Game theory is a branch of economics that studies the behavior of individuals or firms in strategic situations, where the outcome of one’s decision depends on the decisions made by others. It is an important tool used by economists to analyze and understand various economic phenomena.
What is Game Theory?
Game theory is a mathematical framework used to model decision-making in situations where multiple players are involved. In such situations, each player’s decision affects not only their own payoff but also the payoffs of other players. The goal of game theory is to predict how individuals or firms will behave in such situations and what outcomes are likely to result.
The Basic Elements of Game Theory
The basic elements of game theory are players, strategies, and payoffs. Players are the individuals or firms involved in the game. Strategies are the actions that players can take, and payoffs are the outcomes that result from those actions.
For example, consider a simple game between two firms that sell similar products. Each firm has two possible strategies: either to lower its price or to maintain its current price. The payoffs for each strategy depend on what the other firm does.
If both firms maintain their current price, they each earn $10 million in profits. If one firm lowers its price while the other maintains its price, then the firm that lowers its price earns $15 million in profits while the other earns only $5 million. Finally, if both firms lower their prices, they each earn only $1 million.
- Players: Two firms
- Strategies: Lower price or maintain current price
- Maintain current price: Both earn $10 million
- One lowers price while other maintains: Lowering firm earns $15 million, maintaining firm earns $5 million
- Both lower prices: Both earn only $1 million
The Nash Equilibrium
One of the most important concepts in game theory is the Nash equilibrium. The Nash equilibrium is a situation where each player’s strategy is the best response to the other player’s strategy. In other words, no player can improve their payoff by changing their strategy, given that the other players’ strategies remain unchanged.
Using the example above, we can identify a Nash equilibrium by looking for a situation where neither firm has an incentive to change its strategy. One possible Nash equilibrium is for both firms to maintain their current prices.
If one firm were to lower its price, it would earn $15 million in profits while the other firm earns only $5 million. However, if both firms lower their prices, they each earn only $1 million.
Applications of Game Theory
Game theory has many applications in economics and beyond. It is used to analyze situations such as oligopolies (markets with few sellers), auctions, bargaining, and voting systems. It has also been applied in fields such as political science and biology.
In conclusion, game theory is an important tool used by economists to analyze strategic decision-making in various economic situations. By understanding how individuals or firms behave in such situations and what outcomes are likely to result, economists can develop better policies and strategies for maximizing economic welfare.