Question

Using game theory, explain and illustrate how an oligopolistic market differs itself from perfect competition.

Answer 1

In an oligopoly, firms are affected not only by their own production decisions, but by the production decisions of other firms in the market as well. Game theory models situations in which each actor, when deciding on a course of action, must also consider how others might respond to that action.
The prisoner’s dilemma is a specific type of game in game theory that illustrates why cooperation may be difficult to maintain for oligopolists even when it is mutually beneficial. They have a simple choice, either to confess to the crime (thereby implicating their accomplice) and accept the consequences, or to deny all involvement and hope that their partner does likewise.The result of the game is that both prisoners pursue individual logic and betray, when they would have collectively gotten a better outcome if they had both cooperated. The pay off matrix is:

In the game, two members of a criminal gang are arrested and imprisoned. The prisoners are separated and left to contemplate their options. If both prisoners confess, each will serve a 6 year prison term. If one confesses, but the other denies the crime, the one that confessed will walk free, while the one that denied the crime would get a 10-year sentence. If both deny the crime, they will both serve only 2-year sentence. Betraying the partner by confessing is the dominant strategy; it is the better strategy for each player regardless of how the other plays, and this is where Nash equilibrium exists.
So, we can see that in Oligopoly, Each business could maximise its profit , but as they would try to maximise their profit, each will get affected by the decision of other firms, and they would end up by getting a normal profit.

Now if we consider the perefectly competitive industry. Firms will try to maximise their profit as well, but now they have informations about what others are doing. Lets us consider an example, two Firms A and B is making purchase of the competing products and making decision regarding the advertising campaigns. Firm will get affected by competitor’s decision. If Firm A gives an advertisement whereas Firm B does not go for it, Firm A will earn good and Firm B faces loss. The pay off is as follows:

First make consideration of the first firm. It should clearly go for advertisement no matter what the second firm will make decision, Firm A earns by the way of advertisement. If Firm B chooses to advertise, it is possible that Firm A can earn profit of 10. But if it goes for advertising only of 6, it doesn’t. The advertising could become dominant strategy for the first firm. It is similar for Firm B if it does an advertisement.If Firm B goes with the similar strategy irrespective of the plans used by Firm A for advertisement, it is possible that Firm B can earn more through its own plan. Suppose both these firm are rational and going for dominant strategies, then we can predict the outcome. It is most likely that it will be equilibrium because of dominant strategies.Every game does not require dominant strategy. For example, if the Firm A goes for big banners to advertise its product as compare to Firm B, it is likely that Firm A will earn more profit than Firm B. It is clear that Firm A’s intention is to beat Firm B by producing the expensive large banners for its products. It means advertise might cost you at earlier stage but you can get the returns when you sell the items.Decision of Firm A depends on the decision of Firm B.Suppose Firm B has dominant strategy for advertising its products and services irrespective of what Firm A is trying to do. In this case, Firm A will definitely advertise but the winning strategy of Firm B is clear so it is possible that this firm will earn more profit than Firm A.

So, in the competitive market, a firm will always make some profit, and other firms get affected by its decision. The collusive character of firms is one of the main aspect of competitive market.