Evaluate the use of game theory as a tool to explain oligopolistic behaviour
Evaluate the use of game theory as a tool to explain oligopolistic behaviour (25 marks)
An oligopoly is a market structure that consists of a few dominating large firms in a particular industry. Game theory is the theory that explains the interaction between firms and decision that firms make.
To some extent, using game theory as a tool to explain oligopolistic behaviour can have limits as the game theory is based on the idea that humans act rationally in making decisions. However, it could be argued that human beings do not act rationally all the time. Therefore, can we completely rely on game theory to use as a tool to explain oligopolistic behaviour?
Nevertheless, the game theory can still be used in understanding the budget of firms for advertising and branding programmes. This can be seen as being essential as oligopolistic firms prefer non-price competition to prevent price wars in a particular industry (and oligopolistic markets prefer price rigidity). In fact, over the years, Nike has gradually increased the amount of money to put towards sports sponsorship programmes and more TV advertising. Many other competitors such as K Swiss and Reebok have responded by increasing their sponsorship schemes. Therefore, game theory can be used to understand the strategic decisions that firms make on the size of advertising and branding budgets and plays a significant part in making sure that market share in an industry is retained.
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On the other hand, the game theory is based upon human being acting rationally on behalf of companies through taking calculated risks. However, we have seen in the recent bank crisis that this doesn’t seem to be the case. For example, the Royal Bank of Scotland took over ABN AMRO banking group to be more competitive on a global scale, only after the takeover was is realised that ABN AMRO were heavy in toxic debt. Therefore, how can we possibly apply a theory to oligopolistic behaviour such as game theory, based on rationality, when such large and well established institutes behave in a non-rational manner?
Within game theory, there’s the existence of another principle called Nash equilibrium which explains the tendency for firms to change their strategy (such as increasing or decreasing prices).If the strategy of a competing firm is unknown, there is no incentive for another firm to change their prices or strategy as it isn’t worth compromising your current market share. This allows for price rigidity in the marketplace. Therefore, taking into account that oligopolies work to avoid price wars and promote price rigidity, the theory of Nash equilibrium can be applied to the real world as oligopolies DO work like this as they prefer non-price competition such as advertising and branding to compete and retain or gain more market share.
Overall, using the game theory as a tool to explain oligopolistic behaviour can seem very reasonable. Although the criticism that human beings are not always rational in the way we behave, you still have to consider the fact that majority of individuals can act rationally on behalf of companies. Understanding this is essential when discussing the game theory. Nevertheless, making a decision on behalf of a company can still carry risks which individuals are willing to take in order to benefit from rewards and bonuses. In other words, although people are capable of acting rationally, they STILL may choose not to under certain circumstances. Therefore, to suggest the game theory can be used as a unique and specific tool to explain oligopolistic behaviour would be wrong as it carries the flaws I have just mentioned. But, to use as an indicator of how oligopolies may behave under certain circumstances against other firms in a particular industry is a suitable tool.