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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Game theory doesn't only apply to competitors making strategic decisions. Think about other stakeholders that may be caught in a situation like the prisoner's dilemma. A famous example is in the union/workforce versus management tension. Oftentimes, during a strike, each side is focused on what the other side might do, and both sides need to base their actions on some degree of unknown information.
In the NFL strike situations, the NFL players' union was pitted against the owners of the team. The players wanted more money and the salary cap lifted, and the owners wanted their own share of TV money. The NFL players knew if they didn't play, they didn't get paid. But, they also knew it was the same for the owners - if the players didn't play, the owners didn't get paid, or at least, they didn't get the TV money. So, the players said they would strike unless their demands were met.
Well, what should the owners do? They can give in to the players' demands, but that would cost them money. But if the players really don't play, the owners will lose money anyway. Then again, the owners think, if they give in to the strike threats now, what's to stop the players from striking again in another year? These situations are always very tense, and very sensitive, and everything that happens is ultimately a signal to both sides of intentions, possibilities, and priorities.
Since we are reviewing the summary of the lesson, you may feel like we missed something - specifically, what's the answer? What's the answer to the prisoner's dilemma? There is no answer. That's the dilemma. The entire concept of game theory is that strategic decision making between stakeholders - either competitors, employers/employees, or customers and producers - is based on one side needing to make decisions with incomplete information and that decision then becoming a signal to the other side. It's a fascinating phenomenon to observe and a critical, fundamental part of macroeconomic theory.
This video lesson on game theory can prepare you to realize these goals:
Explain what the prisoner's dilemma is and understand the issues surrounding it
Outline the concept of game theory and provide a real-life example
Discuss game theory as it relates to a negotiation scenario
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