Oligopoly (Game Theory and

Prisoner Theory)
Strategic Behavior
 Game Theory
– Players
– Strategies
– Payoff matrix
 Nash Equilibrium
– Each player chooses a strategy that is
optimal given the strategy of the other
player
– A strategy is dominant if it is always optimal
Game Theory
 Game theory has been used to describe
strategic behavior for members of an
oligopoly.
– Game is situation where 2 or more players
pursue their own self interest, and no one
player can dictate the outcome.
– Game is defined in terms of players rules,
information, strategy and payoffs.
 Lets look at the payoff matrix.
Payoff Matrix for Students
Do I cheat on the Collusive
Agreement? Do Others Cheat
No Yes
No

High Grade Low Grade

Do I Cheat

minimal effort minimal effort

Highest Grade Ave. Grade

Yes

Ave. Effort Ave. Effort

What Strategy Do You Use?
One possibility is Maximin Strategy:
Choose option which maximizes the worst you can do.
Do Others Cheat
No Yes
No

High Grade Low Grade

Do I Cheat

minimal effort minimal effort

Highest Grade Ave. Grade

Yes

Ave. Effort Ave. Effort

Dominant vs. Dominated
Strategy
 Dominant strategy is one that is optimal
no matter what an opponent decides to do.
– The maximin strategy is a dominant strategy
 Dominated strategy is one that is always
suboptimal to an alternative strategy no
matter what the opponent does.
 Not all games have a dominant or
dominated strategy.
– ie., your best choice may depend on what your
opponents do.
Players in these types of Games
face a “Prisoner’s Dilemma”
 There is a conflict between self-
interest versus collective-interest
– Ie., what is good for both parties
collectively is not what is best for each
individual.
– Look at example in book of a Prisoner’s
Dilemma on hiring a lawyer to negotiate
a dispute.
Look at Motivation to Collude
using Cartel Model
Competitive Market Structure

Firm Market
$ MC ATC $
S=MC

PC

q Q
qC QC
Suppose Market is Organized as
a Shared Monopoly

This is what a cartel does!

Cartel Market Structure

Firm Market
$ MC ATC $
S=MC

PM
PC

D
MR
q Q
qC QM QC
 Firm Required to reduce its
output proportionately
Firm Market
$ MC ATC $
S=MC

PM
PC

D
MR
q Q
qM qC QM QC
 For Firm, MR>MC
(assuming other firms hold to agreement)
Firm Market
$ MC ATC $
MR S=MC

PM
PC

D
MC MR
q Q
qM qC QM QC
Firm’s Most Desirable Point!

Firm Market
$ MC ATC $
S=MC

PM
PC

D
MR=MC MR
q Q
qM qC q1 QM QC
Cartels and Game Theory
Do Others Cheat
No Yes

Pure Profits Pure losses for me

No

for all members Profits for others

Do I Cheat

Highest Profits for me Normal Profits

Yes

Losses for others for everyone

Thus: If all firm’s cheat, we get
back to competitive world!

These structures frequently self-destruct!

Economists are surprised when these survive!
 Game Theory

Advertising Example

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses to
advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise,
the payoff is 2. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise,
the payoff is 3. Again, the optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
Regardless of what Firm B decides to do, the optimal
strategy for Firm A is to advertise. The dominant strategy
for Firm A is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses to
advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise,
the payoff is 1. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?
If Firm B chooses to advertise, the payoff is 5. Otherwise,
the payoff is 2. Again, the optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
Regardless of what Firm A decides to do, the optimal
strategy for Firm B is to advertise. The dominant strategy
for Firm B is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory
The dominant strategy for Firm A is to advertise and the
dominant strategy for Firm B is to advertise. The Nash
equilibrium is for both firms to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Game Theory

A Second Advertising Example

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses to
advertise?
If Firm A chooses to advertise, the payoff is 4. Otherwise,
the payoff is 2. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm A if Firm B chooses
not to advertise?
If Firm A chooses to advertise, the payoff is 5. Otherwise,
the payoff is 6. In this case, the optimal strategy is not to
advertise.
Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
The optimal strategy for Firm A depends on which strategy
is chosen by Firms B. Firm A does not have a dominant
strategy.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses to
advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses to
advertise?
If Firm B chooses to advertise, the payoff is 3. Otherwise,
the payoff is 1. The optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
What is the optimal strategy for Firm B if Firm A chooses
not to advertise?
If Firm B chooses to advertise, the payoff is 5. Otherwise,
the payoff is 2. Again, the optimal strategy is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
Regardless of what Firm A decides to do, the optimal
strategy for Firm B is to advertise. The dominant strategy
for Firm B is to advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (6, 2)
 Game Theory
The dominant strategy for Firm B is to advertise. If Firm B
chooses to advertise, then the optimal strategy for Firm A
is to advertise. The Nash equilibrium is for both firms to
advertise.

Firm B
Advertise Don't Advertise
Advertise (4, 3) (5, 1)
Firm A
Don't Advertise (2, 5) (3, 2)
 Prisoners’ Dilemma

Two suspects are arrested for armed robbery. They are

immediately separated. If convicted, they will get a term
of 10 years in prison. However, the evidence is not
sufficient to convict them of more than the crime of
possessing stolen goods, which carries a sentence of
only 1 year.
The suspects are told the following: If you confess and
your accomplice does not, you will go free. If you do not
confess and your accomplice does, you will get 10
years in prison. If you both confess, you will both get 5
years in prison.
 Prisoners’ Dilemma

Payoff Matrix (negative values)

Individual B
Confess Don't Confess
Confess (5, 5) (0, 10)
Individual A
Don't Confess (10, 0) (1, 1)
 Prisoners’ Dilemma

Dominant Strategy
Both Individuals Confess
(Nash Equilibrium)

Individual B
Confess Don't Confess
Confess (5, 5) (0, 10)
Individual A
Don't Confess (10, 0) (1, 1)
 Prisoners’ Dilemma

Application: Price Competition

Firm B
Low Price High Price
Low Price (2, 2) (5, 1)
Firm A
High Price (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Price Competition

Dominant Strategy: Low Price

Firm B
Low Price High Price
Low Price (2, 2) (5, 1)
Firm A
High Price (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Nonprice Competition

Firm B
Advertise Don't Advertise
Advertise (2, 2) (5, 1)
Firm A
Don't Advertise (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Nonprice Competition

Dominant Strategy: Advertise

Firm B
Advertise Don't Advertise
Advertise (2, 2) (5, 1)
Firm A
Don't Advertise (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Cartel Cheating

Firm B
Cheat Don't Cheat
Cheat (2, 2) (5, 1)
Firm A
Don't Cheat (1, 5) (3, 3)
 Prisoners’ Dilemma

Application: Cartel Cheating

Dominant Strategy: Cheat

Firm B
Cheat Don't Cheat
Cheat (2, 2) (5, 1)
Firm A
Don't Cheat (1, 5) (3, 3)
Extensions of Game Theory
• Repeated Games
– Many consecutive moves and
countermoves by each player
• Tit-For-Tat Strategy
– Do to your opponent what your
opponent has just done to you
Extensions of Game Theory
• Tit-For-Tat Strategy
– Stable set of players
– Small number of players
– Easy detection of cheating
– Stable demand and cost
conditions
– Game repeated a large and
uncertain number of times
Extensions of Game Theory
• Threat Strategies
– Credibility
– Reputation
– Commitment
– Example: Entry deterrence
 Entry Deterrence

No Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (7, 2) (10, 0)

Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (3, 2) (8, 0)
 Entry Deterrence

No Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (7, 2) (10, 0)

Credible Entry Deterrence Firm B

Enter Do Not Enter
Low Price (4, -2) (6, 0)
Firm A
High Price (3, 2) (8, 0)
 International Competition

Boeing Versus Airbus Industrie

Airbus
Produce Don't Product
Produce (-10, -10) (100, 0)
Boeing
Don't Produce (0, 100) (0, 0)
THANK YOU