Loading the player...

What is 'Game Theory'

Game theory is a framework for hypothetical 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.

BREAKING DOWN '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.  

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 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.

Types of Game Theory

Although there are many types (e.g. symmetric/asymmetric, simultaneous/sequential, et al.) of game theories, cooperative and noncooperative game theories are the most common.  Cooperative game theory deals with how coalitions, or cooperative groups, interact when only the payoffs are known.  It is a game between coalitions of players rather than between individuals, and it questions how groups form and how they allocate the payoff among players.  Noncooperative game theory deals with how rational economic agents deal with each other to achieve their own goals.  The most common noncooperative game is the strategic game, in which only the available strategies and the outcomes that result from a combination of choices are listed.  A simplistic example of a real-world noncooperative game is Rock-Paper-Scissors. 

Classic Game Theory Example

Prisoner's Dilemma is the most well-known example of game theory.  Consider the example of two criminals arrested for a crime. Prosecutors have no hard evidence to convict them. However, to gain a confession, officials remove the prisoners from their solitary cells and question each one in separate chambers.  Neither prisoner has the means to communicate with each other.  Officials present 4 deals:

  1. If both confess, they will each receive a 5-year prison sentence.  
  2. If prisoner 1 confesses but prisoner 2 does not, prisoner 1 will get 3 years and prisoner 2 will get 9 years. 
  3. If prisoner 2 confesses but prisoner 1 does not, prisoner 1 will get 10 years and prisoner 2 will get 2 years. 
  4. If neither confesses, each will serve 2 years in prison. 

The most favorable strategy is to not confess.  However, neither is aware of the other's strategy and without certainty that one will not confess, both will likely confess and receive a 5-year prison sentence.  

RELATED TERMS
  1. Nash Equilibrium

    The Nash Equilibrium is a concept within game theory where the ...
  2. Paradox of Rationality

    The paradox of rationality is the empirical observation that ...
  3. Robert J. Aumann

    Robert J Aumann is a mathematician and economist famous for his ...
  4. Accelerator Theory

    The accelerator theory is an economic theory whereby as demand ...
  5. Accounting Theory

    Accounting theory is the field of assumptions, methodologies ...
  6. Confession of Judgment

    A confession of judgment is a signed agreement that serves as ...
Related Articles
  1. Insights

    The Basics Of Game Theory

    Take an introductory look at game theory and the terms involved, and get familiar with backwards induction, a simple method for solving games.
  2. Tech

    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.
  3. Tech

    You Love Video Games, But Do You Know How The Industry Works?

    Traditionally, the video game industry was limited to consoles, such as Microsoft’s (MSFT) Xbox and Sony’s (SNE) PlayStation, but it now includes PC games, mobile games and, in the near future, ...
  4. Investing

    Seven Controversial Investing Theories

    Find out information about seven controversial investing theories that attempt to explain and influence the market as well as the actions of investors.
  5. Investing

    Prison Stocks Boosted by Justice Dept. Reversal of Scale Back

    The DOJ’s reversal of the decision to scale back private prisons represents good news for prison stocks.
  6. Tech

    Are Big Budget Video Games Dead?

    More people seem to be gaming on tablets and smartphones over consoles, which means this could be the end of big budget console games.
  7. Insights

    Former Convict? Become A Consultant

    Even convicted criminals are becoming consultants with Wall Street prison consulting.
  8. Insights

    5 Nobel Prize-Winning Economic Theories You Should Know About

    Here are 5 prize-winning economic theories that you’ll want to be familiar with.
  9. Tech

    Microsoft to Enable Game Gifting in the Xbox One Store

    Microsoft revealed in a tweet that it will soon let customers gift games via the Xbox One Store.
  10. Personal Finance

    The Best-Selling Video Games Of All Time

    Video games are selling better than ever before, but how can investors get in on the action?
RELATED FAQS
  1. What is the difference between a dominant strategy solution and a Nash equilibrium ...

    Dive into game theory and the Nash equilibrium, and learn why the equilibrium assumptions about information are less important ... Read Answer >>
  2. 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 >>
  3. Does the tradeoff model or the pecking order play a greater role in capital budgeting?

    Understand the difference between the trade-off theory and the pecking order theory, and learn what these theories tell companies ... Read Answer >>
  4. What is capital structure theory?

    Discover capital structure theory as it relates to financial management and the methods in which companies attempt to raise ... Read Answer >>
  5. What is general equilibrium theory in macroeconomics?

    Achieving equilibrium of prices in a single or multi-market setting involves a bidding process that is informed precisely ... Read Answer >>
  6. What are the odds of getting a perfect bracket in Warren Buffett's March Madness ...

    In 2014, Warren Buffett announced that he would give whoever could correctly guess every game of the NCAA men's basketball ... Read Answer >>
Hot Definitions
  1. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  2. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  3. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
  4. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  5. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  6. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
Trading Center