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!