What Is Game Theory and Its Role in Economics?
Game theory is a mathematical framework for analyzing strategic interactions among rational decision-makers, where outcomes depend on others' choices. In economics, it models scenarios like market competition and negotiations, helping predict behaviors in interdependent situations, such as firms setting prices or countries negotiating trade deals.
Core Applications: Oligopoly and Market Structures
A primary application is in oligopolies, where few firms dominate a market. The Cournot model, for instance, examines how firms choose output levels anticipating rivals' responses, leading to equilibrium quantities lower than perfect competition. This explains phenomena like price wars in industries such as airlines or smartphones.
Practical Example: Prisoner's Dilemma in Business
Consider two competing gas stations deciding on prices, akin to the Prisoner's Dilemma. If both lower prices, they earn low profits; if one undercuts while the other maintains high prices, the undercutter gains market share. Rational self-interest often leads to mutual price cuts, illustrating cartel instability and the need for regulations like antitrust laws.
Broader Impacts and Behavioral Extensions
Game theory informs auction design, like spectrum auctions for telecom licenses, optimizing revenue and efficiency. It also integrates behavioral economics to address misconceptions of pure rationality, revealing real-world deviations like fairness concerns in ultimatum games, enhancing policy tools for welfare economics and international trade.