Game Theory

Hi everyone welcome back! Today I have decided to write a little bit about Game Theory. This was first presented to me when my school brought in Mo Tanweer, an incredible Economics professor who studied at Cambridge University, where he began to teach us a snippet of what he covers in the university course he offers to his students. It is a very large concept, so I will only cover a bit in today's entry, however I may revisit this topic later.

So to start, what is game theory? 

By definition, Game theory is a way of modeling the economic activity of competitive firms as a simple game. But what does this actually mean? Well, it's used to strategize, predict, and model different economic situations. It intends to try and produce the most optimal choice when decision-making. Real-world scenarios are used with game theory and through this certain outcomes can be foreseen/predicted. During our session with Professor Tanweer, he said that it studies strategic interactions between agents. In strategic games, agents choose strategies that will maximize their return, given the strategies the other agents choose. The essential feature is that it provides a formal modeling approach to other social situations in which decision-makers interact with other agents to formulate, structure, analyze, and understand strategic scenarios. Behavioral economics introduces psychology into the mix to attempt to predict behaviors.

There are many infamous examples of game theory. Such as the 'Prisoners Dilemma'. In this scenario, two people are arrested for stealing a car and have to serve 2 years of imprisonment. However, the police also suspect that they may be guilty of a bank robbery. They question each prisoner separately and they cannot communicate with one another.

There are 2 situations: 

1: If they both confess to being bank robbers, then each will serve 3-year imprisonment for both car theft and robbery.

2: If only one of them confesses to being a bank robber and the other does not, then the person who confesses will serve 1 year and the others will serve 10 years imprisonment.

With this, you can create a payoff matrix, as seen below. 

In this situation the best choice is to deny, both will be sentenced to two years in prison in this instance. However, there's no guarantee that others wouldn't confess, so chances are good that both of them would admit and serve the three years.

According to game theory with this example, two players making selfish choices to deny creates a suboptimal choice for both of them. In addition to this, it shows that cooperating is not always in the best interests of the agent. 

This can be applied to the real world via two competitors that are against each other within the marketplace. Such as a rivalry between Coca-Cola and PepsiCo. If Coca-Cola is considering cutting the price of its soda, Pepsi will likely have no choice but to do the same to retain its market share, causing a reduction in profits for both of the companies. Either company reducing their price can be considered as something called defecting. This means neither of them cooperates, breaking the 'agreement' that they have to keep the prices high to maximize their profits. Another payoff matrix can be created to help further analyze what is the best choice for the company. This is how market analysts within large competitive companies help choose what is the best option for the company.

How is Game theory used in Economics?

• Oligopoly: In markets dominated by a few large firms, game theory helps predict pricing strategies and competition.

• Bargaining: In negotiations, game theory can predict the outcome based on the bargaining power of each party.

• Public Goods: It explores how individuals decide to contribute to public goods, like public parks or national defense, which benefit everyone but require collective action.

When is it beneficial?

• Predictive Power: It provides a systematic approach to predict how players will act in strategic situations.

• Strategic Insights: It helps businesses and policymakers devise effective strategies by understanding competitors' likely responses.

• Resource Allocation: By understanding strategic interactions, game theory can guide the efficient allocation of resources, leading to better economic outcomes.

However, there are some limitations:

We always have to assume that all of the players are rational decision-makers. Additionally, real-world situations can be far more complex than the simplified models used within game theory. There can also be unforeseen outcomes, if players don't act rationally, unexpected results can occur.

Game theory can also help provide psychological insights into human behavior. 

People are often risk-averse and choose to avoid the chance of losses instead of seeking gains. In addition to this, over repeated 'games', players will develop trust and cooperation over time, which can lead to more cooperative outcomes. People typically tend to value fairness and may choose to adopt strategies that are perceived as fair, even if it means sacrificing personal gains.

That's all for today! I hope you found this entry insightful :) Please feel free to check out some other my other blogs on my page.