Definition of game theory: the study of how strategic decisions are logically made in a competitive environment where the actions of one participant can impact the success of another.
The best economics books may feature game theory as a subset of behaviour economics.
What is game theory?
Game theory ask the question: how do logical individuals make complex strategic decisions?
Starting with simple assumptions, such as:
- All players are logical
- All players act in their best interest
- All players have equal access to information
Game theory can reduce real-world economic decision making into simple ‘games’, which can be reduced into a series of expected outcomes which can be analysed before making a decision.
Game theory is usually introduced to students at University who are studying the field of economics. Like many parts of economic theory, it is a field which heavily draws upon mathematics (like much of economics).
It’s also a field with practical application. Game theory experts help to steer companies and governments through decisions which carry high stakes, such as:
- Whether to declare war on another country
- Bidding for a contract in a competitive tender process
- Public auctions for rights such as a spectrum auction
- Private auctions for rights such as broadcast rights for Premier League football matches.
- Setting production volumes for oil as a member of a cartel such as OPEC
How is the phrase game theory used in a sentence?
“Students of game theory will appreciate that sometimes there is no such thing as a ‘win-win‘”
What else you should know about game theory
Game theory is a fascinating subject, because it can help explain why independent actors sometimes make decisions which appear to go against their best interests.
The classic game theory thought experiment is the prisoners dillema.
I’ll explain the situation and I’d like you to formulate
a) What decision you would make, and why
b) What decision is the most logical to make
The Prisoners Dilemma
Two criminals are captured, and are presented each with a plea deal while they sit in separate isolated cells:
- If one prisoner confesses and betrays the other, the confessor will be set free, while the prisoner who remains silent will serve 3 years (an aggravated sentence because of no admission of guilt).
- If they both confess, they will both serve 2 years.
- If neither of the prisoners confesses, they will only serve 1 year in prison for a lesser charge (of running from the police).
Take a pause for a moment and consider – what would you do?
Analysing the prisoners dilemma
This series of options excites economists so much because the results are so interesting:
By applying game theory, one can conclude that despite the best joint outcome being for both to stay silent (total sentence of 2 years), the logical choice for each prisoner is to actually betray the other – and suffer the combined 4 year sentence instead.
How bizarre – why is this the case?
From the perspective of Prisoner A, they have two choices: confess, or stay silent.
If they confess, two things can happen:
A) 0 years (if other prisoner stays silent)
B) 2 years (if other prison confesses).
However, if they stay silent, look at the new options:
A) 1 year (if the other prison stays silent)
B) 3 years (if the other prison confesses).
If you look at these options carefully – you’ll see that the confessor sees a better outcome regardless of what the other Prisoner does. Let’s pivot the options from the perspective of what Prisoner B does:
If Prisoner B stays silent, then confessing (0 years) is better than staying silent (1). If Prisoner B confesses, then confessing (2 years) is better than staying silent (3 years).
It doesn’t matter what Prisoner B does, Prisoner A would be better off in each scenario if they confess.
Therefore it’s completely logical for both prisoners to reach this conclusion and confess, despite the fact that this inevitably leads to a sub-optimal outcome for them.
How does the definition of game theory relate to investing?
I would encourage you all to do more research about game theory and consider buying a game theory book to become a strategic master. You never know when you may find yourself in a negotiation where being able to think critically and evaluate the options rationally could be very valuable!