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Competition Versus Collusion
A Nash equilibrium is a noncooperative equilibrium: Each firm makes decisions creating highest possible
profit, given actions of its competitors. The profit resulting is lower than it would be when firms colluded.
Firms could agree implicitly (e.g. secret price agreement) or explicitly (e.g. cartel) to maximize joint profits
(which means they would act as if together they were a monopoly)
Problem for firms: The agreed upon prices or quantities are not on the firms’ reaction curves.
⇒ each firm could increase her profit by unilaterally deviating from the agreement
In other words: collusive agreements (implicit or explicit) are not a Nash equilibrium.
⇒ such agreements are inherently unstable.
In deciding what price to set, the two firms are playing a noncooperative game : each firm independently
does the best it can, taken the competitor into account. A payoff matrix is useful in analyzing this game - it
is a table showing profit to each firm given its decision and the decision of its competitor.
Prisoner’s Dilemma
A classic example in game theory is the prisoner’s dilemma , a theory example in which two prisoners
must decide separately whether to confess to a crime; if a prisoner confesses, he will receive a lighter
sentence and his accomplice will receive a heavier one, but if neither confesses, sentences will be lighter
than if both confess.
Oligopolistic firms often have a strong desire for price stability. This is why price rigidity - firms are
reluctant to change prices - can be a characteristic of oligopolistic industries. Price rigidity is the basis of
the kinked demand curve model of oligopoly. This is the oligopoly model in which each firm faces a
demand curve kinked at the currently prevailing price: at higher prices demand is very elastic, whereas at
lower prices it is inelastic.
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Sometimes a pattern is established whereby one firm regularly announces price changes and other firms in
the industry follow suit. This pattern is called price leadership : Where one firm is implicitly recognized as
“the leader”.
In oligopolistic markets where one large firm has a major share of total sales, the larger firm might act as a
dominant firm , setting a price that maximizes its own profits.
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Chapter 13 Game Theory and Competitive Strategy
A Game is any situation in which players make strategic decisions - i.e., decisions that take into account
each other’s actions and responses. Strategic decisions result in payoffs to the players: outcomes that
generate rewards or benefits. A key objective for game theory is to determine the optimal strategy for each
player. A strategy is a rule or plan of action for playing the game.