An industry that consists of only a small number of firms is called an oligopoly. If there are just two firms, the term duopoly is used. Oligopoly stands between pure competition (many suppliers) and pure monopoly (a single supplier).

Facing only a few competitors, each firm is in a “strategic” situation. In choosing its own price or output, it needs to consider how its rivals will individually react. The best price for firm A to charge depends on what firms B and C are charging, and similarly the best choices for B and C depend upon what firm A does. This chapter introduces the theory of games, the method used by economists to predict the likely outcomes when decision-makers find themselves engaged in strategic choices.

STRATEGIC BEHAVIOR: THE THEORY OF GAMES

A game, in the mathematical sense, is a way of picturing social interactions. Two distinct elements must be kept in mind: (a) the pattern of payoffs, and (b) the protocol of play. The pattern of payoffs reflects the mix of shared versus opposed interests. If a particular outcome is good for John, is it also good for Mary? Or can John make himself better off only by making Mary worse off? The other element, the protocol of play, corresponds to the “rules of the game.” Do the parties take turns, or do they move simultaneously? Can a chosen move be revoked? Are the players allowed to communicate?