OLIGOPOLISTIC COMPETITION AND GAME THEORY (2023)

Game theoryis a theoretical framework for conceiving social situations among competing players. In some respects,game theoryis the science of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting.Applying game theory to Oligopolistic competietion help the industry to achieve optimal profits. It also helps the consumer to understand the functioning of oligopolistic industries

Part-1 Oligopoly:

There are basically four different types of Market Structures. They vary based on factors such as No. of Producers, Control over prices, and Barriers to Entry in to the market. Perfect Competition, Monopoly, Monopolistic Competition, Oligopoly.

Oligopoly is a market situation wherein there are few large companies which control the market, and the market has high entry barriers. They are visible all around us. For example, a vast majority of Smartphone market is controlled by Apple, Huawei and Samsung. This is also visible in industries such as FMCG, Air travel, OTT Distributors, Gaming Consoles, etc.,

Oligopolies often sell products that are similar, but not identical, and this gives them some control over their prices. But the main question that comes is “how much”? You may love your PS-5 but if it is priced much higher above the Xbox, you may tend to shift to an Xbox. So, the prices of both these products are kept quite close. And since they can’t compete on price, they tend to compete on non-price factors.

Non-price competition is a marketing strategy wherein one firm tries to differentiate its products / services from that offered by the competing ones on the basis of attributes like style, design, craftsmanship, location, customization, advertising, convenience, branding, etc., Players in oligopolies rely more on Advertising compared to the ones in other forms of market situations because there is no point in advertising in a perfect competition, where the product/service is identical to that of others, and advertising would only increase the costs. Monopolies don’t bother to advertise, as there is no need to advertise.

So, oligopolies look like they operate pretty much like monopolistic competition, but the big difference being that the oligopolies are made up of few large companies. This means that each company has to make decisions with the actions of its competitors in mind, and Game Theory is a tool which Companies use for this.

OLIGOPOLISTIC COMPETITION AND GAME THEORY (1)

Part-2: Game Theory:

(Video) Game Theory and Oligopoly: Crash Course Economics #26

Game theory is a mathematical approach to modelling behaviour by analysing the strategic decisions made by interacting players. It can be explained in simpler words using a classical example called “Prisoner’s Dilemma.” The Prisoner’s Dilemma is a paradox in decision analysis in which two individuals acting in their own self-interests do not produce the optimal outcome. It shows that two completely rational individuals may not co-operate, even if it appears that it is in their best interests to do so.

OLIGOPOLISTIC COMPETITION AND GAME THEORY (2)

Imagine two people Ram and Rahul are suspects in a robbery, and are arrested by police who can place both of them at the scene of crime but can’t convict either of them. Both are placed in isolated interrogation cells. A prosecutor comes to the interrogation cells and makes them the following offer.

(1) if both confess, both go to jail for five years;

(2) if neither confesses, both go to jail for one year (for carrying concealed weapons); and

(3) if one confesses while the other does not, the confessor goes free (for turning state’s evidence) and the silent one goes to jail for 20 years.

The Dilemma of both the prisoners can now be analysed superficially as follows:

Although Ram cannot be sure what Rahul will do, he knows that he does best to confess when Rahul confesses (he gets five years rather than 20) and also when Rahul remains silent (he serves no time rather than a year); Analogously, Rahul will reach the same conclusion. So, the solution would seem to be that each prisoner does best to confess and go to jail for five years.

(Video) Oligopoly and Game Theory- Micro Topic 4.5

Paradoxically, however, the two robbers would do better if they both adopted the apparently irrational strategy of remaining silent; each would then serve only one year in jail. The irony of Prisoners Dilemma is that when each of two (or more) parties acts selfishly and does not cooperate with the other (that is, when he confesses), they do worse than when they act unselfishly and cooperate together (that is, when they remain silent).

Prisoners Dilemma is not just an intriguing hypothetical problem; real life situations with similar characteristics can be observed too often than not. For example, two shopkeepers engaged in a price war may well be caught up in a similar situation. Each shopkeeper knows that if he has lower prices than his rival, he will attract his rival’s customers and thereby increase his own profits. Each therefore decides to lower his prices, with the result that neither gains any customers and both earn smaller profits. Similarly, nations competing in an arms race and farmers increasing crop production can also be seen as manifestations of Prisoner’s Dilemma. When two nations keep buying more weapons in an attempt to achieve military superiority, neither gains an advantage and both are poorer than when they started. A single farmer can increase his profits by increasing production, but when all farmers increase their output a market glut ensues, with lower profits for all.

Part-3: Game Theory in Oligopoly:

Studying both Oligopoly and the Game theory together can explain why prices in oligopoly tend to not lower, despite how hard the companies are trying to compete, and why companies focus so much on non-price competition.

In any of the above scenarios, if the participating individuals understand Game Theory, they would all know that there is no need to compete on price/ confess to their crime, and Instead, they agree to charge the same higher rates and focus on providing knick-knacks, bells and whistles, that differentiate their product from that of the competitor. Neither of the participants may attract a greater number of customers than they previously used to, but all of them tend to enjoy higher profits, benefitting at the expense of consumers.

Imagine a scenario when smartphone makers Orange and Banana are competitors. Each can set prices high or low. The outcome of profit in each scenario can be shown as follows:

OLIGOPOLISTIC COMPETITION AND GAME THEORY (3)

A superficial analysis can show that any of the following outcomes are possible

(Video) Y2 24) Oligopoly - Game Theory

1.If Orange charges low price and Banana Charges high price: Orange will gain a profit of 3,000 compared to Rs. 500 earned by Banana. (Combined profit Rs.3,500)

2.If Banana charges low price and Orange charges high price: Banana will gain a profit of 3,000 compares to Rs. 500 earned by Orange. (Combined profit Rs. 3,500)

3.If both Banana and Orange charge low prices, they will gain a profit of Rs. 800 each (combined of Rs. 1600).

4.However, if they both charge a higher price, then they would earn a profit of Rs. 2,000 each (combined profit of Rs. 4,000).

At a starting point, from the perspective of Orange, when Banana is charging high prices, it may appear to Orange that the most beneficial strategy (a.k.a. Dominant Strategy) is to reduce the prices wherein it can earn a higher profit. And the same holds good from the perspective of Banana. And both these Companies tend to follow their Dominant strategies, and start to lower the prices.

However, if these Companies study Game Theory, they would understand that when they go ahead with their Dominant positions, the final outcome would be resultantly diabolical for both of them and tend to maintain the prices and compete on aspects other than price. While the payoffs may not be as transparent as given in the example the matrix says a lot about how oligopolies operate. It shows how the outcome is optimal when both the companies to charge higher prices.

Game theory helps Companies make decisions, suggesting that what prima-facie appears to be the best, may not lead to the best outcome in a grand scheme of things. But the potential outcomes are never easy to predict. And there are many scenarios when there is a no clear dominant strategy. Sometimes the best response changes depending on what competitors do, and those who adopt / those who don’t keep up and slow to adapt are pushed aside.

References:

(Video) Oligopolies and Game Theory- EconMovies #8: The Dark Knight

Stuart Rosenberg, Patrick O’Halloran(2014): Firm Behavior In Oligopolistic Markets: Evidence From A Business Simulation Game

Bruno Pellegrino, (2019). Product Differentiation and Oligopoly: a Network Approach

Akbar, Tanzila. (2017). Research Paper- Economics and Game theory. Paper.

Ben-Zvi, S. and Helpman, E. (1992). Oligopoly in segmented markets. In Grossman, G. M., editor, Imperfect competition and international trade

Richard Pomfret (1992). International Trade Policy with imperfect competition.

https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/behavioral-game-theory/#:~:text=Game%20theory%20is%20a%20mathematical,self%2Dinterested%2C%20rational%20maximizer.

Hewig J., Kretschmer N., Trippe R. H., Hecht H., Coles M. G. H., Holroyd C. B., et al. . (2011).Why humans deviate from rational choice.

https://imotions.com/blog/game-theory-introduction-examples/

(Video) 4.6 Oligopolistic Competition

FAQs

How does game theory relate to oligopolies? ›

In an oligopoly, firms are affected not only by their own production decisions, but by the production decisions of other firms in the market as well. Game theory models situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.

What is game theory strategy of oligopoly pricing problem? ›

When firms in an oligopoly must decide about quantity and pricing, they must consider what the other firms will do, since quantity and price are inversely related. If all the firms produce too much, then the price may drop below their average total costs, causing them losses.

What is oligopolistic competition? ›

a competitive situation in which there are only a few sellers (of products that can be differentiated but not to any great extent); each seller has a high percentage of the market and cannot afford to ignore the actions of the others.

What is an example of oligopolistic competition? ›

Automobile manufacturing is another example of an oligopoly, with the leading auto manufacturers in the United States being Ford (F), GM, and Stellantis (the new iteration of Chrysler through mergers).

Which type of game theory do we normally use in oligopoly theory? ›

Use simple game theory to illustrate the interdependence that exists in oligopolistic markets. Understanding the prisoners' dilemma and a simple two firm/two outcome model.

Why is game theory used to Analyse the Behaviour of an oligopoly firm? ›

It is because, under oligopoly, the outcome of decisions of any particular firms is influenced by the actions taken by the rivalries. Therefore, the Game theory is an efficient tool to analyze the outcome depending of different strategies that rivalry can opt.

What are the three theories of oligopolistic pricing? ›

There are 3 basic theories about oligopolistic pricing: kinked-demand theory, or non-collusive oligopoly, the cartel model, and the price leadership model.

What is an example of game theory in economics? ›

The prisoner's dilemma is a classic example of game theory.

If they both confess, they get 5 years each. However, if one confesses to the crime and betrays the other, then the one who confesses is given immunity for giving information. But the other who remained silent gets 20 years.

What is oligopoly short answer? ›

An oligopoly is a market characterized by a small number of firms who realize they are interdependent in their pricing and output policies. The number of firms is small enough to give each firm some market power.

What are the characteristics of oligopolistic competition? ›

What are the characteristics of oligopoly in economics? Oligopoly characteristics include high barriers to new entry, price-setting ability, the interdependence of firms, maximized revenues, product differentiation, and non-price competition.

What is the oligopoly theory? ›

The oligopoly theory usually refers to the partial equilibrium study of markets in which the demand side is competitive, while the supply side is neither monopolized nor competitive. It is exclusively concerned with single period models.

Which is the best example of an oligopolistic market? ›

The best illustration of an oligopoly is the automobile industry. An oligopoly is a market with imperfect competition in which a few major businesses dominate the industry as the automobiles industry dominates numerous others by providing identical goods and services.

Why is oligopoly common? ›

Why do oligopolies exist? The biggest reason why oligopolies exist is collaboration. Firms see more economic benefits in collaborating on a specific price than in trying to compete with their competitors.

Why is game theory needed to study oligopolies but not perfectly competitive markets? ›

In an oligopolistic market though, sellers have a lot of market power each and thus, game theory is incredibly useful as you must determine how to change your output given that the actions of others affect you and your actions affect them.

What is the best game theory strategy? ›

One of the most popular and basic game theory strategies is the prisoner's dilemma. This concept explores the decision-making strategy taken by two individuals who, by acting in their own individual best interest, end up with worse outcomes than if they had cooperated with each other in the first place.

Which method is used for game theory? ›

Modern game theory began with the idea of mixed-strategy equilibria in two-person zero-sum game and its proof by John von Neumann. Von Neumann's original proof used the Brouwer fixed-point theorem on continuous mappings into compact convex sets, which became a standard method in game theory and mathematical economics.

What is the importance of game theory? ›

Game theory is a field of study that helps us understand decision making in strategic situations. In addition to being an important methodology within the economics discipline, it also gives insights into pricing and management strategies used by a business.

Why is game theory important in business? ›

If forecasts are accurate, game theory provides a mathematical framework to analyze the course of action most likely to yield the desired outcomes. Such preparation helps leaders make informed choices regarding everything from pricing and product launches to target market selection and marketing campaigns.

Why is game theory important in business decisions? ›

Game theory can help companies make strategic choices within or outside of their organizations, especially against competitors. Different situations are presented through simple games that set up hypothetical scenarios meant to simulate real-world conditions and predict a player's behavior.

What are the four types of oligopoly? ›

Types of oligopoly
  • Pure oligopoly.
  • Imperfect oligopoly.
  • Open oligopoly.
  • Closed oligopoly.
  • Collusive oligopoly.
  • Competitive oligopoly.
  • Partial oligopoly.
  • Total oligopoly.
17 Dec 2021

What are the 3 oligopoly models? ›

We have now covered three models of oligopoly: Cournot, Bertrand, and Stackelberg. These three models are alternative representations of oligopolistic behavior. The Bertand model is relatively easy to identify in the real world, since it results in a price war and competitive prices.

How does game theory affect everyday life? ›

Other examples of using game theory to make a decision in everyday life is when to change lanes in traffic, when to ask for something, or even when to wash the dishes. Although the aspect of game theory is more apparent in some examples compared to others, there is still an aspect of it in most decisions we make.

What are the two types of game theory? ›

Cooperative vs non-cooperative game theories

Cooperative and non-cooperative game theories are the most common types of game theory. Cooperative game theory looks at how cooperative groups, or coalitions, interact when only the payoffs are known.

What is game theory in simple terms? ›

Game theory studies interactive decision-making, where the outcome for each participant or "player" depends on the actions of all. If you are a player in such a game, when choosing your course of action or "strategy" you must take into account the choices of others.

Why is it called game theory? ›

They observed that economics is much like a game, wherein players anticipate each other's moves, and therefore requires a new kind of mathematics, which they called game theory. (The name may be somewhat of a misnomer—game theory generally does not share the fun or frivolity associated with games.)

What are the functions of oligopoly? ›

The distinctive feature of an oligopoly is interdependence. Oligopolies are typically composed of a few large firms. Each firm is so large that its actions affect market conditions. Therefore, the competing firms will be aware of a firm's market actions and will respond appropriately.

What are the benefits of oligopoly? ›

They include the following pros:
  • low level of competition;
  • high potential to receive big profits;
  • a great demand for products and services controlled through oligopolies;
  • a limited number of companies makes it easier for customers to compare and choose products;
  • more competitive prices;
28 Oct 2022

How do you identify an oligopoly? ›

Oligopolies may be identified using concentration ratios, which measure the proportion of total market share controlled by a given number of firms. When there is a high concentration ratio in an industry, economists tend to identify the industry as an oligopoly.

What is the most important characteristic in oligopolistic market? ›

The market is highly concentrated. The term oligopoly is derived from the Greek word. They produce products which are homogeneous and are not close substitutes. The most important characteristic of oligopoly is interdependence because they are dependent on each other.

Why is it called oligopoly? ›

Oligopoly means few sellers. In an oligopolistic market, each seller supplies a large portion of all the products sold in the marketplace. In addition, because the cost of starting a business in an oligopolistic industry is usually high, the number of firms entering it is low.

Why is oligopoly important in business? ›

By controlling prices, oligopolies are able to raise their barriers to entry and protect themselves from new potential entrants into the market. This is quite important, as new firms may offer much lower prices and thus jeopardize the longevity of the colluding firms' profits.

How do oligopoly set prices? ›

Understanding Oligopolies

Firms in an oligopoly set prices, whether collectively—in a cartel—or under the leadership of one firm, rather than taking prices from the market. Profit margins are thus higher than they would be in a more competitive market.

Is oligopoly good for society? ›

The market power of an oligopoly is such that it bars entry to new firms, limiting competition, and is generally bad for consumers because it causes higher prices.

Why oligopoly is the best market structure? ›

The primary idea behind an oligopolistic market (an oligopoly) is that a few companies rule over many in a particular market or industry, offering similar goods and services. Because of a limited number of players in an oligopolistic market, competition is limited, allowing every firm to operate successfully.

Is the video game industry an oligopoly? ›

It's a perfectly competitive market economy. While the AAA industry has long been an oligopoly with relatively few firms and high barriers to entry, it has been disrupted by digital distribution and self-publishing.

How does game theory relate to firms? ›

Game theory offers a way of modeling firms' decisions as optimal strategies in simple games. This allows economists to study market pressures and optimal strategies. Using this structure we can analyze the options players are considering and why they have the incentive to choose a particular option.

How does game theory apply to economics? ›

In economics, game theory attempts to determine equilibrium solutions subject to the rational behavior of market players. These participants are bound by conceivable situations which establish the rules of behavior in any situation.

How is an oligopoly similar to the game of Prisoners dilemma? ›

If both players had denied the crime, they would each be serving only one year in prison. Similarly to the prisoner's dilemma scenario, cooperation is difficult to maintain in an oligopoly because cooperation is not in the best interest of the individual players.

What market is game theory? ›

In economic theory, a strategic market game, also known as a market game, is a game explaining price formation through game theory, typically implementing a general equilibrium outcome as a Nash equilibrium.

Is Netflix an example of oligopoly? ›

The market structure that Netflix operates under is an oligopoly. In an oligopoly, there are a few companies that control the entire market. In the streaming market, Netflix, Hulu, and Amazon Are the main competitors.

Is Walt Disney An example of oligopoly? ›

According to the letter of the law, Disney is an oligopoly, a state of limited competition in which a market is shared by a small number of producers or sellers. Disney seems like a monopoly because it's the home of some of the most recognizable brands the world has seen.

What is the importance of game theory in business? ›

Game theory can help companies make strategic choices within or outside of their organizations, especially against competitors. Different situations are presented through simple games that set up hypothetical scenarios meant to simulate real-world conditions and predict a player's behavior.

What is the purpose of game theory? ›

Game theory is a framework for understanding choice in situations among competing players. Game theory can help players reach optimal decision-making when confronted by independent and competing actors in a strategic setting.

What is an example of game theory in the economics? ›

The prisoner's dilemma is a classic example of game theory.

If they both confess, they get 5 years each. However, if one confesses to the crime and betrays the other, then the one who confesses is given immunity for giving information. But the other who remained silent gets 20 years.

What is game theory explain with suitable example? ›

game theory, branch of applied mathematics that provides tools for analyzing situations in which parties, called players, make decisions that are interdependent. This interdependence causes each player to consider the other player's possible decisions, or strategies, in formulating strategy.

How does oligopoly help in their decision making? ›

Therefore, when one firm in oligopoly decides about their production quantity and price, they must consider the other firms' actions. If all firms produce too much, due to the demand-price principle, the price of the product will frop below their average total costs, and every firm loses.

What does the prisoners dilemma teach us about oligopolies? ›

The prisoner's dilemma is a scenario in which the gains from cooperation are larger than the rewards from pursuing self-interest. It applies well to oligopoly. The story behind the prisoner's dilemma goes like this: Two co-conspiratorial criminals are arrested.

What happens if oligopolists compete hard against each other? ›

If oligopolists compete hard, they may end up acting very much like perfect competitors, driving down costs and leading to zero profits for all. If oligopolists collude with each other, they may effectively act like a monopoly and succeed in pushing up prices and earning consistently high levels of profit.

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