Situations arise all the time prompting individuals to consider whether their own choices or collaborative actions will yield greater payouts. Game theory provides a rich framework for studying interactive decision-making processes. Most decisions, whether collective or individual, usually lead to actions, but games require two or more players acting and reacting in a strategic manner. In our dual roles as employees and as customers, we often exhibit certain behaviors in the marketplace that correspond with those roles and the structures of markets in which we conduct our transactions. Competition and free enterprise are ingrained ideals that favor low prices and wide varieties of consumer goods and services all the while inciting producers to use scarce resources as efficiently and effectively as possible. Digging a little deeper behind the competitive market scene, however, we may find producers who are competitive in appearance but who really have the capacity to charge high prices, maintain market shares, and devise arrangements that empower them to behave as if they were monopolists. A market structure in which a few sellers behave likewise while providing goods or service characterizes an oligopoly. A key feature common amongst oligopolies is their interdependence and their perpetual search for prices. This essay improves the reader's ability to ponder and to answer the question: How do producers know when the price is right?
Imagine a class meeting in which the economics' professor devises an exercise for students to bid on and receive $20.00 in cash. It could be more depending on what college you attend, but the actual dollar amount and the auction rules are insignificant in relation to the learning outcome potential. Like any auction, the highest bidder gets the goods fair and square without any strings, though some bidders are more lucky and/or strategic than others. In this instance, the goods are two $10.00 bills and the professor divides the class at random into two groups of bidders with one sent to visit a nearby empty classroom. For various reasons pending disclosure, your own bid and potential payout will likely differ depending on which group you belong to. One group consists of classmates who have the privilege of discussing their bids with other members of their group. The other group consists of classmates who must remain quiet as they determine their individual bids. It is entirely appropriate to speculate at this point about which individuals or group would receive the bill and the strategies that lead to that outcome.
As a players' board is in sight, the basic rules and payouts set forth by game theory are beginning to emerge. They are relevant to our exploration of varied market pricing strategies. The purpose of game theory may be explanatory, predictive, or prescriptive in nature. Whatever purpose fits a given scenario, this essay aims to help the reader answer the following set of questions.
- How does a group of buyers and sellers act in a market environment?
- How should they act?
- Do their independent or interdependent actions prepare them to develop the best response as they move toward convergence at an equilibrium point?
In contemplating the answers to these questions, readers should keep in mind that traditional economics and its bias for competition centers squarely on the actions of individual decision makers who contemplate prices found in the marketplace. However, recent developments in the field of economics give greater attention to the influences on market price originating through the collective, sometimes very strategic, interactions between and among sellers. Those interactions generate a number of implications for consumers. From a consumer perspective, competition is indeed an ideal economic condition that brings the greatest amount of benefit to the greatest number. Consumers want to pay a low price for a variety of goods or services available in large quantities. Usually, consumers get their way as sellers of those items want to retain them and/or to gain patronage through strategies centered largely on competitive prices.
Sometimes sellers will go as far as engaging in price wars; a situation which favors consumers the most. In contrast, sellers prefer to receive the highest price possible and to maintain their market shares. Some sellers may realize cooperation is better for them than competition. The range of cooperative actions available to sellers includes options that may be illegal. Consider the simplified example in which there are only two sellers of an item. It is illegal in the United States for these two sellers to devise a formal agreement that sets, or fixes, the price of a good or service at a specific amount. Certainly, this kind of strategy especially when it goes undetected would alleviate their concerns over retentions of customers and market share. One step removed from formality is the case in which one of the firms publicly announces its plan to raise prices all the while leaving it to the discretion of the other firms to ignore the increase or to follow suit. Some firms stand to realize gains by following suit, but perhaps they will gain more by ignoring the price leader's strategy. In essence, the choices made between these two firms depend on how well they can play the pricing game and how well they understand game theory, market structures, and microeconomics.
The Profit Payout
Assumptions for Understanding Microeconomics
Microeconomics deals with producer and consumer behaviors in the marketplace and it focuses on the structures of the markets in which suppliers operate. Due in part to the deliberate omission of graphs from this essay, the author encourages readers to consult any economics textbook including those by Arnold (2005), Guell (2007), or McConnell & Brue (2008) whether they do so as they read this essay or afterwards. Aside from the early introduction of graphing techniques and interpretations of basic relationships, students in undergraduate microeconomics courses usually begin their studies by learning a set of assumptions.
- First and foremost, is the ceteris paribus (translation means all else is held constant) assumption.
- The second assumption is that consumers and producers behave as rational agents who have access to full, perfect information relevant to their decisions.
- Another assumption is those agents engage in transactions through which no individual or group brings an inordinate amount of influence to an exchange decision.
Exchanges of items between consumers and producers occur in a market. On the consumer or demand side, students learn very early in their coursework that an inverse relationship exists between price and quantity in accordance with the Law of Demand. Relatively speaking, smaller amounts are in demand at higher prices and vice versa. The specific amounts that consumers are willing and able to purchase at given prices are critical sources of information. The demand curve, or line -- taken here and elsewhere as interchangeable descriptors -- is the graphic construction of those price and quantity combinations. Prices generally reflect an implicit agreement between sellers and buyers who exchange goods and services as they interact in the marketplace. On the producer or supply side, students also learn early in their course work that a positive relationship exists according to the Law of Supply.
Soon afterwards they learn that the price at which producers are willing and able to sell their goods and services is only one constraint. Those prices also take into account the variety of costs that firms incur in their production of goods and services. Total costs are the sum of fixed and variable costs. Fixed costs are those that exist even without any production. Furthermore, they are constant as they do not vary with the scale of production. Some examples of fixed costs include monthly installments paid on machinery, buildings, and land. Variable costs are those that vary with production. Some examples of variable costs include wages, materials, and supplies.
The allocation of costs across larger scales of production results in a variety of cost curve shapes. Graphs depicting these functions show cost on the vertical axis and quantity on the horizontal axis. Average total cost and average variable cost form important U-shaped curves. Their calculation involves dividing them by the production quantity. The lowest points on those curves are significant; at those points is where the marginal cost curve, which is J-shaped, intersects them. Marginal cost is the change in total costs that arise from producing one additional unit.
Firms produce and sell items and they receive a price for each one sold. Total revenue is the mathematical product of price times the quantity sold at each price. Marginal revenue is the change in total revenue that arises from selling one additional unit. Price is equal to marginal revenue in perfectly competitive market structures and it is greater than marginal revenue for imperfectly competitive market structures. Though graphs can become quite confusing with each addition of a line or curve, keep in mind that the marginal revenue line is horizontal in perfectly competitive market structures and it is downward sloping in the other structures.
A key relationship exists where marginal revenue equals marginal cost and where these two curves intersect. The intersection determines the profit-maximizing amount of output. Most, if not all, firms attempt to set production to that amount as they pursue profit-maximizing behaviors. Now, let's bring prices back into the analysis for a short discussion of the rules of production. These rules help gauge whether a firm may continue its operation as a competitive viable entity.
Rules of Production
To comply with the first of two rules, firms must produce at the profit maximizing output, again where marginal revenue equals marginal cost. The second rule is firms must receive a price that is equal to or greater than average variable cost. Why? Their sales must cover, at the least, average variable costs and contribute something toward average fixed costs. In other words, they must cover their variable inputs, labor costs for instance, and make payments on their plants and machinery. Moreover, they must operate at or above the shut-down point, which is where the marginal cost curve intersects the average variable cost curve and at the latter's lowest point.
Depending on the market structures in which they operate, some firms can influence the market price and others merely accept the market price for their outputs. Market structure reflects whether a firm makes the market price or it takes the market price. Structures at the extreme ends of a continuum refer to the relative presence or the absence of competition in a market for a specific output or item. The book ends of that continuum are perfect competition and imperfect competition. In addition to whether firms are price makers or price takers, market structure descriptors often include the number of sellers and buyers, the ease with which firms can enter or exit a market, and the volume of advertising for a product.
One example of a highly competitive market structure is agriculture. In this instance, there are numerous buyers and sellers of an agricultural product such as corn. Grain farmers usually take the price dictated by the market. Almost anyone can obtain enough resources to grow corn. Few variations in corn exist so there is very little need to advertise. In contrast, the production of soft drinks serves as an example of a noncompetitive market structure. In this instance, there are numerous buyers but only a few sellers dominate the market. Pepsi and Coca-Cola are two firms that often come to mind with reference to soft drinks. Consequently, these firms make the market price and remarkably little difference exists between the prices of their cola or other beverages. Furthermore, no other producers can obtain the cola recipes and other resources required for developing and producing the beverages.
Competition may occur between them on the basis of price or by virtue of advertising. The latter creates an image in the mind...
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