Dominick Salvatore Schaums Outline of Microeconomics, 4th edition Schaums Outline Series 2006

274 GAME THEORY AND OLIGOPOLISTIC BEHAVIOR [CHAP. 12
From the table, we see that confessing is the best or dominant strategy for suspect A. The reason is that if suspect B
confesses, suspect A revives a 5-year jail sentence if he also confesses and a 10-year sentence if he does not. Similarly, if
suspect B does not confess, suspect A goes free if he confesses and receives a 1-year sentence if he does not. Similarly,
confessing is also the best or dominant strategy for suspect B. With each suspect adopting his or her dominant strategy
of confessing, each ends up receiving a 5-year jail sentence, instead of only a 1-year jail sentence by not confessing.
Each suspect, however, is afraid that if he or she does not confess, the other will confess, and so he or she would end up
receiving a 10-year jail sentence.
12.5 PRICE AND NONPRICE COMPETITION AND CARTEL CHEATING
Oligopolistic firms often face a prisoners’ dilemma problem in deciding on their pricing and advertising
strategy, or on whether or not to cheat in a cartel. In these cases, each adopts its dominant strategy but
could do better (i.e., earn larger profit) by cooperating (colluding).
EXAMPLE 4. The payoff matrix of Table 12.4 shows that if firm B charged a low price (say, $6), firm A would earn a
profit of 2 if it also charged the low price ($6) and 1 if it charged a high price (say, $8). Similarly, if firm B charged a high
price ($8), firm A would earn a profit of 5 if it charged the low price and 3 if it charged the high price. Thus, firm A should
adopt its dominant strategy of charging the low price. From the payoff matrix of Table 12.4, we see that firm B should also
adopt its dominant strategy of charging the low price. However, both firms could do better (i.e., earn the higher profit of 3) if
they cooperated and both charged the high price (the bottom right cell). Thus, the firms are in a prisoners’ dilemma: each
firm will charge the low price and earn a smaller profit because if it charges the high price, it cannot trust its rival to also
charge the high price.
Table 12.4
Firm A
Firm B
Low Price High Price
Low Price 2, 2 5, 1
High Price 1, 5 3, 3
12.6 REPEATED GAMES AND TIT-FOR-TAT STRATEGY
The best strategy for repeated or multiple-move prisoners’ dilemma games is tit-for-tat. This strategy
postulates that each firm should start by cooperating and continue to do so as long as the rival cooperates,
but stop cooperating once the rival stops cooperating.
12.7 STRATEGIC BEHAVIOR
Oligopolists often make strategic moves. A strategic move is one in which a player constrains its own
behavior in order to make a threat credible so as to gain a competitive advantage over a rival. The firm
making the threat must be committed to carrying it out for the threat to be credible. This may involve
accepting lower profits or building excess capacity. Most real-world business decisions are made in the
face of risk or uncertainty and this greatly complicates the development and conduct of a business strategy
by the firm.
Glossary
Dominant strategy The optimal strategy for a player no matter what the other player does.
Game theory The theory that examines the choice of optimal strategies in conflict situations.