The Social Science Encyclopedia, Second Edition
game theory, economic applications
Game theory is concerned with situations in which several decision makers interact, in the sense that the degree of satisfaction achieved by any one of them depends not only on his or her choices but also on the choices made by all the other players. Situations of this type are referred to as ‘games’. Game theory tries to define what would be rational in the context of such a game, and it tries to predict the actual behaviour of the players.
Games are pervasive in economic life. Examples of economic games are the interaction among employees within a firm, the rivalry among firms operating in the same market, the negotiations between a firm and its suppliers, and the economic policy-making of governments in interdependent economies. The inventors of game theory recognized early that it was applicable to economics, but it was only in the 1980s that game theory became widely used in the field. It is now one of the most frequently used research tools in economics.
Game theory is divided into co-operative and non-cooperative branches, the distinction being that co-operative game theory assumes that decision makers can enter into binding agreements about their strategies, whereas non-cooperative game theory assumes that no such agreements can be made. Initially, it was mainly co-operative game theory that attracted the attention of economists, but non-cooperative game theory has become more important.
To see how game theory can be applied in economics, consider as an example the situation where different firms, competing in the same market, must make decisions about the choice of products, the prices to charge buyers, the extent of advertising, etc. Can firms be induced through competition to make choices that serve the interests of buyers even if this is at the expense of profits? Game theoretic analysis predicts that small groups of firms operating in transparent environments can maintain high profits and evade the forces of competition even if no binding, collusive agreements are permitted. Typically, the firms involved will develop accepted norms of behaviour, with the implicit threat that deviants will be punished through aggressive competitive behaviour. Such punishments are easier to implement in more transparent markets, which suggests that the transparency of markets may not be socially desirable.
Often the terms of economic transactions are not determined through market competition but are an outcome of bilateral bargaining: for example, wages which are negotiated between trade unions and employers’ organizations. In this context, game theory has illuminated the precise way in which factors like patience or the willingness to take risks contribute to the success of a negotiator. Negotiators may be advantaged if they can create the impression that they have an alternative option, excluding the other party, should negotiations fail. This threat may not work, however, if it can be shown to lack credibility, for example because such an option would be less desirable than any outcome of the negotiations that could reasonably be anticipated. Game theory has clarified the distinction between credible and empty threats in bargaining.
Other examples of economic applications of game theory range from the analysis of the internal structure of firms to theories of economic policy-making in an international context. One of the major fields of application concerns games in which some participants lack important pieces of information. Beginning in the 1970s, economics has become increasingly concerned with the question of information, and a field known as ‘economics of information’ has developed, which, for example, studies markets in which goods come in different qualities, and in which buyers cannot observe quality before buying. This may drive high-quality products out of the market, or it may force the suppliers of such goods to make special efforts to distinguish themselves from other suppliers. Game theory has had limited success resolving the problems raised by the economics of information, since the predictions that emerged from its application were not adequately specific. Whether this difficulty can be resolved, perhaps by refining the notions of game theory, is the subject of ongoing research.
Tilman Börgers
University College London
Further reading
Bierman, H.S. and Fernandez, L. (1993) Game Theory with Economic Applications, Reading, MA.
Dixit, A. and Nelbuff, B. (1991) Thinking Strategically, New York.
Gibbons, R. (1992) A Primer in Game Theory, New York.
Rasumusen, E. (1989) Games and Information, Oxford.
See also: game theory; prisoners’ dilemma; rational expectations.
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