Game theory studies strategic interaction among rational agents. In the prisoner's dilemma, individual rationality leads to a worse collective outcome, illustrating how uncooperative behavior can harm all participants. A Nash equilibrium is a set of strategies in which no player can benefit by unilaterally changing their own action. A dominant strategy yields better outcomes regardless of opponents' choices. These concepts are essential for understanding oligopoly behavior and other settings in which outcomes depend on the choices of others.
Collusion occurs when firms cooperate to fix prices or restrict output, and a cartel is an explicit collusive agreement among firms such as OPEC. Such behavior is typically restricted by antitrust law, exemplified in the United States by the Sherman Act of 1890, which prohibits anticompetitive agreements and monopolization. Market concentration can be measured using the Herfindahl-Hirschman Index, computed as the sum of squared market shares of the firms in the market, with higher values indicating greater concentration. Other strategic behaviors include predatory pricing, in which prices are set below cost to drive out competitors, and price gouging, which involves excessively high prices during emergencies and is often illegal.
Price discrimination is the practice of charging different prices to different buyers for the same product, requiring three conditions: market power, the ability to segment buyers, and prevention of resale. First-degree price discrimination charges each consumer their maximum willingness to pay, capturing all consumer surplus. Second-degree price discrimination prices based on quantity or version, as in bulk discounts. Third-degree price discrimination charges different groups different prices, such as student or senior discounts. Mechanism design is the engineering of rules, auctions, and institutions to achieve desired outcomes. Auction theory analyzes how auction formats allocate resources and reveal value, with the Vickrey auction, a sealed-bid second-price auction in which the highest bidder wins but pays the second-highest bid, encouraging bidders to bid their true valuations. Rent-seeking describes the spending of resources to obtain economic rents, payments to a factor above its opportunity cost, without creating new value, often through lobbying for favorable policies.