Example - Cartel | |
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There are two firms in the market, and they can choose to
operate independently (strategy I) or form a cartel (strategy C).
The payoffs are as follows:
How should the two firms operate to maximise their gains? Consider Firm 1: Thus, I is a dominant strategy for Firm 1, because it gives the higher payoff regardless of the other player's strategy. The same reasoning applies for Firm 2: So I is a dominant strategy for Firm 2 as well. This leads to a dominant strategy equilibrium at (4, 4). |
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If a certain strategy pays a player the highest payoff, regardless
of the other player's strategies, then that strategy is known as a
dominant strategy.
If both players have dominant strategies, the point which they both choose is known as the dominant strategy equilibrium. | |
Analysis | |
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We see from our example that the (C, C) strategy
is Pareto Superior
to (I, I).
However, unless the players co-operate in choosing their
strategies, they will choose the inferior (I, I). The dominant
strategy equilibrium does not always provide the best result.
If the players choose (C, C), either player can gain by moving to I unilaterally. In other words, if they agree to form a cartel, either player can gain by reneging on the agreement. This is why cartels are considered unstable and easy to collapse. Both players try to maximise their own profit by defecting. However, as a result, both of them experience reduction of profit. Therefore, it is known as a "tragedy of commons". How do firms keep a cartel strong? |