What Is Game Theory in Economics With Example?


Vincent White

Game theory is a branch of mathematics that studies the behavior of individuals and organizations in strategic situations. It is widely used in economics, political science, psychology, and other social sciences to analyze decision-making processes.

In game theory, a “game” refers to any situation where there are two or more players who can make choices that affect each other’s outcomes. The players can be individuals, companies, or even countries. The choices they make are called “strategies,” and the outcomes they receive are called “payoffs.”

There are many types of games in game theory, but some of the most common ones include:

Prisoner’s Dilemma: In this game, two suspects are arrested for a crime and held in separate cells. Each suspect is given the option to confess or remain silent.

If both suspects remain silent, they will both receive a light sentence. However, if one confesses and the other remains silent, the one who confesses will receive a reduced sentence while the other receives a harsher one. If both confess, they will both receive moderate sentences.

Battle of the Sexes: In this game, a married couple must decide whether to go to a football game or an opera. The husband prefers football while the wife prefers opera.

However, they would both prefer to go together than alone. If they do not coordinate their choices properly, they may end up going to different events.

Chicken: In this game, two drivers head towards each other on a narrow road. Each driver must decide whether to swerve out of the way or stay on course.

If both drivers swerve out of the way, they will avoid a collision and receive no penalty. However, if one driver swerves while the other stays on course (or neither swerves), the swerving driver will lose face (or be injured) while the other driver gains an advantage.

These examples illustrate some basic concepts in game theory such as “dominant strategies,” “Nash equilibrium,” and “payoff matrices.” A dominant strategy is one that is always the best choice for a player, regardless of what the other players choose.

A Nash equilibrium is a situation where each player’s strategy is the best response to the other players’ strategies. A payoff matrix shows the payoffs each player receives for each possible combination of strategies.

Game theory has many applications in real life. For example, it can be used to analyze pricing strategies in markets, voting behavior in elections, and negotiating tactics in business deals. It can also be used to model conflicts between nations, organizations, or individuals.

In conclusion, game theory is a powerful tool for analyzing strategic decision-making processes. By understanding the basic concepts and applying them to real-world situations, individuals and organizations can make better decisions and achieve their goals more effectively.