Game Theory: A method used to analyze strategic behavior.
Oligopoly: A market structure with a few large firms engaging in strategic behavior to maximize profits.
Game theory is particularly useful in analyzing choices in oligopolies.
Duopoly Example
Duopoly: A scenario with only two competing firms, e.g., Rare Air and Uptown.
Firms have two strategies: high price and low price.
Payoff Matrix:
Four possible outcomes based on price strategies.
Blue area represents Rare Air's payoffs; yellow area represents Uptown's payoffs.
Outcomes:
Both firms choose high price: Outcome A
Both firms choose low price: Outcome D
Mixed choices: Outcomes B and C
Strategy Decisions
Firms make decisions based on the strategies of their competitors.
Example:
If Rare Air chooses a high price, Uptown's best strategy is a low price for higher profit.
If Rare Air chooses a low price, Uptown chooses low price for maximum profit.
Dominant Strategy: A strategy that yields the best results regardless of the opponent’s strategy. Here, both firms have a dominant strategy to choose low price.
Nash Equilibrium
Nash Equilibrium: An outcome where all players choose their dominant strategy.
Not always the best outcome. Cooperation could lead to better outcomes (e.g., both choose high price for higher profits).
Collusion
Collusion: Agreement among firms to fix prices or divide the market for higher collective profits.
Types:
Price fixing
Market division (e.g., dividing routes in airlines)
Collusion is illegal in the U.S.
Challenges to Collusion
Differences in production costs among firms.
Legal restrictions and prevention by antitrust laws.
Production quantities and communication issues.
Potential entry of new firms disrupting agreements.
Risk of cheating by firms to gain market share.
Non-Collusive Strategies
Strategies to increase collective profitability without formal agreements.
Price Matching: Informal understanding to follow price changes.
Price Leadership: A leading firm initiates price changes, followed by others.
Infrequent Price Changes: Keeping prices constant to maintain market division.
Conclusion
Non-collusive strategies help firms reach collusion outcomes without direct communication, thereby increasing profitability without legal risks.