Recent Posts

Game theory is the science of strategy depicting the interaction of two or more players in a scenario. With a set of rules and outcomes, the model of optimality also accounts benefits minus accounts. Introduced by Princeton mathematician John Von Neumann. the theory aims to determine the actions that players should take, in a wide array of games, to attain the best results for themselves.

While used in numerous disciplines, this is most notably used tool in studying economics. Its economic application can be a significant tool to help support the fundamental analysis of any relation between two or more companies, as well as sectors and industries.

Before anything else, let us define the terms generally used when studying game theory:

• 
  

  Equilibrium – Juncture in which both players have decided and reached a result

  
  


• 
  

  Game – Any bunch of circumstances in which its result depends on the responses of two or more participants

  
  


• 
  

  Information Set – Details available at a particular point, most normally applied when the game has a sequential element

  
  


• 
  

  Payoff – Earnings of a player from arriving at a given outcome, which can be in any quantifiable form

  
  


• 
  

  Players – Decision maker(s) in a game

  
  


• 
  

  Strategy – Complete plan by a player given the series of circumstances which might occur within a game

  
  

In economics, the assumption of rationality and the assumption of maximization are present. It assumes the participants are sensible and aim to optimize their payoffs. When looking at games that are already placed, it is assumed on your behalf the payouts indicated include the total payouts associated with the outcome, excluding the “what if” inquiries that may emerge. The number of players can be limitless, but most games have two players. Sequential game with two players is one of the simplest games.

Let us apply the theory in resolving sequential games using backwards induction.

Backwards induction is the act of deducing backwards from the last part of a problem or occurrence to infer insinuate a set of optimal actions in game theory. In a simple sequential game, Player 1 and Player 2 have set of details. Each set has two different choices. Player 1 decides first, followed by Player 2.

Backwards induction utilizes rationality and maximization assumptions, similar to all game theory. Hence, Player 2 will optimize his payoff in any situation. After choosing, the tree can be narrowed down.

Following the reduction, Player 1 can optimize the payoffs as Player 2 makes his choice. The result is an equilibrium when Player 1 selects “right” and Player 2 picks “up”.

We can solve the confusing array of results in a real situation by employing game theory’s simple methods. In financial analysis, this tool can be helpful in sorting out chaotic conditions, including mergers and product releases.