Game Theory

Oligopoly exits "when the number of firms in an industry is so small that each firm must consider the reactions of rivals in formulating its price policy" (McConnell at al., Microeconomics, 5th ed., Toronto, McGraw-Hill, 1990. at 254). In an oligopoly, for a firm to maximize its profit, it need to choose the best choice depending its rivals action and reaction. Game theory, introduced by John Neumann and Oskar Morgenstern in the 1940's, is concerned with the choice of the best strategy in conflict situations and analysis of oligopolistic behavior. The main idea of game theory is that payers in oligopolistic market is seeking the best payoff with it strategy; people are motivated by their interest. The payoff is the outcomes of each combination of strategies by the two players.

The following table is one of the most famous example of payoff matrix. Two suspects are arrested for armed robbery;

In the example above, if both suspects don't confess, both will receive a sentence of one year imprisonment for possessing stolen goods. If both confess, the sentence will be reduced to 5 years each. However, if the district attorney promises each suspect that by confessing, he will go free while the other suspect (who does not confess) will receive the full 10 year sentence. Oligopolistic firms often face this kind of dilemma problem in deciding their business strategy.

Not like the example above, in the real world, each player may have chance to communicate with his rival, and thus reach to an agreement for the purpose of setting prices or dividing market - collusion/cartel. One example is the Organization of Petroleum Exporting Countries (OPEC).