Game theory – definition

Game theory was first applied to economics by Hungarian born mathematician and economist John von Neumann (1903-1957).

His most notable contributions were made while at Princeton University, where he collaborated with Oskar Morgenstern to co-author the hugely influential and ground-breaking Theory of Games and Economic Behavior (1944) Princeton University Press.

In short, game theory is the study of how individuals (or organisations) apply strategy to achieve an outcome which is to their benefit – namely, a pay-off.

Players, pay-offs and strategies

Games have three essential components – players, pay-offs (such as win, lose, draw), and strategies. Game theory has been applied to economic transactions precisely because economic transactions contain all three components – players, including consumers and producers, pay-offs, such as gaining more utility (in the case of consumers) or gaining more profit, more market share or reducing the risk of a loss (in the case of firms), and strategies, such as predicting how consumers or other firms will react to decisions taken by firms.

Maximax and maximin strategies

Interdependence and uncertainty

When applied to business economics, game theory attempts to explain the behaviour of interdependent firms operating under conditions of uncertainty. One particular application to business economics involves understanding how and why decisions are made by oligopolists in pursuit of their objectives – such as whether to compete or collude, or raise price or lower price.

Game theory can also be used by regulators to help decide whether to regulate, and to assess the likely effect of fines or penalties on the behaviour of firms.