Game Theory, an important principle of microeconomics that is largely credited to Professor John Nash is a logic system used to decide the best possible option to take in a given situation. It usually assumes that one side, or player, takes a known course of action (for example, “your” choice in the game), and the “other” player’s possible course of action is manifold and unknown.
At its most basic level, Game Theory looks at two competing corporations, each of which has a choice between an action A and an action B that can represent any aspect (pricing, output, marketing, sales) within the economy. Often when either party takes the action it is denoted as “Yes” and when either side chooses not take the actions action it is labeled “No”.
To observe all possible outcomes in the game, the Player creates a two-by-two grid, placing Company 1’s potential actions (A or B; Yes or No; etc) on one axis and Company 2’s listed on the other axis. Numerical values (profit, sales, production, or whatever else the game’s been designed to study) are given for all four of the possible outcomes:
- Corp. 1- Yes, Corp. 2- Yes
- Corp. 1- Yes, Corp. 2- No
- Corp. 1- No, Corp. 2- Yes
- Corp. 1- No, Corp. 2- No
In the game, you only know one side’s choice (“your” company’s choice), so you must review all possible outcomes and decide what your best option is by assuming that your competitor is also thinking rationally and using a similar Game Theory diagram to decide what’s best for his or her company.
Many times, but not always, each corporation will end up picking an option that does not allow them to maximize their benefit because the option also prevents the competitor from maximizing their benefit. Assuming the decision-makers in both companies are rational and applying Game Theory, only one of the four outcomes will be reached–this is the Nash Equilibrium.
Though this is often the case, it is not always the case. If there is no Nash Equilibrium, one company might have a consistent advantage over the other, or the companies will continuously alter their courses of action, resulting in the outcome bouncing around the four possibilities indefinitely. I will post an example of the Game Theory diagram here shortly.
Game Theory, though most common in competitive economic theory, is also applied in almost any situation where you have a choice (or several choices) to make to maximize your own benefit against your unknown opponent’s choices; another common application of Game Theory, as the name suggests, is in games like checkers or chess.
The Prisoner’s Dilemma:
The Prisoner’s Dilemma is a common real world example of Game Theory: this occurs when two people are arrested on suspicion of having committed a crime. The police officers split them up and question them separately. The police offer each prisoner with the incentive of a lesser sentence if they are first to confess, and threaten that the one who does not confess will receive a very severe sentence.
Unfortunately, in this situation, the Nash Equilibrium outcome ends up being for both prisoners to confess, even if innocent, because each one will assume that the other is also confessing. Game Theory is the reason that authority figures are being discouraged from using this coercive tactic that forces false confessions.