Mar 23 2012

Understanding Oligopoly Behavior – a Game Theory overview

What makes oligopolistic markets, which are characterized by a few large firms, so different from the other market structures we study in Microeconomics? 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 (non-collusive meaning a few firms that do NOT cooperate on output and price), 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.

In the game above, both SF Coffee and Starbuck have what is called a dominant strategy. Regardless of what its competitor does, both companies would maximize their outcome by advertising. If SF coffee were to not advertise, Starbucks will earn more profits ($20 vs $10) by advertising. If SF coffee were to advertise, Starbucks will earn more profits ($12 vs $10) by advertising. The payoffs are the same given both options for SF Coffee. Since both firms will do best by advertising given the behavior of its competitor, both firms will advertise. Clearly, the total profits earned are less when both firms advertise than if they both did NOT advertise, but such an outcome is unstable because the incentive for both firms would be to advertise. We say that advertise/advertise is a “Nash Equilibrium” since neither firm has an incentive to vary its strategy at this point, since less profits will be earned by the firm that stops advertising.

As illustrated above, the tools of Game Theory, including the “payoff matrix”, can prove helpful to firms deciding 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.

Game theory as a mathematical tool can be applied in realms beyond oligopoly behavior in Economics.  In each of the videos below, game theory can be applied to predict the behavior of different “players”. None of the videos portray a Microeconomic scenario like the one above, but in each case a payoff matrix can be created and behavior can be predicted based on an analysis of the incentives given the player’s possible behaviors.

Assignment: Watch each of the five videos below. For each one, create a payoff matrix showing the possible “plays” and the possible “payoffs” of the game portrayed in the video. Predict the outcome of each game based on your understanding of incentives and the assumption that humans act rationally and in their own self-interest.

“Batman – the Dark Night” – the Joker’s ferry game:

“Princess Bride” – where’s the poison?:

“Golden Balls” – split or steal:

“The Trap” – the delicate balance of terror

“Murder by Numbers” – the interrogation

Discussion Questions:

  1. Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?
  2. What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?
  3. Among the videos above, which games ended in the way that your payoff matrix and understanding of human behavior and rational decision making would have predicted?
  4. How often did the equilibrium outcomes according to your analysis of the payoff matrices correspond with the socially optimal outcome (i.e. the one where total payoffs for all players are maximized or the total losses minimized)?

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 so far

11 Responses to “Understanding Oligopoly Behavior – a Game Theory overview”

  1. Amiton 16 Dec 2009 at 5:32 pm

    2. Firms are interdependent because their demand schedules will depend on one another. This is due to "sticky" prices and the kinked demand curves which form as a result of the firms not wanting to lose market share in addition to trying to "steal" customers from the other firm. (elastic over price, inelastic under price)

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  2. Jasonon 17 Dec 2009 at 1:58 am

    1. Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?

    In more competitive markets, firms are independent, and their choices have hardly any effects on the other firms. However, in an oligopoly, choices that one firm makes has a huge effect on the other few, and unless they respond, one firm might dominate the market and take all the profits.

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  3. Lara F.on 17 Dec 2009 at 5:23 am

    What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?

    Firms are interdependent, because they have to be ready to make a move at any time, because when the other firm is advertising, it has to do it to, otherwise it would lose consumers. As you can see above in the videos, some people can be trusted and some can't. It's like that for firms, firms can join together and agree we don't do advertising, but still on the next day one did it. It is unpredictable what the components are planning to do. As a oligopoly firm you always have to be ready to react to other firms reactions.

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  4. Lara F.on 17 Dec 2009 at 5:25 am

    What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?

    Firms are interdependent, because they have to be ready to make a move at any time, because when the other firm is advertising, it has to do it to, otherwise it would lose consumers. As you can see above in the videos, some people can be trusted and some can't. It's like that for firms, firms can join together and agree we don't do advertising, but still on the next day one did it. It is unpredictable what the components are planning to do. Every firm wants to do better than the other firms, so they can't trust each other. As a oligopoly firm you always have to be ready to react to other firms reactions.

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  5. Gelando Makrideson 17 Dec 2009 at 5:05 pm

    2. What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?

    This means that the decision that each firm makes in the payoff matrix directly influences the outcome for each firm. Therefore, the firms must make their 'moves' while minimizing costs and maximizing profits and try and predict what the other firm will try and do. In the end, this all means that the firms influence each other's demand curves.

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  6. Mhairion 18 Dec 2009 at 3:11 am

    2. What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?

    Oligopolists are inter-dependent of one another as their decisions directly affect each other. These can be decisions on things such as pricing and advertising. Each market will make their decision or, "move" based on what they think their competition will do. This means each firms demand curve is influenced by the other.

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  7. Felipe R-Lopezon 18 Dec 2009 at 8:54 am

    1.Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?

    An oligopoly is defined as a small number of big firms that control most, if not all, of a particular market. Competition is reduced to these number of firms, and since each controls a relatively large share of the market, one's actions could have considerable impact on others, something known as mutual interdependence. Therefore, firms are in constant surveillance of the other's actions, and the ability to foresee the other's actions can be very useful. Oligopoly behavior is like a game of poker because of the small number of dominant firms in the market and because each firm's decisions and actions has a considerable impact on other firms.

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  8. Pilar M.on 11 Jan 2011 at 6:10 am

    Why is oligopoly behavior more like a game of poker than the behavior of firms in more competitive markets?

    In an oligopolistic market very few firms are controlling the market. The smartphone industry is an example of an oligopoly because there are few sellers. In addition to that, in the case of the smartphone industry every firm tries to foresee and predict what the other firm will do next. Which new product will that firm bring out? What should we add to out product in order to be at the top of innovation? Those questions might be asked by the firms because the prediction of new features of a good or just new good is very important in order to ensure profits. Hence, the oligopoly behavior is like a game of poker, where there are few players trying to guess what the next move of the other players will be.

    What does it mean that firms in oligopolistic markets are “inter-dependent” of one another?

    Firms in oligopolistic markets are "inter-dependent" because since there are relatively few firms in the industry this exactly creates the inter-depent relationship among them. Also, with an oligopoly, the single firm is large enough (few firms in the market) so that its actions actually influences and affects the market overall and thus the other firms. Therefore, also each firm's actions are watched by the other competitors, who may then react with their own strategies and actions.

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  9. [...] http://welkerswikinomics.com/blog/2011/01/10/understanding-oligopoly-behavior-a-game-theory-overview… [...]

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  10. Mannieon 22 Oct 2012 at 2:47 pm

    thanks alot it is helpful for doing my class work activity

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  11. [...] understanding indicates a lack of raw analytic intelligence. Far from it. Decisions made in game theory, pioneered by Nobel Prize winner John Nash, (who is also the protagonist of the outrageously [...]

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