THE GAME

THEORY IN
ECONOMICS
 What is Game
Theory?

Game theory is a mathematical framework used to analyze situations in

which the outcome depends on the actions of multiple decision makers or
players. In economics, it helps to understand and predict behavior in
competitive or cooperative situations, such as market competition or
negotiations. Game theory assumes that all players are rational and will
make decisions that maximize their own benefit, considering the potential
actions of others. By studying these interactions, game theory provides
valuable insights into strategy formation and decision making processes,
which can be applied to a wide variety of economic scenarios like auctions,
pricing, or public goods allocation.
 Players
Key Terms in These refer to the decision makers
01 involved, which could be individuals,
companies, or even government.
Game Theory
Strategies
Each player has a set of strategies
which are the possible choices they
can make.
02

Payoff
It is the result of a particular combination
of strategies chosen by the players, which
03 could be a monetary reward, a
competitive advantage or some other
benefit.

Nash Equilibrium
This concept is central to the game theory and
refers to a situation where no player can
improve their outcome by changing their
strategy, assuming other players keep their
04
strategies unchanged.
 Cooperative games
Players form binding agreements or coalitions.

Simultaneous games Non cooperative games

Players make decision at the same time. Players act independently to maximize their
own profit, without collaboration.

Types of Games

Sequential games Zero sum games

One player’s decision comes after another. One player’s gain is exactly balanced by
another player’s loss.

Non zero sum games

All players can benefit or suffer together.
 Example : The Prisoner’s
Dilemma

The prisoner’s dilemma is one of the most famous examples in game theory. Two individuals are
arrested and offered a deal : if both stay silent, they get a light sentence, but if one betrays the
other while the other remain silent, the betrayer goes free, and the other gets a heavy sentence. If
both betray each other, both receive moderate sentences. The Nash Equilibrium in this case is that
both players betray each other, even though they would both be better off if they cooperated and
stayed silent. This illustrates the conflict between individual rationality and collective benefit, a core
concept in game theory.
 Simple Game Theory in Action

A simple example of game theory can be seen in business competition. Imagine two companies A and B , deciding
whether to lower their prices to attract more customers.

If both companies lower their However, if one lowers prices while

If neither lowers prices, they both
prices, they end up in a price war, the other doesn’t , the lower priced
maintain healthy profits.
losing profits. company will attract more
customers.

In this scenario, both companies are likely to lower prices, even though neither would benefit from doing so. This
outcome is an example of a Nash Equilibrium, where both players make decisions that aren’t optimal for either.
 Application in
Economics

One common application is in Game theory also applies to Additionally, game theory is used to
oligopolies, where a small number auctions, where bidders must analyze public goods and
of firms dominate a market. In these decide how much to bid, externalities, helping to understand
market, each firm must consider the considering the strategies of how individuals or companies
reactions of its competitors when others. decide to contribute to public
setting prices or output levels. goods like clean air or public
Game theory helps explain how infrastructure.
firms in oligopolies often avoid price
wars and settle on mutually
beneficial strategies.
Real World Example : Pricing in Oligopoly

A real world example of game theory can be seen in the airline industry, which is
often considered an oligopoly. In this market , a small number of airlines compete
for customers, and each airline must consider how its competitors will respond to
pricing changes. For example, if one airline lowers its ticket prices, it may attract
more customers, but the other airlines are likely to follow suit to avoid losing
market share. In this situation, all airlines may end up lowering prices, which
benefits customers but harms the airline’s profitability. This demonstrates the
concept of a nash equilibrium in oligopolistic competition, where firms end up in a
suboptimal pricing situation due to the competitive dynamics.
 Conclusion

Game theory provides a powerful framework for understanding strategic decision making in economics. It explains
how individuals and firms make choices when their outcomes depend not just on their own actions, but on the
actions of others as well. Whether in market competition, negotiations, or public policy, game theory can predict
behavior and help guide more informal decisions. Key concepts like nash equilibrium show that players often end
up in situations that are not necessarily the best for everyone involved, but where no one can improve their
situation by changing their own strategy. By understanding these dynamics, we can better navigate competitive
and cooperative environments.