Game Theory As a Logical Study of The Behavior Between Two Firms - Assignment Example

Game Theory Game Theory is a logical study of the behavior between two firms that are interdependent of each other. Interdependent means one company’s profits depend on another company’s success. There can be more than two companies, but no less. The two or more companies are called players. In Game Theory, the players are affected by what the other players do or do not do. By studying the other players’ behavior, firms can build strategies for success. Based on each player’s actions, other players’ can make decisions in a timely fashion (Jaquier 2003). An example of Game Theory would be if Company X makes product X, and Company Y makes product Y. A third company, Company XY, buys product X and Y to produce product XY. Company X, Company Y, and Company XY would be named as players under the Game Theory. If Company X raises the cost of their product, Company XY is affected. The rise in product X’s cost could even affect Company Y, if Company XY’s chooses to increase the price of their product with the result of lower sales of product XY. Game Theory has a few elements that are important to mention. As mentioned before players are one element, the other elements include payoffs, actions, and rules (Jaquier 2003). Players are the actual firms. Payoffs are the rewards or punishment of the players in the game. In the scenario above, Company X could have been punishing Company XY or rewarding Company Y, depending on the circumstances. Actions are the decisions made by the players. The rules define the players, actions and payoffs. This makes up the basics of Game Theory. How useful is game theory in the strategic conduct of firms in oligopolistic markets? An oligopoly is a couple of large suppliers controlling a particular market. The market concentration is normally high. Companies encompassing an oligopoly produce brand quality products. Barriers exist for firms on the outside an oligopoly, due to the necessity of brand quality products the firms on the inside of the oligopoly produce. The interdependence between companies in an oligopoly is vital. Each company in an oligopoly must anticipate what the other companies/players will decide concerning investments, prices, or any other important business decisions. Economists seek to predict these decisions by using Game Theory (Oligopoly 2005). Game Theory helps players logically figure out the decisions other players will make. Game Theory not only helps predict players decisions, but has an impact on politics, other businesses, pricing of products and services, locations for industrial plants, and even enviormental issues if the prime location for an industrail plant is near an endangered species (Oligopoly 2005). Game Theory can show the players the theoretical value of their own company, plus the standings of other players in a specific industy. A model can the be produced on paper predicting corporate stratigies. These models must take into consideration what the goal of the individual firm and the other players/firms’ expectations. The model should use a continuous time table. Sometimes a player’s researcher make assumptions about a firm for lack of hard evidence. Such assumptions could discount price changes, the ablitiy of a firm to change or add to their product. These models can be used to explore theoretical issues, but cannot be relied on completely as fact. Since all the players in an oligopoly are constanly working to improve their firms, the models are helpful in searching out every possiblity of the other players. However there are many variables. Some variables cannot be predicted. These variables can range from natural disasters to an unforseeable change in the market.(Smit 2003). Game Theory provides each firm with the opportunity to change the game for their particular industry. Three benefits stand out above the rest: Using the Game Theory makes a firm consider every possible situation concerning their rival’s decision making, bargaining, and related interactive situations. Game Theory places greater focus on being aware of a rival company’s strategies. Game Theory uses theoretical circumstances to anticipate real world opposing firm’s decisions. The Game Theory gives an imaginative approach to oligopoly markets. The issue of interdependence weaves the companies together. This interdependence has a tendency to make each firm’s manager proceed on the assumption that their rivals are making the most intelligent decisions possible. One common factor in an oligopoly is the value of each firm. Every firm has a certain value that can rise or fall depending on the other firms/players in an oligopoly. Each firm in an oligopoly assumes that it can change their profits if they can correctly predict the other firm’s strategy. In Game Theory, the gains and losses balance out within the oligopoly. If one player gains it is directly related to a loss of another player. For example, if a petrol station raises the price by pound and the other stations do not, the first station loses sales, but depending on the price of petrol, the other stations could be losing more than the first station. This persuades petrol stations to keep petrol the same prices as the other stations. Since firms have to keep their prices close to one another’s, they will have to use other methods to compete effectively with the other firms. In an oligopoly every firm depends on the other firms. This makes it difficult for one player to take advantage of other players in the same oligopoly. To dominate the market a firm must have a strong quality brand. Brand name items generally, but not always, come from established companies. Brand names are something consumers can feel safe upon buying. This can lead to price increases for a strong brand, creating a monopoly, and the demand for the product will not waiver. In order to appreciate an oligopoly better, Pepsi Cola and Coca Cola are the best examples, because they are two known, big firms that acting in one particular oligopoly market. Example: Pepsi Cola and Coca Cola are both carbonated drinks, but have a different taste. Both companies have built reputations around the world. In China, both products are sold for similar prices (The Cola Oligopoly 2005). “Being first in China, we have become what is called a price leader, and therefore there is no competition from our side of the game”, says Summata, marketing manager of Coca Cola in Shanghai, China (The Cola Oligopoly 2005). Summata also claims that competing on price will not give yield to any of the companies. That is why we can see that the price of both Coca Cola and Pepsi Cola in Shanghai is approximately $0.23. The price does changes from place to place in China but in most of the cases the price is the same for the two rivals, and if it’s not then the difference is really slight (The Cola Oligopoly 2005). Just like the fictional petrol stations above which did not profit by competing on price, the cola industry also does not profit by competing with each other by using their prices. If price competing is futile, companies must look into other strategies using the Game Theory. Producing new products help established companies from becoming stagnated in their industry. For example, Coca Cola and Pepsi Cola have started developing non-carbonated drinks for their Chinese consumers (The Cola Oligopoly 2005). The Nash Equilibrium In an established oligopoly suppose the players have made decisions over years and years. Since the oligopoly is established, some players do not even consider what the other players are doing or an individual player thinks their decisions no longer affect the rest of the oligopoly. The oligopoly has gone on for so long that each firm has developed an unsurpassed strategy, a strategy made just for them. The independent strategies merge to form a balance for the whole industry. This balance is called the Nash Equilibrium (Friedman 1986, 1990). Strategy as Quantity - Version 1: Using the above definition of the Nash Equilibrium, each player judges the quantities produced by the other firms in their oligopoly. That helps each individual firm decided what quantity of product to produce to maximize their personal profit. This only works if the firms have a consistent or reliable quantity of product produced which has been proven over time. Companies do not stay stagnate, but under the Nash Equilibrium the quantities can be predicted in these circumstances. David Friedman’s (1986, 1990) following example and illustration explains strategy as quantity in detail: Figure 1.1 shows the situation from the standpoint of one firm. D is the demand curve for the whole industry. Q is the combined output of all the other firms in the industry. Whatever price the firm decides to charge, the amount it will sell will equal total demand at that price minus Q; so Df, D shifted left by Q, is the residual demand curve, the demand curve faced by the firm. The firm calculates its marginal revenue from that, intersects it with marginal cost, and produces the profit-maximizing quantity Q*. Fig 1.1 If the above diagram depicts a Nash Equilibrium, then all of the firms, not just firm D must be producing the quantity that maximizes their individual profits. If all of the firms were producing a quantity for their individual maximum profits, by this example all of the firms are the same. David Friedman (1986, 1990) sums it up this way: On Figure 1.1, Q is eight times Q*, so the situation is a Nash equilibrium provided there are exactly nine firms in the market. Each firm produces Q*, so from the standpoint of any one firm there are eight others, with a total output of Q=8Q*. If the example above is correct, one firm in an oligopoly can calculate optimized profits by the quantity produced compared to the other firms in the oligopoly. This theory only works on firms with quantity outputs are dependable inside their oligopoly. What happens when new firms enter an established industry based on a diagram like the one above? How can we balance out the new firm’s quantity? Using the formula Q=8Q*, we could plug in a number of new firms. If you use 9 in the equation price is still above cost, so all of the firms still make a profit. You could keep raising the number until the number of firms reached make the price fall there are too many firms. This means that if firms do their research correctly, a firm will not join the oligopoly if their entry will drive the price below cost. Version 2 (Duopoly): You can approach the problem of the Nash Equilibrium a different way. We can solve it in terms of reaction curves. To simplify the reaction curves, a study of duopoly is needed. A duopoly is an industry with only two firms (Friedman 1986, 1990). This theory was analyzed a century before Nash, by Cournot ((Friedman 1986, 1990). David Friedman’s ( 1986, 1990) diagram below clarifies the duopoly’s reaction curves: Figure 1.2 shows the situation from the standpoint of one of the firms. D is the demand curve for the industry. D1 is the residual demand curve faced by Firm 1, given that Firm 2 is producing a quantity Q2=40; D1 is simply D shifted left by Q2. Q1 is the quantity Firm 1 produces, calculated by intersecting the marginal revenue curve calculated from D1 with the firms marginal cost curve MC1. Fig 1.2 The only problem with reaction curves and duopoly is it’s hard to track more than two companies at a time. Since many oligopolies have more than two firms, the reaction curves become useless in projecting the future of many oligopolies. The Duopoly Model used with the Nash Equilibrium Theory: After taking a look at duopoly through a quantity perspective, one might wonder if other factors can be used in an equation dealing with duopoly. That is where the Duopoly Equation comes in handy. Schoonbeck and Kooreman (1994-1998) define the Duopoly Equation in this formula: qi = yi0 + aiiPi + ajiPj + yiiA1/2i + yijA1/2j, i,j = 1,2 (j z i), (1) qi = output p = price A = advertising Yi0 = The autonomous demand of firm i. i = company 1 j = company 2 (1) = The reasonable assumption that the demands is linear in prices. Using the above formula the Duopoly Equation proves the Nash Equilibrium Theory in mathematical terms. Company j and i balances out at the end of the equation, even when adding the variables of output (quantity), price, and advertising. The Duopoly Model, the Nash Equilibrium Theory, and Advertising Strategy: It was established above the Duopoly Model worked with the Nash Equilibrium theoretically. How could a company use the Duopoly Model with the Nash Equilibrium to improve Advertising Strategy? The following points answer this question. Both companies can compare advertising using the Duopoly Model. Both duopolistic firms can simultaneously anticipate the effectiveness of advertising expenditures. The Duopoly Model of the situation can determine the firms that only compete in prices and do not advertise at all. Comparing the two different companies with the Duopoly Model can determine the advertising impact on the firms’ consumers. One thing to keep in mind about the Duopoly Model is it depicts two companies that are static, meaning this equation does not take in the consideration of a timetable. To use the Duopoly Model, a company must keep updating the variables of the equation (.Schoonbeck and Kooreman 1994-1998). Conclusion: Game Theory in oligopoly and duopoly markets can be very important in determining corporate strategy. When using the Game Theory with the Duopoly Models and the Nash Equilibrium Theory, corporate strategies can be broke down into mathematical equations. Using mathematical equations to determine a rival company’s strategy in both oligopolies and duopolies makes economics a more precise science. When using the variables of quantity, profit, cost, and advertising, predicting rival corporate strategies becomes a little easier to accomplish. Game Theory also helps companies optimize their quantity, profits, cost, and advertising. while lowering company losses. When every company in an oligopoly and duopoly perfect their strategies the Nash Equilibrium is put into practice. All of the companies’ profits and losses affect each other to create a balance in the individual industry. The only thing to keep in mind about the Duopoly Model, Game Theory, and the Nash Equilibrium Theory is these theories, equations, and models are theoretical. They can be used for practical predicting of company strategies, but predicting the future can never be a perfect science. All of these equations can only guess at these strategies. However, Game Theory and the other equations are the best tools to predict company decisions and strategies today. References 2005, Oligopoly [online]. tutor2u. Available from: http://www.tutor2u.net/economics/content/topics/monopoly/oligopoly_notes.htm. [12 January 2006]. 2005, The Cola Oligopoly [online]. Coursework.info. Available from: http://www.coursework.info/i/10291.html. [12 January 2006]. FRIEDMAN, D.D., 1986, 1990, Price Theory: An Intermediate Text [online]. Chapter 11. South-Western Publishing Co. Available from: http://www.daviddfriedman.com/Academic/Price_Theory/PThy_Chapter_11/PThy_Chapter_11.html. [12 January 2006]. JAQUIER, B., 2003, Game Theory [online]. Ecole Hoteliere de Lausanee, Switzerland, Ecoline. Available from: http://www.ecofine.com/strategy/Game%20theory.htm. [12 January 2006]. SCHOONBECK, L. AND KOOREMAN, P., 1994-1998, The Impact of Advertising in a Duopoly [online]. Gronigngen, Netherlands. Department of Economics University of Gronigen, Netherlands. Available from: http://www.ub.rug.nl/eldoc/som/b/99B42/99b42.pdf [Accessed 12 January 2006]. SMIT, H.T.J., 2003, Infrastructure Investment as a Real Option Game: The case of European Airport Expansion [online]. Financial Management (Financial Management Association). Available from: http://www.findarticles.com/p/articles/mi_m4130/is_4_32/ai_112452264. [12 January 2006]. Read More