As shown in above table, when we compare alternatives, it is always in Smith’s best interest to confess, and the same conclusion is valid for Jones, too. Hence, for both Smith and Jones, the dominant strategy is to confess. The result is that both prisoners will receive 4-year sentences. This is not the optimum result; that would be for them both to deny guilt and each receive 2-year sentences. So, it shows how independent decision making can lead to results that are inferior to those obtained from collective decisions.
In prisoner dilemma, a collective decision was not possible since they were prevented from collaborating.In the real world, however, collaboration between firms is usually possible. The central feature of oligopolies is every firm must take into consideration the likely response of its competitors before making any decision. This suggests that oligopolies will be able to improve their outcomes if they collude. In most countries, in theory, collusion is illegal. However, in practice, it is difficult to detect and there is no doubt it occurs. The simplest way to use game theory is to develop a duopoly game.
A duopoly is an industry with just two firms and they if they collude they can maximize their profits.But, each firm may decide that it is its best interest to cheat on the agreement. Since each firm can either comply or cheat, there are four possible outcomes. If both firms comply, then the best result for the firms that they will make monopoly profits.
In order to maximize profits, firms restrict output to the point where their joint marginal revenue curve equal to their joint marginal cost curve and will share the monopoly profits. When this occurs, each firm realizes that if it cheats on agreement and increases output, the firm will benefit where the other will lose.One common way to cheat is to cut prices to increase sales. In this case, while one will profits, the other will lose. But if both cheats-both cut prices and increase output- both firms will lose while consumer benefit. In real world, duopoly analyses could be applied to several-firm oligopoly by using complex maths but the result is the same. In the analyses it assumed as a one-off game.
In real life, firms learn from their experiences and continue to operate in the industry. In repeated games, results can change. The best result is that the threat of cheating may force the firms to cooperate.The result will then be maximum profits. Both monopolistic competition and oligopoly are characterized by non-price competition. One type of non-price competition is when firms try to improve their product, or to introduce new products. The car industry introduces frequent changes on models in order to attract customers.
Another is when firms try to improve the services which they provide. Free insurance or ‘buy now, pay later’ deals shows that firms seek to compete in non-price areas. However, two main non-price competition areas are: advertising and product differentiation.