Consider this situation. Let’s say we have two people, prisoner A and prisoner B. They have committed some sort of crime, a theft, a heist or whatever. They are detained by the police as prime suspects. They are completely unaware of the fact that evidence against them is very weak which leaves the police in the condition of needing a confession from at least one of the suspects in order to get a conviction. According to the police officer the best way to act is to divide the two of them in isolated rooms and offer the same scenario: confess the crime and you’ll obtain a lighter sentence to prison.
The two prisoners have to face a huge dilemma, which is summarized in the upper figure. If A confesses but B remains silent, A will get a heavier conviction. In the same way if B confesses but A remains silent, B will end up with to jail. What will happen is that, scared by the possibility of the other prisoner’s confession both will confess getting a far heavier prison sentence than the one they would have got remaining silent.
This little “episode” is more known as the so called Prisoner’s Dilemma and it is one of the most classic examples of game theory.
Game Theory is the study of how people behave in strategic situations. The best examples are specific games of strategy such as poker and chess. The best way to play such a game depends on the way one’s opponent plays. Players must pattern their actions according to the actions and expected reactions of rivals.
It is not surprising that one of the cleaner applications of this kind of mathematical, tactical and logical reasoning is the explanation of subtle behavioral patterns in economic models as oligopoly, a system in which the market is controlled by very few powerful firms. The financial strategies at the base of short or long run decisions must take into account the possible reactions of the rivals, which act and react subsequently. Fair competition or unfair collusion may alter considerably the market equilibrium.
Cool, isn’t it?Francesco Pochetti