Reading 1 OLEO2134/2135 1
Reading 1: Economic Strategy and Negotiation
Many of the market that we are interested in have a handful of competitors. The soft drink market is
dominated by two firms. The computer industry has two or three key firms that determine the shape
of that market. Think of phone handsets, department stores, supermarkets and so on; each of these
markets is dominated by several key firms that make most of the sales, determine what customers
expect, effectively set prices, even if there is a competitive fringe of firms competing at the margins.
Industries that are dominated by several key firms are call oligopoly markets.
In this unit we are interested in the strategies of these firms, sometimes called oligopolists (and
firms in markets with two firms are often called duopolists). Given there are relatively few
competitors, what one firm does will impact on what its rival or rivals will want to do, and vice versa.
This strategic interaction is critical to the profitability of the choices that each firm makes – typically
the action a firm wants to take will depend on strategy of its rival(s). To analyse business strategies
in these strategic environments we make use of game theory. Note, the tools of game theory are
very general. The idea in this unit is that you become familiar with these tools so that you can apply
then to any business situation you are interested. The generic nature of the skills you will obtain in
this unit of study makes them more useful than focusing on a particular business case study, as the
specific findings from any given case study are rarely able to be applied elsewhere in other markets.
To start with, what is a game (according to an economist)? A game is a situation in which has
players, rules and payoffs. For example, we will typically will think about markets with two firms (the
players) who can might be able to set prices at the same time as each other (the rules), and the
profits of each firm depend on both their rival’s and their choice of price (the payoffs).
Here, let us examine a classic situation that firms find themselves in called the prisoners’ dilemma.
Consider the soft drink market and assume that there are only two competitors, Coke and Pepsi.
Each firm at their board meeting can simultaneously choose its price for the season, which we will
assume can either be High or Low. To make things more concrete let us also assume that the profits
each firm can make given the possible prices of the two rivals are as follows. If both firms charge a
High price, the payoffs are 6 to each firm. If both set a Low price, the profit/payoff to each firm is 4.
If one firm sets a High price and the other sets a low price the payoffs are 1 to the firm that opted for
High, and 8 for the firm that chose Low.
For convenience, we can represent this information in a diagram (Figure 1) called the normal form of
a game. Here, each row represents the choice for Coke, and each column represents a choice (High
or Low) for Pepsi. The payoffs in the various boxes represents the profits each firm gets given the
actions taken; for example, in the top left-hand box, both firms opted for High, so the payoff is 6 to
each firm. By convention, the first payoff in each box is the row player’s payoff (Coke here), so if
Coke plays High and Pepsi low, we are in the top right-hand box and Coke gets 1 and Pepsi 8.
What is the best market strategy for Coke in this situation? If Coke thinks Pepsi will play High (so we
are in the left-hand column), its choices are play High and get 6 or opt for Low and get 8. As 8 beats
6, Coke will set a low price if it thinks Pepsi will set a High price. On the other hand, what if Coke
thinks Pepsi will opt for Low (so we are in the right-hand column), Coke can play High and get 1 or
play Low and get 4. 4 beats 1, so Coke will set a Low price if it thinks Pepsi is setting a Low price.
So, in summary Coke will set a Low price regardless of what Pepsi will do; in the parlance of game
theory, Coke has a dominant strategy – it will do the same thing regardless of what its rival is doing.
Reading 1 OLEO2134/2135 2
As it turns out, Pepsi also has a dominant strategy to set a Low price (check it using the same
procedure outlined above, that is, thinking about Coke opting for High and thinking about what
Pepsi would do, then thinking about what Pepsi would do if Coke set a Low price).
Figure 1: Normal form of a (prisoners’ dilemma) pricing game
Given both players have a dominant strategy, in the outcome (or equilibrium) of the game both
firms choose a Low price, so the equilibrium can be described as (Low, Low), which means Coke
plays Low and Pepsi plays Low. In a game in which both players have a dominant strategy, the
equilibrium is known as a dominant strategy equilibrium.
What is interesting about this game in terms of market strategy is that both firms are worse off in
the equilibrium outcome than if they had both set a High price; the payoffs in the equilibrium
outcome are 4 for each firm (8 in profits in total), whereas if they had both opted for a High price
they would share industry profits of 12 (getting 6 each). Such a game is known as a prisoners’
dilemma (see the Lecture 1 slides for a classic example of the game using prisoners). A prisoners’
dilemma is any game in which there is a dominant strategy equilibrium and in which payoffs are not
maximised in this equilibrium.
So, what happened? Why don’t the firms get together somehow and maximise profits? Each firm is
actually maximising profit – it is not like the directors of either company is making a mistake. It is
individually rational for Coke to undercut Pepsi if Pepsi sets a High price, and Coke wants to match
Pepsi if it goes Low (and vice versa for Pepsi). Here, each firm only cares about their own profit, and
ignores the fact that a low price hurts the other firm, and industry profits overall. Each is doing their
best, but taken together their actions hurt one another, and both are worse off.
This situation arises in many different market situations: setting price like here; choosing quantities
of output; developing new products; advertising; engaging in R&D; and so on (see Lecture 1 slides
for more real-world examples). For instance, two department stores might be better off if neither
advertised (as customers will shop anyway), but both might have a dominant strategy to advertise
and this could end up reducing overall profits as in a prisoners’ dilemma. Another example could be
a market in which firms choose their level of output (or the quantity they want to sell); it could be
Reading 1 OLEO2134/2135 3
that both firms have a dominant strategy to sell a large quantity, even though both might be better
off if they cut their production and sell a smaller quantity.
This is obviously a bit of an issue for firms that find themselves in a situation like this, and firms like
Coke and Pepsi are usually pretty savvy. Can they get out of a prisoners’ dilemma? Well, maybe. First
thing to note is, in most countries (Australia, New Zealand, the US, the Euro zone etc) two rivals
cannot directly communicate with each other to make agreements on prices and sharing markets etc
– that is, collusion is illegal. (Why? Because it hurts consumers and reduces economic activity
overall.) But sometimes firms can implicitly (that is, without directly communicating with one
another) come up with ways to avoid a prisoners’ dilemma. Using the pricing Low and High example
from above, one way is to get the government to regulate and ban pricing low (maybe under the
guise of guaranteeing safety or quality). In this way, the government makes pricing low not an
option, which allows the companies to avoid the prisoners’ dilemma trap. Another way of avoiding a
prisoners’ dilemma is use punishments and rewards in the future (in coming seasons, years and so
on) to provide an incentive for each firm to price High. For example, assume that the CEO of Coke
thinks that if it chooses Low that Pepsi will retaliate and punish it in the future with a price war (low
prices). It can be the case that even though pricing Low increases short-term profits, if the future
losses from the price war are sufficiently large, Coke might opt to price High today (and Pepsi might
to following a similar logic of potential punishment from Coke). This method of avoiding a prisoners’
dilemma requires that the firms meet each other repeatedly so that there is the possibility of
punishing (and rewarding) bad (and cooperative) behaviour in the future.
Now read:
Ngyuen and Wait (2016), Essentials of Microeconomics, Routledge, Oxford.
Sections 3.1, 3.2, 3.3.1 and 3.3.2 (pp. 13-16), Section 3.4.1 (pp. 18-19)
Sections 15.1, 15.2, 15.3 (pp. 128-134).
Lecture slides 1
Complete Workshop 1 (and review answers).