How Game Theory Informs Economics & Business

by JRO on January 2, 2014

  • SumoMe

The Prisoner’s Dilemma is a hypothetical example where two criminals, arrested for the same crime, are interrogated in separate rooms with no knowledge of each other’s actions. There are essentially four possible scenarios for the criminals, each involving variations of betrayal or keeping quiet.

In one scenario, if both prisoners keep quiet, then they are released. However, if one betrays the other by blaming him, the entirety of the punishment will be doled out to the prisoner who remained quiet (which accounts for two of the scenarios). Lastly, if both betray each other, then they’ll each receive reduced sentences. Since they don’t know what the other is going to do, the best choice for both prisoners is to betray the other. Although on a macro level the best possible outcome would have been for both prisoners to stay quiet, the assumption that each person cares more about their personal freedom than that of their accomplice is made.

The Prisoner’s Dilemma is a very popular example of something called Game Theory. Game Theory, at it’s most basic, is an examination of a relationship between two parties in a particular situation. More specifically, game theory is the “mathematical analysis of strategic thinking.” Economists and business thinkers often use game theory to explain competitive behavior in certain markets and industries.

Game Theory in Economics

The majority of the early study of theoretical economics focused mostly on the two extremes of the economic spectrum: perfect competition and monopoly. Perfect competition is a situation in which many firms are selling fungible (that is, interchangeable) goods to consumers. Firms in perfect competition are “price takers” since the overall market determines the prices of their goods, not any single company. If one firm decides to charge higher prices, customers can purchase the same good from a competitor at a lower price. Thus, any price increase will be met with lost market share and decreased profit for the company that raised its rates.

Monopoly is a situation in which there is only one producer of a certain product or service. That single producer, in essence, IS the market and they can dictate price and supply. Monopolies are characterized by huge barriers of entry, which prevent competitors from entering the market.

Oligopoly and the Power of the Few

In monopoly and perfect competition there is no need for game theory. In monopoly, the one firm doesn’t have to worry about competition; in perfect competition, it is the overall market that sets prices, not any one company. Oligopolies, however, are fertile grounds for the use of game theory. In this market structure it’s imperative for all companies to consider their competition prior to making decisions.

For example, Apple must think hard about pricing for its iPad tablet, considering the competition from Microsoft’s Surface and Google’s Nexus. Though you would still call Apple a “price-maker,” it’s in their interest to anticipate what Google or Microsoft might charge in response. Just like the prisoners, all three companies stand to benefit most from holding their prices high together. However, deliberate “price fixing” is called collusion and it’s illegal in most markets. Thus, with the inability to collude for higher prices, it is in each company’s interest to set prices where margins are good, but where they couldn’t be significantly undercut by their competition.

Due to recent mass conglomeration you could argue that a majority of industries are oligopolies. Within this market structure, companies cannot make decisions in a vacuum. Game theory helps these businesses map anticipated outcomes of various strategies, and assign values to these outcomes.


Jared Madigan writes on accounting, business, economics, finance, banking, investment and other related issues. Jared recommends that curious readers check out the accounting jobs with if they’d like to enter the financial world.

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