The Importance of Game Theory

November 21, 2017 Psychology

Consider this scenario: two criminals were arrested and put in separate rooms to be interrogated. The police do not actually have enough evidence to convict the two, so they try to make at least one of them confess. The police gave them each of them a deal: if one of them confesses and the other remains silent, the confessor will be free while the criminal who refused to talk will be sentenced for 10 years. If they both confess they will both go to Jail for 5 years.

However, if both remain silent, they will only be sentenced for 1 year. Which situation would the criminals fall under? The answer to this problem (assuming that both will act in their best interest) will always be that both criminals will confess. This scenario is known as the “Prisoner’s Dilemma”, which is an example of a game theory. What is game theory? Game theory is defined as “the analysis of strategies in competitive situations where the outcome of a participant’s choice of action depends critically on the actions of the other participants”.

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Game theory mainly involves mathematics, psychology, economics, philosophy, and other academic areas. Despite its academic level, what exactly makes game theory useful and applicable to the world today? Game theory is actually a useful tool to the world today. It is even called as such because it is for analyzing games, which are competitive situations. A main use for game theory is in the field of business. It helps people to decide if it is a good idea to open a new store in a given location, if they should cut down their prices, etc. The

Prisoner’s Dilemma can actually be related to oligopoly, a market structure wherein a particular market is dominated by a small group of firms. Because there are only few producers, their actions will impact price and competitors. The prisoner’s dilemma can be applied, for example, when firms can choose between introducing a lower price schedule or following the basic pricing structure agreed upon by the other firms. Usually, both parties will try to “win” and act in their own best interest, which usually does not provide the optimal result.

Game theory works the opposite way: it is about rationalizing each situation or putting one’s self in someone else’s shoes. Game theory is useful because it helps people figure out the best strategy in a given situation. It helps clients predict and shape competitive dynamics whenever there are new major strategies implemented. Another way to use game theory is when buying stocks. To make profits in the market, people use risk arbitrage. They will simultaneously purchase stock in a company that has announced it will be acquired long with the sale of the company that has announced the acquisition.

Game theory can also be applied to salary negotiations, car deals, and mostly everything that involves numerous parties. Aside from the Prisoner’s Dilemma, there are many game theory scenarios that provide the base for rational decision-making. There is the Nash Equilibrium, the Traveler’s Dilemma, or the Centipede Game.

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