). This however depends on the price changes of the rivals and the reaction of the company to these changes. Key Features of Oligopoly: As seen in the definition that has been discussed earlier, the oligopoly markets are those where there are only a few firms that exist in the market. Based on the definition and the nature of these markets, the main features of an Oligopolistic market are as discussed below: a) Interdependency among Firms: As discussed earlier, there are a few firm that are present in the oligopoly markets. This leads each of the firms to be interdependent on each other. Interdependent here means, each firm is affected by the moves and actions of the other firms in the markets and every single step including changes in prices, advertising, or specification of products leads has an affect on the other companies in the industry (Sloman and Sutcliffe). b) Barriers to Entry: The oligopoly markets have similar barriers to entry like the monopoly markets. These include, a) Economies of scale, b) Economies of Scope, c) Brand loyalty and product differentiations, d) lower costs for established firms, e) Control over or ownership of, retail outlets or wholesale outlets, f) Control over or ownership of, the key factors affecting production, g) Protection – legally, h)Intimidations, i) Tactics, and j) mergers and takeovers (Sloman and Sutcliffe). Collusion and Competition: There are two main ideas that relate to the markets of Oligopoly. Based on the main features, it is seen that the ‘Interdependence’ factor, can lead to two different directions: The interdependence among the firms will lead to collusion among them. If the firms can stay together in the market clubbed together then they can gain a monopoly and maximise the industry profits (Gibbons). The level of competition can increase to a greater extent. Here the firms will try to compete with one another to gain a bigger part of the market share and to earn higher levels of profits. Collusive Oligopolies has been defined as: ‘When oligopolists agree (formally or informally) to limit competition between themselves. They may set output quotas, fix prices, limit product promotion or development or agree not to ‘poach’ each other’s markets’ (Sloman and Sutcliffe). The formal agreement between the companies is referred to as the ‘Cartel’. A Non – Collusive Oligopoly on the other hand has been defined as: ‘When oligopolists have no agreement between themselves – formal, informal or tacit’ (Sloman and Sutcliffe). Game Theory: Game theory has been defined as: ‘The Study of alternative strategies that oligopolists may choose to adopt, depending on their assumptions about the rivals behaviour’ (Sloman and Sutcliffe). This classifies as a non collusive oligopoly and classifies as a simple dominant strategy game. The game theory considers two firms that deal with identical products, costs and demand levels. It is then considered that both of these firms are considering making an alteration to the prices that they charge to the customers. The game theory assumes that both the companies in the current period charge their customers $2 and both companies, A & B make a profit of 10 million. This leads the industry total to be $20 million. If the two companies decide to independently make a change in their prices, a plan to reduce their prices, to $1.80. It is then an essential decision for the other firm to decide what they might do, in case of the price being reduced. Here there are a few alternatives that the firms can undertake. For the sake of understanding of the following terms let’s assume that B reduces the price to $1.80: Cautious Approach: The first alternative available is to use the cautious approach. Here the firm A keeps its price at $2, but the worst thing for A is if B cuts its prices. This is clear in the diagram box ‘C’, the profits of A will fall to $5 million. If A is cautious and it also cuts its prices to $1.80, then the two companies will make profits of $8 million each. This is called as Maximin strategy. Maximin strategy can be defined as, ‘The strategy of choosing the policy whose worst possible outcome is the least bad’ (Sloman and Sutcliffe). Optimistic Approach: Here it is assumed that each rival reacts in a manner which is most favourable to them. If A drops its prices to $1.80, it assumes that the B will leave the prices at $2. If this assumption by the company is accurate then the companies would fall into the ‘B’ box of the diagram below. This is referred to as the maximax strategy. Maximax strategy can be defined as, ‘The strategy of choosing the policy which has the best possible outcome’ (Sloman and Sutcliffe). Here one company, i.e. A will earn a profit of $12 million, while B will earn a profit of just $5 million. Both the approaches, i.e. maximax and maximin, lead to the same strategy, i.e. cutting of prices. This is referred to as ‘Dominant strategy game’. However if there is no collusion among the two companies and both of them reduce their prices, then, this is referred to as ‘Nash Equilibrium’. This is defined as, ‘The position resulting from everyone making their optimal decision based on their assumptions about their rivals’ decisions. Without collusion, there is no incentive for any firm to move from this position’ (Sloman and Sutcliffe). The Game theory is not only applicable in economics, but places an important part in other aspects of life as well. The next section will deal with the use of a similar theory in everyday life. This theory is referred to as, ‘Prisoner’s Dilemma’. Prisoner’s Dilemma: The relevance of game theory is present in almost every subject and aspect of life. One of the best ways to understand this is by ‘The Prisoner’s Dilemma’. Prisoner’s Dilemma is a theory that has been developed to provide a non economic understanding of the ‘Game theory’. Here an example is taken to explain the dilemma. Two people, say A and B, are arrested for a crime which they have been suspected to have done jointly. Both A and B are questioned and interrogated separately. These are the below possibilities that they have: a) If neither A or B tell the court anything about the fraud, then the court will have enough evidence to sentence them both for one year imprisonment. b) If A or B were to confess then they would be given only three months of imprisonment but the other person would get up to ten years c) If both of them were to confess, then both would get three years of imprisonment. The figure below highlights the four choices and the effects of the decision that is made on each of the two prisoners. It is in this situation that the two prisoners are faced with a dilemma and are unsure of what they need to do to get the least amount of time in jail. This is very similar to the situation where the two companies are required to make their decisions knowing that the other company’s is dependent on the decision made by the company. Usefulness of Game Theory: The advantage of the game theory is that the companies do not require knowing the response the rivals might give. There is no perfect response for any of the firms (Riley). The companies will however need to be able to measure the possible effects of the possible decisions of the rivals. This however is impossible to do in the case of a market where there are several companies and several possibilities of decisions that can be made. There are high chances for companies to compete hard for long periods of times and then move on to a situation where no one wins and no one loses. There is however a chance of firms trying to work together to form a success and in this case it is possible that they turn to ‘cheat’. Conclusions: It is clear from the above discussion that oligopoly markets have a few different techniques that are involved in its working. The game theory is one of the most essential theories that is adopted in the markets and is most beneficial especially in the case of oligopoly markets, as the companies in these markets are interdependent and work in accordance with each other. Also the decisions made by the companies, have a major effect on the rival companies within the industry as well. Useful References: Davis, M. A. (2009). Macroeconomics for MBAs and Masters of Finance. Cambridge University Press. Hoover, K. D. (2001). Causality in Macroeconomics, 1st Edition. Cambridge University Press. Mankiw, N. G. (2008). Principles of Macroeconomics, 5th Edition. South-Western College Pub. Mankiw, N. Gregory. Macroeconomics. Worth Publishers, 2006. McConnell, Campbell and Stanley Bruce. Macroeconomics - 17th Edition. McGraw-Hill/Irwin, 2006. McConnell, Campbell, Stanley Bruce and Sean Flynn. Macroeconomics - 18th Edition. McGraw-Hill/Irwin, 2008. Sloman, Jack and Mark Sutcliffe. Ecnomics for Business, Third Edition. London: Pearson Education Limited, 2004. Swanenberg, A. (2005). Macroeconomics Demystified, 1st edition. McGraw-Hill. Works Cited Gibbons, R. Game Theory for Advanced Economists. Princeton University Press, 1992. Riley, Geoff. Oligopoly - Game Theory. September 2006. 1 November 2009 . Sloman, Jack and Mark Sutcliffe. Ecnomics for Business, Third Edition. London: Pearson Education Limited, 2004. Read More