Oligopolistic Rivalry and Game Theory

Decisions can be classified as either non-strategic or strategic. Non-strategic decisions do not

involve other players, so their actions need not be considered. On the other hand, strategic decisions
are characterized by interactive payoffs. A strategy game is therefore any conscious choice of
behaviour between two or more interdependent firms or individuals who share a common goal. For
example, an oligopolistic firm wishing to maximize its profits by changing the product price, the
quantity of the product that it sells, the level of advertising, and so on, must take into consideration
all possible reactions of its competitors. Every action taken by the firm and the reactions of the
competitors would result to different payoffs or outcomes. Under strategic decisions, the optimal
choice of the firm may change, depending on what it believes its competitors will do.
Game theory studies strategic decision making. It is concerned with the choice of the best or
optimal strategy in conflict situations. For example, game theory can help a firm determine the
conditions under which lowering its price would not trigger an unhealthy price war, and whether the
firm should build excess capacity to discourage entry into the industry even though this lowers the
firms short-run profits.
Components of a Game
All strategic games have at least four common components:
1. The players: are the decision-makers whose behavior we are trying to explain and predict. The
decisions of all players determine the outcome.
2. The feasible strategy set: A players strategy is a complete plan describing the possible actions
he or she will take at each conceivable change in the game. For example, the choices to change
price, develop new products, undertake a new advertising campaign, building new capacity, and
all other such actions that affect the sales and profitability of the firm and its rivals.
3. The payoffs: These are the rewards associated with each players choice of strategy and the
rivals response. This may be expressed in terms of the profits or losses of a firm. The table
giving the payoffs from all strategies open to a player and the rivals responses is called the
payoff matrix.

4. The order of play: The game specifies the order in which players reveal their chosen strategy.
Games may be simultaneous if all players reveal their strategy without knowing the strategy of
others or sequential if the order of play is specified so that the players know the rivals action.
Visual Presentation of a Game
There are two ways of presenting payoffs in game theory: in a payoff matrix form, or an extensive
form (game tree).
The Payoff Matrix Representation of a Game
Consider a market comprising of two firms, Xerox and Sharp, and a choice of two strategies for
each: advertise or do not advertise. Each firm expects to earn higher profits if it advertises than if it
does not. But the actual level of profits for each firm depends on whether the rival firm advertises or
not. Thus, each firms strategy (i.e., advertise or do not advertise) can be associated with each of the
rivals strategies (also to advertise or not to advertise). The possible outcomes and payoffs are
illustrated by the following payoff matrix.
Sharp
Xerox

Advertise
Dont Advertise

Advertise
4,3
2,5

Dont Advertise
5,1
3,2

The first number in each of the four cells refers to the payoff for Xerox, while the second is the
payoff for Sharp. From the table, if both firms advertise, Xerox will earn a profit of 4, and Sharp
will earn a profit of 3 (the top left cell of the payoff matrix). The bottom left cell of the payoff
matrix shows that if Xerox doesnt advertise and Sharp does, Xerox will have a profit of 2, and
Sharp will have a profit of 5. The other payoffs in the second column of the table can be similarly
interpreted.
The Extensive Form Representation of a Sequential Game
The extensive form is also called the game tree. The extensive form captures who moves when,
what action (strategy) each player can take, what players know when it is their turn to move, what
the outcome is as a function of the actions taken by the players, and the players payoffs from each
possible outcome.

The following figure shows the game tree of the war between Xerox and Sharp. It is assumed that
the two players move sequentially, rather than simultaneously. In particular, if Xerox advertises first
and Sharp chooses her strategy second.
Game Tree for Sequential Move Advertising Game
Xerox

Advertise

Dont
advertise

Sharp

Sharp
Advertise

Dont
Advertise

Dont
Advertise

Advertise

Xerox payoff

Sharp payoff

3
2

The game starts at an initial decision node represented by a square, where Xerox (player 1) makes
her move, deciding whether to advertise or not to advertise.
Each of the two possible choices for Xerox is represented by a branch from this decision node.
At the end of each branch is another decision node represented by a square, at which Sharp
(player 2) can choose between two actions, advertise or dont advertise, after seeing Xeroxs
choice.
The initial decision node is referred to as player 1s decision node; the latter two as player 2s
decision nodes.
After Xeroxs (player 2s) move, we reach the end of the game, represented by terminal nodes.
At each terminal node, we list the players payoffs arising from the sequence of moves leading
to that terminal node.
The Extensive Form Representation of a Simultaneous Game
In the sequential game presented above, we have assumed that when it is the turn of Sharp (player
2) to take action, she is able to observe all her rivals (Xeros) previous moves. This is a game of
perfect information. However, all simultaneous games are played with imperfect information. That
is, when it is a players turn to make a move, he or she does not know at which decision node the

other player is. The reason for this ignorance is that the player has no opportunity to observe
something about what has transpired in the game.
If the advertising game earlier presented is such that Xerox and Sharp simultaneously make
decision as to whether to advertise or not to advertise, the game tree would be as follows.
Game Tree of Simultaneous Advertising Game

Xerox
Advertise

Dont Advertise

Sharp
Advertise

Dont
Advertise

Xerox payoff

Sharp payoff

Advertise

Dont
Advertise

The figure is identical to the one of sequential games except that a circle is drawn around Sharps
two decision nodes to indicate that these two nodes are in a single information set. The meaning of
this information set is that when it is Xeroxs turn to make a choice of its action, it cannot tell which
of these two nodes it is at because Sharp has not revealed its strategy.
Strategies
A strategy is a complete contingent plan that specifies how the player will act in every possible
distinguishable circumstance in which he or she might be called upon to move.
Dominant Strategies
In attempting to predict the outcome of a game, it is important to identify any possible dominant
strategy of the players. A strategy is said to be dominant for player 1 if it maximizes uniquely
players payoff for any strategy that players rival might play.
If a player has a dominant strategy, we should expect him or her to play it.
Sharp
Xerox

Advertise

Advertise
40, 70

Dont Advertise
45, 55

Dont Advertise

30, 60

35, 45

Xeroxs Preferred Strategy

We determine Xeroxs preferred strategy by comparing its payoffs, given the rivals strategy. For
example, if Sharp advertises, we see that Xeroxs payoff would be 40 if it advertises and 30 if it
does not advertise. Given that Xerox would get less profit if it does not advertise, her most
preferred strategy is to advertise.
If Sharp does not advertise, Xeroxs payoff would be 45 if it advertises and 35 if it does not
advertise.
Xeroxs payoff would always be greater if it advertises regardless of what Sharp does.
Therefore, advertise is the dominant strategy for Xerox.
Sharps Preferred Strategy
If Xerox advertises, Sharps payoff would be 70 if it advertises and 55 if it does not advertise.
If Xerox does not advertise, Sharps payoff would be 60 if it advertises and 45 if it does not
advertise.
No matter what Xerox does Sharps dominant strategy is to advertise.
Equilibrium of the game is {Xerox Advertise, and Sharp Advertise}.
Nash Equilibrium
A strategy constitutes a Nash Equilibrium if it gives a payoff that is greater than all those generated
by other alternative strategies given the rivals strategy so that each players strategy choice is a best
response to the strategies actually played by his rival.
Example 1:
Consider the example presented above.

Player 1

Product D
Product E
Product F

Product A
3, 6
5, 1
6, 0

Player 2
Product B
7, 1
8, 2
6, 2

The following procedure can be used to identify a Nash equilibrium:

Product C
10, 4
14, 7
8, 5

1) For each strategy, indicate the behavior of the other. For example, if player 1 knew (with
certainty) that player 2 will produce product A, what will he do? By looking at the first
numbers in each cell of the product A column, we observe that player A receives 3 if he
introduces product D, 5 if product E, and 6 if product F. Since 6 is the highest of the three
payoffs, player 1 would introduce product F. Circle player 1s payoff to show that it is the
highest payoff given player 2s choice of product A.
2) Do the same for strategies product B and C to find player 1s best response. Note that player
1 selects product E given that player 2 selects product B (circle 8). Player 1 selects product
E given that player 2 selects product C (circle 14).
3) Now, follow the same procedure for player 2. For example, if player 1 produces product D,
what should player 2 choose? By looking at the second numbers in each cell of the product
D row, we observe that the maximum payoff that player 2 can receive is 6 by producing
product A (put a square around payoff 6). Do the same for strategies product E and product
F. Note that player 2 selects product C if player A selects E (put a square around 7). Also,
player 2 selects product (C) if player 1 selects product F (put a square around 5).
The resulting matrix is illustrated below.

Player 2

Player 1

Product A

Product B

Product C

Product D

3,

7, 1

10, 4

Product E

5, 1

8, 2

14 , 7

Product F

6, 2

8,

Any cell with both a circle and a square is a Nash equilibrium. In this game, the Nash equilibrium is
for player 1 to produce E (and receive 14) and player 2 to produce C (and receive 7). Thus, we can
say that a Nash equilibrium is a meeting of best responses. Once the Nash equilibrium is reached,
no player is willing to unilaterally change behavior.
Exercises -Find the Nash equilibrium.
6

Question One
Payoff Matrix for an Advertising Game

Firm B
Firm A

Advertise
4, 3
2,5

Advertise
Dont Advertise

Dont Advertise
5,1
3,2

Question Two
Consider a two-player simultaneous-move game shown in the payoff matrix table below.
Player 2
Player 1

Product U
Product N
Product D

L
5, 3
4, 0
0, 4

M
0, 4
5, 5
0, 4

R
3, 5
4, 0
5, 3