Whitonomics - Issue 2 July 2014 | Página 6

MATHEMATICS P.4 Game Theory The mathematics hidden within oligopolistic markets Kade Stroude This What is Game Theory? Game theory in its essence is the science behind human strategy and human interactions. It briefly attempts to address behavioural economics, mathematics and psychology as to explain how humans use economics to predict another’s thought processes in a battle of wits. can be explained using game theory: Assume Pepsi advertise moderately. You expect Coca Cola will act similarly, and thus expected profits are £120m. However what if Coca Cola advertise heavily? The new expected profit is reduced to £25m, £95m less than before. Table 1  The Invisible Hand Adam Smith, arguably the most influential economist of all time, suggested that if people were to act in selfinterest, it would benefit society as a whole. This phenomenon would be known as the invisible hand. However this is not always the case, according to game theory, when any two (or more) parties are given a choice in which interdependence occurs, self-interest may prevent the most profitable outcome. How does this relate to economics? An example of this is Coca Cola and Pepsi branded soda. Most people are aware of such household names, whether they purchase the products or not, and this is due to large advertisement. In 2010 alone Coca Cola spent $2.9 billion on advertisement worldwide, more than Microsoft and Apple Inc. combined! Large firms who operate in a highly competitive market do not like the possibility of the worst scenario outcome, therefore by advertising heavily they would only receive £70 million less in profits (£120m - £50m), which is significantly less than the previous scenario. This same ideology suggests the reason for collusion (When firms join together to undertake a joint decision i.e. price setting, quantity of goods supplied in a markets). For firms to reach an optimal outcome they have to work together - this logical progression is caused by the impossibility to second-guess an opponent’s choice.   Table 2  However we must ask ourselves why? Game theory suggests an explanation exogenous to Adam Smith’s invisible hand. Coca Cola and Pepsi spend so much on advertising because their competitors spend so much on advertising - they must both in order to maintain a market share. Here it is likely that as the firms act in self-interest, they will lower prices to increase their individual revenue, meaning that in actuality will both lose revenue [Table 2]. Therefore it is argued that collusion will allow for both firms to maintain revenues as market uncertainty is erased. This is called a tacit collusion. Nonetheless collusion is illegal, because the exploitation of consumers is looked down upon.