According to the Stanford Philosophical Encyclopedia, “Game theory is the study of the ways in which interacting choices of economic agents produce outcomes with respect to the preferences (or utilities) of those agents, where the outcomes in question might have been intended by none of the agents. The meaning of this statement will not be clear to the non-expert until each of the italicized words and phrases has been explained and featured in some examples. Doing this will be the main business of this article. 

“An economic agent is, by definition, an entity with preferences. Game theorists, like economists and philosophers studying rational decision-making, describe these by means of an abstract concept called utility. This refers to some ranking, on some specified scale, of the subjective welfare or change in subjective welfare that an agent derives from an object or an event. By ‘welfare’ we refer to some normative index of relative alignment between states of the world and agents’ valuations of the states in question, justified by reference to some background framework. For example, we might evaluate the relative welfare of countries (which we might model as agents for some purposes) by reference to their per capita incomes, and we might evaluate the relative welfare of an animal, in the context of predicting and explaining its behavioral dispositions, by reference to its expected evolutionary fitness. In the case of people, it is most typical in economics and applications of game theory to evaluate their relative welfare by reference to their own implicit or explicit judgments of it. This is why we referred above to subjective welfare.”

So why is game theory significant?

o Game theory is a framework for understanding choice in situations among competing players.

o Game theory can help players reach optimal decision-making when confronted by independent and competing actors in a strategic setting.

o A common “game” form that appears in economic and business situations is the prisoner’s dilemma, where individual decisionmakers always have an incentive to choose in a way that creates a less than optimal outcome for the individuals as a group.

Prisoner’s Dilemma

One of the most popular and basic game theory strategies is the prisoner’s dilemma. This concept explores the decision-making strategy taken by two individuals who, by acting in their own individual best interest, end up with worse outcomes than if they had cooperated with each other in the first place.

In the prisoner’s dilemma, two suspects apprehended for a crime are held in separate rooms and cannot communicate with each other. The prosecutor informs both Suspect 1 and Suspect 2 individually that if he confesses and testifies against the other, he can go free, but if he does not cooperate and the other suspect does, he will be sentenced to three years in prison. If both confess, they will get a two-year sentence, and if neither confesses, they will be sentenced to one year in prison.

To learn more about game theory, I highly recommend Hiam Shapira’s Gladiators, Pirates and Games of Trust: How Game Theory, Strategy and Probability Rule Our Lives (February 14, 2017).