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The game theory is applicable to a host of issues especially in economics. The theory is applicable where there is a multiplicity of decision makers and each player’s action affects or is affected by what the other party does. To cite a specific example, it is worthy examining how firms make production decisions relating to quality, quantity, pricing, etc. the game theory is equally useful in auctions, contract negotiations, and in voting exercises. Literature review Price setting is a difficult task as there is a multiplicity of players in each business or industry.
This is furthered by the fact that each player intends to make the best out of every situation. However, decisions are always taken while accounting for what the rest of the players are going to do. This case holds true especially when the industry being studied is a free market where there is free entry and exit. The fact that competition calls for the adoption of the best possible alternative dictates that a god approach is employed in decision making regarding pricing (Axelrod, 43).
Maintenance of a brand is important in the pricing game. A business which has a dominant brand has little work to do since sellers want to stock the products and customer loyalty remains high (Axelrod, 45). At times, changes may prove worthy undertaking. For example when a company is operating excess productivity, it may be forced to lower prices to increase its sales. However, this is only commendable if it does not spark a price war. The chances of achieving minimal interference in the market are desirable though difficult to achieve.
This is held because lowering prices of a player’s products will lead to an increased demand for the party’s products assuming that the quality produced is similar to other players’ products (Kalai and Stanford, 400). Even if such products may be of lower quality, it is held that the demand for these products will rise. A rise in a player’s products will definitely lower the demand for other players’ goods in the industry (Kalai and Stanford, 400). This is bound to lead to a price war as the other players must take similar action if they are to remain in business.
In the same line of thinking, measures to increase the prices of certain commodities may be counter productive. This means that an attempt to hike the price may lead to resistance from the part of the customers. Such resistance is reflected by the unwillingness to make purchases after a rise in price. An indication of reduced sales also point to an attempt to raise the prices. This indicates that players in any industry or business will always be forced to adopt the lowest possible price. It is only at the lowest prices where firms sell an equilibrium quantity while providing room for profit making.
However, lowering of prices below the normal price may send a wrong signal to the customers who may mistake that act as a deceiving ploy to offer them products of a lesser value or quality and thus scare them away (Kalai and Stanford, 402). Such acts not only lead to brand failure as they also hold the potential of reducing revenue to a business entity. A reversal of the price to reflect the actual market pricing may fail to bring back the deserting customers. This may call for re launching of the brand, an expensive issue to any business.
However, a gamble of this nature may win customers albeit in the short run. On the other hand, if the businesses in the industry respond by lowering prices, the leading party in lowering prices may have failed as the market share will most likely revert to the normal point. But such lower prices can only be sustainable if they allow a business to enjoy certain profit levels (Chamberlin, 45). Sustainable margins are created through three major ways. The first one centers on product differentiation, the second, on economies of scale, and the third, on the barriers to entry (Hotelling, 41-43).
Game theory is useful in pricing strategies especially in oligopolistic industries. In an oligopoly, firms may make decisions regarding whether to increase, to reduce prices or to keep them unchanged (Hotelling, 47-51). The nature of the demand curve in oligopoly is kinked (Kalai and Stanford, 397). This suggests a presence of price stability in the industry. This is possible because in an event of firms increasing prices while others do not change, the end result is a significant fall in demand.
On the other hand, if firms reduce the prices, they will gain a market share, the other firms in the industry do not want such a scenario as they also follow suit and consequently prices drop across the industry (Kalai and Stanford, 398). Such a decline in price would see all firms in the industry lose significantly due to poor pricing. In this market a decision by one firm holds a significant bearing in the industry. However, in real world, the kinked curve may never be attained (Kalai and Stanford, 410). This is attributable to the game theory and the complexities involved.
To begin with, firms may collude and set prices and production quotas which they stick to. Though this is illegal in some countries like the UK, imposing it is very difficult. Firms may not always pursue profit maximization as they may be willing to make lesser profits if this can raise their market share. Wal Mart supermarket is one such example utilizing this strategy in a bid to expand its activities (Kalai and Stanford, 409). Firms could not be aware of the reactions f other players or may simply choose to ignore the reactions of other players in the industry.
To cite an example, a small firm in an oligopoly may avoid cutting prices if it perceives that its action may fail to occasion a significant impact on an industry (Robinson, 22-25). In a monopolistic type of market, the presence of only one buyer implies that price setting is exclusively held by one firm which also happens to act as the industry (Sraffa, 534). This firm can change prices but it must do that carefully (Sraffa, 546). This is held because in as much as the firm can price its products highly, it holds the potential of failing to sell if it goes beyond a certain level of pricing unless it deals in basic goods.
So the game theory applies in this case by dictating to the firm to set its price at the point where it maximizes sales and profits. In a duopoly, the presence of two companies or firms is likely to lead to bidding wars and subsequently benefit the customer as a move by one player is easily countered by the other player (Sraffa, 500). This is however based on an assumption that both players are in a position to produce same or slightly identical products. So in a duopoly, prices charged are lowered if the two engage in a game of trying to outdo the other.
Findings and conclusion This paper presents pricing as a game in which businesses engage in. it is discernable that every business entity seeks to achieve profits and sustain its growth. This depends on such business’s ability to sell its products. Apart from monopolistic markets the rest have a multiplicity of players. This implies that price setting is a function of other firms’ behavior on the same products. In a competitive environment as realized above, if one player changes the price, other players will counter that move by carrying out a similar adjustment.
This may in the end lead to a loss for all players. On the basis of the above realization, industry players are forced to operate on the Nash equilibrium. At this position, each player in an industry is well of playing by the rules of the game. This means the pricing at this point is the lowest the firms can charge, any reduction on the price would seriously affect the profitability of the company. if a player chose to reduce prices in the hope of making profits as a result of increased sales, the other players will follow sit and the end result is a loss for all.
In reference to a monopolistic market, the cost of products is the lowest possible as further increments on the price would portend ill for the business’ profits due to reduced sales. On the basis of the evidence adduced in this paper, the game theory holds a huge influence on pricing of products in all markets. The aim of the firms remains the pursuit of pricing their products at a point where they can sustain the businesses. However, the game theory may not lead to the lowest prices if firms collude and if other firms use underhand tactics like issuing threats to other players.
Cited Works E. H. Chamberlin. The Theory of Monopolistic Competition. Cambridge: MA Harvard University Press, 2003. Ehud. Kalai and William, Stanford. “Finite Rationality and Interpersonal Complexity in Repeated Games,” Econometrica 56(2008), 397-410. Harrison, Hotelling. “Stability in Competition,” Economic Journal, 39 (Mar. 1929):41- 57. John, Robinson. The Economics of Imperfect Competition. London: Macmillan, 2003. Paul, Sraffa, “The Laws of returns under competitive conditions,” Economic Journal 36(2006), 535-550. Robert, Axelrod. The Evolution of Cooperation. NY: Basic Books, 2004.