Game Theory History

Game theory has become increasingly important in microeconomics, as well as other disciplines, such as biology, psychology, sociology, and computer science. In economics, John Neumann and Oskar Morgenstern’s 1944 Theory of Games and Economic Behavior laid the foundation. In 1994, John Nash (pictured) won the Nobel Prize for his revolutionary game theory models. He was also the subject of the 1998 biography by Sylvia Nasar and the 2001 film A Beautiful Mind, starring Russell Crowe.

A Game Theory Simulation

Game theory uses the same setup as regular games, including players, moves, strategies, and rewards. Below is an example of a simple game simulation, which helps to explain some oligopoly behavior.

Let’s say that an oligopoly industry consists mainly of two rival competitors (for example, Pepsi and Coca Cola). The table below illustrates strategies and rewards, depending on whether the firms cooperate in price setting or not. After playing the game simulation, we notice the following outcomes:

Firm B sets a high price Firm B sets a low price
Firm A sets a high price Firm A’s profit = $40 million
Firm B’s profit = $40 million
Firm A’s profit = $10 million
Firm B’s profit = $60 million
Firm A sets a low price Firm A’s profit = $60 million
Firm B’s profit = $10 million
Firm A’s profit = $15 million
Firm B’s profit = $15 million

When firm A sets a high price, but firm B sets a low price (the blue option in the table), then most consumers will purchase firm’s B’s products, and firm B will make a much higher profit than firm A. The opposite happens when firm B sets a high price, and firm A sets a low price (the green option).

If both firms set a high price, then neither firm will have a market share advantage, but the high price will generate a relatively high profit for each firm (the black option). This option often occurs when firms choose to cooperate (collude) and form a cartel. In most industrialized countries, anti-trust laws prohibit explicit cooperation. OPEC (Organization of the Petroleum Exporting Countries) is a cartel and operates outside of countries’ boundaries. Therefore, OPEC is not illegal. OPEC’s profits are high because of cooperation and members’ determination to keep prices high. For more information about OPEC, please click HERE.

If both firms set a low price (the red option), then neither firm will have a market share advantage. However, the low price reduces each firm’s profits. This is beneficial for consumers, but not for firms. This non-cooperation situation occurs when firms engage in a price war. An outcome that stems from non-cooperation is called a Nash equilibrium. The Nash equilibrium in the above table is that both firms end up with a profit of $15 million.

Barriers to Collusion

Fortunately for consumers, cartels often experience problems when it comes to keeping agreements and maintaining high prices.

Incentives to Cheat
Let’s say that both firms cooperate and agree to a high price (the black option in the table above). We can see that both firms will make a profit of $40 million. But what if one firm, say firm A, chooses to cheat on firm B, and secretly charges a slightly lower price to some of its customers. This will increase firm A’s profits to $60 million, and lower firm B’s profits to $10 million (the green option). It pays for firm A to cheat, because it will increase its profits. This incentive to cheat causes problems for cartels.

Below are additional reasons why cartels sometimes experience problems.

Different Goals
Cartel members’ interests and goals differ. This makes it very hard to reach an agreement between members, especially if there are a lot of members. OPEC countries Saudi Arabia, Iran, Iraq, Kuwait, and Venezuela have had many disagreements about how much to produce and what price to charge. The fierce disagreement between Iraq and Kuwait in July of 1990 contributed to the war that began in August of 1990. Saudi Arabia has an interest to supply a large amount of oil to the world market, because its holdings of oil are large. Venezuela’s interest is to offer less, because it wants to preserve its smaller holdings of oil over a longer time, and, therefore, restrict output and maintain a higher price.

Potential of New Competitors
At the high cartel price, it is attractive for new producers to enter the market. In addition, buyers respond to the high price by making adjustments to their consumption. This increase in supply and decrease in demand lowers the price in the long run. In the oil market, this has indeed occurred. After the price of a barrel of oil reached $34 in the 1970s, countries that previously found it too costly to produce oil entered the market. England, Mexico, Norway, the United States, and Russia increased their supply and drove down the price of oil. During the 1980s and early 1990s, the average price of a barrel of oil decreased and it has made OPEC’s life difficult. When the price of a barrel of oil exceeded $70 in 2005 and early 2006, other (Non-OPEC) countries increased their production, and consumers began to limit their consumption of fuel by purchasing more fuel-efficient cars and driving less. In late 2006, the price of a barrel of oil had decreased to around $60 again. Recently we have seen technological developments in hydraulic fracking that have increased the supply of oil and brought down world oil prices and retail prices at the pump.

Prices and Profits in the Free Market

As mentioned in the previous unit, it is difficult for a non-monopoly firm to earn excessively high profits even in the long run. This is often the case, even when firms attempt to collude and form cartels. Usually, in the long run, competitive market forces prevail and keep prices in check for consumers.