Game Theory

For all of us non-economists, the Game Theory which was invented by John von Neumann and Oskar Morgenstern in 1944 might seem like a very unfamiliar and complicated theory. To quote the Stanford Encyclopedia for Philosophy, "Game theory is the study of the ways in which strategic interactions among economic agents produce outcomes with respect to the preferences (or utilities) of those agents, where the outcomes in question might have been intended by none of the agents." (Ross, Don) Confused yet? I would be. It doesn't need to be so complicated. To put it simply, game theory is based strictly on the strategic decisions that one person or business might make to try to out do it's competitor. More often than not though, this has a negative impact on both parties, and not just the one who is having consumers stolen from them.

They say pictures are worth a thousand words, so let's take a look at one to make this crystal clear. I may have a small addiction to Subway, so let's use it in an example along with Quizno's; two companies which could be considered interdependent due to their similar pricing.


Let's say that between the two sub companies, they have a combined total of 200 customers per day. Now, we can clearly see that if both companies charged $7 for a foot long sub, and we'll assume that customers are divided equally (100 & 100) that revenue's of $700/day are achieved. Now, let's say that Subway got a little greedy and lowered their price to $5/sub effectively stealing away 25% of the market share from Quizno's (top right box), their number of consumers may increase, but you can see that revenues have decreased for both competitors. Quizno's due to the loss of customers, and Subway due to the lower price. In the bottom left box, it shows the same scenario only with Quizno's lowering their price instead. Now, the bottom right box is very important. If Subway lowered their price down to $5/sub, Quizno's may choose to do the same in order to gain back the lost clientele. However, this clearly shows that now BOTH companies are making less revenue per day with the same amount of output as they originally had at $7/sub. In summary, lowering the price to steal customers from the competition may seem like a good idea but just ends up having a negative impact for each producer.

Sometimes companies may choose to work in cahoots with a competitor either directly (illegal) or indirectly (not illegal). Parties who work in unison legally or illegally are called cartels.

In order to maximize revenues while maintaining minimal output, some companies may choose to get together to discuss such things as price fixing, or quotas among one another. A good example of this would be OPEC as discussed in section 11.6 of the text. (Sayre, Morris) This illegal activity is known as collusion and comes with stiff penalties and fines if caught.

On the other hand, companies can often predict the actions of their competitors and can make decisions based on that alone. This is known as noncollusion as they are not directly discussing their future actions with one another.

To summarize; if each party in the cartel is honest, everyone wins.


References:

Morris, Alan; Sayre, John, Principles of Economics, p. 390-392

Ross, Don, "Game Theory", The Stanford Encyclopedia of Philosophy (Fall 2011 Edition), Edward N. Zalta (ed.), URL = http://plato.stanford.edu/archives/fall2011/entries/game-theory/.