11/24/24, 6:19 AM Game Theory: A Comprehensive Guide

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ECONOMICS BEHAVIORAL ECONOMICS

Game Theory: A Comprehensive Guide

By ADAM HAYES Updated June 27, 2024

Reviewed by ROBERT C. KELLY

Fact checked by DAVID RUBIN

Investopedia / Katie Kerpel

What Is Game Theory?

Game theory is the study of how and why individuals and entities (called
players) make decisions about their situations. It is a theoretical framework for
conceiving social scenarios among competing players.

In some respects, game theory is the science of strategy, or at least of the

optimal decision-making of independent and competing actors in a strategic
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Game theory is used in a variety of fields to lay out various situations and
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predict their most likely outcomes. Businesses may use it, for example, to set
prices, decide whether to acquire another firm, and determine how to handle a
lawsuit.

KEY TAKEAWAYS
Game theory is the study of how and why players make decisions
about their circumstances.
The intention of game theory is to produce optimal decision-making of
independent and competing actors in a strategic setting.
Using game theory, real-world scenarios for such situations as pricing
competition and product releases (and many more) can be laid out and
their outcomes predicted.
Scenarios include the prisoner's dilemma and the dictator game
among many others.
Different types of game theory include cooperative/non-cooperative,
zero-sum/non-zero-sum, and simultaneous/sequential.

Game Theory
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How Game Theory Works

The goal of game theory is to explain the strategic actions of two or more
players in a given situation with set rules and outcomes. Any time a situation
with two or more players involves known payouts or quantifiable
consequences, we can use game theory to help determine the most likely
outcomes.

The focus of game theory is the game, which is an interactive situation that
involves 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, 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.

Important: According to game theory, the actions and choices of all

the participants affect the outcome of each. It's assumed players
within the game are rational and will strive to maximize their payoffs
in the game. [ 1 ]

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Useful Terms in Game Theory

Here are a few terms commonly used in theJobs
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Game: Any set of circumstances that has a result dependent on the actions
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of two or more decision-makers (players).
Players: A strategic decision-maker within the context of the game.
Strategy: A complete plan of action a player will take given the set of
circumstances that might arise within the game.
Payoff: The payout a player receives from arriving at a particular outcome.
The payout can be in any quantifiable form, from dollars to utility.
Information set: The information available at a given point in the game. The
term "information set" is most usually applied when the game has a
sequential component.
Equilibrium: The point in a game where both players have made their
decisions and an outcome is reached.

FAST FACT
The key pioneers of game theory were mathematician John von
Neumann and economist Oskar Morgenstern in the 1940s. [ 2 ]
Mathematician John Nash is regarded by many as providing the first
significant extension of the von Neumann and Morgenstern work. [ 3 ]

The Nash Equilibrium

Nash equilibrium is an outcome reached that, once achieved, means no player
can increase payoff by changing decisions unilaterally. [ 3 ] It can also be thought
of as a "no regrets" outcome in the sense that once a decision is made, the
player will have no regrets about it, considering the consequences.

The Nash equilibrium is reached over time, normally. However, once the Nash
equilibrium is reached, it will not be deviated from. In such a case, consider how
a unilateral move would affect the situation. Does it make any sense? It
shouldn't, and that's why the Nash equilibrium outcome is described as "no
regrets." [ 4 ]

Generally, there can be more than one equilibrium in a game. However, this
usually occurs in games with more complex elements than two choices by two
players. In simultaneous games that are repeated over
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multiple equilibria is reached after some trial and error.

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This scenario of different choices over time before reaching equilibrium is most
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often played out in the business world when two firms are determining prices
for highly interchangeable products, such as airfare or soft drinks.

Impact of Game Theory

Game theory is present in almost every industry or field of research. Its
expansive theory can pertain to many situations, making it a versatile and
important theory. Here are several fields of study directly impacted by game
theory.

Economics
Game theory brought about a revolution in economics by addressing crucial
problems in prior mathematical economic models. For instance, neoclassical
economics struggled to explain entrepreneurial anticipation and could not
handle the imperfect competition. Game theory turned attention away from
steady-state equilibrium toward the market process.

Economists often use game theory to explain oligopoly firm behavior. It helps to
predict likely outcomes when firms engage in certain behaviors, such as price-
fixing and collusion. [ 5 ]

Business
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 and develop new ones or
employ new marketing strategies.

Businesses can often choose their opponent as well. Some focus on external
forces and compete against other market participants. Others set internal goals
and strive to be better than their previous versions.

Whether external or internal, companies are always competing for resources,

attempting to hire the best candidates away from rivals, and dissuade
customers from choosing competing goods. This ad will end in 15

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Game theory in business may most resemble a game tree, as shown below. A
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company may start in position one and must decide on two outcomes.
However, there are continually other decisions to be made; the final payoff
amount is not known until the final decision has been processed. [ 1 ]

Example of Game Tree.

Internet Encyclopedia of Philosophy

Project Management
Project management involves social aspects of game theory, as different
participants may have different influences. For example, a project manager may
be motivated to successfully complete a building development project.
Meanwhile, the construction worker may be motivated to work slower for safety
or to delay the project to add more billable hours.

When dealing with an internal team, game theory may be less prevalent as all
participants working for the same employer often have a greater shared interest
for success. However, third-party consultants or external parties assisting with a
project may be motivated by other factors separate from the project's success.

Consumer Product Pricing

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The strategy of Black Friday shopping is at the heart of game theory. The
concept holds that should companies reduce prices, more consumers will buy
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more goods. The relationship between a consumer, a good, and the financial
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11/24/24, 6:19 AM Game Theory: A Comprehensive Guide

exchange that transfers ownership plays a major part in game theory, as each
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consumer has a different set of expectations.

Other than sweeping sales in advance of the holiday season, companies must
utilize game theory when pricing products for launch or in anticipation of
competition from rival goods. A balance must be found. Price a good too low
and it won't reap profit. Price a good too high and it might push customers
toward a substitute.

Types of Game Theory

Cooperative vs. Non-Cooperative Games
Although there are many types of game theory, such as symmetric/asymmetric,
simultaneous/sequential, and so on, cooperative and non-cooperative 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.

Non-cooperative game theory deals with how rational economic agents deal
with each other to achieve their own goals. The most common non-cooperative
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 non-cooperative game is rock-paper-scissors. [ 6 ]

Zero-Sum vs. Non-Zero-Sum Games

When there is a direct conflict between multiple parties striving for the same
outcome, it is often called a zero-sum game. This means that for every winner,
there is a loser. Alternatively, it means that the collective net benefit received is
equal to the collective net benefit lost. Lots of sporting events are a zero-sum
game as one team wins and another team loses.

A non-zero-sum game is one in which all participants can win or lose at the
same time. Consider business partnerships that Thisare mutually
ad will end in 15 beneficial and

foster value for both entities. Instead of competing and attempting to win at the
expense of the other, both parties14benefit.
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Investing and trading stocks is sometimes considered a zero-sum game. After

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all, one market participant buys a stock and another participant sells that same
stock for the same price. However, because different investors have different
risk appetites and investing goals, it may be mutually beneficial for both parties
to transact.

Simultaneous Move vs. Sequential Move Games

Simultaneous move situations, which occur frequently in life, mean each
participant must continually make decisions at the same time that their
opponent is making decisions. As companies devise their marketing, product
development, and operational plans, competing companies are doing the same
thing at the same time.

In some cases, there is an intentional staggering of decision-making steps,

enabling one party to see the other party's moves before making their own. This
is usually present in negotiations; one party lists their demands, then the other
party has a designated amount of time to respond and list their own.

One Shot vs. Repeated Games

Game theory can begin and end in a single instance. Like much of life, the
underlying competition starts, progresses, ends, and cannot be redone. This is
often the case with equity traders, who must wisely choose their entry point
and exit point, as their decision may not easily be undone or retried.

On the other hand, some repeated games continue on and seemingly never
end. These types of games often contain the same participants each time, and
each party has the knowledge of what occurred previously.

For example, consider rival companies trying to price their goods. Whenever
one makes a price adjustment, so may the other. This circular competition
repeats itself across product cycles or sale seasonality.

In the example below, a depiction of the Prisoner's Dilemma (discussed in the

next section) is shown. In this depiction, after the first iteration occurs, there is
no payoff. Instead, a second iteration of the game occurs,
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Example of Repeated Game.

Internet Encyclopedia of Philosophy

Examples of Game Theory

There are several games, or situations, that game theory analyzes. Here are a
few:

The Prisoner's Dilemma

The 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 the
other. Officials present four deals, often displayed as a 2 x 2 box.

1. If both confess, they will each receive a three-year prison sentence.

2. If Prisoner 1 confesses, but Prisoner 2 does not, Prisoner 1 will get one year
and Prisoner 2 will get five years.
3. If Prisoner 2 confesses, but Prisoner 1 does not, Prisoner 1 will get five years,
and Prisoner 2 will get one year. This ad will end in 15

4. If neither confesses, each will serve two years in prison.

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The most favorable strategy is to not confess. However, neither is aware of the
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other's strategy and, without certainty that one will not confess, both will likely
confess and receive a three-year prison sentence. The Nash equilibrium
suggests that in a prisoner's dilemma, both players will make the move that is
best for them individually but worse for them collectively. [ 7 ]

"Tit for tat" is said to be the optimal strategy in a prisoner's dilemma. Tit for tat
was introduced by Anatol Rapoport, who developed a strategy in which each
participant in an iterated prisoner's dilemma follows a course of action
consistent with their opponent's previous turn. For example, if provoked, a
player subsequently responds with retaliation; if unprovoked, the player
cooperates. [ 8 ] [ 9 ]

The image below depicts the dilemma where the choice of the participant in the
column and the choice of the participant in the row may clash. For example,
both parties may receive the most favorable outcome if both choose
row/column 1. However, each faces the risk of strong adverse outcomes should
the other party not choose the same outcome.

Example of Static Two-Person Game.

Internet Encyclopedia of Philosophy

Dictator Game
This is a simple game in which Player A must decide how to split a cash prize
with Player B, who has no input into Player A’s decision. While this is not a game
theory strategy per se, it does provide some interesting insights into people’s
behavior. Experiments reveal about 50% keep all the money to themselves, 5%
split it equally, and the other 45% give the other participant a smaller share. [ 10 ]

The dictator game is closely related to the ultimatum game, in which Player A is
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given a set amount of money, part of which has to be given to Player B, who can
accept or reject the amount given.14The catch
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amount offered, both A and B get nothing. The dictator and ultimatum games
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hold important lessons for charitable giving and philanthropy. [ 11 ]

Volunteer’s Dilemma
In a volunteer’s dilemma, someone has to undertake a chore or job for the
common good. The worst possible outcome is realized if nobody volunteers.
[ ]
12 For example, consider a company in which accounting fraud is rampant,
though top management is unaware of it.

Some junior employees in the accounting department are aware of the fraud
but hesitate to tell top management because it would result in the employees
involved in the fraud being fired and most likely prosecuted.

Being labeled as a whistleblower may also have some repercussions down the
line. But if nobody volunteers, the large-scale fraud may result in the company’s
eventual bankruptcy and the loss of everyone’s jobs.

The Centipede Game

The centipede game is an extensive-form game in which two players alternately
get a chance to take the larger share of a slowly increasing money stash. It is
arranged so that if a player passes the stash to their opponent who then takes
it, the player receives a smaller amount than if they had taken the pot.

The centipede game concludes as soon as a player takes the stash, with that
player getting the larger portion and the other player getting the smaller
portion. The game has a pre-defined total number of rounds, which are known
to each player in advance. [ 13 ]

Tip: Game theory exists in almost every facet of life. Because the
decisions of other people around you impact your day, game theory
pertains to personal relationships, shopping habits, media intake,
and hobbies.

Types of Game Theory Strategies This ad will end in 15

Game theory participants can decide between a few primary ways to play their
game. In general, each participant14must decide
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willing to take and how far they are willing to go to pursue the best possible
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outcome.

Maximax Strategy
A maximax strategy involves no hedging. The participant is either all in or all
out; they'll either win big or face the worst consequence. Consider a new start-
up company introducing new products to the market.

Its new products may result in the company's market cap increasing fifty-fold.
On the other hand, a failed product launch will leave the company bankrupt.
The participant is willing to take a chance on achieving the best outcome even if
the worst outcome is possible.

Maximin Strategy
A maximin strategy in game theory results in the participant choosing the best
of the worst payoff. The participant has decided to hedge risk and sacrifice full
benefit in exchange for avoiding the worst outcome.

Often, companies face and accept this strategy when considering lawsuits. By
settling out of court and avoiding a public trial, companies agree to an adverse
outcome. However, that outcome could have been worse if the case had gone
to trial.

Dominant Strategy
In a dominant strategy, a participant performs actions that are the best
outcome for the play, irrespective of what other participants decide to do. In
business, this may be a situation where a company decides to scale and expand
to a new market, regardless of whether a competing company has decided to
move into the market as well. In Prisoner's Dilemma, the dominant strategy
would be to confess.

Pure Strategy
Pure strategy entails the least amount of strategic decision-making, as pure
strategy is simply a defined choice that is made regardless of external forces or
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actions of others.

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Consider a game of rock-paper-scissors in which one participant decides to

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throw the same shape with each trial. As the outcome for this participant is
well-defined in advance (outcomes are either a specific shape or not that
specific shape), the strategy is defined as pure.

Mixed Strategy
A mixed strategy may seem like random chance, but there is much thought that
must go into devising a plan of mixing elements or actions.

Consider the relationship between a baseball pitcher and batter. The pitcher
cannot throw the same pitch each time. Otherwise, the batter could predict
what would come next. Instead, the pitcher must mix their strategy from pitch
to pitch to create a sense of unpredictability that they hope to benefit from.

Limitations of Game Theory

The biggest issue with game theory is that, like most other economic models, it
relies on the assumption that people are rational actors who are self-interested
and utility-maximizing. Of course, we are social beings who do cooperate often
at our own expense.

Game theory cannot account for the fact that in some situations we may fall
into a Nash equilibrium, and other times not, depending on the social context
and who the players are.

In addition, game theory often struggles to factor in human elements such as

loyalty, honesty, or empathy. Though statistical and mathematical
computations can dictate what a best course of action should be, humans may
not take this course due to incalculable and complex scenarios of self-sacrifice
or manipulation.

Game theory may analyze a set of behaviors but it cannot truly forecast the
human element.

What Are the Games Being Played in Game Theory?

Game theory tries to explain the strategic actions ofwill
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given situation with set rules and outcomes. While used in several disciplines,
game theory is most notably used14inLow-Stress
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11/24/24, 6:19 AM Game Theory: A Comprehensive Guide

The games may involve how two competitor firms will react to price cuts by the
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other, whether a firm should acquire another, or how traders in a stock market
may react to price changes. In theoretic terms, these games may be categorized
as prisoner's dilemmas, the dictator game, the hawk-and-dove, and Bach or
Stravinsky.
What Are Some of the Assumptions About These Games?
Like many economic models, game theory contains a set of strict assumptions
that must hold for the theory to make good predictions in practice. First, all
players are utility-maximizing rational actors that have full information about
the game, the rules, and the consequences. Players are not allowed to
communicate or interact with one another. Possible outcomes are not only
known in advance but also cannot be changed. The number of players in a
game can theoretically be infinite, but most games will involve only two
players.

What Is a Nash Equilibrium?

The Nash equilibrium is an important concept referring to a stable state in a
game where no player can gain an advantage by unilaterally changing a
strategy, assuming the other participants also do not change their strategies.
The Nash equilibrium provides the solution concept in a non-cooperative
(adversarial) game. It is named after John Nash, who received the Nobel Prize in
1994 for his work. [ 14 ]

Who Came Up With Game Theory?

Game theory is largely attributed to the work in the 1940s of mathematician
John von Neumann and economist Oskar Morgenstern. It was developed
extensively by many other researchers and scholars in the 1950s. [ 2 ] It remains
an area of active research and applied science to this day.

The Bottom Line

Game theory is the study of how competitive strategies and participant actions
can influence the outcome of a situation. It's relevant to war, biology, and many
other facets of life. Game theory is used in business to represent strategic
interactions in which the outcome for one company or product depends on
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