Game theory in economics: definition, real-life examples, and more

In economics, game theory is a mathematical framework for analyzing strategic interactions between decision-makers, such as businesses, consumers, and governments¹. First conceptualized by John von Neumann and Oskar Morgenstern in 1944, this framework essentially examines how players anticipate and respond to each other’s actions, aiming to identify the optimal strategies across various situations, even in the face of uncertainty.

A straightforward example is the airline industry. When one major airline reduces fares on a major route, competitors often adjust their pricing or offer different incentives. This kind of interaction is usually found in oligopoly markets, sectors dominated by a few firms where each player’s decisions are heavily influenced by the anticipated moves of their competitors.

Introduced by Nobel Laureate John Nash,the Nash Equilibrium is a foundational concept in game theory, helping to identify the outcomes that strategic interactions are likely to produce. It describes a situation in which each player’s strategy is the best response to the others’, so no one can unilaterally change their strategy to achieve a better outcome. Simply put, a Nash Equilibrium is a “no regrets” situation: once everyone has made their choice, no one can improve their outcome by changing their decision, assuming everyone else sticks with theirs².

As an illustration, imagine two competing coffee shops on the same street. If both shops set high prices, they earn moderate profits. However, if one lowers its price, it attracts more customers and earns more, while the other loses out. On the other hand, if both lower their prices, they compete fiercely, yet earn less overall. The Nash equilibrium occurs when neither shop can improve its profit by changing prices alone, where each strategy is the best response to the other.

Microeconomics

In microeconomics, game theory analyzes how businesses and consumers decide when they depend on each other, particularly in oligopoly markets. Take the example of two electric vehicle manufacturers. If one lowers its price, the other might need to follow to stay competitive. Game theory helps predict these interactions, including potential price wars or strategic cooperation, enabling businesses to make more informed decisions in competitive markets.

Political economics

Political economy and international relations are key areas where game theory extends beyond its traditional role in microeconomics.A straightforward example is during elections, where candidates often position themselves based on what others are doing to secure more votes. For instance, when one candidate attempts to gain votes from the youth, others may adjust their strategies by shifting their policies, changing their messaging, or targeting different voter groups to stay competitive and win more support.

In global politics, game theory also helps explain complex negotiations such as trade agreements or arms control deals, where each side tries to achieve the best outcome without triggering conflict.

Health economics

In health economics, game theory helps explain how different sectors make decisions in both competitive and cooperative healthcare environments. Given the complexity of the healthcare system and the need for collaboration among diverse stakeholders, the key question is: How can game theory help design and implement more effective health policies?

One compelling example is Nobel Laureate Alvin Roth’s work on kidney exchange systems. In cases where a patient has a willing, but incompatible donor, Roth applied game theory and matching algorithms to create donor-patient pair exchanges across hospitals in the U.S.. This approach successfully increased the number of successful transplants by aligning incentives and enabling better coordination between hospitals and patients³, which was not possible before. Ultimately, this demonstrates how game theory can support smarter health policy design by improving outcomes through strategic cooperation across the healthcare ecosystem.

Industrial organization

Within the field of industrial organization, game theory is a crucial tool to study how firms behave strategically within different market structures, including monopolies, oligopolies, or highly competitive industries. By applying game theory, economists can model how companies interact, set prices, innovate, and respond to competitors’ moves. This helps explain not only firm-level decision-making, but also broader market dynamics and outcomes⁴.

One notable example in this field is the work of Nobel Laureates Paul Milgrom and Robert Wilson, whose contributions to auction theory revolutionized how firms compete for resources across industries such as telecommunications⁵. Their research played a central role in designing transparent and efficient spectrum auctions, leading to more competitive bidding processes and better allocation of public assets.

More broadly, game theory enables firms to anticipate rivals’ strategies, such as when a smartphone company releases a new flagship product, and others swiftly follow with competing innovations. This creates a dynamic environment where each move is calculated based on expected responses.

Behavioral economics

Behavioral economics explores why people often make decisions that seem irrational, like rejecting a good deal or buying something just because it’s trending. It is a field that combines elements of psychology and economics to understand how people make decisions in the real world. It offers a different perspective from traditional economics, which assumes we always act rationally to maximize our benefits. Behavioral economics, on the other hand, recognizes that emotions, biases, and social influences often guide our decisions⁶.

Game theory can help better understand human decision-making and cooperation strategies when applied to behavioral economics. One influential figure in this field is Nobel Laureate Robert Aumann, who was awarded the Nobel Prize in Economic Sciences in 2005 for his work on conflict and cooperation through game-theoretic analysis. His research showed that when people or groups interact repeatedly, they are more likely to cooperate, even if they only look out for themselves. This idea helps explain how individuals, businesses, or countries can build trust and work together in competitive situations.

Labor economics

Labor economics draws on game theory to better understand wage negotiations, employment contracts, and the dynamics of unions and employers. A critical application in this field is matching theory, which focuses on pairing workers with jobs that lead to stable and mutually beneficial outcomes.

Nobel Laureates Lloyd Shapley and Alvin Roth both made significant contributions to labor economics by developing and applying the Gale-Shapley Algorithm (also known as the deferred acceptance algorithm) to real-world markets. This method pairs two groups, such as job seekers and employers, based on mutual preferences to create stable outcomes where no participants would prefer a different match over their current one.

Shapley introduced the concept alongside David Gale, while Roth extended it and successfully applied it to the National Resident Matching Program (NRMP) in the U.S, which matches medical school graduates with hospital residences. Roth’s contribution helped reduce unfilled positions and significantly improved the efficiency and satisfaction of the matching process⁷.

Public economics

In public economics, game theory is used to better understand how people and governments make decisions about shared resources like clean air, infrastructure, or national defense. However, one significant challenge in public economics is the “free-rider problem”: people or countries that reap benefits like clean air or energy, even if they don’t help pay for or contribute to them.

For instance, consider climate change. Every country benefits when global carbon emissions fall, but each also has an incentive to do less while hoping others will bear the cost. This creates a scenario similar to the prisoner’s dilemma, a game theory-based thought experiment involving agents who can either cooperate for mutual benefit or betray their partner for individual gain.

To help address this particular issue, game theory offers insights into how strategic incentives can be structured to encourage cooperation over defection. By anticipating how countries might act in their interests, the theory can assist government and related sectors in designing policies (e.g., carbon pricing, tax incentives, etc.) that align self-interest with collective benefit.

At the core of it, game theory is an insightful framework that turns complex, strategic situations into clear “games” with predictable outcomes. It also helps us understand the many ‘whys’ of the world that might not be as obvious in hindsight, such as why businesses set certain prices or why countries clash or negotiate over resources. By identifying dominant strategies, game theory enables individuals, firms, and policymakers to anticipate others’ moves and adjust their strategy accordingly, leading to smarter choices in an increasingly interconnected world.

References

¹ Kenton W. Advanced Game Theory Strategies for Decision-Making. Investopedia [Internet]. 2013 Nov 11 [cited 2025 Jun 5]. Available from:https://www.investopedia.com/articles/investing/111113/advanced-game-theory-strategies-decisionmaking.asp

² Seth S. Game theory: Beyond the basics [Internet]. New York: Investopedia; 2009 [cited 2025 Jun 5]. Available from:https://www.investopedia.com/articles/financial-theory/09/game-theory-beyond-basics.asp

³ UBS. Alvin Roth: Matching markets and the Nobel Prize [Internet]. Zurich: UBS; [cited 2025 Jun 5]. Available from:https://www.ubs.com/microsites/nobel-perspectives/en/laureates/alvin-roth.html

⁴ Kenton W. Industrial organization [Internet]. New York: Investopedia; 2023 [cited 2025 Jun 5]. Available from:https://www.investopedia.com/terms/i/industrial-organization.asp

⁵ UBS. Robert Wilson: How can auction theory improve our world? [Internet]. Zürich: UBS; [cited 2025 Jun 5]. Available from:https://www.ubs.com/microsites/nobel-perspectives/en/laureates/robert-wilson.html

⁶ University of Chicago. What is behavioral economics? [Internet]. Chicago: University of Chicago; 2022 Feb 1 [cited 2025 Jun 5]. Available from:https://news.uchicago.edu/explainer/what-is-behavioral-economics

⁷ Freeling N, Wheelock J. How two matchmakers won a Nobel Prize [Internet]. University of California; 2020 Feb 13 [cited 2025 Jun 5]. Available from:https://www.universityofcalifornia.edu/news/how-two-matchmakers-won-nobel-prize