OLIGOPOLY, MONOPOLISTIC COMPETITION, AND THE

THEORY OF GAMES
By OSKAR MORGENSTERN
Princeton University
My assigned task is to show briefly the rdation between the problem
of imperfect conqietition, oligc^oly, and monopoly on the one hand and
the theory of games of strategy^ on the other. I need not here describe
the curroit views on these problems. I wish, however, to pay my re-
spects to those who have made such valiant efforts to solve them by
means of theories that have attracted world-wide attentim. This re-
k is called for, lest the following considerations be misunderstood,
involving, as they do, the proposal for a radical departure from the
present views. Yet this prc^osal may not be unwdcome since there
seons to be a growing conviction that the current thewies have run
up against such serious obstades that a fundamental reorientation is
necessary. Because of lack of time I may be permitted to state the
ideas of the theory of games positively rather than in detailed contrast
with the existing theories.
The present piecemeal investigation of individual cases with a wide
variety of assumptions and constellations shows the lack of imifying
prindples of suflBcient power. Or, to put it differently, the currently
used tools sudi as the marginal revenue, marginal cost concepts together
with product differentiation and the attempt to determine a maximum
of profits do not seem strong enough to unlock the exceedingly complex
problems. In the background, moreover, is the undeniable and disturb-
ing fact, already wdl known to Coumot, that when there are but few
partidpants in a market, t h ^ reflect about each others' behavior and
try to set thdr course accordingly. Here, indeed, is the crux of the
matter and the difficulty should be squardy faced rather than rdegated
to an inferior role. It is in this domain where the need for a new ap-
proach becomes most convincing.
The theory of games of strategy cannot be presented here, because
it is incompressible, in spite—or perhaps because—of the fact that
it is still in its beginnings. New concepts and new tools of analysis had
to be evolved and they would all require careful scrutiny, l l i s it is
impossible to do. Ndther can I give ap^cations to the American scene.
Another difEknilty lies in the mathematical diaracter of the theory.
Moreover, the mathematics used are of a rather uncommon kind. They
are not merdy inddental but concern the very structure of the whole
'John von Neumann and Oskar Morgens Economic
\ekavior (Princeton. 1944, 2nd lev. ed.. 1947).
 DCFEBFECT COMPETITION, OLIGOPOLY, AND MONOPOLY 11
theory. Indeed, a state has been reached where some of the most im-
portant results of the theory could be found only by means of mathe-
matics and cannot even any longer be translated adequatdy into words,
predsdy as it happens in physical theory. But the concepts which are
used can perhaps become accessible for a qualitative description. I want
to emphasize that the mathematical nature of the theory is something
innate and not just a dressing up of fundamentally simple ideas. Of
course, I do believe that a genuinely mathematical and axiomatic theory
is superior to any nonmathematical treatment.
I shall now state what the fundamental problem is : We wish to know
how the individual, pursuing his maximum interest, should behave on
all types of markets. This is a question of rational behavior, of jud^ng
quantitatively any situation in which he may be placed so that with
his information he can assure himself of the maximum gain or utility.
Economic theory must therefore indicate how thefirmor the individual
should bdiave under all concdvable conditions. This is a tall order.
Current theory asserts that for free competition an ordinary maximum
problem results : thefirmachieves its maximum when its marginal costs
equal marginal revenue and should produce until these two are equated.
This is supposed to be exhaustive because the data are allegedly given
immutably. Likewise the individual as a consumer can gain his maxi-
mum utility. Monopoly theory proceeds similarly, and all maxima are
assumed to be obtained simultaneously.
The disconcerting difficulties of oligopoly and monopolistic ccmipeti-
tion arise because now specific assumptions about the reactions of outers
are unavoidable. Yet the belief that one is dealing with clear-cut maxi-
mum problems is not affected. But if one looks more dosdy the maxi-
mization even under free compeition has only been achieved by quietly
assuming that the partidpants in the market do not form coaUtions,
combinations, etc., which would greatly reduce the effective number of
actors. When the number of sellers or buyers or of both is small any-
way, the maximum character of the problem becomes exceedingly
doubtful even on a purdy intuitive basis. Now it is one of the dedsive
steps in the theory of games to show that one is not confronted with
maximum problems (unless dealing with an absolutely isolated Robin-
son Crusoe, and its formal equivalent) but with a fundamentally differ-
ent situation.
Where is the difference? It lies in the fact that the theory of com-
petition assumes that the individual orfirmsare in full control of all
the variables that detennine the outcome of any transaction undertaken.
This is only achieved by the wholly inadmissible trick of holding
everything dse constant and of forbidding, tadtly no doubt, the
previously mentioned agreements among the partidpants. In a bi-
 12 AlCESICAN ECONOUIC ASSOCIATION

lateral monopoly, dearly, ndther of the two o[q)osing parties controls

all the variables determining the outcome. Each has merdy one partial
set of variables while the result, i.e., the prices and the quantity traded,
depends on both partial sets of variables together; i.e., on all variables.
In this case no trick whatever will hdp disguise the fundamental fact
that, while each of the partidpants wishes to maximize his own
the problem as a whole is not a maximum problem. It is a situation
not taken care of anywhere in current economic theory. It is not even
treated in classical mathematics. Furthermore, this kind of problem
does not occur in mechanics from which economic theory has taken
its images, concepts, and logical methods. I need hardly say more to
indicate the extreme seriousness of this problem.
When we have a duopoly or oligopoly against oligopsony, or gen-
erally a few sellers against comparatively few or even against many
buyers, the situation remains substantially the same: there is no maxi-
mum problem. The conjectures of people or firms about each other's
bdiavior are as important as ever. Unless a general theory can be
made embodying all these facts, the efforts are bound to fizzle out in
a maze of incomplete discussions of partly understood cases. The theory
of perfect competition as now generally taught at best remains at the
outskirts of the vast field for which a theory must be established. The
empirical unreality of its restraining assumptions is matched by the
insufficiency of its methodical principles.
If the mechanical, physical model used at present in economics and
the methods appropriate to it fail in providing a theory at once realistic
and logically satisfactory, is there another modd? It will have to fulfill
the customary three requirements: it should be similar to the reality
it is to modd, it must be mathematically manageable, and it must lead
to numerical-computational results. Games of strategy appear to fulfill
the first requirement and, if a theory can be made, then economic
reality can be modded by suitable games. That is to say, it is more
plausible to compare the sparring and jockeying between the large
autcmiobile companies to a game of poker with its bluffing, its bids
and overbids, or, equivalency, to a military situation, rather than to
some mechanical process such as a dance of molecules. Wage negotia-
tions, e.g., between the coal miners and the curators, also have
essential traits found nowhere but in games of strategy. Whether a
theory can actually be made can only be dedded by tíie success of
the attempt.
There can be little doubt that it is intuitivdy satisfactory to relate
games of strategy to economic behavior. Economists and businessmen
speak sometimes in passing, but with good instinct, of economic
fare, of a '^business strate^r," or of the "rules of the game," 3ay of

••
 IMPERFECT COMPETITION, OUCOFOLY, AND MONOPOLY 13
tbe gold standard. In tbe same sense, the games we are thinking of are
not the ordinary classical games of chance, but those of strategy where
the outcome depends primarily on the behavior of tbe players although
frequently chance factors also intervene as they do anywhere in the
world.
I wish to emphasize the claim that tbere is not merdy an analogy
between the two fidds of games of strategy and economics but a strict
Tbus fbe theory is not only related to monopolistic situations
s with all types of markets, with all kinds of economic and
bdiavior.
ier first a two-person game. Each of the two players wishes
to win and if he does, it is at the expense of the other, lii that case we
have a zero-sum same: in economics oresumably both parties gain
from an exchange; hence the sum of thdr gains and losses is g.
than zero and variable. Each player (or duopolist, if we neglect the
buyers for the time being) wishes to gain the maximum. So he has
to devise a strategy against the other. The same is true of the other
player and there is a clear opposition of interests. Now it may be as
disastrous to have one's own strategy found out as it would be profitable
to discover the other's scheme. There are games where "being found
out" does not matter; they are a minority and are called "strictly
d" and rdiable and safe strategies exist. For all other games
the chief thing is to protect onesdf against the calamity of "being
found out." Can it be shown that even in those cases strategies always
exist that offer the necessary protection to each of the two players, thus
making the game again strictiy determined?
The answer is yes. It is based on the empirical observation that the
partidpants playing, say matching pennies, will substitute random
statistical behavior (witbin the rules of the game) for any direct plan
of action, or so-called "pure" strategy, that could be discovered by
the opponent. To demonstrate this—^which makes every zero-sum two-
person game strictly determined—a rigorous mathematical proof has
been given. It involves a very deep-lying theorem of the so-called "min-
max" type which wasfirstproved in 1928 by von Neumann and which,
, reappears in a certain system of simultaneous economic
equations. Each
computationally, but the fundamental theorem assures that the solu-
tion always exists and that the best strategy can always be found. This
is more than can be said of many economic problems today involving
market transactions. Even in the few cases where the existence of a
solution has been determined, it is an open question whether it is
meaningful, in view of the in^propriateness of the modd currently
used. Only for the case of tbe isolated Robinson Crusoe or, equivar
14 AMERICAN ECONOMIC ASSOCIATION

lently, tbe strictly organized axnmunistic sodety can we be sure tbat

a meaningful solution in the form of a maximum can always be found,
although the computational difficulties may be immense or in fact
insuperable.
The transition from the Robinson Crusoe type of economy to the
simplest form of exchange transaction is diaracterized by the appear-
ance of another "will," controlling part of all the variables which de-
termine the outcome. When the number of partidpants increases
further, entirdy new phenomena again appear. When we have three
or more players, structural properties of greatest importance in eco-
nomics emerge. I shall try to give an idea of them by mentioning
tbe prindpal concepts of the general theory in a qualitative way. The
chief point is that the addition of every single new player produces a
new situation. The analysis therefore builds up gradually from that
of individual bdiavior, in the tradition of what is best in modern
economic theory. Wheüier there will emerge a convenient asymptotic
bebavior of tbe tbeory wben tbe number of partidpants becomes really
large, remains to be seen. It is our belief, bowever, tbat no short cuts
are possible.
If we consider three or more partidpants in a game, or equivalently
in a market, we observe immediately the tendency to form coalitions of
some of the players against the others. The urge to combine springs
from the fact that in combinations it is easier to obtain one's maximum
gain tban by proceeding independently. Tbese coalitions will necessarily
oppose eacb other as tbe individual players in a two-person game.
Coalitions will therefore have a value for the members, which is
expressed by tbe so-called "characteristic function" upon which the
entire theory is based. In order to be admitted to a coalition and to
enjoy this advantage over being left alone, payments to others may
be necessary. These "compensations," arising out of higgling and bar-
gaining, must also be taken care of by the theory. It suffices to think
of the fonnation of a cartel with production quotas, profit sharing, etc.,
and of the operation of labor imions, to get a proper empirical back-
ground. In all these cases monopolistic elements come to the fore.
They are thus viewed as something fundamental in economic and
sodal organization and do not appear as mere appendices of an alleg-
edly basic free competition of the Lausanne type.
If it is at all accepted that fundamental tendencies to form coalitions
are at work, then economic theory must account for them by giving
tbese forces thdr proper role. Clearly, free competition will not con-
tinue to prevail when people can gain by combining. On the other hand,
a monopoly may be upset by coalitions of its customers, etc. Any
 IMPERFECT COMPETITION, OLIGOPOLY, AND MONOPOLY IS

investigation of such markets that should neglect these tendencies

will fail to describe innate instabilities and the theory must necessarily
remain incomplete. The influence the recognition of this situation wOl
have upon legal theory and practice is an interesting prospect.
The outcome of a game or of a market transaction is the making of
payments; i.e., the "imputation" or "distribution" of the spoils. The
question arises whether there is only one such imputation ccxnpatible
with stability, where the imputation may also indude the compensa-
tions paid to members of the coalition. This imputation would represent
the solution of the game. Now it is of the utmost importance to realize
that solutions with such single imputations are only found for those
fundamentally uninteresting games where there is no advantage in
combining into monopolistic coalitions. These games are properly
called "inessential."
For the "essential" games the advantage in combining egresses the
complementarity or non-additivity of value which has given so much
trouble in economic theory. Individually the parts of a coalition are
worth less than all put together. In the case of essential games there
is never a solution made up of one single imputation or distribution.
There are only solutions consisting of a set of alternative imputations.
Assume that a given (essential) game has only one single solution: it
would consist of a number of imputations. But only one of these
imputations could materialize at a given time. Is one of these imputa-
tions or schemes of payments, e.g., the one that actually materiidizes,
superior to any other, does one "dominate" the others? The answer is
no, provided these other imputations, too, bdong to the solution. And
also that no other imputation will materialize. A solution is thus defined
as a set of those imputations which are undominated by eadi other.
With these remarks we are in the heart of the theory because now
we get insight into the structure of stability of a market or a sodal
organization. There are clearly other possibilities for payments and
profits than those expressed by the imputations bdonging to the solu-
tion. Why should they then not be adopted? Surdy they must be more
advanta^us to some members of the market, who must, therefore,
strive to see them enforced? This is true. But if one of these imputa-
tions which are outside of the solution, and which thus do not bdong
to the "accepted standard of behavior," should be seriously considered
by those who would profit under the scheme, that imputation would
in turn be promptly upset or discredited by another one. Other com-
binations of players would be found who "are convinced or can be
convinced" that another safe imputation exists which is to thdr advan-
tage and that they could thus disturb the other group in thdr intended
16 AMERICAN ECONOMIC ASSOCIATION

accq)tance of the desired inq>utation. The upsetting imputation in

turn would inevitably bdong to the solution and would thus not be
endangered by any other imputation, also part of the solution.
You may iind these ideas somewhat unfamiliar and perhaps difficult
and you may in particular object to the drcular or impUdt manner
in which I have characterized a solution. You may also ask how one
could be sure of the existence of a solution for all conceivable games.
Yet you wiU probably agree that social organizations can be described
by a criterion of "soundness" which is inevitably of this drcular
nature. But aside from the intuitive appeal these ideas may or may
not have, they find rigorous mathematical formulation and were sub-
jected to the most painstaking scrutiny of which modern logic is
capable. The chief characteristic of a solution is the lack of transitivity
of the imputations bdonging to the solution. The stabiUty of the
imputation that actually materializes thus does not lie in its undis-
puted superiority over all others. This would only be the case if we
had a dear maximum before us according to current economic theory.
The StabOity rests instead with those other "virtual" imputations of
the solution, which, though not materialized, could reidace the chosen
scheme of distribution without themselves being clearly better or su-
perior. They would derive their stabiUty from the same condition. There
is thus no conflict between these imputations and that is why any one
of them and aU together are sound and form an accepted standard of
bdiavior to whidi they impart an inner stability.
Here you will observe tiie mudi greater complexity of forms and
concepts to which the theory of games leads. When present economic
theory worries about indeterminateness, say of the price range in
bilateral monopoly or duopoly, it is concerned but with trivial cases
and has reaUy not touched upon the great wealth of interrelaticHisihips
to be expected in social phenomena. In fact, the theory of games even
shows that single solutions of many imputations each must, for nu-
merous games, give place to many solutions each again consisting of
multiple imputations. Thus we often find several conflicting standards
of behavior but each free from inner contradictions. This is a rigorous
expression of the fact that on the same physical background of eco-
nomic life quite different organizations and income distributions may
be established. This indicates a wide divergence of the theory of games
from physical theory, the current modd of economics, where uniquely
defined numbers or aggregates of numbers predominate and conse-
quently much simpler notions of the stability of a price system and a
scheme of distribution prevail.
I want to mention further that the theory of games almost auto-
matically produces information about the role of monopoUstic priv-
 IMPERFECT COMPETITION, OUGOPOLY, AND MONOPOLY 17

ileges and of discrimination. The theory shows that privileges cannot

always be maintained by the privileged players even if anchored in
the rules of the game. On the other hand, discrimination arises in spite
of the general assumption of complete information of all partidpants.
This is rather surprising and shows that discrimination is not, as seems
to be widdy thought, due to incomplete information. It is of a much
deeper nature. An indication of this is also the demonstration that
exploitation of the losing players by the winners is not always carried
to the limit in the interest of stability of the standard of behavior. All
this will be significant in the further study of monopoly and oligopoly.
What about the rdation between the solutions for a bilateral mo-
nopoly as seen today and that obtained from the theory of games?
The results agree fully when only one unit is transacted; but
both agree—fortunately 1—^with common sense. When the number of
units is left for the market to dedde, both approaches obtain the same
volume of transactions, but the theory of games already shows that
price may actually vary more widely than currently assumed, due to
the fact that all sorts of premiums and rebates are also permitted.
Considering a market of a monopolist selling to two buyers the theory
of games again yidds partly different results. The reason is that it
admits of coalitions and collusions or understandings between the two
buyers, or between one of the buyers and the sdler, etc., so that the
possible prices and the number of units transacted differ from the ac-
cepted views. There are indeed different prices for the two buyers,
an interesting case for monopoly in general. It is unknown in detail
what would happen in very mudi larger markets save that the com-
plexity of rdationships increases fast in conformity with what we ob-
serve in the world around us. One cannot in the least be sure that the
margins between the possible prices would narrow as current theory
desires, so that ultimatdy unique prices prevail when arbitrarily many
buyers and sellers are present. On the other hand, entirdy new vistas
appear even for very sinall markets when account is taken of the im-
portant possibility that some participants may not have as fine utility
scales and as dear a discernment of thdr advantages as others. But
this can only be mentioned here. At any rate I have shown you that
one has moved far away even now from marginal costs and marginal
revenue as prime factors in the theoiy of price.'
In summarizing I should like to stress these points: (1) The theory
of games of strategy is strictiy empirical and thus far purdy static. Its
full development awaits a greatly expanded body of information about
fact even the use and interpietation of such basic and demcntaiy concepts as
that of a demand curve are vitalfy affected. Cf. my (forthcoming) paper: "Demand
Theory ReconsÜetcd," Quarterly Journal of Econondcs, Febniaiy, 1948.
18 AMERICAN ECONOMIC ASSOCIATION

the economy as does the current version of economic tbeory. Yet it can
be developed much farther even with the existing descriptive knowl-
edge (e.g., in the field of location of industry). (2) Its logico-mathe-
matical foundations and techniques appear more natural to the subject
matter of economics than those used otherwise, which stem from the
glamorous but distant and alien field of theoretical physics. (3 ) The
complications it presents are due to the need to take better into account
the extraordinary wealth of phenomena of the social and economic
world of which we all have now only ver>'' inadequate ideas. But the
conceptual structure, of which I tried to give a general notion, has^ I
believe, a considerable intuitive appeal making the access to the exact,
quantitative formulation easier than would otherwise be the case.
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