Profit Pay-Off Matrix

Profit Pay-Off Matrix:

This is a game theory tool which can be used in a duopoly or oligopoly situation to show how each firm’s best strategy depends on the reactions of competing firms. Firms are said to be interdependent.

Using the diagram below, within the matrix, firm X has the lower triangle in each quadrant and firm Y the higher triangle. HP is the high price strategy and LP the low price strategy.

If both firms X and Y maintain high prices, profits will be 10 each, as in the top left quadrant of the diagram. If X thinks Y may keep to the high price, it will be better off cutting its price. It will make profits of 14, while Y will make 2. Alternatively, if Y takes this position and X maintains a high price, the position will be reversed. If in fact both cut prices together, both will have reduced profits of 6 each. (This is the price war type of outcome.) The least risky course of action is to stick to a high price strategy – hence price rigidity is very likely in this situation.