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Business Economics: Game Theory
Business Economics: Game Theory
the interest of public welfare. In a national economy, there are mainly three types of
economic system. There are command economy, free-market economy and mixed
economy. Many of the countries adopted a mixed economy system; this means that some
co-ordinations are planned while others are left to the market. Most of the decisions are
de-centralized while there are some decisions made centrally. The factors of production,
capital, land and labor, are own mainly private but some owned by the public. The
monopolistic, oligopoly and monopoly. It is the interest of this paper to look at oligopoly.
In an oligopoly market structure, there are a few large firms and there is a significant
In this market, the one different characteristic compare to perfect competition and
monopoly is strategic interdependence. In oligopoly, the action of firm A will affect firm
B, similarly the action of firm B will affect firm A. The firms in this market will act and
Economist therefore, has built a model to study oligopoly. The model is called the game
theory. Game theory has a military root. It is a mathematical analysis of strategy. The
analysis is done by putting oneself into the shoes of all the players. By doing so, one can
predict the behavior of each player and advise the best strategy.
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In this case of efficiency, Pareto efficient would be the main concern. Pareto
efficient is concerned with how resources are allocated. A resource allocation is Pareto
efficient when resources cannot be re-allocated to make one person better off without
equilibrium point and whether the market is efficient. In equilibrium, the concept
proposed by John Forbes Nash, later name after him Nash equilibrium, states that each
player will always make the best decision taking into account the decision made by the
opponent.
The assumptions made by economists are name as the rule of the game. There are
five rules to the game, the player, the action, the outcome, the information and the
communication. The player is an individual, a firm or a nation that make decisions. The
actions are all the alternatives between which players decide. The outcomes are all
possible combinations of all players’ possible moves. All the players will have payoffs.
The information is what players know about their opponents, actions and payoffs. The
communication is whether players can make binding agreements e.g. collude with each
other.
The most popular game is known as “The Prisoner’s Dilemma” and there is also
other game such as “Chicken Game”. In this article, only “The Prisoner’s Dilemma”
game will be discussed and analyzed to study the interaction between firms in oligopoly
market structure.
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The Prisoner’s Dilemma
“The Prisoner’s Dilemma” game is the result of two players not trusting each
other. This can be understood by looking at a typical petrol station price war. The owner
of the pump station Shell and owner of the Exxon may come together to collude on the
per liter price they would sell to the consumer. Since, colluding is illegal; therefore there
Even after the verbal agreement between both owners, there are in reality two
options that each of them can decide to take: to set a high price as agree to collude or to
In this example, the following assumptions are made: both station charged
SGD1.60 per liter and sell 5000 liters per day. A research done by an independent
company shows that if the station charged SGD1.50 per liter, it is possible to sell 7500
liters per day. If both stations decided to cut price to SGD1.50 per liter, then both stations
The assumptions above indicates that the profit taken by both stations if they sell
at SGD1.60 per liter is SGD1.60 per liter multiply by 5000 liters equal to SGD8000 per
day. If one of the stations decided to drop price to SGD1.50 while the other station
remained at SGD1.60, the station which dropped the price would capture 7500 liters per
day and leaving 2500 liters per day to the station which did not drop the price. Therefore,
the profit taken by station that dropped the pump price is SGD1.50 per liter multiply by
7500 liters equal to SGD11250 per day. While the profit taken by the other station that
did not drop the pump price is SGD1.60 per liter multiply by 2500 liters equal to
SGD4000 per day. Finally, when both stations decided to have a price war, both will drop
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the pump price to SGD1.50 per liter. Therefore, the profit taken by both firms is SGD1.50
From the data gathered above, a table can be constructed to analyze how each
Exxon
Here is how the analysis done, Shell’s best reply to Exxon when Exxon is
charging SGD1.60 per liter is to drop price to SGD1.50 per liter, because the profit
On the other hand, if Exxon is charging SGD1.50 per liter than the best reply by
Shell is also charging SGD1.50 per liter. This is because the profit SGD7500 is greater
Similarly, for Exxon, the best reply to Shell if Shell was charging SGD1.60 per
liter is to charge SGD1.50 per liter. Again, looking at the profit, when Exxon charge
SGD1.50 per liter knowing that Shell will charge SGD1.60 per liter, the profit is
SGD11250 which is greater than SGD8000. So the best reply for Exxon is to drop pump
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The same strategies apply, if Shell dropped price to SGD1.50, Exxon will also
drop the price to SGD1.50, because the profit SGD7500 is greater than SGD4000.
Both Shell and Exxon will always play the best option that is by dropping the
price to SGD1.50. It can be observed from the table, the profit SGD7500 being underline,
this means Nash equilibrium for Shell and Exxon. It can be observed that at this point,
Nash equilibrium, it is not Pareto efficient. If both firms colluded and fixed the price at
Studies show that the best way to play “The Prisoner’s Dilemma” game is by “Tit-
for-Tat” strategy. Tit-for-tat is “A type of trigger strategy usually applied to the repeated
Prisoner's Dilemma in which a player responds in one period with the same action her
Tit-for-tat can be played by Shell and Exxon and both will gain profit greater than
if they played a defected strategy. The game starts by Shell and Exxon charging SGD1.60
per liter. Since both companies are being nice to each other and would not drop price,
Shell may first to break and start to lower pump price to SGD1.50 per liter, so
Exxon should follow. After some times, Shell increases the price back to SGD1.60 per
Exxon may break from the lower pump price and charge SGD1.60 per liter. In this
case, Shell should follow and increase the pump price to SGD1.60 per liter. When both
companies always follow what the other company is doing there will not be fierce price
war that may drive the company profit down. In the long run, the profit make by both
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Limitation of Game Theory
In the case of Shell and Exxon price war, according to Nash equilibrium, the best
way to play the game is for both petrol stations to drop the price to SGD1.50. This means
that both firms play the best response towards what the opponent would do. This may be
mathematically true but this is irrational. Player, such as firms make rational decision, as
such there is a high chance that firm will choose to charge SGD1.60 because at the end of
the day both firm make higher profit compare to charging SGD1.50. Therefore, in the
game theory, the rational behavior of the player is not taken into consideration. This has
broken the first assumption where player simply make decision but rather player make
rational decision.
we simply state that player knows about their opponent, actions and payoffs.
Unfortunately, in real world this rule can be easily broken. For a firm to know what his
competitors are doing and what the competitors know, the firm needs to hire consultant.
Firm needs to consult the marketing agency to find out what the other firms’ action would
be and what would be the payoffs. This consultation comes with a cost. If the cost of
hiring a consultant to find out more about the opponent, in our case for example Shell
hire an external consultant to find out more about Exxon, is hire than the payoffs, in this
case if the cost is higher than SGD500 per day, it would not be efficient for Shell to have
In most of the country, collusion is illegal. Any two firms come together to sign
an agreement to peg the price of a product will be charged to court. Unfortunately, firms
are very smart; they know how to collude with each other without written agreement.
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This can be observed by looking at the pump price around Singapore. If it is better profit
for pump station to drop price in order to sell more, why are not the petrol stations doing
it. This is because of unwritten collusion among the petrol stations. Shell in Singapore is
the leader among the pack. Shell will drop price and other petrol station will follow, when
Shell increase pump price the rest will follow. Indeed, by observing this behavior, there is
there is no way game theory can be used to analyze the strategic behavior of firms,
Glimcher noticed the limitation of game theory when apply to chicken game the
player may get only one chance to play the game. For this reason it is impossible for
players to study the choice of his opponent and to make adjustment to his own choice
point is achieved. In game theory the static equilibrium can be efficiently described but
This is a real problem because human behavior “must be devoted to solving dynamic
problems – a problem for which we have no adequate theoretical tools.” (Glimcher, 2004)
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Summary
The game theory is a very powerful tool used by economist to anticipate the next
step that the competitors would take. It is also a tool for the firm to gauge the current
position that the firm is in. Some firms may not have any ideas that they may be charging
higher price compare to the competitors and losing customer day by day. By using game
theory, the firm can decide what they would do next in an oligopoly market. In using the
game theory in a “Prisoner’s Dilemma Game” the player could play the game with tit-for-
tat strategy for the optimum payoff, while in a “Chicken Game” there is still limitation
that need to be addressed. Although, there are some limitations to this theory, it has
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Friedman J. W. (1990). Game Theory with Application to Economics. Oxford University
Press
Sloman J. and Hinde K. (2007). Economics For Business. Pearson Education Limited.
Prentice Hall
Shor, Mikhael, "name_of_entry," Dictionary of Game Theory Terms, Game Theory .net,
December 2008
http://en.wikipedia.org/wiki/Tit_for_tat