Some Simple Game Theory
Game theory is used to study decision making in situations in which
there are a number of players, each knowing that others may react to
their actions and each taking account of others’ expected reactions when
making moves. For example, suppose a firm selling a differentiated
product is deciding whether to raise, lower, or maintain its price. Before
arriving at an answer, it asks, “What will the other firms do in each of
these cases, and how will their actions affect the profitability of whatever
decision I make?”
When game theory is applied to oligopoly, the players are firms, their game is played in the
market, their strategies are their price or output decisions, and the payoffs are their profits.An illustration of the basic dilemma of oligopolists, to cooperate or to
compete, is shown in Figure 11-3 for the case of a two-firm oligopoly,
called a duopoly. In this simplified game, we assume that both firms are
producing an identical product, and so there is a single market price. The
only choice for each firm is how much output to produce. If the two firms
“cooperate” to jointly act as a monopolist, each firm produces one-half of
the monopoly output and each earns large profits. If the two firms
“compete,” they each produce more than half (say two-thirds) of the
monopoly output, and in this case both firms earn low profits. As we will
see, even this very simple example is sufficient to illustrate several key
ideas in the modern theory of oligopoly.