Game Theory: study of how people/firms behave in strategic situations
Game Theory Model: can be used to analyse the behaviour of oligopolists
(duopoly is assumed)
Payoff Matrix: multiple-celled chart with each cell divided into halves, showing the multiple possible scenarios influenced by the decision of two firms. You only need to know how to use a 4 celled matrix for now.
Dominant Strategy: A strategy that's best for the player in a game regardless by strategy chose by another player.

Example of a Game Theory Model (using prisoners):



Mutual Interdependence Revisited:

• Oligopolistic firms can influence rival's profits by changing pricing strategies
• Each firm's profit depends on their pricing strategy in relation to their rival's
• Firms make decisions based on how they think other firms will react. They anticipate the next move.

Collusion Tendencies

• Collusion: cooperation between firms to achieve benefits. It is usually ILLEGAL!!!
  • Firms can cooperate and decide on pricing strategies that will provide benefits for both
  • Without collusion, firms may end up in price wars, where their profits decrease significantly
  • When firms work together, they act as one big monopoly power, charging a monopoly price and earning a monopoly profit.
  • It may be legal when firms communicate about where they will put their stores, and not about money.

• Obstacles to collusion
  • Demand and cost differences
  • Number of firms
  • Cheating
  • Recession
  • Potential Entry
  • Legal Obstacles: Antitrust Law

Incentive to Cheat

• Oligopolists are strongly tempted to cheat on collusive agreements
• If two firms agree to set a certain price, one firm may secretly change their price in an attempt to attract more consumers than the rival firm
• Agreements are easier to make between a few firms because it is easier to track if firms begin to cheat. it is harder for a larger amounts of firms to make an agreement.
• This incentive also works with advertisements; if two firms both agree not to increase advertising, both have an incentive to then cheat and begin making more advertisements anyway.