Whether you’re playing Monopoly, Catan or blackjack, most card and board games involve strategy. Players consider how their opponents might play and use that information to inform their own moves.
In economics, strategy is the foundation of game theory, a type of mathematics that explores strategic interactions. And unlike Monopoly, everyone can win — or lose — the economic games we’ll play today.
Welcome to the second week of Econ 101. Chapter 2 of the Core Econ textbook “Economy, Society, and Public Policy” explores how economists measure the payoffs of various decisions using game theory.
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Key Takeaways
In the 1987 movie classic “Wall Street,” ruthless businessman Gordon Gekko, played by Michael Douglas, rhapsodizes on the benefits of greed.
“Greed clarifies, cuts through and captures the essence of the evolutionary spirit,” he tells a crowded room of stockholders. “Greed, in all of its forms — greed for life, for money, for love, knowledge — has marked the upward surge of mankind.”
It’s an idea that’s been around for at least 300 years. Adam Smith, one of the founding fathers of modern economics, likened it to an “invisible hand.” Individuals make decisions based on their self-interest, and the outcome ends up being consistent with the common good, he theorized.
(It’s important to note that Smith still saw greed as a moral vice and sought to distinguish selfishness from self-interest. Other, more recent, economic thinkers who promoted self-interest without boundaries include economist Joseph Schumpeter, who said unfettered greed fueled innovation, and philosopher Ayn Rand, who said greed was a moral virtue.)
But there are many situations in which acting on self-interest can lead to ruin. The book talks about cattle herders overgrazing a field, for instance. They might maximize the number of cows they can raise in the short term, but it hampers their ability to raise cattle if the grass stops growing.
Game theory can help people make decisions when they have conflicting motives.
Another example of self-interested action leading to a suboptimal outcome is known as the paradox of the prisoner’s dilemma. Say two people are arrested for the same crime. The police interrogate them independently, to pull confessions out of both. The prisoners want to minimize jail time, but each person’s sentence will depend on decisions made by the other.
Game theorists use a “payoff matrix” to see how different combinations of actions can deliver unique outcomes. Here’s what that looks like for our two prisoners, who are facing up to 20 years behind bars.
While the prisoners would serve less time if they both deny any wrongdoing, the penalty would fall on the shoulders of only one prisoner if the other chose to confess. Game theorists would predict that since both prisoners have no way to communicate with each other, it would be better to confess than to deny the crime, even if that meant a harsher punishment.
When social dilemmas arise, including the prisoner’s dilemma scenario, individuals often benefit from cooperating rather than making decisions on their own.
The decisions made by these two prisoners are also considered a “one shot” game, meaning there won’t be subsequent rounds of decision making. But most significant relationships in life are ongoing, requiring people to interact repeatedly, and the strategies they choose may change over time. That is what modern economics aims to study and measure. We’ll get to some multistep games next week.
Important Definitions
- Economics: The study of how people interact with each other and their natural surroundings in producing their livelihoods, and how that changes over time.
- Social dilemma: A situation in which individuals, acting independently in pursuit of their own private objectives, produce an outcome that’s inferior to another possible outcome borne of cooperation. The “tragedy of the commons” is a classic example.
- Social preferences: The pros and cons a person will consider when they care about how their action could affect other people. These are distinct from self-interested preferences, which ignore the effects of personal actions on others.
David Brancaccio’s thoughts on Chapter 2
After reading what economics has to say about game theory, I can now explain why the kitchen sink in Marketplace’s New York bureau gets squalid. I also now know how to fix it.
It turns out I have on my hands what economists refer to as a “free rider” problem. This could be happening in your kitchen, too.
My colleagues in the New York bureau are dedicated, funny, brilliant people. Yet they know, deep in their hearts, that someone else will do their dishes if they just dump them in the office sink. That someone is often me or Eva, our office manager. So everybody at the office enjoys what economists call “public goods” (a shared supply of clean dishes, in this case), although only a couple of people invest the time and labor in chiseling fossilized yogurt from bowls.
Real-world tests by economists show that people have social preferences, including altruism — they’re not just motivated by what’s in it for them. (For my part, I’ve found my bureau mates to be supergenerous.)
Another social preference is reciprocity: a desire to help people who act well and punish people who act poorly. Economists have found that many people are even willing to pay money to punish those who aren’t doing their part — more on that next week. So my latest idea is to hire somebody, out of my own pocket, whose job it is to monitor the sink and compile a public register of dish dumpers.
Would I actually do this? Of course not. I am well compensated for cleaning. Not in money, but in the self-righteousness that I feel when I do everyone else’s dishes and then get to write the tart memo asking them to do better.
More from the show
- What the World Cup can teach us about game theory
- A lesson in game theory brought to you by daytime TV
- Robots use game theory to understand how we think