Economics & Essential Skills
Popularized by movies such as "A Beautiful Mind", game theory is the mathematical modeling of strategic interaction among rational (and irrational) agents. Beyond what we call 'games' in common language, such as chess, poker, soccer, etc., it includes the modeling of conflict among nations, political campaigns, competition among firms, and trading behavior in markets such as the NYSE. That's where this class comes in...
If you haven't watched the movie "A Beautiful Mind", you should. It is about John Nash (played by Russell Crowe) who won the Nobel Prize in economics for his foundational contributions to game theory. Nash put some structure around how players in a "game" can optimize their outcomes (if the movie is to be fully believed, this insight struck him when he realized that if all his friends hit on the most pretty girl, he should hit on the second-most pretty one--you saw the clip in class). In this tutorial, we use the classic "prisoner's dilemma" to highlight this concept.
Game theory is mainly concerned with predicting the outcome of games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete information about the others' intentions. It's a way to divine the future--or, at least, companies that spend a bunch of money on research employing game theory hope to be able to predict the future.
Game theory analysis has direct relevance to the study of the conduct and behavior of firms in oligopolistic markets – for example the decisions that firms must take over pricing and levels of production, and also how much money to invest in research and development spending.
Costly research projects represent a risk for any business – but if one firm invests in R&D, can a rival firm decide not to follow? They might lose the competitive edge in the market and suffer a long term decline in market share and profitability.
The dominant strategy for both firms is probably to go ahead with R&D spending. If they do not and the other firm does, then their profits fall and they lose market share. However, there are only a limited number of patents available to be won and if all of the leading firms in a market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one firm opts to proceed.
The Prisoners’ Dilemma
Did you know?
Game Theory remains at the cutting edge of economic theory, with game theorists winning the Noble Prize in Economics in 1994, 1996, 2005, 2007 and 2012. For his path-breaking dissertation that revolutionized economics and many other disciplines, John Nash won the Nobel in 1994, along with game theorists John Harsanyi and Reinhard Selten.
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