What Is Game Theory?
Game theory is a mathematical framework used in economics to analyze strategic interactions among rational decision-makers. It models situations where the outcome for each participant depends on the choices of all involved, such as in markets, negotiations, or competitions. Originating from John von Neumann and Oskar Morgenstern's 1944 work, it assumes players aim to maximize their payoffs while anticipating others' actions.
Key Principles of Game Theory
Core principles include players (decision-makers), strategies (possible actions), payoffs (outcomes), and information (complete or incomplete). Games can be cooperative or non-cooperative, simultaneous or sequential. Basic strategies involve dominant strategies—optimal regardless of others' choices—and Nash equilibrium, where no player benefits from unilaterally changing their strategy given others' fixed choices.
Practical Example: Prisoner's Dilemma
In the classic Prisoner's Dilemma, two suspects decide whether to confess or stay silent. If both stay silent, they get light sentences; if one confesses, they go free while the other gets a heavy sentence; if both confess, both get medium sentences. The dominant strategy is to confess, leading to a Nash equilibrium of mutual confession, even though mutual silence would be better—illustrating how self-interest can yield suboptimal outcomes.
Applications and Importance in Economics
Game theory is vital in economics for understanding oligopolies, auctions, bargaining, and policy design. It explains phenomena like price wars in markets or international trade negotiations. By revealing incentives and potential equilibria, it helps economists predict behaviors, design better regulations, and avoid pitfalls like cartel breakdowns, ultimately fostering efficient resource allocation and strategic foresight.