Key Concepts in Game Theory to Know for Business Microeconomics

Game theory applies strategic decision-making to real-world situations in business microeconomics. It helps analyze how individuals and firms interact, focusing on cooperation, competition, and negotiation. Understanding these concepts can improve decision-making and predict outcomes in various economic scenarios.

1. Prisoner's Dilemma

   • Illustrates the conflict between individual rationality and collective benefit.
   • Each player has a choice to cooperate or defect, with the best outcome occurring when both cooperate.
   • The dominant strategy leads both players to defect, resulting in a worse outcome for both compared to mutual cooperation.
   • Highlights the challenges of trust and communication in strategic decision-making.
   • Commonly applied in economics, politics, and social sciences to analyze competitive behavior.

2. Nash Equilibrium

   • A situation where no player can benefit by changing their strategy while the other players keep theirs unchanged.
   • Represents a stable state of a system involving multiple players, where each player's strategy is optimal given the strategies of others.
   • Can occur in pure strategies (specific actions) or mixed strategies (probabilistic actions).
   • Important for predicting outcomes in competitive environments and understanding strategic interactions.
   • Not necessarily the most efficient outcome, as it may lead to suboptimal results (e.g., the Prisoner's Dilemma).

3. Dominant Strategy

   • A strategy that yields a higher payoff for a player regardless of what the other players do.
   • Simplifies decision-making, as players can confidently choose their dominant strategy without needing to consider opponents' actions.
   • Not all games have a dominant strategy; its existence can lead to predictable outcomes.
   • Often leads to Nash Equilibrium when all players have a dominant strategy.
   • Key in analyzing competitive behavior in markets and strategic interactions.

4. Mixed Strategy

   • Involves players randomizing their strategies to keep opponents uncertain about their actions.
   • Useful in games where no pure strategy Nash Equilibrium exists, allowing players to achieve better expected payoffs.
   • Players assign probabilities to different strategies, balancing risk and reward.
   • Commonly applied in competitive scenarios like sports, auctions, and pricing strategies.
   • Highlights the complexity of strategic decision-making in uncertain environments.

5. Sequential Games

   • Games where players make decisions one after another, allowing for strategic foresight and planning.
   • Often represented using extensive form (game trees) to illustrate the order of moves and possible outcomes.
   • Players can react to previous actions, leading to different strategies compared to simultaneous games.
   • Concepts like backward induction are used to determine optimal strategies by analyzing future moves.
   • Important in negotiations, contract design, and any scenario where timing and order of actions matter.

6. Repeated Games

   • Games that are played multiple times, allowing players to build reputations and establish trust over time.
   • Strategies can evolve based on past interactions, leading to cooperation or retaliation.
   • The possibility of future interactions can change the incentives compared to one-shot games.
   • Key in understanding long-term relationships in business, such as partnerships and competitive markets.
   • Can lead to stable outcomes like cooperation through strategies like tit-for-tat.

7. Coordination Games

   • Games where players benefit from making the same choices or coordinating their strategies.
   • Multiple equilibria may exist, with players needing to communicate or signal to achieve the best outcome.
   • Highlights the importance of trust and common knowledge in achieving cooperation.
   • Common in situations like market entry, technology adoption, and standard-setting.
   • Can lead to inefficiencies if players fail to coordinate effectively.

8. Bargaining Theory

   • Analyzes how parties negotiate and reach agreements, focusing on the distribution of resources or benefits.
   • Key concepts include the bargaining power of each party, reservation prices, and the role of information.
   • Can involve cooperative and non-cooperative approaches, influencing the outcome of negotiations.
   • Important in labor negotiations, mergers and acquisitions, and contract negotiations.
   • Highlights the strategic considerations in reaching mutually beneficial agreements.

9. Auction Theory

   • Studies how different auction formats (e.g., English, Dutch, sealed-bid) affect bidding behavior and outcomes.
   • Players must strategize based on their valuations, competition, and auction rules.
   • Key concepts include bidder behavior, reserve prices, and the winner's curse.
   • Important for understanding market dynamics in selling goods, services, and resources.
   • Applications extend to online auctions, government contracts, and spectrum sales.

10. Oligopoly Models (e.g., Cournot, Bertrand)

    • Analyze markets with a few dominant firms, focusing on their strategic interactions.
    • Cournot Model: Firms compete on quantity, leading to a Nash Equilibrium based on output levels.
    • Bertrand Model: Firms compete on price, often resulting in lower prices and profits due to undercutting.
    • Highlights the importance of strategic decision-making in pricing, output, and market share.
    • Essential for understanding competitive behavior in industries like telecommunications, airlines, and energy.