[MUSIC] The guiding philosophy in game theory is this. You will pick your stategy by asking what makes most sense assuming that your rival is analyzing your strategy and acting in his or her own best interest. Game theory is important for two reasons. First, the many different possible games articulated by the theory, help capture the essence and complexity of oligopoly conduct. This is because with mutual interdependence recognized between firms, oligopoly conduct becomes a game of strategy such as poker, chess or bridge. And the best way to play your hand in a poker game Depends on the way rivals play theirs. Second, game theory sheds a very bright light on the importance of collusion in driving socially undesirable economic outcomes. The insights of game theory thereby help to underscore why such collusion is often made illegal in a given economic system. To show you what I mean let's look at the Prisoner's Dilemma, a well-known game that demonstrates the difficulty of cooperative behavior in certain circumstances. Suppose then that two suspects in a bank robbery, Bonnie and Clyde, are arrested and interrogated in separate rooms. Each of the prisoners is offered the following options. First, if one prisoner confesses and the other does not, the one who confesses will go free and the other will be given a 20 year sentence. Second, if both confess each will receive a five year sentence. Finally, if neither confesses, each will be given a six month sentence on a minor charge. So which strategy would you choose if you were Bonnie or Clyde? Making up your mind, assume that you don't trust your partner, and your partner doesn't trust you. Well, your best strategy is likely to be choice b, confess and take your five year sentence. And that's what makes this prisoner's dilemma interesting. You see, it's pretty clear that if both prisoners could talk to one another after they are arrested, they could collusively agree not to confess, and both would get light sentences if they kept the bargain. In the absence of collusion, however, there is great pressure on each prisoner to confess, because he or she knows that if he doesn't confess and his partner does, he'll get a very long sentence. In the absence of collusion therefore, the typical result is that both prisoners confess, and get medium sentences. This is because the only other way out of the Prisoner's Dilemma, Absence Collusion, is trust. But trust is something that is very hard to come by unless there is an explicit enforcement mechanism. The Prisoner's Dilemma has its simplest application to oligopoly when the oligopoly is a duopoly. That is, when the industry consists of only two firms. A duopoly might emerge in an industry when the minimum efficient scale of production is about half that of the total industry sales. And that's what we will assume in this set of figures, that depict a duopoly in packaging materials. In particular, in the left hand figure, we've drawn the average total cost and marginal cost curves for one of the firms. Note that the minimum efficient scale occurs at point A, where the ATC is at a minimum, and production is 4,000 tons. Assuming that both firms in the duopoly have identical cost curves, we can then draw supply, demand, and several possible equilibria in the packaging materials market. So here's your first question. Suppose that, just like in the prisoner's dilemna. The two firms are unable to communicate with one another and therefore are unable to collude in any way, either explicitly or tacitly. What is the likely strategic pricing decision to be? How much will each produce? And what will be their totally economic profits? The correct choice is a. Did you get it right? In the absence of collusion, the two duopolists are likely to behave like perfect competitors. The market price will be $500 per ton. Output will be 8,000 tons, or twice that of the minimum efficient scale of production. And economic profits will be zero. Suppose on the other hand, the two duopolists are able to fully collude, and each keeps the bargain that they strike. What is the likely market price, output, and profit, and which of the three oligopoly models does this outcome most resemble? The correct choice is b. Did you get it right? If the two duopolists can collude, they will act together, just like a monopolist, and jointly maximize their profits. The price will be $600. Output will be 3000 tons per firm and profits will equal $75,000. Okay so far so good. But now let's entertain the all two distinct possibility. That while the two duopolists fully collude and shake hands on the monopoly deal, one of the duopolists is a no good, back stabbing, four flushing, varmint who decides to cheat on the agreement. In particular, this cheating duopolist refuses to limit his share of production to 3,000 tons and instead produces 4,000 tons. This situation is depicted in this set of figures. What happens now to the market price, output, and profit? The correct choice is A. Did you get this right? Price falls to $550 per ton, and will stay there, so long as the non-cheating firm doesn't increase his production. While industry output increases to 7000 tons. As for the profits of each firm, note in the figure that the non-cheating firm receives $550 per ton, but because it doesn't produce at its minimum efficient scale it incurs costs of $575 per ton. This leads to a loss of $75,000 as indicated by the shaded arrow. In contrast, the cheating firm produces at its MES where costs are $500 per ton. And its profit is the shaded area in the figure, or $200,000. By the way, this example should demonstrate clearly, the often huge incentive to cheat that colluding oligopolists face. In this case the successful cheater can more than double his profits from $75,000 to $200,000. Now it is precisely to provide insight into this type of strategic situation that game theory was developed. It does so by analyzing the strategies of both firms under all circumstances and placing the combinations in a so-called payoff matrix or payoff table. In this matrix, each box shows the payoff from a pair of decisions listed in the columns and rows. The blue triangles show firm A's profit, while the gold triangles show firm B's profit. The box represents the outcome for successful collusion. The lower left and upper right hand boxes are the cheating outcomes and the box in the lower right hand corner is the non cooperative outcome. Notice the dilemma both firms are in, if it is impossible to detect cheating. If they can't detect cheating, and each believes the other is maximizing profit, than each must expect the other to cheat. Just as in the prisoner's dilemma, each prisoner must expect the other to confess. And in this case, the optimal strategy for both firms is to cheat. However, when both firms cheat, they both wind up in the lower right-hand box with the zero profit competitive outcome. By the way, the non-clusive outcome in box D is called the Nash Equilibrium in Game Theory. A Nash Equilibrium describes a situation in which no player can improve his or her payoff given the other player's strategy. The concept of the Nash Equilibrium is important, because it often describes a non-cooperative equilibrium. This is because in the absence of collusion, each party chooses that strategy, which is best for itself, without collusion, and without regard for the welfare of society, or any other party. Well that completes our discussion of oligopoly. Please remember that economics is not something to be memorized But rather something to conceptualize. So as you study it, think about it too. Your job and your business just might depend on it. [MUSIC]