Game Theory refers to a subset of economic study that considers how actors will behave to a given set of incentive structures. To simplify the analysis game theory usually assumes the actors are rational or at least have bounded rationality. Game theory does not consider the morality of a decisions but rather the incentives that would drive actors to make certain decisions.
A game theory model has at least three components:
- Actors – the players of the game
- Rules – the game definition, sometimes referred to as institutions
- Strategies – the decisions made by each actor during each round
Games are defined by a matrix of payoffs resulting in two basic types of game:
- Zero sum games i.e. a game in which if one actor gains the other actor must lose
- Non-zero sum games
Game theory tries to predict a games outcome by identifying the dominant strategy where the dominant strategy is defined as the best choice an actor in the game could make regardless of what choice the other actors make. If the payoff matrix is symmetric we only need to identify the dominant strategy for one player to work out the games outcome.
A key finding of game theory is that the dominant strategy may not lead to the best possible outcome for either actor.
A Nash Equilibrium is a set of choices in which no player has anything to gain by changing their own decision.
A “grim trigger” equilibrium occurs in multiple round games in which if one actor deviates evenly slightly from the dominant strategy then they will cause an endless cycle of punishments between actors.
Games with multiple rounds allow a certain level of coordination to occur between actors. Coordination fails when only a minority of the actors change state but the majority do not.
When coordination is not possible, Schelling points can provide guidance as to the likely behaviour of actors. A Schelling point is something that is likely to be considered special or have some level of symbolic value. In the absence of communication Schelling points can provide some level of coordination between actors because these points feel relevant of natural for them.