How Game Theory Can Contribute to the Economist's Understanding of Oligopoly

In the highly competitive business environment, firms compete in maximizing their profitability not only by providing better products to their customers but also by designing powerful strategic moves. In the market of oligopoly where the market is dominated by a small group of large suppliers (Sloman and Hinde, 2007) each firm will consider and analyze the likely effect of its decisions on its rivals and how the rivals would respond to its action (Dutta, 1999). For example, senior manager in a leading camera company would consider if the company wants to reduce the price of one type of camera in order to grab more market share, whether its competitor will also match the price discount and even decrease the price to a greater extent. Game theory is a useful tool that can be applied to oligopolistic decision making (Lim, 1999) and it is helpful for analyzing strategic interactions between firms in the market of oligopoly. This essay will use three models, namely Cournot model, Bertrand model and Stackelberg model and suitable examples to discuss how game theory can contribute to the economist’s understanding of oligopoly. It will first look at the Nash equilibrium in Cournot model and examine the results when the firms collude as a cartel. Then it will consider the Nash equilibriums in Bertrand model and Stackelberg model respectively. All three models discussed in this essay simplify the real situation of oligopoly by assuming there are only two firms in the market.

The model constructed by Cournot is based on the interaction between two firms about choosing the amount of production. Suppose firm 1 and firm 2 produce homogeneous good that provides exactly the same value to consumers. They simultaneously and independently select the level of production to maximize their own profit. If firm 1 produces the amount of Q1 and firm 2 selects the production of Q2, the total supply of the product would be Q1+Q2 which will determine the price of the product. Suppose the...