Theory of Pricing

Price theory, also known as microeconomics, is concerned with the

economic behaviour or individual consumers, producers and resource
owners. It explains the production, allocation, consumption and
pricing of goods and services.

Price theory, as defined by Prof. Leftwich, “is concerned with the

flow of goods and services from business firms to consumers, the
composition of the flow, and the evaluation or pricing of the
component parts of the flow. It is concerned, too, with the flow of
productive resources (or their services) from resource owners to
business firms, with their evaluation, and with their allocation among
alternative uses.”
Perfect Competition:
Perfect competition describes a market structure where competition is at
its greatest possible level. To make it clearer, a market which exhibits the
following characteristics in its structure is said to show perfect
competition:
1. Large number of buyers and sellers
2. Homogenous product is produced by every firm
3. Free entry and exit of firms
4. Zero advertising cost
5. Consumers have perfect knowledge about the market and are well aware
of any changes in the market. Consumers indulge in rational decision
making.
6. All the factors of production, viz. labour, capital, etc, have perfect
mobility in the market and are not hindered by any market factors or
market forces.
7. No government intervention
8. No transportation costs
9. Each firm earns normal profits and no firms can earn super-normal
profits.
10. Every firm is a price taker. It takes the price as decided by the forces of
demand and supply. No firm can influence the price of the product.
Advantages of Perfect Competition
1. They allocate resources in the most efficient way- both productively
(P=MC) and allocatively efficient (P> MC) in the long run.
2. There is no information failure as all knowledge is spread out evenly
3. Only normal profits made just cover their opportunity cost
4. Maximum consumer surplus and economic welfare

Disadvantages of Perfect Competition

1. No Scope for economies of scale because of the high number of firms in
there
2. Undifferentiated products- all homogeneous. Important in industries like
clothes and cars
3. Lack of supernormal profits may mean the investment of Research
and 4. Development(R&D) is unlikely. Important for industries like
pharmaceuticals.
5. With perfect knowledge there is no incentive to develop new technology
because of the ability to share information

Price determination under perfect competition is analysed

under three different time periods:
(a) Market Period
(b) Short Run
(c) Long Run
(a) Market Period:
In a market period, the time span is so short that no firm can
increase its output. The total stock of the commodity in the
market is limited. The market period may be an hour, a day or
a few days or even a few weeks depending upon the nature of
the product.
For example, in the case of perishable commodities(dairy
products) like vegetables, fish, eggs, the period may be a day.
Since the supply of perishable commodities is limited by the
quantity available or stock in day that neither can be increased
nor can be withdrawn for the next period, the whole of it must
be sold away on the same day, whatever may be the price.
Fig 4.1 shows that the supply curve of perishable commodities
like fish is perfectly inelastic and assumes the form of a
vertical straight-line SS. Let us suppose that the demand curve
for fish is given by dd. Demand curve and supply curve
intersect each other at point R, determining the price OP. If
the demand for fish increases suddenly, shifting the demand
curve upwards to d’d’.

The equilibrium point shift from R to R” and the price rises to

OP’. In this situation, price is determined solely by the
demand condition that is an active agent.

Similarly, if the demand for a product is given, as shown in

demand curve SS in figure 4.2. If the supply of the product
decreases suddenly from SS to S’S’, the price increases from
P to P’. In this case price is determined by supply, the supply
being an active agent.
In this case supply curve shifts leftward causing increase in
price of the reduced supply goods. Given the demand curve
dd and supply curve SS, the price is determined at OP.
Demand curve remaining the same, the decrease in supply
shifts the supply curve to its left to S’S’. Consequently, the
price rises from OP to OP’.
The supply curve of non-perishable but reproducible goods
will not be a vertical straight line throughout its length. This is
for certain goods can be withdrawn from the market if the
price is too low as the seller would not sell any amount of the
commodity in the present market period and would like to
hold back the whole stock.
The price below which the seller declines to offer for any
amount of his product is known as ‘reserve price’. Thus, the
seller faces two extreme price-levels; at one he is ready to sell
the whole stock and the other he refuses to sell any. The
amount he offers for sale will vary with price.
The seller will be ready to supply more at a higher price rather
than at a lower one will depend upon his anticipations of
future price and intensity of his need for cash. The supply
curve of a seller will, therefore, slope upwards to the right up
to the price at which he is ready to sell the whole stock.
Beyond this point, the supply curve will become a vertical
straight line whatever the price.
(b) Pricing in the Short Run- Equilibrium of the Firm:
Short period is the span of time so short that existing plants
cannot be extended and new plants cannot be erected to meet
increased demand. However, the time is adequate enough for
producers to adjust to some extent their output to the increase
in demand by overworking their fixed capacity plants. In the
short run, therefore, supply curve is elastic.
Figure 4.3 shows the average and marginal cost curves of the
firm together with its demand curve. Demand curve, in a
perfectly competitive market, is also the average revenue
curve and the marginal revenue curve of the firm. The
marginal cost intersects the average cost at its minimum point.
The U-shape of both the cost curves reflects the law of
variable proportions operative in the short run during which
the size of the plant remains fixed.
The firm is in equilibrium at the point B where the
marginal cost curve intersects the marginal revenue curve
from below:

The firm supplies OQ output. The QC is the average cost and

the firm earns total profit equal to the area shown by ABCD.
The firm maximizes its profit. Earlier to the point of
equilibrium, the firm does not attain the maximum profit as
each additional unit of output brings more revenue that its
cost. Any level of output greater than OQ brings less marginal
revenue than marginal cost.
For the equilibrium of a firm the two conditions must be
fulfilled:
(a) The marginal cost must be equal to the marginal revenue.
However, this condition is not sufficient, since it may be
fulfilled and yet the firm may not be in equilibrium. Figure
4.4 shows that marginal cost is equal to marginal revenue at
point e’, yet the firm is not in equilibrium as Oq output is
greater than Oq’.
(b) The second and necessary condition for equilibrium
requires that the marginal cost curve cuts the marginal
revenue curve from below i.e., the marginal cost curve be
rising at the point of intersection with the marginal revenue
curve.
Thus, a perfectly competitive firm will adjust its output at the
point where its marginal cost is equal to marginal revenue or
price, and marginal cost curve cuts the marginal revenue
curve from below.
The fact that a firm is in equilibrium does not imply that it
necessarily earns supernormal profits. In the short-run
equilibrium firms may earn supernormal profits, normal
profits or may incur losses.
Whether the firm makes supernormal profits, normal profits
or incurs losses depends on the level of the average cost at the
short run equilibrium. If the average cost is below the average
revenue, the firm earns supernormal profits. Figure 4.5
illustrates that the average cost QC is less than average
revenue QB, and the firm earns profits equal to the area
ABCD.

If the average cost is above the average revenue the firm

makes a loss. Figure 4.6 shows that the Average cost QF is
higher than QG average revenue and the firm is incurring loss
equal to the shaded area EFGH. In this case the firm will
continue to produce only if it is able to cover its variable
costs.
Equilibrium of the Industry:
An industry is in equilibrium at that price at which the
quantity demand is equal to the quantity supplied.

Figure 4.8 explains that DD is the industry demand and SS the

industry supply. The point E at which industry demand and
industry supply equalizes, the price OP is determined. OQ is
the quantity demanded and quantity supplied. This, however,
is a short run equilibrium where at the market-determined
price some firms may be making supernormal profits, normal
profits or making losses. In the long run the firms may not
continue incurring losses. Loss making firms that cannot
adjust their plant will close down.
Firms that are making supernormal profits will expand their
capacity. Simultaneously new firms will be attracted into the
industry. Free movement of firms in and outside the industry
and readjustment of the existing firms in the industry will
establish a long run equilibrium in which firms will just be
earning normal profits and there will be no tendency of entry
or exit from the industry.
(c) Pricing in the Long Run:
The long run is a period of time long enough to permit
changes in the variable as well as in the fixed factors. In the
long run, accordingly, all factors are variable and non- fixed.
Thus, in the long run, firms can change their output by
increasing their fixed equipment. They can enlarge the old
plants or replace them by new plants or add new plants.
Moreover, in the long run, new firms can also enter the
industry. On the contrary, if the situation so demands, in the
long run, firms can diminish their fixed equipment by
allowing them to wear out without replacement and the
existing firm can leave the industry.
Thus, the long run equilibrium will refer to a situation where
free and full scope for adjustment has been allowed to
economic forces. In the long run, it is the long run average
and marginal cost curves, which are relevant for making
output decisions. Further, in the long run, average variable
cost is of no particular relevance. The average total cost is of
determining importance, since in the long run all costs are
variable and none fixed.
In the short run a firm under perfect competition is in
equilibrium at that output at which marginal cost equals price
or Marginal Revenue. This is equally valid in the long run.
But, in the long run for a perfectly competition firm to be in
equilibrium, besides marginal cost being equal to price, price
must also be equal to average cost. If the price is greater than
the average cost, the firms will be making supernormal
profits.
Lured by these supernormal profits, new firms will enter the
industry and these extra profits will be competed away. When
the new firms enter the industry, the supply or output of the
industry will increase and hence the price of the output will be
forced down. The new firms will keep coming into the
industry until the price is depressed down to average cost, and
all firms are earning only normal profits.
On the other hand, if the price happens to be below the
average cost, the firms will be incurring losses. Some of the
existing firms will quit the industry. As a result, the output of
the industry will decrease and the price will rise to equal the
average cost so that the firms remaining in the industry are
making normal profits. Hence, in the long run, firms need not
be forced to produce at a loss since they can leave the
industry, if they are having losses. Thus, for a perfectly
competitive firm to be in equilibrium in the long run, price
must equal marginal and average cost.
Now when average cost curve is falling, marginal cost curve
is below it, and when average cost curve is rising, marginal
cost curve must be above it. Hence, marginal cost can be
equal to the average cost only at the point where average cost
curve is neither falling nor rising, i.e., at the minimum point
of average cost curve. Therefore, it is at the point of minimum
average cost curve, and the two are equal there.
Thus, the conditions for long run equilibrium of perfectly
competitive firm can be written as:
Price = Marginal Cost = Minimum Average Cost.
The conditions for the long run equilibrium of the firm under
perfect competition can be easily understood from the Fig.
4.9, where LAC is the long run average cost curve and LMC
in the long run marginal cost curve. The firm under perfect
competition cannot be in long run equilibrium at price OP’,
because though the price OP’ equals MC at G (i.e., at output
OQ) but it is greater than the average cost at this output and,
therefore, the firm will be earning supernormal profits.
Since all the firms are assumed to be identical, all would be
earning supernormal profits. Hence, there will be attraction
for the new firms to enter the industry. As a result, the price
will be forced down to the level Op at which price, the firm is
in equilibrium at F and is producing OQ” output.
At point F or equilibrium output OQ”, the price is equal to
average cost, and hence the firm will be earning only normal
profits. Therefore, at price OP, there will be no tendency for
the outside firms to enter the industry. Hence, the firm will be
in equilibrium at OP price and OQ output.
On the contrary, a firm under perfect competition cannot be in
the long run equilibrium at price OP”. Though price OP” is
equal to marginal cost at point E, or at output OQ” but price
OP” is lower than the average cost at this point and thus the
firm will be incurring losses.
Since all the firms in the industry are identical in respect of
cost curves, all would be incurring losses. To avoid these
losses, some of the firm will leave the industry. As a result,
the price will rise to OP, where again all firms are making
normal profits. When the price OP is reached, the firms would
have no further tendency to quit.
Thus, to conclude that at price OP, the firm under perfect
competition is in equilibrium in the long run when:
Price = MC = Minimum AC
Now, at price OP, besides all firms being in equilibrium at
output OQ, the industry will also be in equilibrium, since
there will be no tendency for new firms to enter or the existing
firms to leave the industry, because all will be earning normal
profits. Thus, at OP price, full equilibrium, i.e., equilibrium of
all the individual firms and also of the industry, as a whole, is
achieved in the long run under perfect competition.
Monopoly:
Monopoly is the market form in which a single producer
controls the whole supply of a single commodity which has no
close substitute.
From this definition there are 2 points to be noted as follows
1)Single Producer:
There must be only one producer who may be an individual,
partnership firm or joint stock company. Thus, single firm
constitutes the industry. The distinction between firm and
industry disappears under conditions of monopoly.
2)No Close Substitute:
 The commodity produced by the producer must have no
close competing substitutes, if he is to be called a monopolist.
This ensures that there is no rival of the monopolist.
Therefore, the cross elasticity of demand between the product
of the monopolist and the product of any other producer must
be low.
Advantages:
1. Stability of price
2. Sources of revenue
3. Profits
4. Source of essential public utilities
5. Potential to face depression
Disadvantages:
1. Exploitation of consumers
2. Price discrimination
3. Quality of goods
4. Allocation of resources
5. Unfair trade practices
Let us make an in-depth study of the determination of
value or price under monopoly.
Under Monopoly every seller wants to earn maximum Profit.
This fact Prof. Marshall has stated that monopolist wants to
earn “Maximum Monopoly Gain” by selling his goods.
This thing Mrs. Robinson has stated as Net Monopoly
Revenue.
Now, the important question arises that how monopolist
should fix his price, so that he may earn maximum profit? On
this point two economists written above are of this opinion the
price determination under monopoly condition is similar to
those of perfect competition.
The only difference is that in perfect competition the average
revenue curve and marginal revenue curve are same and
parallel to X-axis where as in Monopoly these curves are
downwards sloping curves. The Monopolist behaves like a
firm. His aim is maximisation of profits and if there are
losses, then minimisation of losses. The profits are maximised
when marginal cost is equal to marginal revenue. The losses
are minimum where marginal cost is equal to marginal
revenue but afterwards marginal cost must be rising.
A Monopolist being the only producer and seller of that
commodity can determine its price and the quantity of its
production or supply. He cannot do both the things
simultaneously. Either he fixes the price and leaves the output
to be determined by the consumer demand at that price or he
can fix the output to be produced and leave the price to be
determined by the consumers’ demand for his product. But it
is a common experience that he leaves the price to the market
mechanism and determines the volume of output. Under no
circumstances, he will be ready to bear losses.
If, in a short period, the cost of production of a commodity is
zero, he will go on producing it to the extent or so long the
marginal revenue from the sale of that commodity does not
fall to zero. As soon as the marginal reserve is zero, he will
not increase its supply.
Some economists think that, in a short period, three
different situations may arise before the monopolist:
(i) When the monopolist earns abnormal profits,
(ii) When he gets only normal profits, and
(iii) When he suffers losses.

The explanation and diagrams of these situations are

given below:

On the point E the firm is in equilibrium when MC = MR.

Thereafter MC curve starts to rise. Under the condition, OP is
the price and OQ is the ‘total production’ of the commodity so
determined. In order to calculate profits or losses, we will
have to measure the difference between AR and AC. If AR >
AC, the difference between the two is profit per unit and by
multiply it with total number of units produced we can get
total profit.
In the first figure RQ = OP is the price, TO is the cost of
production per unit. Thus, RS =PT is unit for profit. On the
OQ quantity of production, total profit is PTSR shaded area
which is abnormal profit. In the second figure RQ = OP is the
determined price and RQ is the average cost. Under this
condition, there will be only normal profit.
In the figure three also price per unit is RQ = OP but cost per
unit is SQ. Thus, SR (TP) is loss per unit. As a result, TPRS
shaded area will be the total loss. But this loss is only short
period phenomenon. In the long period, this loss will
disappear, under that condition and situation, only profit will
be earned.
Determination of Price in the Long Period:
In the long period the monopolist introduces changes in his
equipment’s and techniques of production. During this period
in order to gain excess profit, he will change efficiency and
capacity of his resources according to his need. But the
determination of the quantity of production follows, the same
line as under short period.
This is clear from the following figure:

In this figure LMC and LMR intersect each other at the point
E and after that LMC goes on rising. Thus, OQ production is
determined and OP is the price. But average cost is SQ. So,
profit per unit is RS and at OQ output the total profit is PTSR.
Under Perfect Competition AR =MR, where-as under
Monopoly MR <AR.
Under perfect competition price is determined by the
interaction of total demand and supply. This price is
acceptable to all the firms in the industry. No firm can change
this price. So, average revenue and marginal revenue, at every
level of production, will be constant and equal. Their curves
are parallel to X-axis.
Under Monopoly, to sell every additional unit of the
commodity price will have to be lower. In this way, with the
sale of every additional unit, average and marginal income
goes on falling. But the decrease in average revenue is
relatively less sharp than the decrease in marginal revenue, it
is because marginal revenue is limited to one unit, whereas in
case of average revenue, the decrease price is divided by the
number of units. Therefore, the fall in average revenue has
relatively less slope. That is the reason why marginal revenue
is less than average revenue.
COMPARISON OF PRICE DETERMINATION UNDER PERFECT
COMPETITION AND MONOPOLY:
The key points of comparison of price determination under Perfect
Competition and Monopoly is as below:

Perfect Competition Monopoly

(i) The demand curve or average (i) The demand curve or average
revenue curve is perfectly elastic and is revenue curve is relatively elastic and a
a horizontal straight line. downward sloping from left to right.
(ii) The firm is in equilibrium at the level
of output where MC is equal to MR.
Since in perfect competition MR is
equal to AR or price, therefore, when
MC is equal to MR, it is also equal to
AR or price at the equilibrium position,
i.e., MC=MR=AR (Price)
(iii) In equilibrium position, the price
charged by the firm equals to MC.
(iv) The firm is in long-run equilibrium
at the minimum point of the long-run
AC curve.
(v) The firm is in equilibrium at the level
of output at which MC curve is rising,
and is cutting MR curve from below.
(vi) In the long run, the firm is earning
normal profit. There may be super
normal profit in the short run but they
will be swept away in the long run, as
new firms entered into the industry.
(vii) Price can be set lower at greater
output in case of constant-cost and
decreasing-cost industries.
Monopolistic Competition:
(ii) The firm is in equilibrium at the level
of output where MC is equal to MR.
(iii) In equilibrium position, the price
charged by the firm is above MC.
(iv) The firm is in long-run equilibrium
at the point where AC curve is still
declining and has not reached the
minimum point.
(v) The firm is in equilibrium at the level
of output at which MR curve is sloping
downwards, and MC curve is cutting it
from below or above.
(vi) The firm can earn abnormal or
supernormal profit even in the long run,
as there is no competitor in the
industry.
(vii) Price is set higher and output
smaller by the monopolist.
In monopolistic competition, the market has features of both perfect
competition and monopoly. A monopolistic competition is more
common than pure competition or pure monopoly.

In order to understand monopolistic competition, let’s look at the

market for soaps and detergents in India. There are many well-known
brands like Lux, Rexona, Dettol, Dove, Pears, etc. in this segment.

Since all manufacturers produce soaps, it appears to be an example of

perfect competition. However, on close scrutiny, we find that each
seller varies the product slightly to make it different from its
competitors.

Hence, Lux focuses on making beauty soaps, Liril on freshness, Dettol

on antiseptic properties, Dove on smooth skin, etc. This allows each
seller to attract buyers to itself based on some factor other than price.

This market has a mix of both perfect competition and monopoly and is
a classic example of monopolistic competition.

Features of Monopolistic Competition

1. Large number of sellers: In a market with monopolistic

competition, there are a large number of sellers who have a
small share of the market.
2. Product differentiation: In monopolistic competition, all
brands try to create product differentiation to add an element
of monopoly over the competing products. This ensures that
the product offered by the brand does not have a perfect
substitute. Therefore, the manufacturer can raise the price of
the product without having to worry about losing all its
customers to other brands. However, in such a market, while
all brands are not perfect substitutes, they are close
substitutes for each other. Hence, the seller might lose at least
some customers to his competitors.
 3. Freedom of entry or exit: Like in perfect competition, firms
can enter and exit the market freely.
4. Non-price competition: In monopolistic competition, sellers
compete on factors other than price. These factors include
aggressive advertising, product development,
better distribution, after sale services, etc. Sellers don’t cut
the price of their products but incur high costs for
the promotion of their goods. If the firms indulge in price-
wars, which is the possibility under perfect competition,
some firms might get thrown out of the market.
Price-output determination under Monopolistic
Competition: Equilibrium of a firm
In monopolistic competition, since the product is differentiated
between firms, each firm does not have a perfectly elastic demand for
its products. In such a market, all firms determine the price of their
own products. Therefore, it faces a downward sloping demand curve.
Overall, we can say that the elasticity of demand increases as the
differentiation between products decreases.

Fig. 1 above depicts a firm facing a downward sloping, but

flat demand curve. It also has a U-shaped short-run cost curve.
Conditions for the Equilibrium of an individual firm
The conditions for price-output determination and equilibrium of an
individual firm are as follows:

1. MC = MR
2. The MC curve cuts the MR curve from below.
In Fig. 1, we can see that the MC curve cuts the MR curve at point E.
At this point,

• Equilibrium price = OP and

• Equilibrium output = OQ
Now, since the per unit cost is BQ, we have

• Per unit super-normal profit (price-cost) = AB or PC.

• Total super-normal profit = APCB
The following figure depicts a firm earning losses in the short-run.

From Fig. 2, we can see that the per unit cost is higher than the price
of the firm. Therefore,

• AQ > OP (or BQ)

• Loss per unit = AQ – BQ = AB
 • Total losses = ACPB
Long-run equilibrium

If firms in a monopolistic competition earn super-normal profits in

the short-run, then new firms will have an incentive to enter
the industry. As these firms enter, the profits per firm decrease as the
total demand gets shared between a larger number of firms. This
continues until all firms earn only normal profits. Therefore, in the
long-run, firms, in such a market, earn only normal profits.

As we can see in Fig. 3 above, the average revenue (AR) curve

touches the average cost (ATC) curve at point X. This corresponds to
quantity Q1 and price P1. Now, at equilibrium (MC = MR), all super-
normal profits are zero since the average revenue = average costs.
Therefore, all firms earn zero super-normal profits or earn only
normal profits.

It is important to note that in the long-run, a firm is in an equilibrium

position having excess capacity. In simple words, it produces a lower
quantity than its full capacity. From Fig. 3 above, we can see that the
firm can increase its output from Q1 to Q2 and reduce average costs.
However, it does not do so because it reduces the average revenue
more than the average costs. Hence, we can conclude that in
monopolistic competition, firms do not operate optimally. There
always exists an excess capacity of production with each firm.

In case of losses in the short-run, the firms making a loss will exit
from the market. This continues until the remaining firms make
normal profits only.

Oligopoly:
The word Oligopoly is derived from two Greek words – ‘Oligi’
meaning ‘few’ and ‘Polein’ meaning ‘to sell’. An Oligopoly market
situation is also called ‘competition among the few’. Oligopoly is
either perfect or imperfect/differentiated. In India, some examples of
an oligopolistic market are automobiles, cement, steel, aluminium,
etc.

Characteristics of oligopoly:
• There are large few firms although exact number of firms is
undefined
• A firm can earn super-normal profits in the long run as there are
barriers to entry
• Firms try to avoid price competition due to fear of price wars in
the oligopoly
CLASSIFICATION OF OLIGOPOLY:
The oligopolistic industries are classified in a number of ways:
(a) Duopoly: If there are two giant firms in an industry it is called duopoly. Duopoly
is further classified as below:
• (i) Perfect or Pure Duopoly: If the duopolists in an industry are
producing identical products it is called perfect or pure duopoly.
• (ii) Imperfect or Impure Duopoly: If the duopolists in an industry are
producing differentiated products it is called imperfect or impure duopoly.
(b) Oligopoly: If there are more than two firms in an industry and each firm takes
consideration the reactions of the rival firms in formulating its own price policy it is
called oligopoly. Oligopoly is further classified as below:
• (i) Perfect or Pure Oligopoly: If the oligopolists in an industry are
producing identical products it is called perfect or pure oligopoly.
• (ii) Imperfect or Impure Oligopoly: If the oligopolists in an industry are
producing differentiated products it is called imperfect or impure oligopoly.
PRICE DETERMINATION UNDER OLIGOPOLY:
The price and output behaviour of the firms operating in oligopolistic or duopolistic
market condition can be studied under two main heads:

1. Price and Output Determination under Duopoly:

(a) If an industry is composed of two giant firms each selling identical or
homogenous products and having half of the total market, the price and
output policy of each is likely to affect the other appreciably, therefore there is
every likelihood of collusion between the two firms. The firms may agree on
a price, or divide the total market, or assign quota, or merge themselves into
one unit and form a monopoly or try to differentiate their products or accept
the price fixed by the leader firm, etc.
(b) In case of perfect substitutes, the two firms may be engaged in price
competition. The firm having lower costs, better goodwill and clientele will
drive the rival firm out of the market and then establish a monopoly.
(c) If the products of the duopolists are differentiated, each firm will have a
close watch on the actions of its rival firms. The firm good quality product with
lesser cost will earn abnormal profits. Each firm will fix the price of the
commodity and expand output in accordance with the demand of the
commodity in the market.

2. Price and Output Determination under Oligopoly:

(a) If an industry is composed of few firms each selling identical or
homogenous products and having powerful influence on the total market,
the price and output policy of each is likely to affect the other appreciably,
therefore they will try to promote collusion.
(b) In case there is product differentiation, an oligopolist can raise or lower
his price without any fear of losing customers or of immediate reactions from
his rivals. However, keen rivalry among them may create condition
of monopolistic competition.
There is no single theory which satisfactorily explains the oligopoly behaviour
regarding price and output in the market. There are set of theories like Cournot
Duopoly Model, Bertrand Duopoly Model, the Chamberlin Model, the Kinked
Demand Curve Model, the Centralised Cartel Model, Price Leadership Model, etc.,
which have been developed on particular set of assumptions about the reaction of
other firms to the action of the firm under study.

COLLUSIVE OLIGOPOLY:
The degree of imperfect competition in a market is influenced not just by the number
and size of firms but by how they behave. When only a few firms operate in a
market, they see what their rivals are doing and react. ‘Strategic interaction’ is a term
that describes how each firm’s business strategy depends upon its rivals’ business
behaviour.

When there are only a small number of firms in a market, they have a choice
between ‘cooperative’ and ‘non-cooperative’ behaviour:
 • Firms act non-cooperatively when they act on their own without any explicit
or implicit agreement with other firms. That’s what produces ‘price wars’.
• Firms operate in a cooperative mode when they try to minimise competition
between them. When firms in an oligopoly actively cooperate with each other,
they engage in ‘collusion’. Collusion is an oligopolistic situation in which two or
more firms jointly set their prices or outputs, divide the market among them, or
make other business decisions jointly.

A ‘cartel’ is an organisation of independent firms, producing similar products, which

work together to raise prices and restrict output. It is strictly illegal in Pakistan and
most countries of the world for companies to collude by jointly setting prices or
dividing markets. Nonetheless, firms are often tempted to engage in ‘tacit collusion’,
which occurs when they refrain from competition without explicit agreements. When
firms tacitly collude, they often quote identical (high) prices, pushing up profits and
decreasing the risk of doing business. The rewards of collusion, when it is
successful, can be great. It is more illustrated in the following diagram:

The above diagram illustrates the situation of oligopolist A and his demand curve
DaDa assuming that the other firms all follow firm A’s lead in raising and lowering
prices. Thus the firm’s demand curve has the same elasticity as the industry’s DD
curve. The optimum price for the collusive oligopolist is shown at point G on DaDa
just above point E. This price is identical to the monopoly price, it is well above
marginal cost and earns the colluding oligopolists a handsome monopoly profit.
PRICE DETERMINATION MODELS OF OLIGOPOLY:
1. Kinky Demand Curve: The kinky demand curve model tries to explain that in
non-collusive oligopolistic industries there are not frequent changes in the market
prices of the products. The demand curve is drawn on the assumption that the kink
in the curve is always at the ruling price. The reason is that a firm in the market
supplies a significant share of the product and has a powerful influence in the
prevailing price of the commodity. Under oligopoly, a firm has two choices:

(a) The first choice is that the firm increases the price of the product. Each
firm in the industry is fully aware of the fact that if it increases the price of the
product, it will lose most of its customers to its rival. In such a case, the upper
part of demand curve is more elastic than the part of the curve lying below the
kink.
(b) The second option for the firm is to decrease the price. In case the firm
lowers the price, its total sales will increase, but it cannot push up its sales
 very much because the rival firms also follow suit with a price cut. If the rival
firms make larger price cut than the one which initiated it, the firm which first
started the price cut will suffer a lot and may finish up with decreased
sales. The oligopolists, therefore avoid cutting price, and try to sell their
products at the prevailing market price. These firms, however, compete with
one another on the basis of quality, product design, after-sales services,
advertising, discounts, gifts, warrantees, special offers, etc.

In the above diagram, we shall notice that there is a discontinuity in the marginal
revenue curve just below the point corresponding to the kink.During this discontinuity
the marginal cost curve is drawn. This is because of the fact that the firm is in
equilibrium at output ON where the MC curve is intersecting the MR curve from
below.

The kinky demand curve is further explained in the following diagram:

In the above diagram, the demand curve is made up of two segments DB and
BD’. The demand curve is kinked at point B. When the price is Rs. 10 per unit, a firm
sells 120 units of output. If a firm decides to charge Rs. 12 per unit, it loses a large
part of the market and its sales come down to 40 units with a loss of 80 units. In
case, the producer lowers the price to Rs. 4 per unit, its competitors in the industry
will match the price cut. Its sales with a big price cut of Rs. 6 increases the sale by
only 40 units. The firm does not gain as its total revenue decreases with the price
cut.
2. Price Leadership Model: Under price leadership, one firm assumes the role of a
price leader and fixes the price of the product for the entire industry. The other firms
in the industry simply follow the price leader and accept the price fixed by him and
adjust their output to this price. The price leader is generally a very large or dominant
firm or a firm with the lowest cost of production. It often happens that price
leadership is established as a result of price war in which one firm emerges as the
winner.

In oligopolistic market situation, it is very rare that prices are set independently and
there is usually some understanding among the oligopolists operating in the
industry. This agreement may be either tacit or explicit.

Types of Price Leadership: There are several types of price leadership. The
following are the principal types:

(a) Price leadership of a dominant firm, i.e., the firm which produces the
bulk of the product of the industry. It sets the price and rest of the firms simply
accepts this price.
(b) Barometric price leadership, i.e., the price leadership of an old,
experienced and the largest firm assumes the role of a leader, but undertakes
also to protect the interest of all firms instead of promoting its own interests as
in the case of price leadership of a dominant firm.
(c) Exploitative or Aggressive price leadership, i.e., one big firm built its
supremacy in the market by following aggressive price leadership. It compels
other firms to follow it and accept the price fixed by it. In case the other firms
show any independence, this firm threatens them and coerces them to follow
its leadership.

Price Determination under Price Leadership: There are various models

concerning price-output determination under-price leadership on the basis of certain
assumptions regarding the behaviour of the price leader and his followers. In the
following case, there are few assumptions for determining price-output level under
price leadership:

(a) There are only two firms A and B and firm A has a lower cost of
production than the firm B.
(b) The product is homogenous or identical so that the customers are
indifferent as between the firms.
(c) Both A and B have equal share in the market, i.e., they are facing the
same demand curve which will be the half of the total demand curve.
In the above diagram, MCa is the marginal cost curve of firm A and MCb is the
marginal cost curve of firm B. Since we have assumed that the firm A has a lower
cost of production than the firm B, therefore, the MCa is drawn below MCb.

Now let us take the firm A first, firm A will be maximising its profit by selling OM level
of output at price MP, because at output OM the firm A will be in equilibrium as its
marginal cost is equal to marginal revenue at point E. Whereas the firm B will be in
equilibrium at point F, selling ON level of output at price NK, which is higher than the
price MP. Two firms have to charge the same price in order to survive in the
industry. Therefore, the firm B has to accept and follow the price set by firm A. This
shows that firm A is the price leader and firm B is the follower.

Since the demand curve faced by both firms is the same, therefore, the firm B will
produce OM level of output instead of ON. Since the marginal cost of firm B is
greater than the marginal cost of firm A, therefore, the profit earned by firm B will be
lesser than the profit earned by firm A.

Objectives of Pricing:
The task of fixing reasonable value of any product or services is called pricing.
To fulfill this task all the costs and profits should be included. Various expenses
are included under production cost. They may be direct and indirect expenses.

1. Profit oriented objective

All the business organizations or companies are conducted with the main
objective of earning profit. Their profit making objective may be for long term or
short term. Under such task, companies or organizations form two types of
objectives as follows:
• To achieve a target result: The certain rate of profit intended by an
organization or company to earn during certain period is called target
result. Business firms or companies fix prices of their products with the
objective to get certain result from sale or investment, for instance, 8%
 profit from sale, 7% profit from investment, etc. Most of the wholesalers
and retailers estimate targeted result with the objective of earning short
term profit. The firms or companies who do not need to face strangling
competition take decision to fix such price.
• To maximize profit: There are various types of profit making
objectives. Among them profit maximization is the second important
objective. Fixing maximum rate of price of any product or service to earn
maximum profit in very short term adversely affects the customers. So, a
strategy should be adopted to earn maximum profit in long term. Sales
volumes should be maximized with the minimization profit margin for
earnings maximum profit. As a result, profit amount increases. This
becomes beneficial to the company/firm and society in the long run.

2. Sales oriented objective

A company may adopt a policy to increase sales volume by fixing lower rate of
price of products or services. In fact, sales oriented objectives aims
to increase sales quantity and market share. This objective can be studied by
dividing into two classes as follows:
• To increase sales volume: Increasing sales quantity of any product
also may be one of the objectives of pricing. The emphasizes
to increase certain percent of sales quantity can be increased getting
permission from sales department or adopting other pricing strategies.
Such strategy discourages possible competitions. Besides this, profit
can increase in the long run due to minimum production cost.
• To increase market share: Every company or firm wishes to
promote sale of its products. The objective of pricing may be
to increase sales quantity. This also increases market share. In this age of
competitive environment of market, it is also necessary to increase market
share. Some companies adopt a policy to expand market share gradually;
some others adopt the policy to expand market share immediately and
control it. In order to expand market share, price of products or services
should be low in comparison of competitors. Japanese auto products have
become very high in price in American market due to which Toyota,
Nissan, Honda Companies have cut down production cost fixing low
margin profit and adopted a policy to increase share in American markets.
This makes it clear that market share can be increased fixing low profit
margin.

3. Status-quo oriented objective

Status-quo objective is formed to maintain the present situation for long time. In
this objective, price of products remains same for long. Firm or company does
not take any step to change the price. This status-quo includes the objectives like
continuation of same price, facing competition and continuation of existence.
They can be mentioned as follows:
• Stability in price: Price stability is one of the importance
objectives. This remains effortful to maintain price at the same rate for
time. Price leadership companies, frequent demand changing companies
and the companies wishing to maintain reputation try not to let price
fluctuate. All such companies make their objective to maintain price same
at the same level. Such organizations or companies also wish to maintain
revenues, price of their products, profits etc. at the same level. They do not
want to take risk. They try to maintain same price by increasing production
and supply in prosperity period and decreasing production and supply in
depression period.
• To meet competition: This is the age of market competition. Every
business company needs to face competition for survival/existence.
Companies/firms have to fix price of their products or services as fixed in
the markets. So, price is fixed with a view to facing/meeting competition
in market. The price leadership companies should fix/determine price of
their products by studying and considering market prices. Otherwise, the
prices of their products cannot face/meet competition in market; as a result
they are compelled to flee away from the market.
• Survival: It becomes very difficult to save the company/firm from
high competition in market. In such situation, the firm should fix prices of
their products in a way that only production cost can be recovered. In such
situation, production cost may be equal to revenue. (Production cost =
Revenue). This situation is called breakeven point. In this situation, there
is neither profit nor loss. In this way, company’s existence is saved and it
expects improvement in future. Business companies make such objectives
waiting for bright future.
Methods of pricing:
An organization has various options for selecting a pricing method.
Prices are based on three dimensions that are cost, demand, and
competition.

The organization can use any of the dimensions or combination of

dimensions to set the price of a product.
Cost-based Pricing:
Cost-based pricing refers to a pricing method in which some
percentage of desired profit margins is added to the cost of the
product to obtain the final price. In other words, cost-based pricing
can be defined as a pricing method in which a certain percentage of
the total cost of production is added to the cost of the product to
determine its selling price. Cost-based pricing can be of two types,
namely, cost-plus pricing and markup pricing.

These two types of cost-based pricing are as follows:

i. Cost-plus Pricing:
Refers to the simplest method of determining the price of a product.
In cost-plus pricing method, a fixed percentage, also called mark-up
percentage, of the total cost (as a profit) is added to the total cost to
set the price. For example, XYZ organization bears the total cost of
Rs. 100 per unit for producing a product. It adds Rs. 50 per unit to the
price of product as’ profit. In such a case, the final price of a product
of the organization would be Rs. 150.

Cost-plus pricing is also known as average cost pricing. This is the

most commonly used method in manufacturing organizations.

In economics, the general formula given for setting price in case

of cost-plus pricing is as follows:
P = AVC + AVC (M)

AVC= Average Variable Cost

M = Mark-up percentage

AVC (m) = Gross profit margin

Mark-up percentage (M) is fixed in which AFC and net profit margin
(NPM) are covered.

AVC (m) = AFC+ NPM

ii. For determining average variable cost, the first step is to fix prices.
This is done by estimating the volume of the output for a given period
of time. The planned output or normal level of production is taken
into account to estimate the output.

The second step is to calculate Total Variable Cost (TVC) of the

output. TVC includes direct costs, such as cost incurred in labour,
electricity, and transportation. Once TVC is calculated, AVC is
obtained by dividing TVC by output, Q. [AVC= TVC/Q]. The price is
then fixed by adding the mark-up of some percentage of AVC to the
profit [P = AVC + AVC (m)].

ii. Markup Pricing:

Refers to a pricing method in which the fixed amount or the
percentage of cost of the product is added to product’s price to get the
selling price of the product. Markup pricing is more common in
retailing in which a retailer sells the product to earn profit. For
example, if a retailer has taken a product from the wholesaler for Rs.
100, then he/she might add up a markup of Rs. 20 to gain profit.

It is mostly expressed by the following formulae:

a. Markup as the percentage of cost= (Markup/Cost) *100

b. Markup as the percentage of selling price= (Markup/ Selling Price)

*100

c. For example, the product is sold for Rs. 500 whose cost was Rs.
400. The mark up as a percentage to cost is equal to (100/400) *100
=25. The mark up as a percentage of the selling price equals
(100/500) *100= 20.
Demand-based Pricing:
Demand-based pricing refers to a pricing method in which the price of
a product is finalized according to its demand. If the demand of a
product is more, an organization prefers to set high prices for products
to gain profit; whereas, if the demand of a product is less, the low
prices are charged to attract the customers.

The success of demand-based pricing depends on the ability of

marketers to analyze the demand. This type of pricing can be seen in
the hospitality and travel industries. For instance, airlines during the
period of low demand charge less rates as compared to the period of
high demand. Demand-based pricing helps the organization to earn
more profit if the customers accept the product at the price more than
its cost.

Competition-based Pricing:
Competition-based pricing refers to a method in which an
organization considers the prices of competitors’ products to set the
prices of its own products. The organization may charge higher,
lower, or equal prices as compared to the prices of its competitors.

The aviation industry is the best example of competition-based

pricing where airlines charge the same or fewer prices for same routes
as charged by their competitors. In addition, the introductory prices
charged by publishing organizations for textbooks are determined
according to the competitors’ prices.

Other Pricing Methods:

In addition to the pricing methods, there are other methods that
are discussed as follows:
i. Value Pricing:
Implies a method in which an organization tries to win loyal
customers by charging low prices for their high- quality products. The
organization aims to become a low cost producer without sacrificing
the quality. It can deliver high- quality products at low prices by
improving its research and development process. Value pricing is also
called value-optimized pricing.

ii. Target Return Pricing:

Helps in achieving the required rate of return on investment done for
a product. In other words, the price of a product is fixed on the basis
of expected profit.

iii. Going Rate Pricing:

Implies a method in which an organization sets the price of a product
according to the prevailing price trends in the market. Thus, the
pricing strategy adopted by the organization can be same or similar to
other organizations. However, in this type of pricing, the prices set by
the market leaders are followed by all the organizations in the
industry.

iv. Transfer Pricing:

Involves selling of goods and services within the departments of the
organization. It is done to manage the profit and loss ratios of
different departments within the organization. One department of an
organization can sell its products to other departments at low prices.
Sometimes, transfer pricing is used to show higher profits in the
organization by showing fake sales of products within departments.

What Is Game Theory?

Game theory is a theoretical framework for conceiving social
situations among competing players. In some respects, game theory is
the science of strategy, or at least the optimal decision-making of
independent and competing actors in a strategic setting.

The Basics of Game Theory

The focus of game theory is the game, which serves as a model of an

interactive situation among rational players. The key to game theory
is that one player's payoff is contingent on the strategy implemented
by the other player. The game identifies the players' identities,
preferences, and available strategies and how these strategies affect
the outcome. Depending on the model, various other requirements or
assumptions may be necessary.

Game theory has a wide range of applications, including psychology,

evolutionary biology, war, politics, economics, and business. Despite
its many advances, game theory is still a young and developing
science.

Types of Game Theory:

In the game theory, different types of games help in the analysis of

different types of problems.

The different types of games are formed on the basis of number of

players involved in a game, symmetry of the game, and cooperation
among players.

1. Cooperative and Non-Cooperative Games:

Cooperative games are the one in which players are convinced to
adopt a particular strategy through negotiations and agreements
between players. Let us take the example cited in prisoner’s dilemma
to understand the concept of cooperative games. In case, John and
Mac had been able to contact each other, then they must have decided
to remain silent. Therefore, their negotiation would have helped in
solving out the problem.

Another example can be cited for pan masala organizations. Suppose

pan masala organizations have high ad-expenditure that they want to
reduce. However, they are not sure whether other organizations would
follow them or not.

This creates a situation of dilemma among pan masala organizations.

However, the government restricts the advertisement of pan masala
on televisions. This would help in reducing the ad-expenditure of pan
masala organizations. This is an example of cooperative game.
However, non-cooperative games refer to the games in which the
players decide on their own strategy to maximize their profit. The best
example of a non-cooperative game is prisoner’s dilemma. Non-
cooperative games provide accurate results. This is because in non-
cooperative games, a very deep analysis of a problem takes place.

2. Normal Form and Extensive Form Games:

Normal form games refer to the description of game in the form of
matrix. In other words, when the payoff and strategies of a game are
represented in a tabular form, it is termed as normal form games.
Normal form games help in identifying the dominated strategies and
Nash equilibrium. In normal form games, the matrix demonstrates the
strategies adopted by the different players of the game and their
possible outcomes.

On the other hand, extensive form games are the one in which the
description of game is done in the form of a decision tree. Extensive
form games help in the representation of events that can occur by
chance. These games consist of a tree-like structure in which the
names of players are represented on different nodes.

In addition, in this structure, the feasible actions and pay offs of each
players are also given. Let us understand the concept of extensive
form games with the help of an example. Suppose organization A
wants to enter a new market, while organization B is the existing
organization in that market.

Organization A has two strategies; one IS to enter the market and

challenge to survive or do not enter the market and remain deprived
of the profit that it can earn. Similarly, organization B also has two
strategies either to fight for its existence or to cooperate with
organization A.

Figure-2 shows the decision tree for the present situation:

In Figure-2, organization A takes the first step that would be followed
by organization B later on. In case, organization A does not enter the
market, then its payoffs would be zero. However, if it enters the
market, the market situation would be totally dependent on
organization B.

If they both get into the price war, then both of them would suffer the
loss of 3. On the other hand, if organization B cooperates, then both
of them would earn equal profits. In this case, the best option would
be that organization A enters the market and organization B
cooperates.

3. Simultaneous Move Games and Sequential Move Games:

Simultaneous games are the one in which the move of two players
(the strategy adopted by two players) is simultaneous. In simultaneous
move, players do not have knowledge about the move of other
players. On the contrary, sequential games are the one in which
players are aware about the moves of players who have already
adopted a strategy.

However, in sequential games, the players do not have a deep

knowledge about the strategies of other players. For example, a player
has knowledge that the other player would not use a single strategy,
but he/she is not sure about the number of strategies the other player
may use. Simultaneous games are represented in normal form while
sequential games are represented in extensive form.
Let us understand the application of simultaneous move games with
the help of an example. Suppose organizations X and Y want to
minimize their cost by outsourcing their marketing activities.
However, they have a fear that outsourcing of marketing activities
would result in increase of sale of the other competitor. The strategies
that they can adopt are either to outsource or not to outsource the
marketing activities.

The payoff matrix for the two organizations is shown in Table-10:

In Table-10, it can be seen that both the organizations X and Y are

unaware about the strategy of each other. Both of them work on the
perception that the other one would adopt the best strategy for itself.
Therefore, both the organizations would adopt the strategy, which is
best for them.

The same example can also be used for the explanation of sequential
move games. Suppose organization X is the first one to decide
whether it should outsource the marketing activities or not.

The game tree that represents the decision of organization X and

Y is shown in Figure-3:

In Figure-3, the first move is taken by organization X while

organization Y would take decision on the basis of the decision taken
by X. However, the final outcome depends on the decision of
organization Y. In the present case, the second player is aware of the
decision of the first player.
4. Constant Sum, Zero Sum, and Non-Zero-Sum Games:
Constant sum game is the one in which the sum of outcome of all the
players remains constant even if the outcomes are different. Zero sum
game is a type of constant sum game in which the sum of outcomes of
all players is zero. In zero sum game, the strategies of different
players cannot affect the available resources.

Moreover, in zero sum game, the gain of one player is always equal to
the loss of the other player. On the other hand, non-zero sum game are
the games in which sum of the outcomes of all the players is not zero.

A non-zero sum game can be transformed to zero sum game by

adding one dummy player. The losses of dummy player are
overridden by the net earnings of players. Examples of zero-sum
games are chess and gambling. In these games, the gain of one player
results in the loss of the other player. However, cooperative games are
the example of non-zero games. This is because in cooperative games,
either every player wins or loses.

5. Symmetric and Asymmetric Games:

In symmetric games, strategies adopted by all players are same.
Symmetry can exist in short-term games only because in long-term
games the number of options with a player increase. The decisions in
a symmetric game depend on the strategies used, not on the players of
the game. Even in case of interchanging players, the decisions remain
the same in symmetric games. Example of symmetric games is
prisoner’s dilemma.

On the other hand, asymmetric games are the one in which strategies
adopted by players are different. In asymmetric games, the strategy
that provides benefit to one player may not be equally beneficial for
the other player. However, decision making in asymmetric games
depends on the different types of strategies and decision of players.
Example of asymmetric game is entry of new organization in a market
because different organizations adopt different strategies to enter in
the same market.
Impact on Economics and Business
Game theory brought about a revolution in economics by addressing
crucial problems in prior mathematical economic models. For
instance, neoclassical economics struggled to understand
entrepreneurial anticipation and could not handle the imperfect
competition. Game theory turned attention away from steady-state
equilibrium toward the market process.

In business, game theory is beneficial for modelling competing

behaviours between economic agents. Businesses often have several
strategic choices that affect their ability to realize economic gain. For
example, businesses may face dilemmas such as whether to retire
existing products or develop new ones, lower prices relative to the
competition, or employ new marketing strategies. Economists often
use game theory to understand oligopoly firm behaviour. It helps to
predict likely outcomes when firms engage in certain behaviours,
such as price-fixing and collusion.
KEY TAKEAWAYS

• Game theory is a theoretical framework to conceive social situations

among competing players and produce optimal decision-making of
independent and competing actors in a strategic setting.
• Using game theory, real-world scenarios for such situations as pricing
competition and product releases (and many more) can be laid out and
their outcomes predicted.
• Scenarios include the prisoner's dilemma and the dictator game among
many others.

What is Dominant Strategy?

The dominant strategy in game theory refers to a situation where one

player has superior tactics regardless of how their opponent may play.
Holding all factors constant, that player enjoys an upper hand in the
game over the opposition. It means, regardless of the strategies
employed by the opponent, the dominant player will always dictate
the outcome.
Understanding Dominant Strategy

In game theory, players employ different independent strategies to

optimize their decision-making with the goal of beating the opponent.
Players in an oligopolistic market, military, managers, consumers, or
games like the chase, often use game theory as a strategic tool.

In game theory, the outcomes of the actors are different depending on

their actions. Some players enjoy an upper hand, while others are less
fortunate. The dominant strategy describes a state where one of the
players has a superior tactic that always leads to a winning outcome,
despite the opponent’s employed choice of strategy.

Dominant Strategy Outcomes

In game theory, the following are the outcomes players can expect:

1. Strictly Dominant Outcome

In some situations, one player enjoys a strict advantage over their

opponent. It means that, no matter how good the losing party’s tactic
is, the dominant strategy will always prevail. Here, there is no other
possible strategy the opponent can use to alter their odds.

2. Weakly Dominant Outcome

In a weakly dominant outcome, the dominant player dominates the

game but against some strategies, only weakly dominates.

3. Equivalent Outcome

In an equivalent outcome, none of the actors benefit or lose against

each other. They each choose the one optimal result that is fair for
both players. In case one of the players selects the alternative, it
would mean an outlandish gain or loss.

4. Intransitive Outcome

In an intransitive outcome, none of the above three outcomes are

experienced – no equivalent, strictly, or weak dominant outcome
results. The available outcome happens by chance. Either player can
win, while the other loses depending on the strategy employed.
Therefore, in this outcome, there is no well-defined approach to point
to the dominance strategy.

What Is Nash Equilibrium?

Nash equilibrium is a concept within game theory where the optimal
outcome of a game is where there is no incentive to deviate from the
initial strategy. More specifically, the Nash equilibrium is a concept
of game theory where the optimal outcome of a game is one where no
player has an incentive to deviate from their chosen strategy after
considering an opponent's choice.

Overall, an individual can receive no incremental benefit from

changing actions, assuming other players remain constant in their
strategies. A game may have multiple Nash equilibria or none at all.

Understanding Nash Equilibrium

Nash equilibrium is named after its inventor, John Nash, an American
mathematician. It is considered one of the most important concepts of
game theory, which attempts to determine mathematically and
logically the actions that participants of a game should take to secure
the best outcomes for themselves.

The reason why Nash equilibrium is considered such an important

concept of game theory relates to its applicability. The Nash
equilibrium can be incorporated into a wide range of disciplines,
from economics to the social sciences.

To quickly find the Nash equilibrium or see if it even exists, reveal

each player's strategy to the other players. If no one changes their
strategy, then the Nash equilibrium is proven.

Nash Equilibrium vs. Dominant Strategy

Nash equilibrium is often compared alongside dominant strategy, both
being strategies of game theory. The Nash equilibrium states that the
optimal strategy for an actor is to stay the course of their initial
strategy while knowing the opponent's strategy and that all players
maintain the same strategy, as long as all other players do not change
their strategy.

Dominant strategy asserts that the chosen strategy of an actor will

lead to better results out of all the possible strategies that can be used,
regardless of the strategy that the opponent uses.

Both the terms are similar but slightly different. Nash equilibrium
states that nothing is gained if any of the players change their strategy
if all other players maintain their strategy. Dominant strategy asserts
that a player will choose a strategy that will lead to the best outcome
regardless of the strategies that other plays have chosen. Dominant
strategy can be included in Nash equilibrium whereas a Nash
equilibrium may not be the best strategy in a game.

Example of Nash Equilibrium

Imagine a game between Tom and Sam. In this simple game, both
players can choose strategy A, to receive $1, or strategy B, to lose $1.
Logically, both players choose strategy A and receive a payoff of $1.

If you revealed Sam's strategy to Tom and vice versa, you see that no
player deviates from the original choice. Knowing the other player's
move means little and doesn't change either player's behaviour.
Outcome A represents a Nash equilibrium.

What Is the Prisoner's Dilemma?

The prisoner's dilemma is a paradox in decision analysis in which two
individuals acting in their own self-interests do not produce the
optimal outcome. The typical prisoner's dilemma is set up in such a
way that both parties choose to protect themselves at the expense of
the other participant. As a result, both participants find themselves in
a worse state than if they had cooperated with each other in the
decision-making process. The prisoner's dilemma is one of the most
well-known concepts in modern game theory.

Understanding the Prisoner's Dilemma

The prisoner’s dilemma presents a situation where two parties,
separated and unable to communicate, must each choose between co-
operating with the other or not. The highest reward for each party
occurs when both parties choose to co-operate.

The classic prisoner’s dilemma goes like this: two members of a gang
of bank robbers, Dave and Henry, have been arrested and are being
interrogated in separate rooms. The authorities have no other
witnesses, and can only prove the case against them if they can
convince at least one of the robbers to betray his accomplice and
testify to the crime. Each bank robber is faced with the choice to
cooperate with his accomplice and remain silent or to defect from the
gang and testify for the prosecution. If they both co-operate and
remain silent, then the authorities will only be able to convict them on
a lesser charge of loitering, which will mean one year in jail each (1
year for Dave + 1 year for Henry = 2 years total jail time). If one
testifies and the other does not, then the one who testifies will go free
and the other will get three years (0 years for the one who defects + 3
for the one convicted = 3 years total). However, if both testify against
the other, each will get two years in jail for being partly responsible
for the robbery (2 years for Dave + 2 years for Henry = 4 years total
jail time).

In this case, each robber always has an incentive to defect, regardless

of the choice the other makes. From Dave’s point of view, if Henry
remains silent, then Dave can either co-operate with Henry and do a
year in jail, or defect and go free. Obviously, he would be better off
betraying Henry and the rest of the gang in this case. On the other
hand, if Henry defects and testifies against Dave, then Dave’s choice
becomes either to remain silent and do three years or to talk and do
two years in jail. Again, obviously, he would prefer to do the two
years over three.

In both cases, whether Henry co-operates with Dave or defects to the

prosecution, Dave will be better off if he himself defects and testifies.
Now, since Henry faces the exact same set of choices he also will
always be better off defecting as well. The paradox of the prisoner’s
dilemma is this: both robbers can minimize the total jail time that the
two of them will do only if they both co-operate (2 years total), but
the incentives that they each face separately will always drive them
each to defect and end up doing the maximum total jail time between
the two of them (4 years total).

Examples of the Prisoner's Dilemma

The economy is replete with examples of prisoner’s dilemmas with
can have outcomes that are either beneficial or harmful to the
economy and society as a whole. The common thread is situations
where the incentives faced by each individual decision maker who
gets to choose would induce them each to behave in a way that makes
them all collectively worse off, while individually avoiding choices
that would make them all collectively better off if all could some
somehow cooperatively choose.

One such example is the tragedy of the commons. It may be in

everyone’s collective advantage to conserve and reinvest in the
propagation of a common pool natural resource in order to be able to
continue consuming it, but each individual always has an incentive to
instead consume as much as possible as quickly as possible, which
then depletes the resource. Finding some way to co-operate would
clearly make everyone better off here.

On the other hand, the behaviour of cartels can be also be considered

a prisoner’s dilemma. All members of a cartel can collectively enrich
themselves by restricting output to keep the price that each receives
high enough to capture economic rents from consumers, but each
cartel member individually has an incentive to cheat on the cartel and
increase output to also capture rents away from the other cartel
members. In terms of the welfare of the overall society that the cartel
operates in, this is an example of how a prisoner’s dilemma that
breaks the cartel down can sometimes actually make society better off
as a whole.

Escape from the Prisoner's Dilemma

Over time, people have worked out a variety of solutions to prisoner’s
dilemmas in order to overcome individual incentives in favour of the
common good.
First, in the real world most economic and other human interactions
are repeated more than once. A true prisoner's dilemma is typically
played only once or else it is classified as an iterated prisoner's
dilemma. In an iterated prisoner’s dilemma, the players can choose
strategies that reward co-operation or punish defection over time. By
repeatedly interacting with the same individuals, we can even
deliberately move from a one-time prisoner's dilemma to a repeated
prisoner's dilemma.

Second, people have developed formal institutional strategies to alter

the incentives that individual decision makers face. Collective action
to enforce cooperative behaviour through reputation, rules, laws,
democratic or other collective decision making, and explicit social
punishment for defections transforms many prisoner’s dilemmas
toward the more collectively beneficial cooperative outcomes.

Last, some people and groups of people have developed

psychological and behavioural biases over time such as higher trust in
one another, long-term future orientation in repeated interactions, and
inclinations toward positive reciprocity of cooperative behaviour or
negative reciprocity of defecting behaviours. These tendencies may
evolve through a kind of natural selection within a society over time,
or group selection across different competing societies. In effect they
lead groups of individuals to “irrationally” choose outcomes that are
actually the most beneficial to all of them together.

Put together, these three factors (the repeated prisoner’s dilemmas,

formal institutions that break down prisoner’s dilemmas, and
behavioral biases that undermine “rational” individual choice in
prisoner’s dilemmas) help resolve the many prisoner’s dilemmas we
would all otherwise face.
KEY TAKEAWAYS

• A prisoner's dilemma is a situation where individual decision makers

always have an incentive to choose in a way that creates a less than
optimal outcome for the individuals as a group.
• Prisoner's dilemmas occur in many aspects of the economy.
• People have developed many methods of overcoming prisoner's
dilemmas to choose better collective results despite apparently
unfavourable individual incentives.