Game Theory Strategy of Oligopoly Pricing Problem
When it comes to economics, oligopoly pricing is a concept that is often discussed. This type of market structure refers to an industry where a few companies dominate the market. As a result, these companies have significant control over the price of goods and services, which can make it difficult for smaller businesses to compete.
The Basics of Oligopoly Pricing
In an oligopoly market, there are only a few companies that sell similar products or services. Due to the limited competition, these companies have considerable power in setting prices. The pricing strategy adopted by each company will depend on how they anticipate their competitors will behave.
One way that companies can determine their pricing strategy is through game theory. Game theory is a mathematical approach used to study decision-making in situations where multiple players are involved. In the case of oligopoly pricing, each company is considered a player in the game.
The Prisoner’s Dilemma
The most well-known game theory model for oligopoly pricing is called the Prisoner’s Dilemma. This model assumes that each company has two options: cooperate with its competitors or act independently.
If all companies choose to cooperate and set high prices, they will all earn high profits. However, if one company chooses to act independently and lower its prices while others continue to cooperate, this independent company will earn higher profits while other companies see their profits decline.
This creates a situation where each company has an incentive to act independently and lower its prices, resulting in lower profits for everyone. This scenario demonstrates why cooperation between firms is often difficult in an oligopoly market, even when it would lead to higher profits overall.
The Kinked Demand Curve Model
Another game theory model for oligopoly pricing is the Kinked Demand Curve. This model assumes that each company faces a demand curve that is kinked at the current price level.
The curve is steep above the current price, indicating that customers are willing to switch to competitors if prices increase. The curve is relatively flat below the current price, indicating that customers are not very price-sensitive and will not switch to competitors if prices decrease.
If one company raises its prices, it will lose a significant number of customers to its competitors. However, if one company lowers its prices, it may not gain many new customers as they are already satisfied with their current provider. Therefore, in this model, each company has an incentive to maintain its current pricing level.
The game theory strategy of oligopoly pricing problem can be challenging for companies in this market structure. Game theory models such as the Prisoner’s Dilemma and Kinked Demand Curve can help companies understand how their competitors may behave and determine a suitable pricing strategy.
However, these models also demonstrate why cooperation between firms can be difficult in an oligopoly market. It is essential for businesses in this industry to carefully consider their pricing decisions and anticipate how their competitors will respond.