The Game Theory

The game theory is defined as a method of analyzing firm behavior that highlights mutual interdependence among firms.  In an easier way as explained on Wikipedia, it is "the study of mathematical models of conflict and cooperation between intelligent rational decision-makers”.  Game theory was developed by economists John Neumann and Oskar Morgenstern in the 1940s to analyse strategic behavior.  The game theory is developed base on a firm’s greed, how they cheat strategically to gain more market shares and earn revenue for their own organization. 

Although collusion is illegal in our society, game theory exists in today’s world.  Some of the most obvious examples are in the food industry.  Think of two coffee shops opening right across the street from each other, competition is inevitable for the two shops to survive.  When coffee shop A sells coffee for $2, coffee shop B will also try to match their price to stay in competition.  Once the market share has been split between the two shops, one of the firm will eventually become greedy, and try to lower their price by a slight margin to attract more customer and obtain more market shares.  Eventually, this may or may not start a price war between the two shops, depending on both firm’s reaction to the price change and competition.  This is where a payoff matrix comes in.

A payoff matrix calculates what happen in different scenarios.  In the example above, four different scenarios are identify, and it shows what happens when Yellow and white keep their pricing balanced, then what happened when one of the firms cheat, and what happened when they both cheat and lower their product’s price.  It is clear that the best scenario for both firms is when they keep a balanced price level, maximizing their revenue by selling maximized quantity, splitting the market share evenly.  However, in the right bottom corner, when both firms cheat, they both lose.  In the real world, a perfect scenario rarely exist, and firms plan and act strategically to maximize their profit, and the best strategy will win the most revenue and market shares within the field.  There are a few ways companies can make agreement to ensure they work with each other, while competing against each other, to maximize their profits.  They are collusive and cartel actions.  Collusive and cartel actions are similar.  Collusive is when firms unofficially split the market share, limiting their production and setting a price level at the highest possible price to maximized jointed profits.  Cartel action is similar, but it is a formal agreement of cooperation between competitors, and they are usually divided up between regions, demographics, an existing client list or a quota.