Oligopoly and Game Theory Essay Example

Oligopoly and Game Theory Essay Example Oligopoly and Game Theory Paper Oligopoly and Game Theory Paper ECO 152 December 9, 2013 Photo by Christian Gooden, [emailprotected] dispatch. com St. Louis Christmas Tree Lots: Oligopoly and Game Theory Since Christmas is drawing near, the annual Christmas tree lots are beginning to open. This brings memories of my father cursing in the car every Sunday before mass because half the church lot is taken up by trees. For a few weeks Ted Drew becomes the king of Christmas not the king of custard in St. Louis. Pretend the image I selected is not taken from the St. Louis Post Dispatch but is in fact my family having a wonderful time together at the St. Peters Church Christmas tree lot in Kirkwood. This picture does not exist because our time spent at the Christmas tree lot is usually spent arguing over what tree to choose and ultimately ending in my sister crying because my father says we cannot bring a 30 foot tall tree into our home. The Christmas tree market in St. Louis can be considered an oligopoly because there are relatively few locations which sell Christmas trees in St. Louis. An oligopoly is a market structure in which a small number of independent firms compete, somewhere in between a monopoly and a competitive industry with many firms. In this case let us Just consider the Ted Drewes lot and the St. Peters Church lot as a duopoly to represent the St. Louis Christmas tree market. Christmas tree prices are determined by St. Peters and Ted Drewes in order to maximize profits. The prices are not only determined by demand, but also by the price at which competitors choose to sell. We analyze this price competition by what economists call game theory. Game theory is the study of the decisions of firms in industries where the profits ofa firm depend on its interactions with other firms. In ligopolies, firms are very large compared to the market therefore their interactions are what determine success and profit. Three characteristics of game theory are payoffs, rules and strategies. In the example of the Christmas tree lots, we can use game theory to analyze price competition between Ted Drewes and St. Peters Church. To make the maximum profit, the price Ted Drewe and Father Smith decide to sell the average Christmas tree is dependent on what the competing firm prices are. They will either sell them at an average of $40 or $50 per tree. The action a firm takes to achieve the goal of aximizing profits is an example of business strategy. In fgure 1, the possibilities for each firm are organized into a matrix to determine the payoffs for each firm based on their and the competing firms price decision. Figure 1 Ted Drewes $50 STP earns $10,000 profit St. Peters TD earns $40 $10,000 profit STP earns $5,000 $15,000 profit STP earns $15,000 _$5,OOO profit STP earns $7,500 _$7,500 profit St. Peters Church profits are in blue and Ted Drewes profits are in red. If both St. Peters and Ted Drewes charge an average of $40 per tree, each win earn a profit of 7,500 in total sales. If St. Peters charges a higher price than Ted Drewes at $50 per tree, they will lose customers to price competition and earn $5,000 total profit while Ted Drewes earns $15,000 total profit. If the situation is reversed and Ted Drewes charges a higher price, their total profits will be $5,000 while St. Peters earns $15,000 total profit. If both Ted Drewes and St. Peters charge $50, they with each earn $10,000 total profit. Looking at the matrix it seems that the firms would be better of both charging $50 to earn $10,000 total profit each. Ted Drewe and Father Smith could do this by making an agreement between their firms to charge the same price or otherwise not to compete. This is an example of collusion, which is against the law in the United States. Here we see the characteristic of rules implemented in game theory. Since the firms cannot collude and set their prices they must guess the price which the other firm will choose. If Ted Drewe thinks that Father Smith will charge $40 per tree at St. Peters, he will choose to also sell at $40 per tree because this would earn 7,500 in profit instead of $5,000 if they Ted sold at $50. If Ted Drewe believes Father Smith will sell at $50 per tree, he would still choose to sell at $40 per tree because this would increase total profits from $10,000 to $15,000. This means either way, Ted Drewe will sell at $40 per tree. Father Smith has the same situation as Ted Drewe, so it is expected that he will also sell at $40 per tree. Both Ted Drewes and St. Peters Church will choose to sell at $40 per tree no matter what the other firm does. Either firm selling at $40 per tree is n example of dominant strategy because it is the best choice in any situation. When each firm is maximizing profits no matter what choice the other firm makes it is called a Nash equilibrium. The example of the firms Ted Drewes and St. Louis Church in the St. Louis Christmas tree industry shows how game theory uses payoffs, rules and strategies to analyze oligopoly. photo: Gooden, Christian. Stltoday. com. N. p. , 20 Dec. 2011. Web. 09 Dec. 2013. http:// www. stltoday. com/news/multimedia/live-christmas-tree-fee-on-hold-for-now/ image_30ae5b2e-84de-5313-a8d8-3abc99f6bc6e. html