Unit 3: Oligopoly - Game Theory

“When I am getting ready to reason with a man I spend one-third of my time thinking about myself and what I am going to say, and two-thirds thinking about him and what he is going to say.”



Abraham Lincoln

Click here to access a link to a game theory presentation.

A game occurs when there are two or more interacting decision-takers (players) and each decision or combination of decisions involves a particular outcome (pay-off.) The fate (or the payoff) of a player in a game depends not only on the actions of that player but also on the other players!

The Monty Hall problem!

Suppose you’re on a game show, and you’re given the choice of three doors. Behind one door is a car, behind the others, goats. You pick a door, say number 1, and the host, who knows what’s behind the doors, opens another door, say number 3, which has a goat. He says to you, “Do you want to pick door number 2?” Is it to your advantage to switch your choice of doors?



Game theory is mainly concerned with predicting the outcome of games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete information about the others' intentions.
The Prisoners’ Dilemma

The classic example of game theory is the Prisoners’ Dilemma, a situation where two prisoners are being questioned over their guilt or innocence of a crime. 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.

Confess or keep quiet? The Prisoner’s Dilemma is a classic example of basic game theory in action!


The “pay-off” is measured in terms of years in prison arising from each of their choices and this is summarised in the table below. No communication is permitted between the two suspects – in other words, each must make an independent decision, but clearly they will take into account the likely behaviour of the other when under interrogation:-

Two prisoners are held in a separate room and cannot communicate

They are both suspected of a crime

They can either confess or they can deny the crime

Payoffs shown in the matrix are years in prison from their chosen course of action

Decisions made under uncertainty

What is the optimal strategy for each prisoner?

Equilibrium occurs when each player takes decisions which maximise the outcome for them given the actions of the other player in the game.

In our example of the Prisoners’ Dilemma, the dominant strategy for each player is to confess since this is a course of action likely to minimise the average number of years they might expect to remain in prison.

But if both prisoners choose to confess, their “pay-off” i.e. 6 years each in prison is higher than if they both choose to deny any involvement in the crime.

However, even if both prisoners chose to deny the crime (and indeed could communicate with each other to agree this course of action), then each prisoner has an incentive to cheat on any agreement and confess, thereby reducing their own spell in custody.

The equilibrium in the Prisoners’ Dilemma occurs when each player takes the best possible action for themselves given the action of the other player.

The dominant strategy is each prisoners’ unique best strategy regardless of the other players’ action

Is the best strategy to confess?

Yes, but this is still a bad outcome – prisoners could do better by both denying – but once collusion sets in, each prisoner has an incentive to cheat!


Real world applications of game theory

Game theory analysis has direct relevance to our study of the behaviour of businesses in oligopolistic markets – for example the decisions that firms must take over pricing of products, and also how much money to invest in research and development spending. Costly research projects represent a risk for any business – but if one firm invests in R&D, can another rival firm decide not to follow? They might lose the competitive edge in the market and suffer a long term decline in market share and profitability.

The dominant strategy for both firms is probably to go ahead with R&D spending. If they do not and the other firm does, then their profits fall and they lose market share. However, there are only a limited number of patents available to be won and if all of the leading firms in a market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one firm opts to proceed.

In game theory, nothing is fixed!

Conventional economics takes the structure of markets as fixed. People are thought of as simple stimulus-response machines. Sellers and buyers assume that products and prices are fixed, and they optimize production and consumption accordingly. Conventional economics has its place in describing the operation of established, mature markets, but it doesn’t capture people’s creativity in finding new ways of interacting with one another.

Game theory is a different way of looking at the world. In game theory, nothing is fixed. The economy is dynamic and evolving. The players create new markets and take on multiple roles. They innovate. No one takes products or prices as given. If this sounds like the free-form and rapidly transforming marketplace, that’s why game theory may be the kernel of a new economics for the new economy.”

The Prisoners’ Dilemma can help to explain the break down of price fixing agreements between producers which can lead to the out-break of price wars among suppliers, the break-down of other joint ventures between producers and also the collapse of free-trade agreements between countries when one or more countries decides that protectionist strategies are in their own best interest.

The key point is that game theory provides an insight into the interdependent decision-making that lies at the heart of the interaction between businesses in a competitive market – particularly those dominated by a few leading players!

John Maynard Keynes’ “The Beauty Contest”:

“...professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.

We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”

J.M. Keynes; General Theory, p.156, 1936

Unit 4: Should Greece leave the Euro?

With even intellectual heavyweights like Boris Johnson suggesting Greece should leave the Euro, what are the economic arguments for and against?

I wrote a post here on some of the pros and cons of Greece leaving. (click here)

European political leaders seem to discount the possibility of anyone leaving the Euro, yet the head of Germany's prestigious think-tank IFO Institute, Hans-Werner Sinn, predicted that further austerity would be self-defeating and leaving the Euro could be the least bad option.

He said "The policy of forced 'internal devaluation,' deflation and depression could risk driving Greece to the edge of civil war,"
The scope of the problem can be seen in the size of Greece's current account deficit (click here) and unemployment (click here)

Whether Greece will leave the Euro is very hard to answer. The Greek government and European leaders seem to discount it as an option, but it is hard to see the current approach creating anything other than higher unemployment and greater civil rest. To fight for Euro survival is to fight for the wrong thing. Even if they were to survive this current crisis (and it is hard to see how) the fundamental problems of the Euro remain. It just doesn't work for a country who has different productivity rates, different levels of borrowing and different rates of growth.

Also, the Eurozone has shown it is not an optimal currency zone (click here). The unemployed in Greece can't easily move to other areas of the Euro where vacancies are available.

Greece should leave Euro, default on some debt and concentrate on reducing unemployment and creating economic growth.

Unit 4: Supply side policies - Education spending

This is a great info graphic which highlights the issue of effective spending on education around the world.

Unit 4: Problems of a 2 speed Europe (excellent for Macro paper)

A quick follow up to the problem of unemployment, is the issue of a two speed Europe.Increasingly there is a divergence between different blocks of countries within the EU. Some economies are showing signs of economic recovery. Others (the likes of Portugal, Ireland, Greece and Spain) are facing an unwelcome combination of stagnant growth, high unemployment, unpopular spending cuts, budget crisis and current account deficits.

Another useful graph is the divergence in unit labour costs. Previously if Greece saw rising wages, it would probably lead to a depreciation in Greek currency. But, now that can't happen - leading to the record current account deficit. To deal with uncompetitiveness it is necessary to require a much more painful process of deflation and lower growth.I've often posted about the inherent problems of a single currency for a two speed Europe (basically you can set monetary policy for two different economic regions)However, are there any practical problems with the two speed Europe?

• Fiscal transfers, e.g. from Germany to Greece. This would help solve budget crisis without the need for so much austerity. Fiscal transfers could help reduce geographical unemployment. To some extent the UK did this when unemployment was higher in north of UK than south during the 1980s. However, German tax payers are unlikely to want to fund 'the profligacy of their neighbours' It's one thing to give funds to different regions in your country. But, to give funds to other countries who beat you at football and speak another language is really stretching to the limits of European idealism. - Also there is a danger of moral hazard. If they pay up now, it may keep happening in future.
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• Supply side policies to regain competitiveness. Reducing labour market regulation, reducing power of trades unions, reducing benefits may all help put downward pressure on wages and restore competitiveness. However, it would be wrong to expect too much from supply side reforms. For example, Ireland already has one of lowest levels of labour market regulation in EU. Definitely structural unemployment is a problem for Spain, but it's only part of the problem, there is also the fundamental lack of demand in economy.

Unit 1: A new example of a public good?

It could be argued that as technology increases, the number of examples of public goods is decreasing, with the road network being a case in point. But here is a possible new example that will engage students and lead to a discussion on the features of a public good.


This BBC news article reveals that the Leicester City Council have been forced to admit that they are unprepared for a zombie invasion. A concerned citizen said that the possibility of an event such as this is something that the council should be aware of. Although a zombie invasion is perhaps highly unlikely, the council do have plans for other emergencies that are also highly unlikely and admit that elements of these plans could be transferred.

So does protecting an area against a zombie invasion meet the criteria for a public good? Firstly, it is likely that the protection offered is non-excludable by price as it is unlikely that zombies can be directed to only attack those who have not paid the protection fee. Either the protection is for everybody or for no-one which also leads in to it being non-rival as use of the “umbrella of protection” by one person doesn’t mean there is less protection available for others.

So it seems that zombie protection is a good example of a public good and the obvious conclusion is that it should be provided by the government. The Leicester City Council (and others) need to get their act together!

Unit 3: Key Diagrams

Key diagrams for unit 3

View more documents from mattbentley34.

Unit 4: Development Econ: Wealth and Inequality in China

The BBC is running a special series of short reports on the chasm in wealth inequality in fast-growing China (Click here for report). One in a Billion looks at China’s new super rich.

This set of video reports on Chinese development from Carrie Gracie (Nov 2010) is also worth looking at A portrait in miniature of China’s transformation (Click here for clips)

Unit 1: Market Failure - Blocking the bike lanes - Government Failure?

Bike users in NYC are doing the city a favour, reducing pollution, staying fit etc. So should the NYPD come down so hard on a cyclist who has inadvertently swerved out of the bike lane? Enjoy…

Unit 2 & 4: Interactive graphic comparing petrol prices around the world..

Infographic by Staveley Head

Mr Bentley's new 'Audio' blog

Unit 3: Different objectives other than MC=MR

The standard theory of the firm assumes that businesses have enough information, market power and motivation to set prices that maximise profits (MC = MR). But this assumption is now criticised by economists who have studied the organisation and objectives of modern-day corporations. Not only do most businesses frequently move away from pure profit seeking behaviour, many are not organised and set up in a way where profit is not the only objective.


There will always be a range of business objectives:

1. Profit maximisation

2. Revenue maximisation

3. Increasing and protecting market share

4. Surviving an economic downturn

5. Pursuing ethical business objectives

6. Providing a public service

So why dont firms profit maximise?

Below are some of the reasons, really useful for your Unit 3 examination.......
Imperfect information

It might be hard for a business to pinpoint precisely their profit maximising output, as they cannot accurately calculate marginal revenue and cost. Often the day-to-day pricing decisions of businesses are taken on the basis of “estimated demand conditions” or “rules of thumb”. Or a business might simply look to add a profit margin on top of their average cost – this is known as “cost-plus pricing”.

Secondly, most businesses are multi-product firms operating in a range of markets across countries and continents – as a result the volume of information that they have to handle can be vast. And they must keep track of the ever-changing preferences of consumers. The idea that there is a neat, single profit maximising price is redundant.

Behavioural Theories of the Firm

Behavioural economists believe that modern large-scale businesses are complex organizations made up various stakeholders. Stakeholders are defined as any groups who have a vested interest in the activity of a business.

Examples might include:

o Managers employed by the firm

o Shareholders – people who have an equity stake in a business

o Customers

o The government and it’s agencies including local government

Each of these groups is likely to have different objectives or goals at points in time. The dominant group at any moment can give greater emphasis to their own objectives – for example price and output decisions may be taken at local level by managers – with shareholders taking only a distant and imperfectly informed view of the company’s performance and strategy.

If firms are likely to move away from pure profit maximising behaviour, what are the alternatives?

1. Satisficing behaviour involves the owners setting minimum acceptable levels of achievement in terms of business revenue and profit.

2. Sales Revenue Maximisation

The objective of maximising sales revenue rather than profits was initially developed by the work of William Baumol whose work focused on the behaviour of manager-controlled businesses. Baumol argued that annual salaries and other perks might be closely correlated with total sales revenue rather than profits. Companies geared towards maximising revenue are likely to make frequent and extensive use of price discrimination as a means of extracting extra revenue and profit from consumers.
3. Managerial Satisfaction model

An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial satisfaction (or managerial utility). This can be enhanced by raising sales revenue.

Price and output differs if the firm changes its objective from profit to revenue maximisation. Assuming that the firm’s costs remain the same, a firm will choose a lower price and supply a higher output when sales revenue maximisation is the main objective.

A change in the objectives of the business has an effect on welfare. Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower. Producer surplus is greater when profits are maximised

Economics Trip: Freakonomics - The Movie

Some of you may have read the book, but most of you will be blissfully unaware of its exixtence...therefore we are going to watch the movie on Tuesday at 2.00pm in the Marina Mall (you miss core PE).

This is not compulsory and you will have to make your own way there. I will meet you outside the cinema at 1.30.

Hope you all want to come, you may learn something!

Mr B

Unit 3: Collusion in the accounting industry??

Check out this interesting article found by the upcoming economist, Sami Al Suedi. It discusses how 99 out the 100 top firms in the UK are audited by only 4 accountancy firms.....ripe for collusuion!

They sell a similar product
they have a very high concentration ratio
the service they provide is relatively inelastic
it is difficult for new entrants to gain market share

Click here for article!

Unit 4: World Inflation

Great couple of radio programmes here from the BBC World Service looking at the economic effects and reasons for the ”skyrocketing prices of the world’s basic goods.”

In our globalised world, our economies are more inter-dependent than they ever have been and the rise in price of various commodities, from oil and copper to sugar and wheat have increased inflation in countries all over the world and these price rises have possibly played a role in toppling governments in the Middle East and North Africa more recently.

These programmes look at the reasons behind such price volatility. (Click here for programmes)