chapter  10
17 Pages

Imperfect competition and game theory

Game theory is a subdiscipline within economics that studies decision making in a competitive environment. In traditional economic analysis, a company takes as given its cost structure and the demand curve that it is facing and uses those to fi nd strategies that maximize its profi t or other objective function (such as market share or a discounted fl ow of profi ts over some multi-year planning horizon). Game theory suggests that most companies are smarter than this (or operate in a more complex economic environment than this) and realize that competitors will respond to whatever strategy they choose. When a company makes decisions in a game-theoretic framework, the company considers how to choose an optimal strategy given its cost structure, the demand curve it faces, and the anticipated reactions of its competitors. For example, if Coca-Cola is deciding on an optimal pricing and advertising strategy for the next year, it factors into those decisions the most likely responses of Pepsi instead of the traditional economic assumption that Pepsi would just continue with whatever it had been previously doing.