Introduction to Game Theory in Business and Economics

by James Green, Demand Media

    Game theory is a model used in business and economics that examines the strategies and decisions of firms given the strategies and decisions of competing firms. Although game theory had long been used to analyze poker games, it rose to prominence after the work of the Nobel Prize-winning economist John Nash.

    The Prisoner's Dilemma

    The prisoner's dilemma is a common concept in game theory. It outlines the problems two actors face in predicting the actions of the other player. A commonly cited example is as follows: You are a world-renowned jewel thief who has been hired by a businessman to steal the world's most precious diamond. The burglary is successful, and you arrange to hand it over to the businessman in exchange for a reward. However, you realize that the businessman may attempt to take your life as well as the diamond instead of handing over the large reward. So you agree to deposit the diamond in a large field while the businessman deposits the money in another field. But then you realize that the businessman may betray you by collecting the diamond and not leaving the cash. He realizes that you may have the same strategy as well. Hence the dilemma.

    Analyzing the Dilemma

    Given the prisoner's dilemma, each player realizes he has two strategies: cooperate or defect. The consequences for each player depend on both of their strategies. If both players cooperate, they will both receive their agreed rewards. If both players defect, then neither player receives anything. If one player cooperates and one defects, the defecting player receives the "sucker payoff," which is composed of both the diamond and cash reward in this example. It is assumed that the thief wants the cash more than the diamond and that the businessman wants the diamond more than the cash. However, having both is better than just one.

    Solving the Dilemma

    In order to receive the sucker payoff, the other player must take a cooperative strategy. If both players wish to receive the sucker payoff, they will both defect. However, the consequences of both players defecting is a zero payoff for both players since neither has left her items in the fields. They thus realize that the only way to receive any payoff is to cooperate. In the end of the game the businessman receives his money, and the thief receives his cash reward.

    Application in Business and Economics

    The prisoner's dilemma game is one of the simpler models of game theory. However, the model may be extended to include multiple plays. The general idea is that one player will generally have a sound idea of the strategies of the other player. Thus, one player will play his own strategy, given the possible strategies of the other player. In business and economics, game theory is often applied to an oligopoly setting. An oligopoly is where there are few firms producing a similar product. A good example is that of supermarkets. A supermarket will make price decisions based on the supposed price decisions of its competitor. Of course, undercutting your competitor will ensure more sales. However, if both supermarkets have this strategy, the end result is zero profits since prices are cut down to minimal levels. If the costs of each supermarket are the same, the end result is to collude with pricing strategies.

    About the Author

    James Green has composed economic research reports on a freelance basis since 2008. Specializing in business and finance, he also writes for various websites. Green possesses a Master of Science in real estate from the University of Aberdeen and a Master of Science in economics from the University of Lund.