1.

Introduction:
Game theory indeed is a prescribed study to prop up conflict and cooperation.
Moreover “it is a distinct and interdisciplinary approach to the study of human
behavior”(Mc Cain 1994) . Introducing the field of game theory through book ‘The
Theory of Games and Economic Behavior’, the two great economists John von
Neumann and Oskar Morgenstern have blessed enormous with its power. Krugman
cites in Passell (1994) that, “Game theory opens up terrain for systematic thinking that
was previously closed". The power of internal consistency and numerical foundations
has crafted game theory as key instrument for modeling decision making progressions
in interactive environments, (Turocy and Stengel, 2001). It inspects the strategic
interactions, creating interdependence between economic actors. Thereby the outcome
of such interdependence between actors (players) is that, each player tries to evaluate
the opponent’s strategic decisions for its own safe movement (Straffin, 1993). Being
strong mathematical tool it strengthens the decision makers in making and analyzing
strategic choices.
According to Turocy and Stengel (2001), the discipline of game theory, “ has the
potential of providing the decision-maker a clearer and broader view of the situation.”
For the ease this mathematical tool is categorized into sequential and simultaneous.
The theories of Game tree, working backwards and sub game perfect Nash equilibrium
are the key ingredients of sequential game, while those of pay off matrix, dominant
strategy, prisoner’s dilemma and Nash equilibrium are the console of simultaneous
game (Besanko, 2003). This essay provides a framework to understand the game
theories and its application in business world using examples. Moreover the work also
concentrates on application of game theory model and highlights the prisoner’s dilemma
on business applications to provide a broader and realistic view of this numeric tool on
OPEC Cartel.

2. Game theory: So how it works????

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 The section starts with reflecting the concept of sequential game. In sequential
game the decisions are made by the players sequentially where one makes the first
move to begin the game. So, very often one player is the leader in the game while the
other is the follower (Besanko, 2003). This extensive sequential game illustrates the
choices with reverence of time. Therefore a Game tree is employed which contains
nodes that shows the choices players can make. “A game-tree is an example of what
mathematicians call a directed graph, that is a set of connected nodes in which the
overall graph has a direction” Malpas (2003). Moreover it also consists of subtle
branches from nodes which resemble the further choices for players. The game tree can
be better simplified by an example shown in figure 1, which is a game between 2
players.

Left
(1,4)
Top Player
2
Player (1,4)
Left
1
Botto
Player (0,0)
m 2

Right
(2,1)
Figure.1: The Game Tree

Complying figure 1, player 1 leads the game while player 2 is follower. Thereby
observing player 1’s move in the game player 2 composes his optimal decision. The
desirable outcome for a player in the game is represented in numbers called payoffs,
which are weighted with their probabilities (Turocy and Stengel, 2001). In the above
example the 4 payoffs are shown. Such game is not treated to be fair enough as it
creates an element of threat to one player. For the given example, player 2 can easily
threat player 1 by optimizing its choice with bottom branch forcing player 1 with payoff of
ZERO.

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 Contrarily the simultaneous games on the other hand is more interesting and
played in the real world as it helps organizations in determining the competitor’s
strategies. Simultaneous games of complete information are confined to three major
elements of set of players, strategies and payoff functions for each possible move in the
game, (Erhun and Keskinocak, 2003). Pay off matrix is the powered tool used in
simultaneous games for visualization of the strategic moves. Thus the matrix
representation is shown in table 1 which is transformed from the tree game.

Player
Left Right
Player 1
2

Top (1,4) (1,4)

Bottom (0,0) (2,1)

Table 1: Payoff Matrix

Keeping player 1 at the row side and player 2 at the column side the payoff can be
easily retrieved. From the above analysis none of the players have dominant strategy.
A dominant strategy is one with which a player neglects the competitors strategy as it
hardly effects the player in the game. A strategy dominates if it always outstand any
other strategy, for whichever sketch of other players' actions Mikhael (2006). With a
dominant strategy a player is always with a better payoff with respect to its competitor.
But at the same time the above pay off matrix resembles an example of Nash
Equilibrium (top, left). According to (Levine, 1998), “For games without dominant
strategies the equilibrium notion most widely used by game theorists is that of Nash
equilibrium.” A Nash Equilibrium according to (Besanko, 2004) is a strategy which
satisfies both the players in the game depending either one decides that strategy and
vice versa. To be more clear , in table 1 when player one decide to move to move on top

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leaving only to possible choices to player 2, where both have same results. If player 2
decides to move on left then undoubtedly player one would go for the top as 1>0. Thus
it explanation clearly resembles that there is similarity in choices for both players as
result, the top left of the pay off matrix punctuates the Nash equilibrium.

3. Prisoners Dilemma:

Another concept in simultaneous game is prisoner’s dilemma. (Axelrod, 1984) cites

in Heylighen (1995) that, “Cooperation is usually analyzed in game theory by means of
a non-zero-sum game called the Prisoner's Dilemma". It is a static game as players
simultaneously selects a strategy only ones unknowing the strategy of the other player,
(Erhun and Keskinocak, 2003). This concept explains rationality of individual over
collective behavior. In concise, two players in a game can choose between either to
‘cooperate’ or ‘defect’ but the idea behind prisoner’s dilemma is that both player gains
only when they cooperate but with strategy of individual benefit both receive less payoffs
Heylighen (1995). The prisoner’s dilemma can be better analyzed with the pay off matrix
shown in table 2.
Player

Left Right
Player 1
2

Top (8,8) (1,9)

Bottom (9,1) (5,4)

Table 2: Prisoner’s Dilemma

From the above payoff matrix is very clear that if both the players cooperate and settle
on tactic of (top, left) then both are sufficed with a maximum payoffs of 8, which is the
best move rather than non cooperative move. But with the introduction of human
tendency of selfishness by John Forbes Nash (mathematician) in the field of economics,
each player in the game has an option to cheat. Like in the above matrix, both players

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decide to cooperate to receive the payoff of 8 but if player 1 or vice versa pretend of
cooperating but instead of playing on top (left for player 2) he moves of bottom, he
receives much more pay off of 9. Thus with this move in the game a player (cheater)
gains more payoff but in-turn losses further cooperation with another player. As
companies interact with players number of time the cheater in the game can be easily
penalized. “Such a distribution of losses and gains seems natural for many situations,
since the cooperator whose action is not returned will lose resources to the defector,
without either of them being able to collect the additional gain coming from the "synergy"
of their cooperation”, Heylighen (1995).

4. OPEC Oil Cartel and Game Theory:

After understanding the concepts of game theory we now move to OPEC oil cartel to
understand how game theory facilitates the strategic interactions of organizations in real
world. The oil giant stretches across 80 percent of the world’s oil reserves and also
accounts to 51 percent of international oil trade each day (HardAssetsInvestor, 2007). It
wields up enormous power shaping the world’s economy. The Organization of the
Petroleum Exporting Countries (OPEC) is confined by some as the ‘oil price elevation
cartel’. Being world leader OPEC is viewed as the price maker as it determines the oil
supply into the market. OPEC has shown steepest rollercoaster rides in the oil price in
2008. It soared the oil price to $145 per barrel which washed off huge sum of wealth
crosswise the globe but at the same time it also lowered the price to $32 a barrel in
2008 (Waselchuk, 2009). This price monopoly is played not only within the cartel but
also outside the cartel as OPEC did with Russia in 2005.

To a great extent it can be concluded that due to the dominant strategy to deceive
on the contracts of the cartel. Though the cartel is presumed to be strong enough
however the reality is quite different. The OPEC in its meeting decides on the quantity of
oil to be produced and also the productions corresponding to each country. With this the
OPEC generates the quotas depending upon the oil reserves for its each assigned
members. Moreover quota is assigned in such a way that oil supply does not surpass
the demand by an elevated margin which otherwise lowers the oil price (Besanko,
2004). In spite of configuring such strong strategy the figure 2 shows the fluctuation in
the price and production which is mainly due to the breaching of the quotas.
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 Figure 2: Price and Production of OPEC, Source: www.wtrg.com/prices.htm

There has been much violation of overproduction which forced the price of oil to fall
below $32 per barrel in 2008 (Waselchuk, 2009). Members of OPEC like Saudi Arabia,
Kuwait and Qatar are to be likely contented with the price of oil between $80 and $ 100
due to American pressure but at the same time the members like Venezuela and Iraq
want the price to be much higher than $100. For various countries in OPEC, the profit
from oil contributes a substantial segment of their GDP and governments of these
countries depend on the oil returns as a basic source of income (Shane, 2009). With the
drop in oil prices, these countries experienced a broad constraint on their governmental
expenditure. Another view to this issue is that members rich in oil are rarely rich in other
resources. “Crude oil becomes there only export which makes them uniquely vulnerable
to world oil prices, so when the prices of the oil falls down their economies are badly hit”
BBC (News, 2007). So this pictures a dilemma between choosing the strategy for higher
price or lower price amongst the member countries. In fact by slicing the oil production
it lowers the oil supply in the global market thereby profiting the OPEC members. But
with the instance of individualism each member in the cartel acts with the instance to
cheat in order to earn higher revenue (as increased supply would contribute to higher
revenue, (Shane 2009)). Thus the entire game of pricing can be explained through the
figure 3.

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 OPEC Cheat OPEC Don’t Cheat

Individual Cheat Market – High supply, low price, Market – High supply, low
low profit price, low profit
Individual – High supply, low price, Individual – Low supply, low
low profit price, low profit

Individual Don’t Market – Low supply, High price, Market – Low supply, High
Cheat High profit price, High profit
Individual – High supply, high price, Individual – Low supply,
high profit High price, High profit

Figure 3: Payoff matrix for OPEC vs. Individuals, (Shane, 2009)

This scenario of breaching the quotas can be shown using game theory, for example,
consider the two members countries Iraq and UAE. The game confines to keep the oil
price high by following the quota of production (low). The table 3 shows the payoff
matrix for this game.

Iraq/ UAE Low High

Low (10,10) (2,15)

High (15,2) (4,3)

Table 3: Prisoner’s Dilemma (Iraq vs. UAE)

The above pay off matrix is a peculiar example of prisoner’s dilemma. It clearly
shows that by cooperating on terms of quota (ie. Keeping low supply) both the countries

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will receive a maximum payoff of 10 each. But if any of the two tries to breach the
agreement of quota by overproducing, then cheater gains higher payoff. While with the
condition of both trying to cheat they end up in the forth quadrant that is the worst
payoffs for the both. This is where prisoner’s dilemma clearly complies. With the
incentive to earn more by overproducing both countries intend to cheat there by forgoing
collective rationality over individual. This behavior of individual rationality has created
serious problems for the OPEC and because of these reasons Indonesia has decided to
leave the OPEC. The only hand supporting this cartel is Saudi Arabia. Being the largest
resource holder it plays fair game following the quotas and cutting the production when
needed (HardAssetsInvestor, 2007). (Carl Steidtmann, 2000) cite in (Erhun and
Keskinocak, 2003) that, “‘It’s the same problem that OPEC has. You benefit if you cheat
a little bit, but if everyone cheats a little bit, everyone gets hurt.”

The Pricing Rivalry of OPEC:

According to (Besanko, 2003), in the collusion of dynamic pricing rivalry firms

prefer prices closer to their monopoly levels. But in the case of OPEC the members
often over-sighted these pricing strategies. In fact many divergent views have been laid
by economist regarding the pricing power of OPEC. The frequent change in price has
also acknowledged the economist with the dilemma weather to consider OPEC as price
setter or follower.
According to (House, 2008), “In the game to control oil prices, it appears that cheating is
the dominant strategy.” This is the basic reason (excessive oil production) that prevents
the OPEC from reaching its objective to increase the oil price. Successively in 1998,
1999 and in 2004 OPEC ambushed its power by embarking the production to attempt to
end the slide in oil price (Fattouh 2007). On the other hand the pricing power of OPEC is
not constant which is mainly due the rationalism of the members and the market
conditions. Smith (2005) argues in (Fattouh 2007) that “OPEC acts as a bureaucratic
cartel; i.e. a cooperative enterprise weighed down by the cost of forging consensus
among members and therefore partially impaired in pursuit of the common good.” Thus
viewing the case of OPEC it is inferred that though it incumbent many of the pricing
theories but still its price moves are different from what to be expected in this rivalry

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(Besanko,2003).

5. Conclusion:
Game theory to end with can be summarized as powerful framework in to determine
the future strategies as it is very much influenced by economic ideologies. Condignly it
is also assessed that game theory overlooks the macroeconomic factors like
accommodating political as well as government interventions but still it helps the
economic actors in making their strategic decisions by analyzing the move in the game
of business.

6. Bibliography

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3. Fattouh, B. (2007), “OPEC Pricing Power: The Need for a New Perspective”,
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