TOPIC 6

Monopoly, Imperfect Competition, and Oligopoly

Costs of Monopoly

Price Discrimination

Imperfect Competition and Oligopoly

 

Behaviour of Monopolistic Firms

The development of neo-classical economics in the late 19th century coincided with the maturing of the "Industrial Revolution" in Britain and the rapid expansion of industrialization in continental western Europe and North America. Competitive industrial capitalism had become a world-wide force, but, as industrial production and organisation expanded, free competitive markets appeared to be giving way to monopolistic forms of business organisation. Many of the most rapidly expanding modern industries, such as iron and steel, ship-building, railroads, chemicals and machine-making,  were already showing signs of  increasing concentration of ownership and, in many instances, outright monopoly. Large corporate entities were replacing traditional family-owned and operated business, single proprietorships and partnerships of the kind Adam Smith and his followers seem to have assumed would be the normal forms of business enterprise. During the 19th century, business amalgamations, mergers and buy-outs became commonplace and have continued ever since. 

Even in Britain, where the resistance to monopoly was more strongly entrenched in law and popular opinion than in other European countries, by the time of World War I a number of large monopoly organisations had developed. An often cited example in the business history literature would be the J.& P. Coates cotton sewing thread organisation which controlled not only the British domestic market, but most of the world market as well. In other industries a few large firms (oligopolies) exercised effective control over prices and output levels. These developments were particularly conspicuous in continental European countries, in part because there a different legal tradition permitted them to be more overt than in Britain.  In Germany, quickly emerging as the dominant industrial power on the continent, there was no resistance, either in law or opinion, to monopoly practices. The formation of "cartels", producer organisations set up to control the market for particular products, was actually regarded as desirable. Why? Because such organisations it could be (and was) argued, eliminated wasteful competition and duplication of production facilities, made it easier for firms to plan their activities, and ultimately might yield benefits to consumers in the forms of secure supplies and lower prices.

In the other great industrial economy emerging at the turn of the century, the United States, the growing concentrations of economic power also taking place there presented something of a paradox. Then, as now, most Americans professed a commitment to the ideals of competition, freedom and individual opportunity. Powerful constitutional and legislative enactments were in place to protect these ideals. Yet the legal apparatus which was supposed to ensure such freedom also served to shelter large corporate enterprises from any serious intervention by government in their activities. For example, Americans could point with pride to the Fourteenth Amendment to their Constitution (ratified by the States in 1868) which, most learned at school, was intended to confer equal rights on the black population. But, in practice, the so-called "due process" provision (which prohibited any state legislature from depriving any person of life, liberty, or property without due process of law) was instead most often used by corporations to prevent state legislatures from interfering with their business arrangements ó corporations having the legal status of persons and their purchases and sales of assets clearly involving "private" property. When World War I began in Europe in 1914, the United States was already in a position to become the worldís leading industrial country and most of its major industries were dominated by one or a few very large firms.

World War I, if anything, reinforced these trends. On both sides of the conflict the niceties of competition were subordinated to the critical task of maximising production, particularly in the heavy industries upon which military output depended. During the 1920s there were further rounds of mergers and acquisitions. In the United States a highly influential book, published in 1932, The Modern Corporation and Private Property, by Adolf A. Berle and Gardner C. Means, focused attention on the issue of what was happening to the business sector. Berle and Means undertook to show (a) how the corporate form of business enterprise had become dominant in modern society and (b) how its distinguishing feature was the separation of ownership (in the hands of widely-dispersed shareholders) and control (in the hands of professional managers who had little if any ownership interest in the enterprise). The evidence they presented suggested that business decisions were designed to promote the interests of managers and not the shareholders or, necessarily, the customers. 

Berle and Means had a great impact on scholarly and public opinion relating to business, especially in the US, and their influence remains significant even today. But for our purposes such ideas were particularly important for bringing into question the relevance of the neo-classical assumption of "perfect competition" in basic economic theory. Not surprisingly, a number of economists began trying to develop theory capable of explaining a world in which perfect competition was the exception rather than the rule. 

The extreme case at the opposite end of the scale from perfect competition is monopoly. A pure monopoly would be an industry comprising a single firm, instead of the "large number" of firms which is characteristic of perfect competition. Such a situation could be imagined if a firm were producing a good which was virtually unique, having no good substitutes and if some kind of barriers existed, such as patent rights, which prevented other firms from participating in its production 

A firm with a monopoly is in a position to influence the market price by deciding how much of the good to produce. Unlike a perfect competitor, a monopolist does not have to take the market price as a "given" and adjust output accordingly. A monopolist is said to be a "price seeker" rather than a "price taker" because maximising monopoly profits (or minimising monopoly losses ó monopolies are not necessarily profitable) entails finding the optimum price to charge for the product. While it is common to think of monopolies as possessing power over the market it is still the case that buyers retain the capacity to refuse to buy at a price they consider too high for the value they receive. In fact, the monopolist faces the same demand curve as the industry in perfect competition. (The monopolist is the industry.) And the common characteristic of such a market demand curve, as we have seen, is that it slopes downward to the right. If the monopolist wants to increase sales, price will have to be lower than if a lower level of sales is preferred by the firm.

The monopolistís production decision, then, entails finding a level of output that maximises profits or minimises losses, just as was the case for the perfectly competitive firm already discussed.The decision rule for the monopolist is also the same: to choose a level of output that maximises the difference between costs and revenues or, in terms of marginal analysis, to expand output until marginal cost equals marginal revenues. The reasoning behind this is the same as for the competitive firm. So far as the costs of a monopoly firm are concerned, again they are conceptually the same as those of a competitive firm. However, applying the standard decision rule has quite different consequences in the two cases. When the monopolist sets output to equate marginal cost and marginal revenue, average revenue, or price, is greater than marginal revenue, whereas under perfect competition marginal revenue and average revenue are the same.

At the monopolistís most profitable level of output marginal cost equals marginal revenue but not, as in the case of the perfectly competitive firm, average revenue (price). To equate marginal cost with average revenue would entail producing a larger output at a lower price. This is the key to the criticism of monopoly which is inherent in conventional market theory. Monopolists restrict output and may charge higher prices than firms would in a competitive setting.

This means that monopolists may earn profits. In the case of competitive firms, such profits would attract increased competition. In the long run profits would attract new firms to the industry. This would result in a further increase in total output and a fall in price ó ultimately to the point where all greater than normal returns were eliminated. But a monopoly situation precludes such a corrective development, even in the long run, because of the "blocked entry" which makes monopoly possible in the first place. (If there were no obstacles to prevent firms from entering this industry, the monopoly situation would not, of course, exist.) Therefore the social losses caused by the reduced output and higher prices which exist under monopoly compared to perfect competition may be even greater than the short run analysis would predict. When monopoly exists, too few resources are allocated to the production of the goods affected and the total satisfaction of consumers could, consequently, be increased by altering the allocation of resources among alternative uses. How serious a problem this allocative inefficiency may be is, however, difficult to determine with any certainty.
 

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The Cost of Monopoly

Several attempts have been made to measure the costs monopoly imposes on the economy as a whole. The classic study was carried out by an American economist, A.C. Harberger. His analysis of monopoly demonstrated that the real social costs of monopoly were probably quite modest, amounting in the US case to only some 0.1 to 1 per cent of the total value of output in the American economy in the 1920s.

Another American economist, Harvey Leibenstein, however, criticised this estimate of the real cost of monopoly on the grounds that monopoly power permits managers and workers to function at lower levels of productivity than they would be required to achieve in a competitive environment. Leibenstein called this slack x-efficiency and suggested that if it were included with the traditional measure of welfare loss due to monopoly, the total would be much larger than previously estimated. This renewed attack on monopoly power was itself subsequently blunted by further analysis of monopoly in which it was argued that if managers and employees of firms resorted to such inefficient methods, the profitability of such a firm would decline and the capital market would function in such a way as to make it difficult for a firm practising x-(in)efficiency to attract new investment or even to retain what it had. Capital would tend to move from x-inefficient firms to those that were more efficiently operated. (More recently the issue of the social costs of monopoly has been approached using the concept of "rent seeking" which we will study later, in Topic 10.)

The misallocation of resources associated with monopoly power, however extensive, is the main reason most economists have been opposed to monopoly, and the related popular perception that monopolists use their market power to exploit consumers explains why most governments, at least in countries with British common law traditions, have passed legislation making the kind of monopolisation of potentially competitive industries illustrated earlier illegal. Defences of monopoly have also been proposed, often by spokespersons for firms possessing or seeking such powers, but also by some economists, such as the Austrian-American economist Joseph Schumpeter, who argued that monopoly serves to promote research, development, and more effective methods of production.

Born and trained in Austria, Schumpeter had a distinguished career at Harvard University from 1932 to the time of his death in 1950. His first major work, Business Cycles, published in 1939, received little attention. Somewhat disillusioned, but not discouraged, Schumpeter next wrote a very different kind of book, a lighter, more general work in which he expressed his views on a variety of topics relating to history and politics as well as economics. The breadth of the work, published in 1942, is suggested by the title, Capitalism, Socialism and Democracy. Available in any reasonably adequate library, it is readable, its style suggesting a sceptical pessimism combined with irony and wit. In 1942 it was not difficult to feel that the world, even the United States, was going to hell. Not noted for his modesty (he was apparently unsure whether he would be remembered as the greatest economist or the greatest lover of his time), Schumpeter was surprised that this relatively small book, produced with so much less effort than his massive study of business fluctuations, proved to be enormously popular. What was in it?

Part of the book is devoted to a critical analysis of the work of Marx, founder of the socialism Schumpeter both feared and disliked, but which he thought would ultimately overwhelm capitalism, not because it was a superior form of economic organisation, but because it had an emotional appeal he thought capitalism, for all its superior achievements, unhappily lacked. But for our purposes the most relevant part of the book is the treatment of the neo-classical problem with competition and monopoly. Schumpeter was struck by the discordance between observed forms of business organisation and the neo-classical assumption of perfect competition. Unlike the other innovators in the field of non-competitive theories of the firm, Schumpeter pursued an alternative approach to the issue, not by reworking the methods of mainstream economic theory so much as by ignoring it in favour of an historical analysis. For him, the current structure of the economy was the consequence of a long process of evolution, of what he called a process of "industrial mutation" through which existing structures of economic organisation were continuously destroyed, to be replaced by new ones. To describe this process he coined an unforgettable term: creative destruction. This is one of the few "oxymoronic" phrases which is worth the name: the two words are not just antithetical, there is a point to their contradiction of one another. And the point in this case was that the success of capitalism was rooted in the way established businesses had sooner or later to be destroyed to make way for new and more productive ones. Under capitalism, as the producers in eastern Europe are discovering today, there can be no standing still, no "quiet life". 

The agents of creative destruction in Schumpeterís system are the entrepreneurs. These are the individuals who crop up from time to time with a new idea that actually can be made to work. It may be a new product, a new method of producing an existing product, a marketing strategy, whatever. Schumpeterís entrepreneur, you might think, would be regarded as something of a heroic figure in a capitalist system. Not so. The true entrepreneur is regarded as an enemy of established business, a threat to be squashed by those presently in control as soon as he appeared so as to preserve the status quo. This opposition tests the mettle of the entrepreneur. If success is realised and the old lions are driven off to grumble in retirement, the entrepreneur achieves profits and may go on to build a great enterprise. (At time of writing it is hard not to think of Bill Gates and his Microsoft Corporation.) Should such success be penalised? Should the upstart firm which succeeds in capturing an industry be charged with some offence? Surely not, Schumpeter argued, for this is what provides the driving force which made capitalism work, raising the productive efficiency of business to levels unheard of in any alternative system known to history. Not surprisingly, Schumpeter was opposed to American anti-trust (anti-monopoly) legislation and the efforts of government to preserve competition and protect inefficient (often small) business enterprises from the giants who owed their position to successful innovation. 

The problem with the neo-classical economic theory of producer behaviour, in Schumpeterís view, was that it simply failed to take the historical evidence into account. Marshall and his followers appeared to be obsessed with "price", yet people running modern business were more concerned with other things. The last thing they were interested in doing, for example, was competing through price. The way a modern business succeeds or fails is not in cutting price, but coming up with a new product, or a new technology, or a new source of supply, or by reorganising (possibly becoming big by grabbing more market share), none of which preclude being able to sell at a lower price, but all of which involve attending to other priorities. As for government regulations designed to "preserve competition", Schumpeter thought them both unproductive and unnecessary. In fact, he argued, the historical evidence shows that monopoly, when it does arise, seldom persists. Attempts to penalise big business amount to penalising success, the very success which has enabled capitalism to raise living standards for workers and capitalists alike to unprecedented levels. Monopoly profits, he seemed to think, are more like prizes, less important for what they confer on a few lucky winners than as an incentive to encourage many to seek success and in the process advance productivity and the well-being of all.

(By the time he was writing in the early 1940s, Schumpeter could foresee only a bleak future for capitalism. In the United States, public opinion following the experience of the Great Depression was swinging in favour of more government control of business, not less. And as for business itself, he saw firms adopting conservative policies, hiring professional "managers" who were little different than the functionaries who would run socialist enterprises. The age of the free-wheeling entrepreneur was over, he thought, and conformity and mediocrity were about to prevail, even in America.)

Schumpeterís defence of monopoly was not the only one possible. Others have argued that it is technically possible that the monopolisation of a previously competitive industry could result in a lowering of costs. A large, well-financed organisation might be able to introduce new, more efficient methods of production, causing the cost curves in the example just given to shift down. Whether the benefits of such cost reduction would be passed on to consumers or not is another question. The monopolist is motivated (as is the competitive firm, of course) to maximise profits, not minimise price.
 
 

There is unfortunately no good solution for technical monopoly. There is only a choice among three evils: private unregulated monopoly, private monopoly regulated by the state, and government operations.

óMilton Friedman
There is also the phenomenon of so-called natural monopolies (or "technical monopolies") which was mentioned earlier.In such situations there may be no feasible alternative to a monopolistic structure of industry. Where economies of scale are very large and the size of the market limited, it may not be feasible to have more than a single producer. Electric power generating systems and other public utilities such as rapid transit systems provide examples of situations where competition is simply not practical. In these circumstances various methods may be used to limit the negative social impacts of monopoly power: public ownership and rate regulation by some publicly-appointed agency are familiar examples in most countries. 

Another mitigating aspect of monopoly arises from the possibility of price discrimination. There may be circumstances under which monopolists are able to charge customers different prices for the same product. There are at least two different ways this may be done. One is by charging the same consumer different prices for different units of the product, another entails separating consumers into different groups and charging each of these groups a different price for the same product. 

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Price Discriminating Monopoly

In perfectly competitive markets firms have no influence on price and consequently they cannot practice any kind of pricing strategy. But when competition is imperfect and firms can influence price by increasing or decreasing their output, pricing strategy becomes an important part of doing business. This is particularly easy to understand in the case of a completely monopolised industry.

Recall the concept of consumer surplus introduced in Topic 3. The point there was that normally there is only one price for a product in a particular market. This meant that if the market price for a good was lower than a consumer would have been willing to pay for one or more units of it, the consumer would realise a surplus of benefit over whatever had to be paid for it. In a monopolised market, however, the supplier of a good may be able to find ways to charge a buyer different prices for different units.

In practice it is not easy to charge the same customer different prices for different units of the same good, although devices such as charging membership fees to join a buying club to gain access to purchasing privileges may have something of the same effect. It is probably easier in practice for monopolists to separate customers into different groups having different elasticities of demand for the monopolistís product. This type of discriminatory pricing is familiar to airline passengers.

Consider a seat on an flight from Hong Kong to Toronto. Each seat on the aircraft costs the airline company the same amount to supply. Suppose a real-estate executive must get to Toronto on short notice to sign a contract. Her demand may be highly inelastic and the airline may be able to charge such a passenger a relatively high price. Consider another possible passenger, a retired scholar who is mildly interested in visiting some place foreign as a matter of general interest. His demand may be quite elastic for space on any particular flight. To sell him a seat may require offering a low price. This is why airlines typically have different prices for different groups of customers.

Thus, in situations where price discrimination is feasible,  the restriction on output which makes monopoly undesirable in other circumstances may be considerably ameliorated. Indeed, if "perfect price discrimination" is possible, the monopolist might end up expanding output to the same level as a perfectly competitive industry would produce, as shown here. (By being able to charge each buyer the maximum price that buyer is willing to pay, the monopolist avoids having to reduce price to increase sales and, consequently, sees a demand curve corresponding to marginal revenue.) Of course the monopolist's incentive to do this is to capture in the form of monopoly profits benefits which would accrue to consumers under competitive conditions. But defenders of monopoly would make arguments even on this score: negative income redistribution effects of  monopoly pricing may be offset in some circumstances by positive redistributive effects. It has sometimes been suggested, for example, that price discrimination by private schools which charge wealthy parents high fees and poorer parents lower fees (often disguised as "scholarships") gives some children access to elite schooling which would otherwise be unavailable to them.

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The (More) Real World of Imperfect Competition and Oligopoly

Competition in the real world seldom conforms to the simplified cases of perfect competition and full-fledged monopoly. Instead of finding such a large number of firms that no one of them has a significant influence on total output and price or a single firm functioning as the industry as a whole, typical real world market structures involve a considerable number of producers, some of whom may have considerable market power while most of the others do not. Managers of firms operating in such situations must keep a close eye on what their competitors or potential competitors are doing and take into account how they will react to any output or pricing decisions which are taken.

One very common type of market arrangement which is studied in more advanced treatments of industrial organisation is called monopolistic competition (or, sometimes, imperfect competition). This is a situation, first analysed by Joan Robinson in England and Edward Chamberlin in the US, in which there may be quite a number of firms (as in perfect competition), but they produce products which are somewhat different from one another. Such "product differentiation" is familiar from everyday experience. Many people have a favourite brand of tooth paste or believe that their cars run better on one brand of gasoline than another. What is important in such cases is not whether there is any real difference among brands, but whether consumers believe there is. Obviously this is an area where advertising, as well as other considerations such as a sellerís location and the quality of service provided, enter into the picture. 

A firm practicing product differentiation is trying to establish a "monopoly" of that particular version of the product, and to the extent it succeeds, it will operate much like a monopoly in making its output and pricing decisions. Like a monopoly, it faces a downward sloping demand curve for its product. But unlike a monopoly, firms in imperfect competition are likely to be vulnerable to the entry of competitors if they are earning profits. This means that in the long run, their profits are likely to be "competed away" as new firms enter the market with similar products and prices will tend to fall toward the level at which price equals long run average costs. This does not mean, however, that the desirable features of perfect competition are restored. Imperfect competitors still restrict output to below the competitive level for the same reasons monopolists do: they determine their best (most profitable) output at the point where marginal cost equals marginal revenue, not where marginal cost equals average revenue (price) as the perfectly competitive firm inadvertently does because it faces a horizontal, not a downward sloping demand curve.

A brilliant theorist, Joan Robinsonís (1903Ė1983) first professional acclaim came with her book, Economics of Imperfect Competition, published in 1933 (a few months after Chamberlinís book was published in the US). It was a work firmly within the great neo-classical tradition of Marshall so far as technique was concerned, but directed to the analysis of "imperfectly" competitive markets. In her view, the important entity in business was not the firm, but the industry (defined as all the firms producing the same product). Her treatment of the behaviour of firms emphasises their interdependence, the way each individual firmís decisions influence others, a necessity arising from the fact that the individual firmís demand is a portion of the demand facing the industry as a whole. Her analysis shifts attention from the perfectly elastic demand of the competitive firm imagined by Marshall to a business environment in which it is necessary to reduce price to sell more product, an environment characterised by monopoly rather than competition in the traditional sense.

As she wrote in the introduction to Economics of Imperfect Competition,

... economists, misled by the logical priority of perfect competition in their scheme, were somehow trapped into thinking that it must be of equal importance in the real world. When they found in the real world some phenomenon, such as "economies internal to the firm", which is inconsistent with the assumptions of perfect competition, they were inclined to look for some complicated explanation of it, before the simple explanation occurred to them that the real world did not fulfil the assumptions of perfect competition. The significance of this went beyond the technical issues of economic analysis, for in this, as in her later work, Joan Robinson made no attempt to repress her social conscience. What Imperfect Competition was ultimately directed to was establishing the extent to which monopoly was responsible for redistributing income in society from workers to capitalists. This stands in stark difference to the conclusions drawn from an remarkably similar analysis of non-competitive markets by the American economist, Edward Chamberlin.

A greatly respected American academic, Chamberlin devoted much of his career to refining his early work on competition, initially published in The Theory of Monopolistic Competition in 1933. He and Joan Robinson are usually taken to be co-creators of this revision of the neo-classical theory of the firm, although there are some differences between the two approaches which might be mentioned. Perhaps most important is Chamberlinís refusal to pursue the broader implications of recognising that competition in the traditional sense was largely irrelevant to modern business organisation and practice. On the analytical level what stands out is that, unlike Robinson, Chamberlin focuses attention on the firm, rather than the industry, and in the process introduces the concept of product differentiation by which firms in the same industry market products which are in some way "unique". In Chamberlin, firms have product strategies which they implement in a variety of ways, including the use of advertising to persuade buyers that the particular firmís product is preferable to that marketed by some other firm. As he expressed it in The Theory of Monopolistic Competition:

A general class of product is differentiated if any significant basis exists for distinguishing the goods (or services) of one seller from those of another. Such a basis may be real or fancied, so long as it is of any importance whatever to buyers, and leads to a preference for one variety of the product over another. Where such differentiation exists, even though it be slight, buyers will be paired with sellers, not by chance and at random (as under pure competition), but according to their preferences. And further: Differentiation may be based upon certain characteristics of the product itself, such as exclusive patented features; trade-marks, trade names; peculiarities of the package or container, if any; or singularity in quality, design, color, or style. It may also exist with respect to the conditions surrounding its sale. In retail trade, to take only one instance, these conditions include such factors as the convenience of the sellerís location, the general tone or character of his establishment, his way of doing business, his reputation for fair dealing, courtesy, efficiency, and all the personal links which attach his customers either to himself or to those employed by him. While this could be interpreted as undermining the case for free markets, an interpretation Joan Robinson had no difficulty accepting, as a staunch supporter of free-market economics Chamberlin was apparently unconcerned about it. Clearly the existence of a degree of monopoly power in the hands of a producer meant that output would be restricted and the price of the firmís product would be higher than in a perfectly competitive situation. On the other hand, Chamberlin could argue that the consumer was getting something in return for the higher price ó a more desirable product! Why else do people buy brand name acetasalycilic acid (Aspirin) instead of the less expensive generic product? 

The other common type of organisation found in the real world is oligopoly, a market structure in which the industry is dominated by a few large firms. The classic example used to be the North American automobile industry at the time when three firms produced virtually all the automobiles marketed in the United States and Canada. Even today, with competition in this market from a number of foreign firms, Japanese and European, the auto industry would be classified as oligopolistic because the market is dominated by no more than eight or ten large producers.

The significant feature of oligopoly is the interdependence of the firms in the industry. Each firm in such a situation must make decisions with due attention to how other firms in the industry will react. Increasing price may induce other firms to increase their prices too. Or they may decide not to in the hope of increasing their share of the market. Much of what makes the world of business (or at least the world of big business) interesting and even glamorous is the fact that decision-makers in oligopolistic situations have to be strategists. Like generals in a war, or chess players, they win or lose on the basis of out-guessing or out manoeuvring their opponents. Not surprisingly, the economic theory of oligopoly makes much use of the theory of games, a fascinating but technically challenging body of theory which seeks to explain what determines the outcomes of competitions in which players, bound by a set of (perhaps more or less) agreed rules, choose among alternative strategies to find their way to a better rather than a worse conclusion.

A simple illustration of the approach taken by game theory is provided by the case of the "prisonerís dilemma." Suppose two college students are arrested in Singapore and charged with chewing gum on the subway system. They are held and interrogated separately. Each is told the same thing: If your partner confesses and you refuse to, you will be given ten years in prison; if your partner confesses and you also confess, you will be given five years in prison. If you both refuse to talk, we will let you both off with only a stern talking to and a year in prison; but if your partner refuses to talk and you confess, we will let you go with only a stern talking to. The interrogator points out to each of the prisoners that if the other one confesses, he or she is better off confessing and he or she is also better off confessing if the other one refuses to confess. To make it clear, the interrogator draws them a diagram:
 
 
Bill Confesses
Bill Refuses
Alice Confesses
Alice gets 5 years
Alice gets off
 
Bill gets 5 years
Bill gets 10 years
Alice Refuses
Alice gets 10 years
Alice gets 1 year
 
Bill gets off
Bill gets 1 year

Obviously it would be best for them both to remain silent. But from the point of view of each as an individual it would seem best (unless each had total confidence in the other!) to confess. This kind of situation arises in many contexts where self-interested behaviour, in the absence of conviction that another party is completely trustworthy, leads to an outcome (a "payoff") which is less than optimal for those involved. Two firms in an oligopoly, for example, may be in a position to maximise their joint profits by agreeing to restrict output and drive up prices. But if each suspects the other might cheat, each will decide to produce more than was agreed on, reasoning that they would be better off by doing so whether the other cheated or did not cheat. 

In the real world, especially when there is the possibility of learning from experience, such strategies may become much more complex. Nevertheless, even the simplest analysis helps explain why producer agreements, such as those which led to the creation of the OPEC oil cartel in the 1970s, tend to break down under the pressure of self-interest on the part of those involved. 

The analysis of such situations was initially developed by John von Neumann and Oskar Morgenstern of Princeton University in a book, The Theory of Games and Economic Behaviour, published in 1944. It was subsequently further developed by another American, John Nash, who devised a simple model in which rival firms determine their optimum strategies based on perfect knowledge of their own self interests. This rather restrictive model was expanded by another pioneer in the field, John Harsanyi, who demonstrated how the assumption of perfect knowledge could be relaxed, requiring only that the behaviour of the players in the game be predictable in terms of probabilities. Another limitation of the Nash model was that games could have only one outcome. This was overcome by Reinhard Selten, a German economist, who showed in 1965 that alternative outcomes could be explained by determining their degree of "reasonableness". 

Today game theory is one of the most active fields of economic theory. Its importance has been recognised by the 1994 award of the Nobel Prize in Economics to Nash, Harsany and Selten. Unfortunately the literature itself is largely inaccessible to all but the specialist equipped with extensive mathematical and analytical skills, but anyone interested in learning a bit more about it might begin with these links.

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