Lecture 19: Oligopoly and Game Theory

Objective: These notes introduce game theory in the context of strategic interactions among firms, particularly relevant for understanding oligopolies. A key focus is on Nash Equilibrium, defining it as a state where no player can unilaterally improve their outcome, and illustrating its application in various economic and real-world scenarios.

Introduction to Game Theory

  • Game theory is the study of strategic interactions among firms in an economy.

  • Essential for understanding oligopoly, as it involves a few firms (typically 2-5).

Connection Between Marginal Revenue and Marginal Expenditure

  • Comparison of marginal revenue (monopoly) and marginal expenditure (monopsony)

    • Marginal Revenue (Monopoly):

    • A monopoly faces a downward-sloping demand curve.

    • As it sells additional units, the price decreases, affecting overall revenue.

    • Negative marginal revenue:

      • Bringing in less revenue for each additional unit sold often due to price cuts affecting all units sold.

    • Marginal Expenditure (Monopsony):

    • A monopsonist is a single buyer in a market with many sellers.

    • The marginal expenditure curve rises faster than supply.

    • As the monopsonist buys more, it needs to increase the price it pays for all units (due to paying a premium).

Assumptions Made in Comparing These Concepts

  • No Price Discrimination:

    • This assumption allows for the understanding of the shapes of the marginal curves without complicating effects from price variations.

Minimum Wage and its Effects

  • Comparison in Labor Markets:

    • In perfect competition, minimum wages lead to surplus transfer from workers to firms, generating a deadweight loss due to fewer employment opportunities.

    • In monopsony, minimum wages can occasionally benefit workers, potentially increasing overall surplus.

    • Different outcomes arise depending on the level of the minimum wage:

    • A high minimum wage might decrease labor hired but positively affect marginal expenditure.

    • A low minimum wage (above the usual wage) can potentially lead to more hiring.

Game Theory Introduction for Oligopoly

  • Firms in oligopoly must consider not just their own actions but also competitors’ responses.

  • Each firm has market power and strategic discretion, making game theory essential for understanding their interactions.

Strategic Interactions in Decision Making

  • General Decision-Making Framework:

    • Firms consider both supply and demand curves, as well as competitor behaviors.

    • Unlike perfectly competitive firms, oligopolists must think strategically due to fewer competitors.

Activities Demonstrating Strategic Thinking

  • Poll Activity (Guessing Game):

    • Participants were asked to guess a number between 1 and 100, where the winner is closest to half the average guess. This showcases strategic thinking and how competitors might adjust based on rational expectations of others’ behavior.

Nash Equilibrium in Game Theory

  • Defined as a set of strategies where no player can benefit from changing their strategy unilaterally.

    • Players must choose strategies considering anticipated actions of others, leading to mutual best responses.

    • Example: In the Prisoner's Dilemma, cooperation may lead to better outcomes than non-cooperation, but individual incentives lead to a Nash Equilibrium that isn't optimal (both choose to defect).

Game Theory Structure

  • Elements of a Game:

    • Players: The firms or individuals in the game.

    • Strategies: Possible actions players can take.

    • Payoffs: Outcomes resulting from the combination of players’ strategies, often reflecting benefits or losses in terms of profit, utility, or resources.

Applications of Game Theory

  • Game theory is applicable in various scenarios, including:

    • Market dynamics (competition among firms like Coca-Cola vs. Pepsi or Airbus vs. Boeing).

    • Political strategies (government negotiations, policy-making).

    • Environmental interactions and evolutionary biology.

Conclusion and Future Directions

  • Understanding concepts of Nash Equilibrium and strategic interaction is vital for future studies in economics or policy development.

  • Game theory forms a foundational framework for analyzing situations in oligopolies and other competitive industries.

Example of Nash Equilibrium: Driving on the Same Side of the Road

  • Driving behaviors can be identified as equilibrium strategies where no individual has an incentive to switch to the other side (higher risk).

  • This example illustrates how these equilibriums can exist in various forms and contexts, reinforcing the concepts taught.