Feb 27 2009

## The “delicate balance of terror”: How game theory can be used to predict firm behavior (oh, and save the human race from utter annihilation)

This week in AP Microeconomics students get to play online games, watch movies, and compete with their classmates in strategic competitions in which there are proud winners and sad losers. That’s right, we’re studying oligopoly!

What makes oligopolistic markets, which characterized by a few large firms, so different from the other market structures we study in Microeconomics? The answer is that unlike in more competitive markets in which firms are of much smaller size and one firm’s behavior has little or no effect on its competitors, an oligopolist that decides to lower its prices, change its output, expand into a new market, offer new services, or adverstise, will have powerful and consequential effects on the profitability of its competitors. For this reason, firms in oligopolistic markets are always considering the behavior of their competitors when making their own economic decisions.

To understand the behavior of non-collusive oligopolists, economists have employed a mathematical tool called Game Theory. The assumption is that large firms in competition will behave similarly to individual players in a game such as poker. Firms, which are the “players” will make “moves” (referring to economic decisions such as whether or not to advertise, whether to offer discounts or certain services, make particular changes to their products, charge a high or low price, or any other of a number of economic actions) based on the predicted behavior of their competitors.

If a large firm competing with other large firms understands the various “payoffs” (referring to the profits or losses that will result from a particular economic decision made by itself and its competitors) then it will be better able to make a rational, profit-maximizing (or loss minimizing) decision based on the likely actions of its competitors. The outcome of such a situation, or game, can be predicted using payoff matrixes. Below is an illustration of a game between two coffee shops competing in a small town.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful in helping firms decide how to respond to particular actions by their competitors in oligopolistic markets. Of course, in the real world there are often more than two firms in competition in a particular market, and the decisions that they must make include more than simply to advertise or not. Much more complicated, multi-player games with several possible “moves” have also been developed and used to help make tough economic decisions a little easier in the world of competition.

While Game Theory can be useful in predicting firm behavior in oligopolistic markets, believe it or not that is not its most useful application developed. In fact, would you believe me if I told you that Game Theory may be precisely what saved the world from nuclear holocaust during the 20th Century? It’s true. The US government employed Game Theory to avert annihilation by nuclear attack from the Soviet Union during much of the 20th Century. This video tells the story!

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

### 11 Responses to “The “delicate balance of terror”: How game theory can be used to predict firm behavior (oh, and save the human race from utter annihilation)”

1. Bjorn Kvaaleon 01 Mar 2009 at 4:52 am

The game theory is a very important part of economics because it is used in many oligopolists firms to predict a company's moves in the future. A company must always predict that a competitor will cheat on them. In the coffee example given above, we can see that both would competitors would be earning good economic profits if they didn't advertise, but since Starbucks thinks SF Coffee will advertise, Starbucks must advertise also. With both companies advertising, a Nash equilibrium is met. Yet if Starbucks advertised and SF Coffee didn't advertise, Starbucks Coffee would be better off because they would make \$20 profits instead of 15\$ profits. The best way to go is for oligopolists to collude or to employ there best move possible, which is to advertise in this case. An even better tactic is to buy up the other firm, which Starbucks did with many other coffee firms.

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2. Alexandriaon 01 Mar 2009 at 10:01 pm

The video didn't work for me but I think I understand the point. The Soviet Union and US both armed themselves with nuclear missiles. By doing this, they were at an equilibrium point. Of course, it probably would have been better if they were at the other equilibrium point (with no nuclear missiles). Had only the Soviet Union armed themselves, then the US would be weak and at constant risk, the same goes if it had been the other way around. By both arming themselves, they both put themselves at risk but encountered a standstill, where no one would make the first move. This resulted in the missiles not being launched.

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3. Yael Burlaon 02 Mar 2009 at 2:31 am

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4. Benji Rosenon 02 Mar 2009 at 4:08 am

Since game theory has been explained twice now in the above responses I wont regurgitate any more informatoin. The video did not link economics to game theory, but indirectly it was very on topic in the selfish aims of the people involved which are similair to the profit maximising aims of the firms. However both firms are making selfish decisions, for example not to change the price since they have analyzed the other companies and beleive they would loose money since the other firms would lower their prices too. This though is descreet Colluding!!! They are working together, they just dont know it. Their selfish driven stratedgy combined with their use of gametheory has resulted in them deciding it is more profitable to collude and keep the prices high/costs low (when investing in advertisement) and work together. That said, there are occations where oligopolistic firms will engage in price or non price competition tactics in the hope that the other firms are not paying attention/cannot afford to do the same. This selflish black mail technique described by a paranoid schizophrenic is not far from the truth, though it doesent account for human error nor for the fact that often firms will choose to collude for those selfish reasons.

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5. Bastion 03 Mar 2009 at 6:11 pm

I agree with Bjoern that the game theory is important in an oligopoly. It allows a firm to analyze what opposing firms are going to do and how they can use that to their advantage. The game theory is a bit like a goalie before a penalty, if hes left footed the goalie knows a bit about where hes going to shoot. If he knows the player he can predict which way he is going to go. It is similar with firms, in the coffee example we see how Starbucks reacts to SF coffee and therefore makes more of a profit. If SF coffee advertises Starbucks must advertise to mke a profit, because STarbucks thought SCoffee would advertise and they didint so Starbucks will make a profit.

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6. Justuson 05 Mar 2009 at 3:47 am

I think it is fascinating this technique. In the game series "Total War" this technique springs up as well. You are one of several large nations and your are competing for the best economically rhich nations on the globe. As in this gaming theory you are interdependent from one another and must always guess what his next move will be. It is interesting that a technique like a game is being used today in real life situations. The technique also makes perfect sense, because Oligopolies are interdependant from each other and always have to make their next move in response of what their opponent did. In this case the two firms STarbucks and SCoffee have the choice of advertising, or not to advertise. The best choice is for both of them not to advertise, however due to the fact that neither trust each other and think that at least one of them will advertise and gain more profit, both of them will always advertise. The result will be that both will make a profit of \$12 rather than \$15. The Nash Equilibrium will be at \$12, because both of them have their dominant strategy to advertise. In all a really interesting technique.

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7. sabrina walshon 05 Mar 2009 at 4:04 am

I find it interesting as well that we are able to apply the economic concept of "game theory" in instances not related profit oriented. for example the USSR vs. USA cold war arms race, and the prisoners plea bargain example. Today in class we learned about dominant strategies which refers to the point at which Firm A (starbucks) maximizes its profit regardless of what firm B (San Fran coffee) chooses to do. In this case how ever, both firms share the same dominant strategy which is to advertise. This is not always the case, we learned today that is also possible to not have a set dominant strategy if the firm has knowledge of the pay off matrix.

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8. Dimitri Da Ponteon 05 Mar 2009 at 5:43 am

Nash’s equation would mean an absolute rule of complete distrust between human beings. If people were so definable, life would be much easier as everyone reaction to a certain situation could be known. Unfortunately the grey areas of the human condition make us unpredictable and irrational. One may say that Nash’s assumptions are like perfect competition or a monopoly, two extremes which are possible in only rare occasions. Yet as we are all different, with different presumptions and different moral values, we will collaborate to a certain point. When talking about oligopolies, I have always wondered why they simply did not talk to each other. It is obvious that the will both have higher profits by colluding. Firms will reach a second, yet less profitable, equilibrium by being completely selfish. Oligopolistic firms, though, go half way; sometimes they talk, sometimes they collude, sometimes they act independently, resulting in lower profits. This just goes to show that most of the times humans are very unreasonable beings.

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9. Zac Queryon 05 Mar 2009 at 7:15 am

This idea, Game Theory, is effective in attempting to analyze oligopoly behavior. It can only apply, however, to non-collusive oligopolies because cooperation would disturb the basic premise behind game theory, self-interest. Theoretically, if each "player" in the "game" acts accordingly to their own self-interest, they will play their dominant strategy. When both "players" play their dominant strategy an equilibrium is reached known as the Nash Equilibrium. As the video proves, the applications of Game Theory extend beyond the realm of economics. John Nash aided the US government during the Cold War and also believed he could use Game Theory to explain and justify all human interactions.

Ok, well I just got back from a basketball game against a club team, the Zurich Wildcats, and I think I may have stumbled into a situation involving Game Theory. Before the game, our team and the Wildcats both had to use the same locker room. After changing, players from both teams had to make the decision of leaving their bags in the locker room or taking them out onto the court. Each team, though, was worried about the opposing team stealing their belongings. Therefore, each team had two options. Using Game Theory, I knew exactly what the outcome would be. Each team would play their dominant strategy (taking their bags with them) and therefore each team wouldn't have to worry about the other team stealing their valuables. This is not EXACTLY the kind of example we would use in class, but you can see the application.

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10. Matt Coucheron 05 Mar 2009 at 7:00 pm

It is interesting to see that not only does "game theory" apply to the analyzing of oligopolies but many other topics that are come across through out the world. A major example that has been brought up was the Cold War between the USA and the Soviet Union. The options were to build more nuclear weapons or to not build any for each nation. With the arms race between the two nations, one could observe that there is no dominant strategy unlike the prisoners example that we were shown in class as the obvious dominant strategy was to confess.

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11. Markus von der Marwion 12 Mar 2009 at 3:02 am

Game theory shows how interdependant firms in an oligopoly are. Their actions completely depend on the moves of their competitors. For example should they advertise or should they not. This is true in other situations as well. The decisions made are often not the ones that are best for both firms. If there was a way for each firm to collaborate then the outcome might be very different. However firms and people always assume the other firm or person is going to cheat. This is why in the example both firms choose to advertise, instead of neither firm advertising, which would have left both firms in a better position.

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