Economic Applications of Game Theory
This article focuses on the economic applications of game theory. The foundation for the basis of game theory is introduced followed by examples of some simple games. The concept of Two-Person Zero-Sum Games is evaluated. There is also a discussion on how social norms influence behaviors when playing games. One particular game, the exclusion game, is highlighted.
Keywords: Bona fide player; Combinatorics; Exclusion Game; Game Theory; Lausanne Theory; Norms; Robinson Crusoe Economy; Social Exchange Economy; Zero-Sum Games
Economic Applications of Game Theory
Economically speaking, people have choices, wants and needs. The ultimate goal of economic action is to satisfy one's desires. While it is expected that individuals will act in a rational way in order to be in compliance with social norms, the process is complicated due to external factors such as prices, production, gains and expenses. Additionally, individual behavior is dictated by choice, or free will. The act of making a rational decision regarding choices involves what is referred to as social exchange economy.
Social Exchange Economy Models
A social exchange economy can be described in terms of three models, which are:
• Robinson Crusoe Economy
This type of economy focuses on how the economic well being of a single person is influenced by a single will. The person in this model must decide how to satisfy a need to obtain commodities that will provide maximum satisfaction. For example, Crusoe is given information that describes his desires and commodities. His goal is to select a combination of choices that will give him maximum satisfaction. The key to this model is that Crusoe controls all of the variables that influence the decision. Once Crusoe enters into a social exchange economy, he loses some of his autonomy. He no longer has control over all of the variables as he seeks to enter into an exchange relationship with another person.
• Free Competition
In contrast to the Robinson Crusoe model, free competition is a theory that emphasizes the notion that there are many people involved in a social exchange economy. In addition, these individuals are aware that their choices have an effect on the decision making process of others. The participants in this process believe that as more people enter into the equation, the influence of each person becomes a mute point. Free competition encourages diversity and variety while discouraging seller involvement in monopolies, duopolies, and oligopolies.
• Lausanne Theory
This theory values individual planning as well as an interrelated network of individual plans. One can assume that this theory takes the best of the Crusoe model as well as the free competition philosophy. In essence, each individual develops an individual plan and utilizes it to interact with the masses and obtain maximum satisfaction.
As one looks at the individual and collective behaviors of a group, the focus centers around how one obtains maximum satisfaction, which could be referred to as the game.
Individuals play the game, which is governed by a set of rules. Each player has the choice of making a move, which ultimately has consequences. In many cases, the players participate in two types of procedures; direct and inverted signaling.
Game theory came to prominence in 1944 when von Neumann and Morgentern published a book entitled, "Theory of Games and Economic Behavior." The second edition was published in 1947. One of the reasons for the book's popularity was its focus on decision- making involving more than one decision maker. World War II activities led many scholars to seek opportunities to model decision situations. At the time, the military was a large proponent of game theory.
Game Theory can be viewed as a mechanism for resolving conflicts of interest (Thomas, 1984). Conflicts of interest evolve as a result of disagreement between people. According to Thomas (1984), game theory:
- Is a way to resolve these types of conflicts;
- Describes types of results that may occur;
- Suggests the best solution to the game and how the players should respond;
- Suggests which players will work together to resolve problems (p. 15).
Some of the key assumptions for a game include:
- There are at least two participants who are referred to a players;
- Players make moves, which are decisions made by the players;
- Players receive a payoff at the end of the game; and
- Players develop strategies in order to win the game.
Players are constantly developing strategies throughout the game. The goal is to anticipate moves to make, which will lead to ultimate victory. Players seek to gain the greatest payoff in order to win. Payoff can be explained in terms of two concepts — zero sum and non-zero sum games. Zero sum occurs when the payoff for all players is zero regardless of the strategy. In this scenario, there is always a winner and a loser. Poker is an example of this strategy. On the other hand, games that do not have a clear distribution of wins and losses are considered non-zero sum games.Game Theory & Economics
How is game theory applied to economic decision making and forecasting? Firstly, forecasting involves the ability to predict future behavior based on historical evidence. For example, forecasting models are applied to problems that need to be resolved on a number of levels (i.e. managerial strategic plan, operational decisions). A manager may want to review sales from previous years in order to predict what the sales will be for a certain product line in the future. There is a review of consumer trends to predict future spending habits. Game theory allows the manager to speculate what the different alternatives will be as he seeks to make the decision that will yield the greatest sales.
Shefrin (2002) has argued that "traditional game theory assumes that players are fully rational in respect to preferences (expected utility), judgments, and strategic choices" (p. 375). Scholars have supported the concept of rational choice theory to support this notion. The concept of rational choice theory is significant in microeconomics. In the model, the assumption is that individuals will make choices based on favorable conditions, preferences and constraints.
When making a choice, one can assume that all parties will make decisions based on amount of return. Each player studies all of the possible choices and determines...
(The entire section is 3022 words.)