A Level Economics 44: Oligopoly and Game Theory

Game theory is a powerful tool for understanding the interdependent behavior of firms in oligopolistic markets. It helps analyze strategic decision-making where each firm's actions directly impact its competitors' choices. One essential concept in game theory is the Nash equilibrium, where no firm can improve its position by unilaterally changing its strategy.

Example: The Prisoner's Dilemma

Let's consider a classic example of the Prisoner's Dilemma to illustrate the interdependent behavior of firms in an oligopolistic market. Imagine two major airlines, Airline A and Airline B, competing on a popular route.

1. If Both Airlines Charge High Prices:

   • In this scenario, both airlines pursue profit maximization by charging high ticket prices. Both firms earn substantial profits individually.
   • However, since the prices are high, fewer passengers choose to fly, leading to lower total demand in the market.
   • As a result, both airlines experience a reduction in overall revenue and profits due to the limited number of customers.

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3. If Both Airlines Charge Low Prices:

   • In this case, both airlines try to attract more passengers by offering lower ticket prices. As a result, the number of passengers increases for both airlines.
   • However, the aggressive price competition leads to reduced profits for both airlines due to lower ticket revenues.

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5. If One Airline Charges High, While the Other Charges Low:

   • If Airline A decides to charge high prices while Airline B opts for low prices, Airline A may gain a larger market share since some passengers might prefer the lower prices of Airline B.
   • Airline B, on the other hand, may attract more customers but will earn lower profits due to the lower ticket prices.
   • In this situation, Airline A may experience higher profits than Airline B.

Nash Equilibrium in the Prisoner's Dilemma: The Nash equilibrium occurs when both airlines choose to charge high prices (Scenario 1). In this situation, neither airline can improve its profits by unilaterally changing its pricing strategy. If one airline deviates from high prices to low prices, it risks losing revenue to the competitor, leading to lower profits.

This outcome is a classic illustration of the Nash equilibrium, where each firm's strategy is the best response to the other firm's strategy. Despite both airlines earning higher profits individually by charging low prices (Scenario 2), they end up in a situation where neither wants to deviate from high prices due to the fear of losing market share and potential revenue.

Observation of Nash Equilibrium: In the Nash equilibrium, neither firm has an incentive to change its strategy given its competitor's choice. The airlines reach a stable situation where they are interdependent, and their profits are maximized under the current circumstances.

This example demonstrates how game theory and the concept of Nash equilibrium help understand the interdependent behavior of firms in oligopolistic markets. It shows that even when both firms could potentially benefit from different strategies, they often settle into a stable equilibrium where they are mutually dependent on each other's decisions.