What is Game Theory?

Game theory is used to explain the behaviour of firms in an oligoply. Take a look at the table below.

Game theory shows us why there is price rigidity in an oligopoly and why there is a huge incentive to collude.

Why do we use Game Theory?

Using game theory, firms can work the expected behaviour of rivals.

If firm B price their goods at £1, firm A can make £2.2 million (m) by pricing at 90p. Firm B will make a smaller profit of £1m.

If firm B price their goods at 90p, firm A can earn £1.5m by pricing at 90p. Firm B will also earn the same value of £1.5m.

The price is therefore likely to remain rigid at 90p because pricing at £1 carries a significant risk of being undercut by the rival firm thus making less profit. This also shows us that there is a huge incentive to collude. If firms A and B agreed to price their goods at £1 they could both earn £2m.