Game theory deals with situations where several decision-makers, called players, interact with each other to reach an agreement. The most common application of game theory in economics includes one player's strategy affecting the other players' choices and vice versa.
Game theory is an essential part of economics because it is one of the few fields that examine rational human behavior and predict how people will react to given conditions.
Studying game theory in economics also helps us understand why some countries are prosperous while others are not, enabling us to learn about efficient development strategies and better policies.
In economics, game theory applications explain how the decisions made by individuals or firms affect others in the market. The following article will overview some game theory applications in economics, showing you how and why such games work.
What Is Game Theory the Study of?
In behavioral economics, game theory studies people's incentives and actions to create the best outcome for themselves. It is important to learn game theory because, many times, financial results depend on a mix of altruism and self-interest (according to economists).
Understanding what causes someone to behave rationally is key. Hence, taking online courses or assistance from skilled tutors can help in understanding what is game theory.
Understanding what constitutes a good decision for an individual and how different choices interact can be helpful when creating policies or rules that govern interactions between individuals.
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What Is The Importance Of Game Theory In Economics?
Game theory is an important economic tool widely applied to economic matters, such as determining the best possible strategy in a particular situation. It is the realm of zero-sum games, where one player's gain is another player's loss. One example would be how two countries may play with tariffs to maximize their profits.
It can also be used for cooperative situations; for instance, to figure out how many farms a company should buy to keep business operating smoothly and avoid disruptions in production.
Besides, psychology has also used game theory to examine rational decision-making and influence peoples' thoughts and desires.
By analyzing the outcomes of certain events, researchers have found that some decisions seem more rational than others. These models might not fit every situation, but they provide a fascinating insight into human behavior and thought processes.
Game theory is extensively applied to biological sciences and helps examine evolutionary strategies that depend on different outcomes when playing against opponents (for example, predators).
Several economists have come up with three main approaches to modeling behaviors. One is the Nash equilibrium which suggests players will always want to choose the most efficient option available. The second is iterated elimination of dominated strategies, which means if there are multiple options, players will eliminate those less advantageous until they only have two options left. The third approach is stochastic dominance, which claims humans always want to choose the outcome that is most likely or has the highest probability of success.
What Are The Applications Of Game Theory In Economics
The main application of game theory in economics is its use in forecasting market behavior. Forecasting market behavior helps experts create more efficient supply chains.
When making decisions on whether or not they should enter certain markets or invest more money into inventory models, many forecasting strategies are used by firms.
Here are a few prominent examples of game theory in economics;
A Stag Hunt
A classic game theory problem is the Stag Hunt. Suppose there are two hunters in a clearing, one is stalking a deer, and the other must wait thirty minutes before they can start hunting.
If they both hunt simultaneously, neither will catch anything, but if one hunts while the other waits, whoever catches it gets all the meat for themselves. But, what should each person do, given that the other might not cooperate?
There are four possible outcomes:
- They both hunt together
- One hunter decides to wait
- Only one person hunts
- Neither hunts
What is best for each individual depends on their expected payoff under each situation. This payoff is calculated as their personal share of the meat multiplied by how likely they think they will get to keep it (given that their counterpart cooperates).
For instance, if you think your partner has more than a 50% chance of cooperating with you when you decide to hunt (which would give you 10 points), then waiting while your partner hunted would give you 5 points instead of 0 points from not hunting.
Battle Of The Sexes
This strategy is about achieving the optimal outcome for a certain decision-making process by examining its strategic behavior and formulating an optimum response to other actors.
Originally, game theory was developed as a mathematical modeling technique to evaluate the behavior of people interacting with each other.
It means they consider how different individuals might react to reach the best possible solution to what they are trying to achieve together. The simplest example of this would be a battle of the sexes between husband and wife with one car.
Both spouses want to leave the town individually at 02:00 PM on Saturday, and only one car is available. Leaving at 12:00 PM will not work because both will have to drive back from their destinations, adding 3 hours to their trip.
If the husband leaves first and the wife follows him later, she can't do anything but wait around for him because he has the keys. So, instead, she should leave one hour before him so that she gets to her destination sooner than he does.
Voting Paradox
To fully grasp what is game theory in economics, it is first necessary to understand the voting paradox. The voting paradox works as follows; voters are asked to rank their preferences for one of two candidates, A and B.
They are then allowed to vote as many times as they want, ranking A first and B second. For instance, one voter might give their rankings as ABBABBABABAB, indicating that the voter prefers candidate A over candidate B.
Still, if it were not the case, the rankings would be reordered so that there would be a higher preference for candidate B (BBAAAB). Votes cast by this system should theoretically allow a winner to be determined mathematically.
What Are The Different Types Of Game Theory?
There are two categories in game theory; cooperative and non-cooperative. Cooperative games always have an equilibrium where every player is content with their strategy because they are satisfied with the outcome.
Non-cooperative games do not always have an equilibrium where every player is content with their strategy, which makes it difficult to find one.
There are three main ways economists use game theory. Studying how people react to figure out if they make predictable decisions, as a way to discuss when fairness should be placed on one side or another, and as a way to understand people's motivations for cooperation vs. self-interest.
Let's take a look at different types of game theory;
Decision Tree
Decision tree analysis is a technique for evaluating complex decisions with many potential outcomes. It helps analyze decisions by breaking them into manageable parts and representing the different possible outcomes as branches on a decision tree.
In this case, the decision being evaluated is whether or not to invest in stocks. The investor first asks him/herself what will happen if they invest in stocks and then follows that branch of the tree to determine the outcome.
They then ask themselves what will happen if they do not invest in stocks and follow that tree branch to determine the outcome.
Dominant Strategy
This application of game theory in economics primarily uses the concept of a dominant strategy to study strategic behavior and interactions among people or firms. The idea behind a dominant strategy is to determine the best decision if you are faced with different possible outcomes in some situations.
For instance, if you were trying to decide which of two doors on your left and right you should open, what would your best course of action be if one door had a vicious dog on the other side and the other door had nothing at all?
A good solution would be to open both doors at the same time. If there's no dog, then nothing wrong, and at least one door reveals that there was a nice prize waiting for you inside.
Nash Equilibrium
In game theory, a Nash equilibrium is a set of strategies for each player. If they are played against each other in an individual game, no player can do better than by playing according to the strategy in the set.
A consequence is that if one player has a weak strategy, at least one other player with a weak strategy can still improve their situation by playing that ineffective strategy. A Nash equilibrium should not be confused with a solution to a game.
Instead, it is best understood as one possible outcome of play when players interact with all the possible strategies open to them.
Collusion
The most apparent application of game theory in economics is the examination of collusion. It is also one of the most complicated and poorly understood, particularly when a cartel or oligopoly is involved. In these cases, people will often find themselves in what's called a Prisoner's Dilemma.
If two people try to get each other to reduce prices, they may feel tempted to defect against the other.
However, if they both agree not to act this way and instead cooperate to lower prices, they're more likely going to be able to cooperate and enjoy lower prices.
Where Can I Study Game Theory Online?
Some online game theory courses that might be relevant to economics are algorithmic games, coalition formation, bargaining, and persuasion. Some areas of study in economics where game theory is applied include environmental science, international trade, and labor markets.
Game theory courses can teach people how to apply concepts such as incentives, negotiation strategies, and coordination tactics.
Students who take these courses will learn how games can be analyzed mathematically using different tools such as Nash equilibrium, the minimax theorem, or the folk theorem. These tools will help them determine what their opponents may do next.
Price Comparison Of Online Game Theory Courses
Here is the price comparison of some popular online game theory courses;
| Course | Price |
|---|---|
| Games People Play: Thinking Strategically With Game Theory | $84.99 |
| Game Theory: How Co-operation And Competition Works | $13.99 |
| Hands-On Microeconomics: A Primer In Game Theory | $44.99 |
| Game Theory - Operations Research | $19.99 |
| Game Theory In Operations Research And Decision Making | $39.99 |
| Game Theory And Its Applications | $19.99 |
| The Game Theory - John Nash | $24.99 |
Want To Learn More About Game Theory With Superprof?
Game theory is applied extensively in economics because economists want to know what decisions agents take when they can't communicate with each other or otherwise know the state of each other's minds.
Superprof is a platform that offers more than just game theory courses. The tutors have a wealth of knowledge of game theory and its various elements that they are willing to share via online classes and private lessons.
Superprof offers game theory courses, ideal for those who want to explore this field more deeply. You will learn how to apply the concepts in specific cases and answer some interesting questions. The course includes many exercises and simulations that will allow you to put your knowledge into practice effectively.
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