Tuesday, May 15, 2007

Game Theory Pricing Strategies

Definition Game Theory:

Game Theory involves the modeling of interactions among agents. Game theory is used in a variety of economic models to examine various different potential outcomes. Game Theory usually involves looking at events where the decisions of others have some influence on your own decisions.

Game Theory can be used for pricing strategies.

For example, in oligopoly firms may be deciding whether to cut prices, increase prices or keep them static.

The kinked demand curve model suggest the most likely outcome is for price stability. This is because

  1. If firms increase price, others don't - Therefore demand falls significantly. (demand is elastic)
  2. If firms cut price, you would gain an increase in market share. Other firms don't want to allow this. Therefore, they cut prices as well. Basically causing a price war where everybody loses out.
Therefore, in oligopoly an important feature of firms decisions is the impact of interdependence. Decisions of one firm significantly impact on others.

Real World Examples of Game Theory

In the real world pricing strategies may not occur as the kinked demand curve model suggests. This is because game theory can be more complex in the real world:

  • Firms may be able to collude. - This is where they agree to raise prices and stick to output quota's. In the UK this is illegal, however, it can be difficult to enforce in practice.
  • Firms may not be profit maximisers. For example, they may be willing to make lower profits in order to gain a small increase in market share. For example, the supermarket, Wal Mart often claims to have this strategy towards expansion.
  • Firms may not be aware, or choose to ignore the reactions of rivals. For example, in an oligopoly, a small firm may feel that if it cuts price it will not have a significant impact on its bigger rivals.

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