Theory on how people behave when interacting with others, whilst trying to maximise personal welfare

Analysis of how people try to use their knowledge of what they think others will do in order to maximise their own welfare.

Economists try to predict how firms will react in various scenarios

Firms need to predict how other firms will behave when making their own decisions

Most relevant in Oligopoly - few enough firms for individual players to attempt to predict others’ decisions

Explains why firms collude to maximise welfare or why they may cheat on collusive agreements

Sally

Deny Confess

Jane

Deny A: Each gets 1 year

B: Jane gets 10 years; Sally gets 6 months

Confess C: Sally gets 10 years; Jane gets 6 months

D: Both get 3 years

Firm X

£2 £1.80

Firm Y

£2 A: Each gets £10m

B: Firm Y gets £5; Firm X gets £12

£1.80 C: Firm Y gets £12;Firm X gets £5

D: Both firms get £8m

A: Collude

B & C: ‘Maximax’ – each firm attempts to go for the best for themselves, hoping the other does not

D: ‘Maximin’ – both firms go for the failsafe option to minimise reducing the risk of ending up on the wrong side of the other

*All of B, C, and D end up at D* Only collusion will achieve A

Firm X

Update image

Price promotions

Firm Y

Update image

A: Firm Y: £5M

Firm X: £5M

B: Firm Y: £3MFirm X: £3M

Price promos

C: Firm Y: £2MFirm X: £1M

D: Firm Y: - £1

Firm X: - £1

Where a single strategy is best for one player, irrespective of what strategy the other player adopts.

Here, Y is better off updating their image, regardless of the choice made by X.

‘Update image’ is Y’s dominant strategy.

• Where no player has anything to gain by changing only his or her own strategy.

• If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of choices and the corresponding payoffs constitute a Nash equilibrium.

January 2013(c) With reference to an industry of your choice, examine strategies firms might use to increase consumer loyalty. Use game theory to support your answer. (12)

June 2013(d) Assess reasons why supermarkets are not increasing the retail price of eggs to cover the increased production costs of egg farmers. Use game theory to support your answer. (16)