Question

n a market structure where firms are mutually interdependent, price competition is not common. Explain using the game theory matrix, with relevant assumptions, how firms make decisions when they behave collusively and non-collusively.

Answer 1

Under a structure where mutual interdependence exists the market is said to be oligopolistic in nature. In such a situation price competion is not effective and so firms will resort to product differentiation and non price tactics to capture the market. In such a situation collusion is only sustainable if the firms cooperate and will break down if there is no cooperation. Thus in the matrix below the firms have 2 strategies (collude, not collude). The structure of the matrix will be as follows:

The matrix shows that the Pareto optimal outcome is when both firms earn greater payoffs and hence collusion is a better outcome for both firms. The assumptions here are that all firms act rationally and so the firms will choose the result that gives them greater benefit. Thus firms dont compete on prices, they use non price factors like advertising to differentiate with other firms.