Game theory is the study of how people or companies make decisions when the outcome depends on the actions of others. It focuses on strategic thinking where every player must predict what someone else will do.
Key concepts:
- Players: The individuals or companies making the decisions.
- Strategies: The different choices or actions available to a player.
- Payoffs: The results of those choices, such as profit or personal benefit.
- Nash equilibrium: A situation where no player can gain an advantage by changing their strategy alone.
Game theory in business (oligopoly):
- Companies are interdependent, meaning one firm’s success depends on what its competitors do.
- This creates strategic behavior and uncertainty in the market.
Classic examples:
- Prisoner’s dilemma: A situation where two players may not cooperate, even when it would be better for both if they did.
- Dominant strategy: The best choice for a player, no matter what the other players decide to do.
- Tit-for-tat: A strategy where you begin by cooperating and then copy whatever the opponent did in the previous turn.
Why it is useful:
- It helps explain how companies set prices in competitive markets.
- It predicts the results of interactions between competitors.
- It is used to analyze when businesses might work together (collusion) or compete aggressively.