Oligopolies in Transportation and Related Markets: Game Theory
Game Theory is not as trivial as it sounds, but it is sure is a lot of fun!
For one of your Ride On writers, his favourite Economics courses as an undergrad and an M.A. student were macroeconomics-oriented. However, that preference changed after he started working at the Canadian Competition Bureau in 1999. His work there on abuse of dominance cases, as well as merger and cartel cases, led him to absolutely love microeconomics because studying strategic human interaction — and strategic interaction between businesses and governments operated by humans — thrilled him to no end! This is why he likes to tell people that, contrary to popular opinion, Economics is not all about money.
His love for the study of strategic interaction is also why his favourite topic to teach is Game Theory, and he found his students tended to find it most interesting, too, even when they otherwise did not care for Economics. It is truly thrilling for him to think logically about how a person, business, or government will react to their counterparts, based on how they expect those counterparts to react to that reaction.
In fact, he got his job as an Assistant Professor in a previous life largely because of his teaching demonstration on Game Theory, so that is yet another reason why this topic means so much to him.
In future issues of this newsletter, we will focus a lot on strategic interaction, so we feel it is valuable to first devote an issue to introducing Game Theory so everyone is on the same page regardless of background. So that is what we will do today, and we hope you all react well to it!
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Setting Up a Game
Game Theory is used to analyze strategic interaction between people, businesses, politicians, and even birds! In short, it can answer the following two questions that are important in the lives and careers of both economists and politicians:
How can anarchy result from the absence of the rule of law? In the simple world of Adam Smith where the Invisible Hand rules, people will only work to do what is best for themselves; hurting other people will also hurt themselves, so what is in their own self-interest is also in society’s best interest — even if there is no rule of law forcing them to “do the right thing”.
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However, the world is not as perfect as Adam Smith described because there are market failures — such as market power and externalities. These market failures enable people to increase their own welfare at the expense of other people, without having to worry about hurting themselves.
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This is no secret, so without the rule of law, Person A will not trust Person B to behave ethically, motivating Person A to seek protection by also not behaving ethically either. As such, in the real world we often find no one gets what they want the most — this is known as the Prisoner’s Dilemma, and it gives the government a reason to exist so that it can define and enforce social norms.
How can governments use the rule of law to coax people into “doing the right thing”? In other words, how can a government motivate people to take into account their actions on others, or to make the distribution of economic welfare more equitable? Game Theory can be used to answer this question by figuring out ways to “solve” the Prisoner’s Dilemma.
Before answering these questions, we need to know how exactly to set up a game, which requires some definitions:
A game is any situation in which participants (players) make strategic decisions: rules/plans of action for playing the game that take into account other players’ actions and responses. Strategic decisions can include prices (set or bid), quantity produced, advertising, location, investment in capacity, etc.
These strategic decisions result in the players receiving payoffs: outcomes that generate rewards or benefits (e.g., profits or consumer surplus). Each player will strive to maximize their payoff, and will therefore choose their optimal strategy.
Games are either cooperative or non-cooperative: a cooperative game is one in which players can negotiate binding contracts to plan joint strategies. If contracts cannot be negotiated and enforced, then the game is a non-cooperative game that can lead to anarchy. Therefore, one role of government can be to turn these non-cooperative games into cooperative games, if it is to the benefit of society.
Players are rational: each person thinks about the consequences of their actions, so they do what best for themselves. This person — who does not really exist in such an extreme form — has been called Homo Economicus.
However, rationality does not mean people make perfect decisions — they only think they are doing so. Really, bounded rationality exists due to:
Imperfect information: we are uncertain of everything that has happened in the past, i.e., we do not exactly know where we have been.
Incomplete information: we are uncertain of all possible consequences of each possible action, i.e., we do not know exactly where we are going.
Asymmetric information: one player has better information than another player. For example, we might have different work/life experiences, be in different geographic locations, etc. Some differences are subjective, and so are difficult to prove more wrong — less rational — than another view.
Again, this is why we need a government and rule of law to minimize opportunities for the strong to take advantage of the weak.
To summarize the above lessons, a game is described by the following information:
Players: who are the decision makers of the game?
Rules:
The options that are available each time a player makes a choice.
The order of play: simultaneous or sequential — where “simultaneous” means both players make their decisions before knowing the decision made by their “opponent”, not that they literally make their decisions at the same time.
Each player’s knowledge of one another and the rules of the game.
Outcomes: every possible combination of strategies throughout the game.
Payoffs: what rewards or benefits do players receive from each outcome? Note the absolute payoffs are not as important as the relative payoffs since comparisons of payoffs are what determines the equilibria of the game.
It is now time for an example to clarify how a game is set up. Suppose there are two firms — Petro Canada and Esso — which are deciding which prices to charge for retail gasoline. In oligopoly theory, the price one firm sets will affect the profitability of the other firm, so we want to incorporate such strategic interaction into our game.
As such, the game is summarized as follows and is shown visually below in Figure 1: