Game Theory

Game theory describes how different actions by firms (usually in oligopoly) can result in different economic outcomes for each firm, whilst neither of the firms may have intended the outcome which occurs.

An example of game theory in terms of profit of firms:
                                                        
                                                                 Firm B

                                              High Price          Low price
                                      
                                             A1: £50 mil         A3: £30 mil
                  High Price
                                             B1: £50 mil         B3: £80 mil

Firm A

                                             A2: £80 mil         A4: £40 mil

                  Low Price
                                             B2: £30 mil         B4: £40 mil


The above table (which may be slightly unclear as i can't draw lines to separate each box) shows the outcomes of different decisions taken by two firms. If the firms act in a collusive way and both set a high price, then they both make a significant level of profit (see A1, B1). However if they agree to set a high price and Firm A chooses to undercut Firm B by setting a lower price, Firm A is likely to be far more popular with consumers than Firm B (as goods are cheaper) and therefore Firm A will make a huge profit of £80 million at the expense of B which only makes £30 million (A2, B2). If both firms try to undermine one another by setting a low price (A4, B4) then both will have lost out on the £10 million profit which they would have made if they'd stuck to their original agreement of a high price.
For this situation to occur the firms don't necessarily have to in collusion, however it is much more likely to occur if they are. The most commonly used example of game theory is the prisoner's dilemma.

Game theory is commonly used in economics and can be applied to many situations e.g. advertising budget. If one firm spends lots of money on advertising and another does not, this could hugely improve the profits of the first firm. If both set high budgets then they both make good profit. If both set low budget, they both make low profit - its the same situation as above.

                                                               Firm B


                                           High Ad Budget     Low Ad Budget
                                      
                                             A1: £50 mil             A3: £30 mil
            High Ad Budget
                                             B1: £50 mil             B3: £80 mil

Firm A

                                            A2: £80 mil             A4: £40 mil

            Low Ad Budget
                                             B2: £30 mil             B4: £40 mil