Game theory- Playing with the big companies

posted in: Economic ideas | 1

Game theory is also useful in an oligopoly market form. An oligopoly market is where there are a few big firms in the market for a product (for example the automobile industry is an oligopoly as there are only a few big companies in the market). The companies in an oligopoly market form engage in non-price competition, and this policy is also determined by game theory. Companies in an oligopoly do not try to undercut the other firm’s prices, as it would just result in the other firm also reducing their prices. Take the situation of 2 firms in an oligopoly, A and B. If A reduces their prices in order to attract more customers, B is also likely to do the same thing. Whatever measures are taken by A with relation to reduction of price are likely to be mirrored by B, meaning that once price competition starts, both companies will end up reducing the prices of their products while retaining the same market share, leading to a loss of revenue for all involved. On the other hand, firms A and B can cooperate and agree to keep the prices high, ensuring that both A and B make bigger margins of profit. This is known as collusion, and A and B are forming a cartel in this situation (however, there are many laws in place to reduce the formations of cartels as much as possible, as it leads to the exploitation of consumers).

The relationship between oligopolies and game theory can be further explained through a payoff matrix. As an example, let us take 2 firms, A and B, who are 2 oligopolist firms selling the same product, and compare the absolute profits they make. Let us say both A and B price their products highly and make the same profit, Rs. 500. However, if one undercuts the other in price, they will attract more customers, sell more units and therefore earn more profit. If firm A price their product lesser than B, it will earn a higher profit of Rs. 750 while B earns reduced profits of only Rs. 250, and vice versa. If both A and B decide to cut their prices, they will both retain the same consumer base, but their profits will decrease to Rs. 350 each. In this situation, it seems like it makes sense for both the firms to price highly, earning higher profits in the process. However, the firms look at things differently. To them, pricing low makes sense, no matter what the other firm does. If firm A prices their products low and B prices their products highly, A will earn larger profits. If B prices their products lower, A will still earn the same amount of profit as B. In both cases, A gets the same profit as B or more, which wouldn’t be the case if A decided to price high. The same logic applies to B, meaning that they are also incentivized to price low. This is called dominant strategy, where the best possible outcome is attained no matter what the other person does.

Game theory is what helps businesses take important decisions in relation to their business to ensure that they receive the maximum possible profits. The beautiful thing about game theory is that since it relates to just the analysis of human behaviour in a competitive environment, the scope of game theory is much more than just in economics. All in all, it can be concluded that game theory is certainly no game or no child’s play. It is an interesting and complex topic, and the fortune of many large corporates and indeed the economy, depend on it.

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