Game Theory Can Help Solve Economic Ills

Article excerpt

The term "game theory" conjures up images of someone studying football films or poker odds.

But the Swedish Academy wasn't being frivolous last week when it awarded the Nobel Memorial Prize in Economics to three economists who did pioneering work in the field. The same kind of thinking used by a good football coach or a good poker player can be applied to real-life problems.

Game theory was originated 50 years ago by two economists, John von Neumann and Oskar Morgenstern, who wrote a book on the behavior of firms in imperfect markets. This year's three Nobel winners - John C. Nash, John C. Harsanyi and Richard Selten - advanced game theory to the point where it's now used by businesses and government agencies to solve practical problems.

The Federal Communications Commission, for example, used game theory to design its recent auction of frequencies for new paging services.

Game theory is all about anticipating how other players - competitors, customers or employees, for instance - will react to a given move. The best-known illustration is the classic prisoners' dilemma, in which two prisoners are suspected of committing a crime together.

If both confess, they get five-year prison sentences. If both stay silent, they get one-year sentences. But if one confesses and the other is mum, the honest one goes free and the other goes to jail for 20 years.

Obviously, the two robbers do best by cooperating - that is, by staying silent. But neither prisoner knows what the other will do, so there's a temptation to be selfish and confess in hopes of getting off scot-free.

Game theory has obvious applications in international trade. Free trade would bring the greatest mutual prosperity to the United States and Japan. But if U.S. leaders feel Japan is refusing to cooperate, do they put up punitive trade barriers? If so, when do they relent and make the first move toward cooperation?

Neoclassical economics can tell us that free trade is optimal, but game theory helps explain how - and whether - nations will move to such an optimal solution.

Game theory also has public-policy applications. Patricia Pollard, an economist at the St. …