Economics Terms A-Z
Game theory refers to the study of the choices actors make which produce outcomes based on their preferences. In short, it's a way of predicting how economic agents are going to act, which has real-world application, meaning the results of releasing products or competing in business can be more accurately predicted. It is assumed in game theory that actors act rationally, that is, that they act in order to maximise benefits to themselves. (Some ideas, such as those of behavioural economics, are in conflict with this assumption.) If actions are 100% rational, theoretically they can be predicted by placing actors into a ‘game’ and controlling their actions until certain outcomes are reached.
The game refers to a set of circumstances and actions between two or more players that result in a particular outcome. Each player has a strategy, and the payoff of the game benefits an actor depending on what their strategy is. The information set refers to what the actors in the game know at any given moment. The game finishes when an equilibrium is reached, after all players have made their decisions and the outcome becomes clear. The concept of game theory has many applications, but initially referred to zero-sum games, in which the gains of one player are exactly equal to the losses of another. It has now been expanded to refer to a wide range of situations and refers generally to the study of decision making, generally of humans, but also of animals and computers. There are many types of game theory, some of which may be familiar, such as the prisoners’ dilemma and the dictator game.
An oligopoly is a market in which there are only a few sellers of the item being traded. The decisions of one seller thus affect the decisions of the other sellers in the market. Sellers compete strategically in the market by taking each other’s interests and actions into account.
If market players have different levels of information about each other’s valuations of the market then the information is asymmetric, or asymmetrically distributed. In classical economic theory, information is assumed to be complete and evenly distributed among market players: each player knows how the other players value the items being traded in the market. This simplifies the analysis of the market because the players’ actions will be certain and predictable. Market outcomes (prices and quantities) can then be easily calculated.
Nash equilibrium is an important equilibrium or solution concept in non-cooperative game theory. A Nash equilibrium is a strategy profile (i.e. a strategy for each player) in which each player is playing a best response to the strategy of the other(s). More simply, a Nash equilibrium describes a situation in which each person acts optimally given the actions of the others, so that no one wants to change his or her action.