Game theory is the process of modeling the strategic interaction between two or more players in a situation containing set rules and outcomes. While used in a number of disciplines, game theory is most notably used as a tool within the study of economics. The economic application of game theory can be a valuable tool to aide in the fundamental analysis of industries, sectors and any strategic interaction between two or more firms. Here, we'll take an introductory look at game theory and the terms involved, and introduce you to a simple method of solving games, called backwards induction.
Definitions
Any time we have a situation with two or more players that involves 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 of 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.
Assumptions
As with any concept in economics, there is the assumption of rationality. There is also an assumption of maximization. It is assumed that players within the game are rational and will strive to maximize their payoffs in the game. (The question of rationality has been applied to investor behavior as well. Read Understanding Investor Behavior to learn more.)
When examining games that are already set up, it is assumed on your behalf that the payouts listed include the sum of all payoffs that are associated with that outcome. This will exclude any "what if" questions that may arise.
The number of players in a game can theoretically be infinite, but most games will be put into the context of two players. One of the simplest games is a sequential game involving two players.
Solving Sequential Games Using Backwards Induction
Below is a simple sequential game between two players. The labels with Player 1 and two within them are the information sets for players one or two, respectively. The numbers in the parentheses at the bottom of the tree are the payoffs at each respective point, in the format (Player 1, Player 2). The game is also sequential, so Player 1 makes the first decision (left or right) and Player 2 makes its decision after Player 1 (up or down).
Figure 1 
Backwards induction, like all game theory, uses the assumptions of rationality and maximization, meaning that Player 2 will maximize his payoff in any given situation. At either information set we have two choices, four in all. By eliminating the choices that Player 2 will not choose, we can narrow down our tree. In this way, we will bold the lines that maximize the player's payoff at the given information set.
Figure 2 
After this reduction, Player 1 can maximize its payoffs now that Player 2's choices are made known. The result is an equilibrium found by backwards induction of Player 1 choosing "right" and Player 2 choosing "up". Below is the solution to the game with the equilibrium path bolded.
Figure 3 
For example, one could easily set up a game similar to the one above using companies as the players. This game could include product release scenarios. If Company 1 wanted to release a product, what might Company 2 do in response? Will Company 2 release a similar competing product? By forecasting sales of this new product in different scenarios, we can set up a game to predict how events might unfold. Below is an alterexample of how one might model such a game.
Figure 4 
Conclusion
By using simple methods of game theory, we can solve for what would be a confusing array of outcomes in a realworld situation. Using game theory as a tool for financial analysis can be very helpful in sorting out potentially messy realworld situations, from mergers to product releases.

Investing Basics
5 Tips For Diversifying Your Portfolio
A diversified portfolio will protect you in a tough market. Get some solid tips here! 
Entrepreneurship
Identifying And Managing Business Risks
There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them. 
Forex Education
Explaining Uncovered Interest Rate Parity
Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates. 
Fundamental Analysis
Using Decision Trees In Finance
A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to. 
Economics
Understanding Tragedy of the Commons
The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource. 
Investing
What’s the Difference Between Duration & Maturity?
We look at the meaning of two terms that often get confused, duration and maturity, to set the record straight. 
Forex Education
Time Value Of Money: Determining Your Future Worth
Determining monthly contributions to college funds, retirement plans or savings is easy with this calculation. 
Investing
Understanding High Yield Fund Performance
For exchange traded fund, not all highyield ETFs are the same. So, we take a look at one high yield investment in particular to set the stage for you. 
Options & Futures
Terrorism's Effects on Wall Street
Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover. 
Stock Analysis
Analyzing Porter's 5 Forces on Facebook
Read about how you can use Porter's five forces to analyze Facebook's competition. This simple methodology looks at several different factors or forces.

What is the difference between a dominant strategy solution and a Nash equilibrium ...
Game theory is the science of strategy in situations that involve more than one actor. This can include actual games, military ... Read Full Answer >> 
How do modern corporations deal with agency problems?
Agency problems – also known as principalagent problems or asymmetric informationdriven conflicts of interest – are inherent ... Read Full Answer >> 
How do you make working capital adjustments in transfer pricing?
Transfer pricing refers to prices that a multinational company or group charges a second party operating in a different tax ... Read Full Answer >> 
How do mutual funds split?
Mutual funds split in the same way that individual stocks split, but less often. Like a stock split, mutual fund splits do ... Read Full Answer >> 
What is the utility function and how is it calculated?
In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >> 
What does marginal utility tell us about consumer choice?
In microeconomics, utility represents a way to relate the amount of goods consumed to the amount of happiness or satisfaction ... Read Full Answer >>