How does game theory work in economics?

Can you explain how game theory is applied in economics?

Sure! Game theory is a mathematical framework used to analyze strategic interactions among rational decision-makers. In economics, it helps to model situations where individuals or firms make decisions that are interdependent, meaning the outcome for each participant depends on the choices of others.

Can you give me an example of game theory in action?

Absolutely! A classic example is the Prisoner's Dilemma, where two criminals are arrested and interrogated separately. If both remain silent, they get a light sentence. If one betrays the other, the betrayer goes free while the other gets a heavy sentence. If both betray each other, they both get moderate sentences. This illustrates how individual rational choices can lead to a worse outcome for both.

How does this relate to competition between companies?

In competitive markets, companies often face similar dilemmas. For instance, if two firms are deciding whether to lower prices, they might both benefit from maintaining higher prices. However, if one lowers prices while the other doesn't, the one that lowers prices could capture a larger market share. This strategic decision-making is where game theory comes into play.

What are some limitations of game theory?

Game theory assumes rational behavior and complete information, which may not always reflect real-world scenarios. Additionally, it can be complex and difficult to apply to situations with many players or where emotions influence decisions.