Game Theory in Oligopolies and Collusion
http://www.slideshare.net/tutor2u/oligopoly-collusion-and-game-theory
This article provides an interesting insight on how firms might behave given the opportunity to collude and form oligopolies by using game theory. In the prisoner’s dilemma, the dominant strategy of the prisoner is to confess, and both prisoners confessing is a Nash equilibrium. However, this is not the best outcome for both parties. The prisoner’s dilemma is based on independent decision making. Each prisoner’s payoff is based on self-interest, so they do not base their decisions on the mutual interest both prisoners even though it would lead to a better outcome for both players than the Nash equilibrium. Firms in a competitive market economy serve as analogs to the two prisoners. The firms’ control over their output is reflected in this payoff matrix.
The top left is the Nash equilibrium of the matrix, and high output is the dominant strategy. Just as in the prisoner’s dilemma, the Nash equilibrium is bad for both parties. Both firms having high output results in saturation of supply and both firms making less money than if both had low output. However, if both firms act independently of the other, each firm is forced into the Nash equilibrium.
This payoff matrix of price points is another example of a Nash equilibrium that is bad for both firms. The dominant strategy for both firms is to keep a high price point, so both firms will do so and make no money.
If the firms decided acted in mutual interest and colluded to fix supply and price points, they could form an oligopoly and control the market together. This would be analogous to the two prisoners communicating in secret to both remain silent for mutual benefit. It is for this reason that the US government has outlawed collusion. This forces firms to decide independently of one another, keeping the market stable.