What Is Game Theory?

Game theory is a theoretical framework for conceiving social situations among competing players. In some respects, game theory is the science of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting. The key pioneers of game theory were mathematicians John von Neumann and John Nash, as well as economist Oskar Morgenstern. The Basics of Game Theory

The focus of game theory is the game, which serves as a model of an interactive situation among rational players. The key to game theory is that one player's payoff is contingent on the strategy implemented by the other player. The game identifies the players' identities, preferences, and available strategies and how these strategies affect the outcome. Depending on the model, various other requirements or assumptions may be necessary.

Game theory has a wide range of applications, including psychology, evolutionary biology, war, politics, economics, and business. Despite its many advances, game theory is still a young and developing science.

According to game theory, the actions and choices of all the participants affect the outcome of each.

Game Theory Definitions

Any time we have a situation with two or more players that involve known payouts or quantifiable consequences, we can use game theory to help determine the most likely outcomes. Let's start out by defining a few terms commonly used in the study of game theory:

•  Game: Any set of circumstances that has a result dependent on the actions of two or more decision-makers (players)
• Players: A strategic decision-maker within the context of the game
• Strategy: A complete plan of action a player will take given the set of circumstances that might arise within the game
• Payoff: The payout a player receives from arriving at a particular outcome (The payout can be in any quantifiable form, from dollars to utility.)
• Information set: The information available at a given point in the game (The term information set is most usually applied when the game has a sequential component.)
• Equilibrium: The point in a game where both players have made their decisions and an outcome is reached

The Nash Equilibrium

Nash Equilibrium is an outcome reached that, once achieved, means no player can increase payoff by changing decisions unilaterally. It can also be thought of as "no regrets," in the sense that once a decision is made, the player will have no regrets concerning decisions considering the consequences.

The Nash Equilibrium is reached over time, in most cases. However, once the Nash Equilibrium is reached, it will not be deviated from. After we learn how to find the Nash Equilibrium, take a look at how a unilateral move would affect the situation. Does it make any sense? It shouldn't, and that's why the Nash Equilibrium is described as "no regrets." Generally, there can be more than one equilibrium in a game.

However, this usually occurs in games with more complex elements than two choices by two players. In simultaneous games that are repeated over time, one of these multiple equilibria is reached after some trial and error. This scenario of different choices overtime before reaching equilibrium is the most often played out in the business world when two firms are determining prices for highly interchangeable products, such as airfare or soft drinks.

Impact on Economics and Business

Game theory brought about a revolution in economics by addressing crucial problems in prior mathematical economic models. For instance, neoclassical economics struggled to understand entrepreneurial anticipation and could not handle the imperfect competition. Game theory turned attention away from steady-state equilibrium toward the market process.

In business, game theory is beneficial for modeling competing behaviors between economic agents. Businesses often have several strategic choices that affect their ability to realize economic gain. For example, businesses may face dilemmas such as whether to retire existing products or develop new ones, lower prices relative to the competition, or employ new marketing strategies. Economists often use game theory to understand oligopoly firm behavior. It helps to predict likely outcomes when firms engage in certain behaviors, such as price-fixing and collusion.