Before discussing some advantages – and correspondingly some disadvantages – that the widespread use of game theory in industrial organisation entails, a very short description of the basic components of games might be in order. Game theory helps to analyse situations in which strategic uncertainty is present. Strategic uncertainty is always present if the outcome of an action does not only depend on my own action but at least on the action of one more actor. Strategic uncertainty is distinguished from parametric uncertainty in which the outcome depends on some move of nature, e.g., whether it rains or snows. A game is regularly made up of six components:
(1) The players. A distinction is often made between two- and more actor games.
(2) The rules. They describe the options of the various players. An important distinction with regard to competition issues is whether players are assumed to move simultaneously or sequentially. It depends on the structure of the game whether it is an advantage or a disadvantage to be the first mover.
(3) The strategies. A strategy is a complete description of all possible options that could open to the player during the entire course of a game.
(4) The information set. Assuming complete information means that the players fully know the rules of the game, the strategies available to all actors, but also the payoffs that result from various strategy combinations. Perfect information, in turn, is present if an actor perfectly knows all the previous moves of the players he interacts with.
(5) The payoff-function. It contains the utility values that all players attach to all possible outcomes of a game.
(6) The outcome. Here, the concept of (Nash-)equilibrium is of special importance. Nash equilibrium is a situation in which, given that all other players have chosen their moves and will stick to them, no player has an incentive to deviate unilaterally because there is no possibility to make himself better off by such a move.
Game theory assumes players to be individual utility maximisers that act rationally in their pursuit to maximise individual utility. The Prisoners’ Dilemma famously shows that individual rationality does not automatically translate into collective rationality. What is best for oneself is not necessarily best for the group. Individual rationality does not necessarily lead to collectively optimal results. Formulated differently: there are situations in which Adam Smith’s invisible hand simply does not work. One example are cartel agreements: although all participants to a cartel could make themselves better off by fulfilling the terms of the agreement, individual rationality will often lead to some cartel members reneging on the agreement and thus let the entire cartel agreement bust.
Empirically, the overwhelming majority of all markets have oligopolistic structures. It is well known and economists have long explicitly recognised that in oligopolies, strategic interactions among the members play an important role (“oligopolistic interdependency”). Quantities sold, prices and profits realised depend not only on my actions but also on what my competitors do. Strategic uncertainty is thus present and game theory is an excellent tool to analyse interaction situations involving strategic uncertainty.
Additionally, game theory carries with it the potential to bring to an end the perennial conflict between outcome-oriented and process-oriented approaches to competition. The Harvard approach would be the paradigmatic example of an outcomeoriented competition approach: some performance characteristics are declared as normatively desirable, if these characteristics are not fulfilled empirically, some interventionist act is called for. Representatives of process-oriented approaches, in turn, believe that the outcomes of competitive processes are systematically unpredictable. They, therefore, refrain from stating criteria that competition should bring about but rather focus on the rules according to which the competitive process should be organised. Being able to make normative statements about how the process should be organised (what antitrust rules would make the process welfareenhancing) presupposes knowledge concerning the working of the process. Game theory has the potential to help us understand some processes better. At the same time, it also carries the potential to understand interrelationships between process and outcome better. If these processes are better understood, this might eventually enhance our capacity to pass more adequate competition rules.
Game theory might also help to question the outcome-oriented view of competition policy. An eminent scholar of the new industrial organisation, Louis Phlips (1995, 12), observes: “Pervasive to the entire argument is the idea that antitrust authorities are not social planners. A social planner wants price equal to marginal cost, plus optimal taxes and subsidies. Antitrust authorities want the best possible market structure given technology and tastes, and, given this market structure, as much competition as is compatible with it and with entrepreneurial freedom. But that is precisely, it seems to me, what is described by a perfect competitive Nash equilibrium.” Phlips here seems to argue that a decision needs to be made between the concept of antitrust authorities as social planners and a concept that sees their function in strengthening and maintaining as much competition as possible under the concrete circumstances. He seems to argue against the social planning concept which is built on the model of perfect competition and that plays such a dominant role in the structure-conduct-performance paradigm. Instead, he is an advocate of the Nashequilibrium, which he interprets as a description of how much competition is possible given the relevant circumstances.
This is an interesting position because it implies that an either-or decision needs to be made. Many adherents of the new industrial organisation do, however, supposedly not share this position. Instead, the outcomes postulated by welfare economics would still be hailed as the theoretical ideal. Game theory can be interpreted as a theory informing actors what would be in their (utility-maximising) interest given that they were rational. Assuming that they are rational, it can be used to predict what actors will do under various circumstances. It can thus also be interpreted as a positive theory. The either-or view advocated by Phlips is therefore not convincing: one can still believe in the fundamental theorems of welfare economics and simultaneously analyse what the results of certain interactions are given specific circumstances. If the predictions deviate too much from the ideal striven for, then many policy-oriented game theorists would be ready to propose changing the circumstances. This could, e.g., mean to change competition rules, to increase sanctions, etc. All these changes would be aimed at bringing reality closer to a theoretical ideal. Game theory does thus not fundamentally alter the policy stance of industrial organisation. Proponents of a game-theory based industrial organisation could still be advocates of far-reaching interventions.
In the literature, a number of additional advantages for the use of game theory in industrial organisation are named:
– the introduction of sequential decision-making processes (Güth 1992);
– the explicit recognition of incomplete information (Güth 1992).
These advantages should, however, not lead one to conclude that the heavy use of game theory in industrial organisation is warmly welcomed everywhere.
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