Question

Explain how advertising can result in a prisoners dilemma for companies in an oligopoly.

Answer 1

An oligopoly is a market form wherein a market or industry is dominated by a small group of large sellers (oligopolist). Oligopolies can result from various forms of collusion that reduce market competition which then typically leads to higher prices for consumers.

Prisoners dilemma is one of the most famous game theory which explains how rivals (oligopolist) behaving selfishly act contrary to their mutual or common interests. It basically provides a framework for understanding how to strike a balance between cooperation and competition for mutually beneficial existence.

For a company in a oligopoly model, if it increases its expenditure on advertising, other oligopolist will follow suit. This ultimately reduces the profit of the firm with no concurrent benefits.

Consider the case of Coca-Cola versus PepsiCo, and assume the former is thinking of increasing the advertisement of its iconic soda drinks. If it does so, Pepsi may have no choice but to follow suit for its cola to retain its market share. This may result in a significant drop in profits for both companies. For example, if two firms have an implicit agreement to leave advertising budgets unchanged in a given year, their net income may stay at relatively high levels. But if one defects and raises its advertising budget, it may earn greater profits at the expense of the other company, as higher sales will offset the increased advertising expenses. However, if both companies boost their advertising budgets, the increased advertising efforts may offset each other and prove ineffective, resulting in lower profits, due to the higher advertising expenses than would have been the case if the ad budgets were left unchanged.

Thus, we get a classic case of prisoners dilema among oligopolist with regard to advertisement.