Theory of Games and Strategic Behaviour

Introduction

• Earlier oligopoly models assumed profit maximisation as the objective of firms, but some alternative models explain oligopoly behaviour by assuming objectives other than profit maximisation; one such approach applies Game Theory to the oligopoly problem.

• John von Neumann and Oskar Morgenstern, in their 1944 book The Theory of Games and Economic Behavior, developed a new analytical framework for studying situations involving conflicting interests, providing a fresh approach to economic and non-economic decision-making problems.

• The application of Game Theory extends beyond oligopoly to issues such as demand under uncertainty, and has also been used in fields including business administration, sociology, psychology, political science, and military planning.

• Game Theory studies the outcomes of situations involving interaction among parties whose interests conflict and seeks to identify the rational course of action for an individual facing uncertainty, where outcomes depend not only on his own decisions but also on the decisions of others confronting the same problem.

• In an oligopolistic market, each firm faces the problem of selecting a rational strategy while taking into account the possible reactions of rival firms, since those reactions directly influence its own results; this makes the oligopolist’s problem analogous to that of a player in a game.

• In the basic form of Game Theory:

  • A player must choose among several possible courses of action called strategies.

  • A strategy is a course of action or policy that a participant adopts during the game.

  • Although many strategies may be available, only one can be chosen at a given time.

• In oligopoly, important strategic alternatives include:

  • Price decisions.

  • Output decisions.

  • Advertising expenditure decisions.

  • Product variation decisions.

• Each broad strategy can be divided into specific alternatives:

  • Price strategy: lowering price, raising price, or keeping price unchanged.

  • Output strategy: increasing output, decreasing output, or maintaining current output.

  • Advertising strategy: choosing among different media such as radio, television, newspapers, magazines, handbills, posters, etc.

  • Product variation strategy: modifying characteristics such as packaging colour, package type, product quality, and other product attributes.

• A fundamental characteristic of oligopoly is mutual interdependence, requiring every firm to consider rivals’ reactions before taking any action.

• For example, if Maruti Udyog raises the price of its product, it must consider how rival firms’ prices, profits, and responses will be affected, since competitors are unlikely to remain passive.

• Oligopolistic behaviour therefore resembles a game, where each player must anticipate how rivals will react to his moves and adjust decisions accordingly.

• Game Theory emphasises strategic behaviour in oligopoly:

  • Firms make decisions on price, output, advertising, and other variables after considering likely rival responses.

  • Firms assume rivals are rational and will act in ways that best promote their own interests.

  • Expected rival reactions become an integral part of a firm’s decision-making process.

• Game Theory provides important insights into oligopolistic decision-making by explaining:

  • Why individual firms may cheat on cartel agreements.

  • Why and how oligopolistic firms attempt to prevent the entry of new firms into the industry.