What is Game Theory? - Explanation & Application in Economics

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  • 0:11 The Prisoner's Dilemma
  • 2:48 Game Theory in Real Life
  • 3:36 Game Theory Between…
  • 5:09 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.

Economics is just as much about consumer and producer behavior as it is about finance or the allocation of resources. With that in mind, this lesson will explain one of the most fundamental tools economists use to frame competitive decision making.

The Prisoner's Dilemma

Before we discuss game theory, let's talk about a very popular example of this idea. This example will give us something to refer back to as we learn why game theory is so important to economics. Here is our example.

Two small-time criminals are out breaking into cars, stealing what they can. They are working together in the same area of town. Fortunately, they get caught and booked down at the station. The detective goes in to question them separately and offers them both the same deal: they can either confess or stay silent. Their punishment will be determined by what action they take and what action the other perp takes. Here's what could happen:

a) If both perps confess, they each get 3 years.

b) If both perps stay silent, they each get 1 year.

c) If perp #1 stays silent and perp #2 confesses, perp #2 serves NO time and perp #1 serves 10 years.

d) If perp #2 stays silent and perp #1 confesses, perp #1 serves NO time and perp #2 serves 10 years.

So, if you were perp #1, what would you do? You could stay quiet and count on only getting one year, hoping that your friend stays quiet as well, and you'll both only serve 1 year. But, what if you admit to being involved and they admit being involved as well, then you'll both get 3 years. Or, what if you stay silent but your friend admits? Then you'll get 10 years; that wouldn't be good! So maybe you should just come clean and admit your involvement. Confessing seems like the best deal, right? Well, it is if your friend stays quiet.

The lesson to be learned from the prisoner's dilemma described above is how difficult it is to make an optimal decision when two competitors - and that's what these two perps are right now - can't collaborate. Typically, the economic man (or woman) is someone who makes decisions based on their own self-interest and chooses that which maximizes their own benefits.

The entire idea behind game theory is that the result of your decision isn't known to you until you find out what your friend (or competitor) is going to do, so you have to make the best decision you can based on the information you have.

Game Theory in Real Life

Okay, so we know how game theory works in a fictional situation that would never really happen, but what about how game theory applies to real life? Well, we can talk about that, too.

Think about any strategic decision a business might make. The success or failure of that decision may very well depend on how the competition reacts. Perhaps a fast food restaurant wants to build a new location on the corner of a popular intersection. They complete their analysis of traffic flow, demand, other options in the area, etc., and ultimately decide it's a good idea. Then, once construction begins, another restaurant opens up a new location across the street, with a new building plan that includes drive-through ordering. What does our first restaurant do now?

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