Monday  May 29, 2023
 AmosWEB means Economics with a Touch of Whimsy!
 INDEX: A measure of the relative average of a group of items compared to a given base value. Index measures are commonly used in economics to combine and compare diverse measures. One common type of index measure is for prices, such as the Consumer Price Index and the Dow Jones Industrial Average of corporate stock prices. Another noted type of index measure is to track macroeconomic activity, especially the index leading economic indicators. Indexes are usually weighted averages rather than simple arithmetic means that are measured relative to a base value or period. The Consumer Price Index, for example, measures the prices of consumer good, weighted by the quantities purchased. The value of a given period is then stated relative to a base year value, which generates a pure, "unitless" number in the range of 100 (give or take).

GAME THEORY:

An analysis that illustrates how the choices between two players affect the outcomes of a "game." Game theory is commonly used to explain the behavior and decision making of oligopolistic firms. It illustrates that cooperation, rather competition, between two "players" can lead to an outcome that is more beneficial to both players.
Game theory is a handy way to analyze the type of interdependence often found with oligopoly. Oligopoly is a market structure containing a small number of large firms that practice competition among the few. The actions of one firm in an oligopoly is likely to prompt counter actions by other firms. One firm lowers its price, prompting a competing firm to lower its price. One firm launches a new advertising campaign, prompting a competing firm to step up its own advertising.

The moves and counter moves among oligopoly firms can be analyzed with game theory, developed by John Nash, a Nobel Prize winning economist and mathematician. The standard game theory analysis is based on alternative outcomes that arise given a choice that each of two players face. The key is that the choice made by each player affects the outcome of both players.

For example, suppose that Firm A introduces a new product. This act not only affects sales and profit of Firm A, but also the sales and profit of a competitor, Firm B. Competing Firm B, recognizing this fact, is likely to take a counter action, introducing a new product of its own, which affects its sales and profit, but also the sales and profit of Firm A. Much like a game of chess, each firm plans moves and counter moves based on the actions or anticipated actions of competitors.

To illustrate game theory, consider how two competing firms in the hypothetical Shady Valley soft drink market engages in a game of advertising. One of the two firms, OmniCola, is considering a new advertising campaign. The question is how might a major competitor, Juice-Up, react to this decision. Juice-Up might choose to counter with an advertising campaign of its own.

In particular, suppose each firm is thinking about spending \$50 million on advertising. The key to this analysis is that the benefit that each firm derives from its advertising expense depends on the actions of the other firm.

The exhibit to the right presents the outcome table summarizing alternative profit received by OmniCola and Juice-Up based on the advertising choice of each firm. Each firm can choose to advertising or not.

• The lower right square indicates that if NEITHER OmniCola or Juice-Up decide to advertise, then each receives \$250 million in profit. The top left triangular half of the square is the \$250 million profit received by OmniCola and the lower right triangular half of this square is the \$250 million profit received by Juice-Up. The total industry profit in this case is \$500, divided evenly between the two firms.

• However, if OmniCola and Juice-Up BOTH decide to spend \$50 million each on advertising, then each ends up receiving \$200 million in profit. The advertising by each firm effectively cancels out that of the other firm. As such, neither gains greater sales or market share, but both end up reducing profit by \$50, the amount of the advertising expense. The top left triangular half of the square is the \$200 million profit received by OmniCola and the lower right triangular half of this square is the \$200 million profit received by Juice-Up. The total industry profit in this case is only \$400, a decline of \$100, which is the total advertising expense.

• Alternatively, if OmniCola advertises but Juice-Up does not, then OmniCola receives \$350 million in profit and Juice-Up receives only \$100 in profit. This outcome is found in the lower left square. The top left triangular half of the square is the \$350 million profit received by OmniCola and the lower right triangular half of this square is the \$100 million profit received by Juice-Up. OmniCola receives a big boost in profit, and Juice-Up has a big drop because OmniCola advertising attracts customers away from Juice-Up. The total profit for this alternative is \$450, which reflects the \$50 advertising expense undertaken by OmniCola.

• The situation is exactly reversed if Juice-Up advertises but OmniCola does not. In this case, Juice-Up receives \$350 million in profit and OmniCola receives only \$100 in profit. This outcome is found in the upper right square. The top left triangular half of the square is the \$100 million profit received by OmniCola and the lower right triangular half of this square is the \$350 million profit received by Juice-Up. Juice-Up now receives a big boost in profit, and OmniCola has a big drop because Juice-Up advertising attracts customers away from OmniCola. The total profit for this alternative is also \$450, which reflects the \$50 advertising expense undertaken by Juice-Up.
Given these alternative outcomes, what is likely to happen? Is OmniCola likely to spend \$50 million on advertising? What actions might Juice-Up take?

Consider what would seem to be the "best" option, that is, most profitable outcome. If neither firm advertises, then total industry profit is \$500--the lower left square. If the two firms had a cooperative arrangement, or collusive agreement, then they would most likely select this outcome. Each avoids the \$50 million advertising expense and ends up with \$250 million of profit. Each maintains their individual market share and total industry profit is maximized.

Both firms are best off if neither advertises. But the firms do not have a collusive arrangement. OmniCola must select an option NOT knowing what Juice-Up will do. Juice-Up must select an option NOT knowing what OmniCola will do. OmniCola must select the outcome that is best for OmniCola regardless of the decision made my Juice-Up. Likewise, Juice-Up must select the outcome that is best for Juice-Up regardless of the decision made my OmniCola.

Consider the options facing OmniCola

• First, suppose that Juice-Up decides TO ADVERTISE. If OmniCola also advertises, then its profit is \$200 million, but it OmniCola does not advertise, then its profit is only \$100 million. If Juice-Up advertises, then OmniCola is also wise to advertise, with an extra \$100 million in profit.

• Second, suppose that Juice-Up decides NOT TO ADVERTISE. If OmniCola advertises, then its profit is \$350 million, but if OmniCola does not advertise, then its profit is \$250 million. If Juice-Up does not advertise, the OmniCola is once again better off advertising, with an extra \$100 million in profit.
The best choice for OmniCola is therefore to advertise, regardless of the choice made by Juice-Up. In either case, advertising generates \$100 million more for OmniCola.

Juice-Up, however faces EXACTLY the same choice. Regardless of the decision made by OmniCola, Juice-Up is also wise to advertise. Juice-Up generates \$100 million more, regardless of the choice made by OmniCola.

The end result is that both firms decide to advertise. In so doing, they end up with less profit (\$200 million each), than if they had colluded and jointly decided not to advertise (\$250 million each).

Game theory illustrates the key problem of interdependent decision-making found in oligopoly. Competition among the few can lead to inefficiency and competitive actions that waste resources without generating corresponding benefits.

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Recommended Citation:

GAME THEORY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2023. [Accessed: May 29, 2023].

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