Game Theory and its

Applications in Economics

Made by:- Shivang

Enroll. No.- 15112094
Batch :- K10

Game Theory
Game theoryis the study ofmathematical models of conflict
and cooperation between intelligent rational decision-makers.
Game theory is mainly used in economics,political science,
andpsychology, as well aslogic,computer science,biology
andpoker.
Originally, it addressedzero-sum games, in which one person's
gains result in losses for the other participants.
Game theory considers situations where agents (households or
firms) make decisions as strategic reactions to other agents
actions.

Game Theory
One of the most general problems in economies is outguessing
a rival.
For example, a firm seeks to determine its rivals most profitable
counterstrategy to its own current policy.
Game theory provides an avenue for economists to investigate
and develop descriptions of strategic interaction of agents.
Theory emphasizes study of rational decision-making based
on assumption that agents attempt to maximize utility.

The Game
A game-theory model is composed of

a set of players.

a set of strategies for each player

the payoffs to each player for every possible list of strategy choices
by the players.

The Prisoners Dilemma

Clyde
S
(5,5)

(30,1)

C (1,30)

(10,10)

S
Bonnie

What plays are we likely to see for this game?

The Prisoners Dilemma

Clyde
S
Bonnie

(5,5)

(30,1)

C (1,30)

(10,10)

If Bonnie plays Silence then Clydes best reply is

Confess.

The Prisoners Dilemma

Clyde
S
Bonnie

(5,5)

(30,1)

C (1,30)

(10,10)

If Bonnie plays Silence then Clydes best reply is

Confess.
If Bonnie plays Confess then Clydes best reply
is Confess.

The Prisoners Dilemma

Clyde
S
Bonnie

(5,5)

(30,1)

C (1,30)

(10,10)

So no matter what Bonnie plays, Clydes best

reply is always Confess.
Confess is a dominant strategy for Clyde
(and for Bonnie also).

Now what we have reached is referred to as Nash

equilibrium
(named after the American
mathematician John Nash who also has a biopic to his
name A Beautiful Mind .
It is a situation in which every participant has optimized his
outcome based on other players expected decision.
If each player has chosen a strategy and no player can benefit
by changing strategies while the other players keep theirs
unchanged, then the current set of strategy choices and the
corresponding payoffs constitutes a Nash equilibrium.
So the only Nash equilibrium for this game is the situation in
which both confess.

But wait !!
They can do better, cant they. What happens if both
remain silent.
Each will serve a sentence of 5 years which is
definitely better than the situation of Nashs
equilibrium in which both serve a sentence of 10
years. Hence the equilibrium is inefficient.
This is a simultaneous game. But what if it was
sequential?
This illustrates situation, common in economics, where
cooperation (not confessing) can improve welfare of all
players.

 If the two prisoners could find a way to agree on the

joint strategy of not confessing and, of equal
importance, a way to enforce this agreement.
Both would be better off than when they play the
game independently. However, it is still in the
interest of each prisoner to secretly break
agreement.
One who breaks the deal and confesses will only
receive 1 year while the other will pay price of
receiving 30 years.

Nash Equilibrium

Consider 2 companies producing cookies. Each

producing 1 million cookies each year and
selling at 30 dollars each.

Crispy Nikki
Boosts
production to 2
million

But its profit would drop down as

Jazz Ovens will also boost
production.

This is in Nash equilibrium as neither business can

make profit by unilaterally deciding to boost
production.

Co-operation
In general, agents attempt to cooperate
Agents defecting from cooperative agreements are
usually not observed in societies
Agents often instead cooperate, motivated by feelings of
solidarity or altruism
In business agreements, defection is relatively rare.
One can ensure the co-operation of other individual in two
ways:
By repeating the game infinite times.
Or playing tit for tat, or the grim strategy.

Preemption Games

In many economic game-theory models, firms who act first

have an advantage.
For example, a firm adopting a relatively large production
capacity in a new market can saturate market and make it
difficult for ensuing firms to enter

Market niches

If a firm offering discount enters a market. The

most suitable situation for the incumbent firm is not
to fight and keep its price higher.

Threats
Firm 1 could threaten firm 2 by stating it will
produce the product regardless of what firm 2
does.
Consider two competing firms advertising

Airbus and Boeing: No Government

Intervention
Boeing and Airbus Produce a Super-Jumbo:
No Government Intervention

Boeing

Develop SuperJumbo
Stay Out

Airbus
Develop SuperJumbo
-100A,-100B
500A,0B

Stay Out
0A, 500B
0A,0B

Airbus and Boeing: No Government

Intervention
Boeing and Airbus Produce a Super-Jumbo:
Boeing is Subsidized by the US Government

Boeing

Develop SuperJumbo
Stay Out

Airbus
Develop SuperJumbo
-100A, 10B
500A,0B

Stay Out
0A, 610B
0A,0B

Conclusion
A powerful tool, BUT
outcomes are very sensitive to the protocols
there may be many equilibria
sometimes players commonsense tells them what to do despite multiple
equilibria

Some very useful insights

Nash equilibrium concept
collusion; the price matching result
entry deterrence; the importance of credibility

The degree of complexity involved may limit its usefulness

as a predictive tool
The degree of rationality which has to be assumed on the
part of players is uncomfortable

THANK YOU