Game Theory: Strategic Decision-Making Explained
A simple guide to making better choices when your outcomes depend on others.
Game theory is the mathematical study of strategic decision-making between rational players. Whether you're negotiating a business deal, playing poker, or deciding when to merge in traffic, game theory provides a framework for understanding how people make choices when their outcomes depend on others' actions.
Key Concepts at a Glance
- Players, Strategies, Payoffs: Every "game" has decision-makers (players), their available choices (strategies), and the outcomes (payoffs).
- Nash Equilibrium: A stable outcome where no player can benefit by changing their strategy alone.
- Prisoner's Dilemma: A classic game showing why rational individuals might not cooperate, even when it appears to be in their best interest.
The Prisoner's Dilemma: A Classic Example
Two suspects are arrested and interrogated separately. Each faces a choice: cooperate with their partner (stay silent) or defect (betray them).
| Prisoner B | ||
|---|---|---|
| Prisoner A | Stays Silent (Cooperate) | Betrays (Defect) |
| Stays Silent (Cooperate) | A: 1 year B: 1 year |
A: 5 years B: Goes Free |
| Betrays (Defect) | A: Goes Free B: 5 years |
A: 3 years B: 3 years |
Betraying is the dominant strategy for both—it produces a better outcome regardless of what the other does. Yet both would be better off if they cooperated. This paradox explains why cooperation is difficult without trust.
Real-World Application: Coffee Shop Pricing War
Consider two competing coffee shops deciding their pricing. Each can choose premium or competitive (lower) pricing.
| Shop B | ||
|---|---|---|
| Shop A | Premium Price | Competitive Price |
| Premium Price | A: $5,000 B: $5,000 |
A: $2,000 B: $6,000 |
| Competitive Price | A: $6,000 B: $2,000 |
A: $3,000 B: $3,000 |
The dominant strategy for both is to choose competitive pricing, leading to a Nash Equilibrium where both earn less than if they had cooperated on premium pricing.