Oligopoly pricing resembles a repeated prisoners' dilemma game.

Each firm has an incentive to moderately lower its price and thus increase its sales at its competitors' expense. However, each firm knows that its rivals would promptly discover such deviation and follow suit shortly The problem of interdependence has thwarted economists' attempts to develop a good theory of oligopoly. When there are only a few sellers, each recognizes that his decisions affect others who may react to what he does.

The Oligopolist is big enough to affect the market in some way, dealing with a multitude of individual consumers. His decision can hugely impact sales

The"prisoners' dilemma" was first described in the field of "game theory", which is a branch of applied mathematics and economics dealing with choices made under conflict and uncertainty. Suppose that the police believe Dave and Henry have committed a crime but the evidence is weak. The police have placed Dave and Henry in jail, in separate cells. The police need the confession of at least one of the prisoners in order to get a conviction. If neither prisoner confesses, then the police can only convict them on a minor charge with a three-month prison term. Each prisoner is offered the following deal: if one testifies against the other while the other remains the silent, the one who testifies will not be convicted of anything, while the one who remains silent will go to jail for 20 years. If both confess, then each will receive a five-year jail term.

The optimum result for the two together is to stay silent, in which Dave and Henry will each get only three months prison time. However, each prisoner does not have knowledge of what the other prisoner will do. The most rational response from the individual is to confess. If the other prisoner stays silent, then that person gets off free; if the other prisoner confesses, then the prison term will be less (five years vs. 20 years. The prisoners' dilemma illustrates a situation in which individuals arrive at a non-optimal solution, due to a lack of cooperation and trust. A similar situation occurs with oligopolies. If firms within an oligopolistic industry have cooperation and trust with each other, then they can theoretically maximize industry profits by setting a monopolistic price. Firms would then have to figure out how to fairly divide up the Profits.

Confess Confess Deny -5, -5 -10, 0 0, -10

Deny -3, -3 (montths)

The Prisoners Dilemma is a good example of a static game of complete information. This is probably the simplest form of a game that involves the interaction of multiple individuals in a decision making process.

One obvious response to the analysis of the prisoner's dilemma is that its result is correct, but only because the game is being played only once. Many real-world situations involve repeated plays. Both Convicts will eventually get out of jail, resume their profession, and be caught again. Each knows that if he betrays his partner this time around, he can expect his partner to treat him similarly next time, so they both refuse to confess. The argument is persuasive, but it is not clear if it is righte. The victim will respond by betraying on the next turn, and perhaps several more. On net, it seems that both players are better off cooperating every turn.

A Game is defined as : 1. A set of players 2. A set of possible strategies for each player 3. A payoff or outcome function that assigns payoffs to each player for each combination of strategies (one strategy for each player).

Nash equilibrium concept we have to remember what an equilibrium here means. equilibrium means that no one wishes to change their behavior as long as nothing else changes. Remember that a simple demand and supply equilibrium means that consumers are purchasing their desired quantity demanded and suppliers are selling their desired quantity supplied and neither wants to change as long as the other doesn't. But, we also learned that a change on one side of the market (such as a change in income or a change in production costs) will lead to new desired quantities on both sides

A Nash equilibrium exists when each player is doing the best she can given what the other player is doing. In other words, neither wishes to change strategies so long as the other player doesn't. This approach assumes that the oligopoly firms make no attempt to work together. Perhaps they believe that agreements are not worth making because they are too hard to enforce, or that there are too many firms for any agreement to be reached. In such a situation, each firm tries to maximize its profit independently. If each firm acts independently, the result is a Nash equilibrium.

Consider the driving game to the right. In many coutries drivers drive on the right hand side of the road, in other countries they drive on the left. But, no matter where you drive, it's best to do what the other drivers are doing.

This simple payoff matrix illustrates this.

In the US for

Part of the definition of Nash equilibrium is that each player takes what the other players are doing as given when deciding what he should do; he holds their behavior constant and adjusts his to maximize his gains. This means that, in describing the game, we must be careful what we define a strategy to be; as you will see, different definitions lead to different conclusions. The two obvious alternatives are to define a strategy by quantity or by price. In the former case, each firm decides how much to sell and lets the market determine what price it can sell it at; in the latter, the firm chooses its price and lets the market determine quantity.

On this interpretation of Nash equilibrium, each firm observes the quantities being produced by the other firms and calculates how much it should produce to maximize its profit, assuming that their output stays the same. One firm in an oligopoly calculates its profitmaximizing quantity of output where marginal revenue equals marginal cost. Marginal revenue is calculated from the residual demand curve (its share in the industry demand curve). Other firms are assumed to hold the quantity they produce constant.

Each firm observes the prices that other firms are charging and picks the price that maximizes its profit on the assumption that their prices will not change. One firm in an oligopoly chooses its profitmaximizing price. All other firms are assumed to hold their prices constant; the lowest such price is P1. The firm maximizes its profit producing Q* and selling it for just under P1.