Game Theory

AAA

DEFINITION of 'Game Theory'

A model of optimality taking into consideration not only benefits less costs, but also the interaction between participants.

Game theory attempts to look at the relationships between participants in a particular model and predict their optimal decisions.

INVESTOPEDIA EXPLAINS 'Game Theory'

One frequently cited example of game theory is the prisoner's dilemma.

Suppose there are two brokers accused of fraudulent trading activities: Dave and Henry. Both Dave and Henry are being interrogated separately and do not know what the other is saying. Both brokers want to minimize the amount of time spent in jail and here lies the dilemma. The sentences vary as follows:

1) If Dave pleads not guilty and Henry confesses, Henry will receive the minimum sentence of one year, and Dave will have to stay in jail for the maximum sentence of five years.
2) If nobody makes any implications they will both receive a sentence of two years.
3) If both decide to plead guilty and implicate their partner, they will both receive a sentence of three years.
4) If Henry pleads not guilty and Dave confesses, Dave will receive the minimum sentence of one year, and Henry will have to stay in jail for the maximum five years.

Obviously, pleading guilty is the most attractive should the other plead not guilty since the sentence is only one year. However, if the other party also chooses to plead guilty, both will have to serve three years. On the other hand, if both parties plead not guilty, they'd have to serve two years in jail. Consequently, the risk of pleading not guilty is a five-year sentence, should the other choose to confess.

RELATED TERMS
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s ...
  2. Contract Theory

    The study of how individuals and businesses construct and develop ...
  3. Reinhard Selten

    An economist and mathematician who won the 1994 Nobel Memorial ...
  4. John F. Nash Jr.

    An American mathematician who won the 1994 Nobel Memorial Prize ...
  5. John Harsanyi

    An economist who won the Nobel Memorial Prize in 1994 along with ...
  6. Trembling Hand Perfect Equilibrium

    In game theory, an equilibrium state that takes into consideration ...
RELATED FAQS
  1. 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 >>
  2. 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 >>
  3. What is the difference between JIT (just in time) and CMI (customer managed inventory)?

    Just-in-time (JIT) inventory management focuses solely on the need to replenish inventory only when it is required, reducing ... Read Full Answer >>
  4. What are some examples of Apple and Google's best-selling product lines?

    There are many good examples of product lines in the technology sector from some of the largest companies in the world, such ... Read Full Answer >>
  5. What is a negative write-off?

    A negative write-off is a write-off conducted by a company or accountant after deciding not to pay back an individual or ... Read Full Answer >>
  6. How can tariffs cause inefficiencies in domestic industries?

    Any government regulation naturally creates inefficiencies in a pure supply and demand marketplace. When it comes to the ... Read Full Answer >>
Related Articles
  1. Economics

    Economics Basics

    Learn economics principles such as the relationship of supply and demand, elasticity, utility, and more!
  2. Options & Futures

    Game Theory: Beyond The Basics

    Take your game theory knowledge to the next level by learning about simultaneous games and the Nash Equilibrium.
  3. Fundamental Analysis

    The Basics Of Game Theory

    Break down and examine the potential consequences of economic/financial scenarios.
  4. Options & Futures

    Financial Concepts

    Diversification? Optimal portfolio theory? Read this tutorial and these and other financial concepts will be made clear.
  5. Economics

    Understanding the Product Life Cycle

    Product life cycle is the period of time during which a product is conceived and developed, brought to market and eventually removed from the market.
  6. Economics

    What's a Centrally Planned Economy?

    A centrally planned economy is one where the government controls the country’s supply and demand of goods and services.
  7. Economics

    What are Barriers to Entry?

    A barrier to entry is any obstacle that restricts or impedes a company’s efforts to enter an industry.
  8. Economics

    Explaining Aggregate Supply

    Aggregate supply is the total supply of goods and services an economy produces in a given time period.
  9. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P 500 Trust

    Find out more about the SPDR S&P 500 ETF Trust, the characteristics of the exchange traded fund and the suitability of investing in the fund.
  10. Active Trading Fundamentals

    Five Biggest Obstacles Facing First-Year Traders

    Address these five obstacles and you'll make significant progress as a first-year trader.

You May Also Like

Hot Definitions
  1. Hedging Transaction

    A type of transaction that limits investment risk with the use of derivatives, such as options and futures contracts. Hedging ...
  2. Bogey

    A buzzword that refers to a benchmark used to evaluate a fund's performance. The benchmark is an index that reflects the ...
  3. Xetra

    An all-electronic trading system based in Frankfurt, Germany. Launched in 1997 and operated by the Deutsche Börse, the Xetra ...
  4. Nuncupative Will

    A verbal will that must have two witnesses and can only deal with the distribution of personal property. A nuncupative will ...
  5. OsMA

    An abbreviation for Oscillator - Moving Average. OsMA is used in technical analysis to represent the variance between an ...
  6. Investopedia

    One of the best-known sources of financial information on the internet. Investopedia is a resource for investors, consumers ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!