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M08.L01 — Strategic Interaction and Game Theory Basics

Module: Module 08 — Game Theory and Oligopoly Lesson: L01 of 05 Duration: ~30 minutes Level: Introductory Provenance: OpenStax Principles of Microeconomics 3e | Khan Academy Microeconomics

Learning Objective

Understand how strategic interaction shapes decision-making in competitive markets.

Introduction to Strategic Interaction

Strategic interaction occurs when the payoff of one player's decision depends on the choices of others. In business, this is common in markets with few competitors, such as Australia's supermarket duopoly (Coles and Woolworths). Firms must anticipate rivals' reactions to price changes or marketing strategies.

Game Theory Basics

A normal form game consists of: - Players (e.g., firms, individuals) - Strategies (possible actions each player can take) - Payoffs (outcomes based on combined strategies)

Example: A simplified payoff matrix for Coles and Woolworths deciding whether to "Discount" or "Maintain Prices":

Woolworths: Discount Woolworths: Maintain
Coles: Discount -5, -5 10, -10
Coles: Maintain -10, 10 0, 0

Worked Example: Supermarket Price War

Scenario: Coles and Woolworths must decide whether to discount prices for Christmas sales.

  1. Identify strategies: Discount or Maintain.
  2. Analyze payoffs:
  3. If both discount, profits drop (mutual loss).
  4. If one discounts and the other doesn’t, the discounter gains market share.
  5. Dominant strategy: Discount (higher payoff regardless of rival's choice).

Common Misconception

"Game theory only applies to zero-sum games."

While zero-sum games are a subset, most real-world scenarios (like pricing) involve mixed incentives where cooperation can benefit all parties.

Key Takeaways

  • Payoffs depend on others' choices in strategic interactions.
  • A dominant strategy yields the best outcome regardless of rivals' actions.
  • Oligopolies (e.g., Coles/Woolworths) frequently engage in strategic pricing.
  • Game theory models help predict competitive behavior.

Practice

  1. If Coles believes Woolworths will discount, what should Coles do?
  2. Define "best response" in your own words.
  3. Why might a dominant strategy lead to suboptimal group outcomes?

Further Resources

Provenance: OpenStax Principles of Microeconomics 3e | Khan Academy Microeconomics