strategies is driving them to low prices and low profits. One might ask, Why
can’t the firms achieve the beneficial, high-price outcome? The answer is
straightforward. To set a high price, anticipating that one’s rival will do likewise,
is simply wishful thinking. Although high prices are collectively beneficial, this
outcome is notan equilibrium. Either firm could (and presumably would) prof-
itably undercut the other’s price. An initial high-price regime quickly gives way
to low prices. As long as the firms act independently, the profit incentive drives
down prices.
Before leaving this example, we make an additional point. The strategic
behavior of rational firms can be expected to depend not only on the profit
stakes as captured in the payoff table but also on the “rules” of the competi-
tion.^8 In the present example, the rules have the firms making their price deci-
sions independently. There is no opportunity for communication or collusion.
(In fact, any kind of price collusion is illegal under U.S. antitrust laws.) We say
that the firms behave noncooperatively.However, the “rules” would be quite dif-
ferent if the firms were the two largest members of an international cartel.
Opportunities for communication and collusion would be freely available.
Clearly, the firms would strive for a cooperativeagreement that maintains high
prices. However, it is worth remembering a lesson from Chapter 8’s analysis of
cartels: A collusive agreement can facilitate a mutually beneficial, cooperative
outcome, but it hardly guarantees it. Cartels are unstable precisely because of
the individual incentives to cut price and cheat. Thus, even a collusive agree-
ment is not ironclad.370 Chapter 9 Oligopoly(^8) The example of price competition also serves as an introduction to game theory. Payoff tables, the
rules of the game, and the analysis of optimal strategies are all topics taken up in greater depth in
Chapter 10.
CHECK
STATION 3
In the price war, suppose that some consumers display a strong brand allegiance for one
firm or the other. Consequently, any price difference between the duopolists is expected
to produce a much smaller swing in the firms’ market shares. Specifically, suppose that
if one firm charges a price of $6 and the other $8, the former sells 4 million units and
the latter 2 million (instead of the original 6 million and 1.25 million sales). All other facts
are as before. How does this change the payoffs in Table 9.2? What price should each
firm set? Explain.
THE PRISONER’S DILEMMA So frequent are situations (like the preceding
example) in which individual and collective interests are in conflict that they
commonly are referred to as the prisoner’s dilemma. The origin of the term
comes from a well-known story of two accomplices arrested for a crime. The
police isolate each suspect in a room and ask each to confess and turn state’s
evidence on the other in return for a shortened sentence. Table 9.3 shows the
possible jail terms the suspects face. If the police can garner dual confessions,
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