Sometime back when I was reading a book on economics, I came across the term "Game Theory". This term has always fascinated me and always reminds me of the movie 'The Beautiful Mind'. I have always wanted to know what this theory is but never had the patience to go into the depth.
This theory was first put forward by Cournet in 1837. After that many others have put it forward, most important ones being Von Neumann and John Nash. It is a branch of applied mathematics which is used to examine strategic behaviour of a human being, in which his decision to make a choice depends on what the other one chooses.
In any game all the players try to maximise their gain by choosing a particular course of action, and each players gain depends on what course of action other players have taken. In any game one person's gain leads to other person's loss and it is assumed that each player is rational enough to calculate all the moves of the opponent. Under this situation, all the players stick to a particular strategy and this profile of strategies is said to be in equilibrium. The profile of strategies is said to be in equilibrium when no player can gain more by switching to some other strategy unilaterally.
Prisoner's Dilemma example
Two suspects in a crime are put into separate cells. If they both confess, each will be sentenced to three years. If only one of them confesses, he will be set free and used as a witness against the other, who will receive a sentence of ten years. If neither confesses, they will both convicted and will have to spend just a year in prison. Now, each prisoner has two options, either to betray the other one by confessing, or remain silent. Neither of them, however, knows for sure what the other one would do. In this case both will want to take the best decision but their decision depends on what the other one does.
The solution for both of them is to take the best course of action, given the action taken by the other one. So both the prisoners decide to confess. If first prisoner remains silent, best option for the second one is to confess and go free. If first one confesses, best option for the second one is to confess and get three years of imprisonment instead of ten. Same is the case for the first prisoner. So they both confess.
A example from Economics
This game theory has wide spread application in economics. One such example is its application in a Oligopolistic market. In a oligopoly there are small number of sellers and there is interdependence among the competitor. In this decision made by one firm affects the demand, price and profit of other firms. Auto industry is one such example. In any market the price of a good is inversely proportional to the quantity supplied. So in a oligopoly the firms can decide amongst themselves to produce restricted amount of good to earn greater profit. By doing this the firms can create the situation of a monopoly market. Such a agreement is called a collusion in which firms decide not compete, particularly price competition. But such a situation is rarely seen because the producers are in a dilemma similar to the prisoners in the above example. They are not sure whether the other producers will stick to the clause or will cheat. If one of the producer cheats, it will increase his profit but will decrease the overall economic profit of the industry. So this will decrease the profit of the producer which honours the agreement. On the other hand if the other one honours the agreement, its better for the producer to cheat to maximise his profit. So in any case the producer is better off cheating. So in a oligopoly these agreements rarely last. So in oligopoly all the firms try to produce try to maximise their profit by producing to the point where price equals marginal cost. This results in price and output approaching that of a perfectly competitive market. So it is very difficult to create a monopoly in a oligopolistic market.
This theory was first put forward by Cournet in 1837. After that many others have put it forward, most important ones being Von Neumann and John Nash. It is a branch of applied mathematics which is used to examine strategic behaviour of a human being, in which his decision to make a choice depends on what the other one chooses.
In any game all the players try to maximise their gain by choosing a particular course of action, and each players gain depends on what course of action other players have taken. In any game one person's gain leads to other person's loss and it is assumed that each player is rational enough to calculate all the moves of the opponent. Under this situation, all the players stick to a particular strategy and this profile of strategies is said to be in equilibrium. The profile of strategies is said to be in equilibrium when no player can gain more by switching to some other strategy unilaterally.
Prisoner's Dilemma example
Two suspects in a crime are put into separate cells. If they both confess, each will be sentenced to three years. If only one of them confesses, he will be set free and used as a witness against the other, who will receive a sentence of ten years. If neither confesses, they will both convicted and will have to spend just a year in prison. Now, each prisoner has two options, either to betray the other one by confessing, or remain silent. Neither of them, however, knows for sure what the other one would do. In this case both will want to take the best decision but their decision depends on what the other one does.
The solution for both of them is to take the best course of action, given the action taken by the other one. So both the prisoners decide to confess. If first prisoner remains silent, best option for the second one is to confess and go free. If first one confesses, best option for the second one is to confess and get three years of imprisonment instead of ten. Same is the case for the first prisoner. So they both confess.
A example from Economics
This game theory has wide spread application in economics. One such example is its application in a Oligopolistic market. In a oligopoly there are small number of sellers and there is interdependence among the competitor. In this decision made by one firm affects the demand, price and profit of other firms. Auto industry is one such example. In any market the price of a good is inversely proportional to the quantity supplied. So in a oligopoly the firms can decide amongst themselves to produce restricted amount of good to earn greater profit. By doing this the firms can create the situation of a monopoly market. Such a agreement is called a collusion in which firms decide not compete, particularly price competition. But such a situation is rarely seen because the producers are in a dilemma similar to the prisoners in the above example. They are not sure whether the other producers will stick to the clause or will cheat. If one of the producer cheats, it will increase his profit but will decrease the overall economic profit of the industry. So this will decrease the profit of the producer which honours the agreement. On the other hand if the other one honours the agreement, its better for the producer to cheat to maximise his profit. So in any case the producer is better off cheating. So in a oligopoly these agreements rarely last. So in oligopoly all the firms try to produce try to maximise their profit by producing to the point where price equals marginal cost. This results in price and output approaching that of a perfectly competitive market. So it is very difficult to create a monopoly in a oligopolistic market.
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