Game theory is a theoretical framework for analyzing strategic interactions between individuals, where the outcome of each individuals decision depends on the decisions of others. It models these interactions using games and analyzes the optimal strategies for each player in different game scenarios, taking into account their preferences. Game theory is used extensively in economics to study how firms make decisions under different market conditions, such as oligopolies, auctions, bargaining, mergers and acquisitions pricing, fair division, duopolies, social network formation, agent-based computational economics, general equilibrium, mechanism design, and voting systems.
The focus of game theory is the game, which serves as a model of an interactive situation among rational players. The key to game theory is that one players payoff is contingent on the strategy implemented by the other player. The game identifies the players identities, preferences, and available strategies and how these strategies affect the outcome.
Game theory has provided insight to economists in several classical settings not only in markets but also in international affairs. It is a way of modeling the economic activity of competitive firms as a simple game, and through the use of game theory, the most efficient outcomes can be more easily identified. Furthermore, games can show how certain decisions that lead to seemingly poor outcomes can arise from rational self-interest.
Game theory has multiple limitations, such as the assumption that participants know about their payoff but not other players’, which is unrealistic. However, it is still a useful tool in economics.
