Ali Asghar Khurshid

ERP: 01265
Oligopoly Games
Game theory is a tool for studying strategic behavior, which is behavior that takes into account the expected
behavior of others and the mutual recognition of interdependence.

The Prisoners’ Dilemma

The prisoners’ dilemma game illustrates the four features of a game.
 Rules
 Strategies
 Payoffs
 Outcome
Rules
• The rules describe the setting of the game, the actions the players may take,
and the consequences of those actions.
• In the prisoners’ dilemma game, two prisoners (Hassan and Faizan) have been
caught committing a petty crime.
• Each is held in a separate cell and cannot communicate with each other.
• Each is told that both are suspected of committing a more serious crime.
• If one of them confesses, he will get a 1-year sentence for cooperating while
his accomplice get a 10-year sentence for both crimes.
• If both confess to the more serious crime, each receives 3 years in jail for both
crimes.
• If neither confesses, each receives a 2-year sentence for the minor crime only.
Strategies
Strategies are all the possible actions of each player.
• Hassan and Faizan each have two possible actions:
1. Confess to the larger crime.
2. Deny having committed the larger crime.
• With two players and two actions for each player, there are four possible
outcomes:
1. Both confess.
2. Both deny.
3. Hassan confesses and Faizan denies.
4. Faizan confesses and Hassan denies.
Payoffs
• Each prisoner can work out what happens to him—can work out his payoff—
in each of the four possible outcomes.
• We can tabulate these outcomes in a payoff matrix.
• A payoff matrix is a table that shows the payoffs for every possible action by
each player for every possible action by the other player.
• The next slide shows the payoff matrix for this prisoners’ dilemma game.
Prisoner Dilemma Matrix
Hassan Strategies

Faizan Strategies
Outcome
• If a player makes a rational choice in pursuit of his own best interest, he
chooses the action that is best for him, given any action taken by the other
player.

• If both players are rational and choose their actions in this way, the outcome
is an equilibrium called Nash equilibrium—first proposed by John Nash.

• The following slides show how to find the Nash equilibrium.

Faizan’s view:
Hassan Strategies

Faizan Strategies
Faizan’s view:
Hassan Strategies

Faizan Strategies
Hassan’s view:
Hassan Strategies

Faizan Strategies
Hassan’s view:
Hassan Strategies

Faizan Strategies
Equilibrium
Hassan Strategies

Faizan Strategies

In the prisoners’ dilemma game, the Nash equilibrium is a dominant strategy equilibrium, by which
we mean the best strategy for each player is independent of what the other player does.
Ashhar Mashhood
ERP: 01275
Competing Oligopoly
Even if there is no agreement, oligopolistic firms don’t end up changing their output with changes in cost.
This behavior can be seen in the diagram (next slide); there is a ‘stickiness’ in price as firms produce the
same output at varying marginal cost curves.

The assumption is that when a rival firm increases its price, other companies will not follow, but if a
competing business decreases its price then others will follow.

This leads to a ‘kink’ in the demand curve.

The upper part of the Demand Curve is more price elastic than the lower part. This is because of the
assumption that at the higher price, firms will not follow but at the lower price, other firms will cut prices
too.
 Kinked Demand Curve
Above the kink, demand is relatively elastic because all
other firm’s prices remain unchanged.

Below the kink, demand is relatively inelastic because all

other firm’s prices change in line with the price of the firm
shown in the figure.

The kink in the demand curve means that the MR curve is

discontinuous at the current quantity—shown by that gap
AB in the figure
Fluctuations in MC that remain within the
discontinuous portion of the MR curve leave the
profit-maximizing quantity and price unchanged.

For example, if costs increased so that the MC curve

shifted upward from MC0 to MC1, the profit-
maximizing price and quantity would not change.
Problem with Oligopoly Demand Curve

The beliefs that generate the kinked demand curve are not
always correct and firms can figure out this fact.

If MC increases enough, all firms raise their prices and the

kink vanishes.

A firm that bases its actions on wrong beliefs doesn’t

maximize profit.