Defining Oligopoly and Game Theory

Oligopoly is a common market structure.  It is an industry mad e up of a few large firms, which means that the concentration ratio is high.   Firms in the industry, each would realize that by producing more it would drive down the market price.  So each firm realize that profits would be higher if it limited its production. In this case, these companies will engage in collusion.     An agreement among suppliers to set the price of a product or the quantities each will produce.   And the strongest form of collusion is a cartel – an agreement of several firms that increase their profits by telling each other’s how much to produce.  Cartel work to the advantage of their members only if there is no cheating among the participants.

When the decisions of firms significantly affect other’s profits, they are in a situation of interdependence.  The study of behaviour in situations of interdependence is known as game theory.  Game theory was first developed by economists John Neumann and Oskar Morgenstern in the 1940s to analyze strategic behaviour.   The profit earned by an oligopolist, is that player’s payoff.  A payoff matrix shows how the payoff to each of the participants depends on the actions of both.  A matrix helps us analyze interdependence.

I think the game theory is consistently in use in the current economy. The world of oligopoly is a struggle between cooperating and competing.  It pays for oligopoly firms to cooperate because that is how they can make the most joint profits.  But even when they cooperate, there is still the incentive to compete and outdo the rival, which could result in even greater individual profits for one of the firms.