Game Theory – does it exist beyond the board games?

Game theory is discussed in economics in terms of oligopolies.  Oligopolies are markets that are dominated by a few large firms and includes industries such as tobacco, cement and motor vehicles.  The main ideas behind game theory is that the rivals are competing against each other and they make the best moves for themselves.  They will adjust to other’s strategies; however, the main point is that each rival wants to achieve the greatest profit in the end. 

Game theory was developed by john Neumann and Oskar Morgenstern in the 1940s and initially analysed strategic behaviour between firms.

Is game theory still valid in today’s economy?  I say yes!  The proof is in the price wars that you will see when four brand name gas stations are situated at each corner of an intersection.  Initially, all of the gas stations have the same price per litre listed and it appears that they are colluding.  Before long, you see the price at one of the gas stations lower in order to entice more business to that location.  The other gas stations follow suit by lowering their prices then the war is on.  What they do not realise is that eventually no one is maximizing the profits that could be made at that location.

Using the example above, I will explore how the payoff matrix works and how it would be beneficial for the gas stations involved in the price war.  The pay off matrix is a visual analysis of the decisions that these rivals can make as well as the ramifications of each of the decisions.  Each rival has the opportunity to cheat or not cheat.  The best overall revenue earned is when all rivals decide not to cheat with the lowest revenue achieved when all the rivals decide to cheat. 

I touched on collusion above.  Collusive actions are where rivals create an agreement or understanding in order to set the prices and split the market into fair portions.  In many countries, collusive actions are illegal and not tolerated.  Cartel actions are formal agreements between firms who are colluding.  An example of this would be the gas refineries as they regulate the supply they handle and do not increase supply when demand is high in order to manipulate the prices or perception of availability.

In conclusion, the game theory is alive and well in our economic system today and next time you see a price war going on at the gas pumps, you can think of the factors influencing the deal that you are about to receive.