Game Theory

Loading the player...

What is 'Game Theory'

Game theory is 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.

BREAKING DOWN '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. Prisoner's Dilemma

    A paradox in decision analysis in which two individuals acting ...
  2. Insider Trading Act of 1988

    An act enabled in 1988 to increase the liability penalties to ...
  3. Michael Milken

    As an executive at investment bank Drexel Burnham Lambert Inc. ...
  4. WorldCom

    Formerly known as WorldCom, now known as MCI, this U.S.-based ...
  5. Tit For Tat

    A game-theory mechanism which is subject to a payoff matrix similar ...
  6. Basis Differential

    The difference between the Henry Hub spot price and the corresponding ...
Related Articles
  1. Markets

    Understanding Game Theory

    Game theory is a model for making decisions that weighs the benefits of a choice along with the interaction between participants.
  2. Markets

    Utilizing Prisoner’s Dilemma In Business And The Economy

    The Prisoner’s Dilemma, one of the most famous game theories, provides a framework for understanding how to strike a balance between cooperation and competition, and is a very useful tool for ...
  3. Markets

    Advanced Game Theory Strategies For Decision-Making

    The importance of game theory to modern analysis and decision-making can be gauged by the fact that since 1970, as many as 12 leading economists and scientists have been awarded the Nobel Prize ...
  4. Markets

    Prisoner's Dilemma

    Learn more about this classic game theory scenario.
  5. Markets

    The Basics Of Game Theory

    Break down and examine the potential consequences of economic/financial scenarios.
  6. Investing

    How To Game The Video Game Industry

    Investopedia explores the business, current developments, future trends of video games industry and how the overall industry makes money.
  7. Retirement

    Footnotes: Early Warning Signs For Investors

    These documents hold very important information, but reading them takes skill.
  8. Investing

    How The Video Game Industry Is Changing

    Video game creation has become increasingly complex, and the cost of creating a game to run on one of the major consoles has risen with this greater complexity.
  9. ETFs & Mutual Funds

    The 3 Biggest Hedge Fund Scandals

    Learn about major scandals at hedge funds including the Madoff investment scandal and insider trading cases at SAC Capital and the Galleon Group.
  10. Trading

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
RELATED FAQS
  1. How is game theory related to the Nash equilibrium?

    Learn how Nash's equilibrium is an important concept in game theory, and understand how it applies to the common prisoner's ... Read Answer >>
  2. Why is Game Theory useful in business?

    Game theory was once hailed as a revolutionary interdisciplinary phenomenon bringing together psychology, mathematics, philosophy ... Read Answer >>
  3. Dave, a conservative investor, comes to you for advice on a diversified fixed-income ...

    The correct answer is c: When setting up a diversified bond portfolio you should consider the following factors- maturity, ... Read Answer >>
  4. Who are the most famous people convicted of insider trading?

    Learn about some famous people who were convicted of illegal insider trading and find out about the reasons for their criminal ... Read Answer >>
  5. What's the difference between agency theory and stakeholder theory?

    Learn how agency theory and stakeholder theory are used in business to understand common business communication problems ... Read Answer >>
  6. What is the chaos theory?

    The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant ... Read Answer >>
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center