Game theory in the oligopolistic decision making process
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Game theory we study in class can be applied to Oligopolistic pricing strategies in the business world. The key trait of game theory is that the decisions of one person are dependent on and will influence those of other participants. This is exactly the case in oligopolistic decision making. For oligopolistic firms, it is difficult to determine their product price and marginal revenue, because the quantity of product that be sold at a given price depends on product prices set by other firms in the oligopoly and their production quantity. Therefore, when one firm in oligopoly decides about their production quantity and price, they must consider the other firms’ actions.
If all firms produce too much, due to the demand-price principle, the price of the product will frop below their average total costs, and every firm loses. On the other hand, if they act together as a integral whole, and restrict their common quantity to when marginal cost = marginal revenue, the group can maximize their profit.
When oligopolistic firms work together as a whole, they will have a dominant strategy based on choices each firm makes that maximizes profit, and therefore reach a Nash Equilibrium. To reach maximum profit and efficiency, firms sometimes try to eliminate the guessing process in game theory and forms a cartel, where they agree on a profit-maximizing output, and sell at the ideal price. However, this is an ideal situation when there is no guesses. But since it’s a game, the result always remain unclear until the last second.
When firms form a cartel and sell at the agreed quantity and price, each firm gets Po for its product by restricting quantity to Qo(at this point each firm’s MR = MC output). Then each firm can earn the revenue bove its marginal cost: area 1+3. At this point, the oligopoly reachs the nash equilibrium.
However, if none of the cartel members cooperate, then most of them will over produce, the quantity increases to Qc, and the market price declines to the competitive price Pc. In this case, each firm will only earn a revenue of area 3+4.
The third situation is that when most of the firms cooperate, but one firm cheats, then it can earn area 1+2+3+4, by producing more than Po, which equals the quantity Qcheater.
Game theory is really fasinating in the way that it calculates results based on dynamic and interacting decisions and choices. It is even more thought-provoking when put into the real-world context of busniess.