Game Theory, Oligopoly and Bargaining

Abstract

Game theory is currently having as much impact on certain topics in microeconomics as rational expectations has had on macroeconomics.¹ Yet whilst the modern undergraduate typically has a reasonable grasp of rational expectations macroeconomics, his or her understanding of game theory is likely to be both rudimentary and, even worse, faulty. Most microeconomic texts have a section on the ‘prisoners’ dilemma’ to highlight the problem of establishing cooperation; and somewhere else there will be an exposition of Cournot duopoly which suggests it could only apply to shortsighted firms which cannot predict a rival’s reactions; and that is about it. It is one of the purposes of this chapter to point out the richness of the prisoners’ dilemma game and another to correct the misperceptions surrounding Cournot. But our hope is that we can take the reader much further. Game theory provides a unifying framework with which to analyse properly any question involving the interaction of rational agents. This includes topics as apparently diverse as oligopoly, externality, public goods, tariff-setting, bequests by parents to their children, wage-bargaining, Mrs Thatcher’s macroeconomics, and much more besides. Clearly, there is insufficient space to treat each of these adequately here.