The term ‘game’ represents a conflict between two or more parties. A game is a decision situation with multiple decision makers where each person’s welfare depends on his/her own as well as other individuals’ actions. That is, a game is a decision situation with strategic interactions among all decision makers.
| Game theory is a theory of individual rational decisions taken under conditions of less than full information concerning the outcomes of those decisions. This theory examines the interaction of individual decisions given certain assumptions concerning decisions made under risk, the general environment, and the cooperative or non-cooperative behavior of other individuals. |
In the words of Richard G. Lipsey and K. Alec Chrystal, “Game theory is an approach to analyzing, rational decision-making behavior in interactive or conflict situation.”
According to N. Gregory Mankiw, “Game theory is the study of how people behave in strategic situations." By ‘strategic’, we mean a situation in which each person, when deciding what actions to take, must consider how others might respond to that action. Game theory is a mathematical technique used to show for example, how oligopoly firms play their game of business.
Importance of Game Theory
Game theory is an analysis that illustrates how choices between two plays affect the outcome of a “game”. Game theory which sounds playful/laughing in its terminology is filled with significance. It has been used by economists to study the interaction of oligopolistic markets, union-management bargaining disputes, countries’ trade policies, international environmental agreements, reputations, conflicts such as games and war and a large number of other situations. Game theory offers insights for politics, warfare, and everyday life as well.
- Game theory is commonly used in economics to illustrate interdependent decision-making among oligopoly firms. It illustrates that one firm makes a decision based on the decision expected from the other firm. One key conclusion from the game theory analysis is that firms often make decisions that are “second best” or the “lesser of two evils”. The classic example of such a decision is the prisoners’ dilemma, in which two prisoners both confess to a crime to avoid harsher punishment when not confessing would avoid any punishments.
- Thus, game theory has proved to be useful in analyzing suspects of economic behavior such as natural resource depletion and public goods. The theory of cooperative games which allows collaboration between individuals has been used to analyze cartel formation and industrial and labor market collusion.
- Game theory is a body of knowledge which is concerned with the study of decision-making in situations where two or more rational opponents are involved under conditions of competition and conflicting interests. It deals with human processes in which an individual decision making unit who can be an individual, a group, a formal or informal organization, or a society, is not in complete control of the other decision making units, the opponents, and is addressed to problems involving conflict, co-operation or both at various levels.
- The main objective in the theory of games is to determine the rules of rational behavior in the game situations, in which the outcomes are dependent on the actions of the interdependent players. A game refers to a situation in which two or more players are competing it.
- Game theory is quite useful for understanding the behavior of oligopolies. When game theory is applied to oligopoly, the players are firms. Their game is played in the markets, their strategies are their price/output decisions, and the payoffs are their profits. Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all the other firms.
In summary, a game theory framework can often help us understand the strategic choices available but it does not always help to predict which of many possible outcomes may occur.
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