Practical Applicability of Game

Theory in Economics in Recent

Times: A Case Study

Submitted By-
Shambhavi Vatsa
Uid- SF0120074
1st Year, 2nd Semester

FACULTY-IN-CHARGE: Ms. Nishibrata Hazarika

DATE OF SUBMISSION: 23-05-2021

Introduction
A theory, in general sense, is a supposition or a system of ideas
intended to explain something, especially one based on general
principles independent of the thing to be explained. 1 It is on the basis
of these principles that an activity can be practised. In economics,
theory can be defined as a simplified representation of how two or more
variables interact with each other.2 It helps in accessing the feasible and
effective solutions for the economic problems and in explaining to a
great extent as to why and how such problems arises in an economy. It
simplifies a complex, real-world issue to its essentials. This is the
reason why the application of economic theories to understand the real-
world issues is at rise. These theories are evolved and developed with
time to keep pace with the changing economy.
There are various theories provided by different theorists, such as the
theory of demand and supply, the theory of labour productivity, Keynes
theory of employment, interest and money, etc., concerning different
economic problems. However, one of the most interesting theory that
also became an interdisciplinary field of research is the ‘Game theory’.
It was published in the year 1944 under the name ‘Theory of Games
and economic behaviour’ by mathematician John von Neumann &
economist Oskar Morgenstern.3 This theory was further provided
extension by John Nash through his ‘two-person game equilibrium’
also called ‘Nash equilibrium’. For their contribution to this economic
theory, they were awarded the ‘The Sveriges Riksbank Prize’ in
Economic Sciences in 1994.4

1
Cambridge Dictionary, https://dictionary.cambridge.org/dictionary/english/theory
2
BCcampus, https://opentextbc.ca/principlesofeconomics/chapter/1-3-how-economists-use-theories-and-
models-to-understand-economic-issues/ , (last visited- 21st may,2021)
3
Jesus Najera, towards data science, Game Theory — History & Overview,
https://towardsdatascience.com/game-theory-history-overview-5475e527cb82 , (last visited- 21st May,2021)
4
AMY FONTINELLE, Investopedia, 5 Nobel Prize-Winning Economic Theories You Should Know About,
https://www.investopedia.com/articles/economics/12/nobel-prize-winning-economic-theories.asp, (last
visited- 21st May,2021)
Game Theory
Game as understood means to engage in activity directed toward
bringing about a specific state of affairs, using only means permitted
by specific rules, where the means permitted by the rules are more
limited in scope than they would be in the absence of the rules, and
where the sole reason for accepting such limitation is to make possible
such activity.5 Likewise, Game theory is the process of modelling the
strategic interaction between two or more players in a situation
containing set rules and outcomes.6 It determines the players' interests,
priorities, and possible strategies, as well as the impact of these
strategies on the outcome. The concept to game theory is that one
player's outcome or profit is dependent on the other player's strategy,
i.e., the decision of each participant is based on the expected behaviour
of the other party without knowing how they will actually behave.
Each economic theory comes with its own set of assumptions that are
made to explain how and why an economy function.7 Likewise, the
assumptions in the Game theory are as follows8:
1. Players are assumed to be rational and they tend to maximise their
payoff (the pay out a player receives from arriving at a particular
decision) in the game.
2. The pay outs listed are presumed to include the total of all payoffs
associated with that result.
3. There should be no communication or interaction between the
players.
4. The number of players in a game can theoretically be infinite, but
most games will be put into the context of only two players.

5
Suits, Bernard. "What Is a Game?" Philosophy of Science 34, no. 2 (1967): 148-56. Accessed May 22, 2021.
http://www.jstor.org/stable/186102.
6
Daniel Mcnulty, Investopedia, The Basics of Game Theory, https://www.investopedia.com/articles/financial-
theory/08/game-theory-basics.asp (last visited- 22nd may,2021)
7
Sean Ross, Investopedia, Economists' Assumptions in their Economic Models
https://www.investopedia.com/ask/answers/032515/why-do-economists-build-assumptions-their-economic-
models.asp (last visited- 22nd may,2021)
8
Supra 6
Nash Equilibrium
To simplify, game theory is the notion of strategy and payoff9, where
strategy is a complete plan of action that a player will take in the given
set of circumstances which might arise during the game and payoff is
the expected outcome. There are different strategies that the players
might adapt. Such as, Maximax strategy, where the player tries to get
the maximum benefit available. Then there is maximin strategy where
a player tries to obtain the best of the worst outcome or payoff. The two
very important strategies are the ‘dominant strategy’ and the ‘Nash
equilibrium’ strategy. These two are often compared alongside each
other as there is only slight difference between them. Nash equilibrium
states that optimal outcome of a game is one where no player has an
incentive to deviate from their chosen strategy after considering an
opponent's choice.10 If either of the players changes their strategy while
the other players continue with the same, then nothing is achieved or
gained. On the other hand, Dominant strategy asserts that a player will
choose a strategy that will lead to the best outcome regardless of the
strategies that other players have chosen.11 Hence, in the dominant
strategy, each player's best strategy is unaffected by the actions of other
players.12
Thus, in order to find the Nash equilibrium in a game, firstly each of
the possible scenarios must be modelled in order to decide the
outcomes, and then the best strategy should be selected. A Nash
equilibrium is reached when neither player changes their strategy after
learning all of the facts. However, it is not necessary that the strategy
adopted through this method would be the best.

9
Nitisha, Economic Discussion, Game Theory: Assumptions and Structure of Game Theory,
https://www.economicsdiscussion.net/game-theory/game-theory-assumptions-and-structure-of-game-
theory/3797 (last visited - 23rd may,2021)
10
James Chen, Investopedia, Nash Equilibrium, https://www.investopedia.com/terms/n/nash-equilibrium.asp
(last visited - 23rd may,2021)
11
Christina Majaski, Investopedia, Comparing a Dominant Strategy Solution vs. Nash Equilibrium Solution
https://www.investopedia.com/ask/answers/071515/what-difference-between-dominant-strategy-solution-
and-nash-equilibrium-solution.asp (last visited - 23rd may,2021)
12
Ibid.
Prisoner’s Dilemma
One of the well-known examples of Game theory, i.e., “Prisoner’s
Dilemma” employs the concept of Nash Equilibrium. In this game, it is
seen that there are two criminals who are kept in confinement and there
is no means for them to communicate with each other. Due to lack of
the evidence to convict the pair, the prosecutor offers each prisoner four
deals. First being that if both of them confess then they will receive 5
year in jail each. Second, if one confesses and other don’t then the one
who confessed will get 1 year jail and the other will get 3 years and
vice versa. Fourth, if neither confess then they will serve 2 years in jail
each. The rational strategy for both the players would be to not confess
and get away with the minimum years in imprisonment (two years
each) but since neither is aware of each other’s strategy, they would
confess and end up with 5 years in jail. This phenomenon is explained
through Nash equilibrium, as each player will make the move that is
best for them individually but worst for them collectively.13
Implications of Game theory
Game theory has a wide range of application in various fields of study
such as mathematics, psychology, evolutionary biology, war, politics
and business. However, the most prominent use of game theory is in
the study of economics. This theory can be a useful instrument to
provide assistance in the basic study of markets, sectors, and any
competitive engagement between two or more companies.
It provides many insights into the behaviour of oligopolists (market
structure where few firms rule over many).14 There are number of
strategic choices faced by firms which governs their ability to achieve
a desired pay-off. Such as decision on price and output (whether to
increase, decrease or hold), on products (whether to Keep existing
products or develop new ones) and on promoting their products
(whether to spend more on advertising or spend less or keep spending
13
Adam Hayes, Investopedia, Game Theory, https://www.investopedia.com/terms/g/gametheory.asp (last
visited- 23rd May, 2021)
14
ARTHUR PINKASOVITCH, Investopedia, Game theory and Business,
https://www.investopedia.com/ask/answers/09/game-theory-business.asp (last visited- 23rd may,2021)
constant). For example, pharmaceutical companies consistently face
decisions regarding whether to market a product immediately and gain
a competitive edge over rival firms, or prolong the testing period of the
drug.15
A range of possible pay-offs could be derived by firms from their
strategic choices which may include more profits for shareholders or
greater market share or improved chances of survival or getting rid of
a rival. Hence, the strategy to be followed must be devised carefully
keeping in mind the consequential reaction of its rival firms. These
strategic choices made by a firm affects the decision of other firms and
hence the way in which other firms might react to its plan can be
determined by the Game theory. In other words, game theory helps to
predict likely outcomes when firms engage in certain behaviour, such
as price-fixing and collusion.16
Limitations
Every theory in some way or the other has some limitations and lacunae
in it and game theory is no exception in this case. Some of the
prominent limitations to Game theory are:
1. It assumes that all the players are rational who are self-
interested and utility maximising. However, it does not take
into consideration the people who cooperate and care about
others, sometimes at their own costs. And hence this theory
cannot be said to be universally applicable to all players.
2. Another drawback of this theory is that it becomes more
difficult to comprehend with the increase in the number of
players, as all the competitive problems cannot be analysed
through this theory.17
3. It does not take into account the various uncertainties that
are prevalent in actual field of business and also many

15
Ibid
16
Supra 13
17
Universal Teacher Publication, Advantages & Limitations of Game Theory,
http://www.universalteacherpublications.com/univ/ebooks/or/Ch9/limit.htm (last visited- 23rd may,2021)
 businessmen do not have adequate knowledge of this
theory.18
4. Another problem is that after playing a game many times,
intelligent human players can profoundly alter their
strategies.
5. Last but not the least, it simply provides a general rule of
logic and not the winning strategy.19
Conclusion
So, to sum up, the Game theory may be helpful in simplifying the
decision-making process and also has the potential to aid decision
making in dynamic contexts involving several players (individuals,
companies, and governments) interacting in a world marked by strong
strategic interdependence. Through this theory, firms can better
understand their rival companies’ actions and strategy and then
formulate their own strategy accordingly.20 Although game theory has
made many advances yet it is still a young and developing science.

18
Kalpana R, Game Theory: Assumptions, Application and Limitations,
https://www.businessmanagementideas.com/management/game-theory-assumptions-application-and-
limitations/523 (last visited-23rd May, 2021)
19
Ibid
20
Wiley Online Library, https://onlinelibrary.wiley.com/doi/pdf/10.1002/9781119419761.oth1