When a firm’s decision significantly affects the profits of other firms in the industry, the firms are in a situation of interdependence.
In our duopoly example and in real life, each oligopolistic firm realizes both that its profit depends on what its competitor does and that its competitor’s profit depends on what it does. That is, the two firms are in a situation of interdependence, where each firm’s decision significantly affects the profit of the other firm (or firms, in the case of more than two).
The study of behavior in situations of interdependence is known as game theory.
In effect, the two firms are playing a “game” in which the profit of each player depends not only on its own actions but on those of the other player (or players). In order to understand more fully how oligopolists behave, economists, along with mathematicians, developed the area of study of such games, known as game theory. It has many applications, not just to economics but also to military strategy, politics, and other social sciences.
Let’s see how game theory helps us understand oligopoly.