THE GAMES ECONOMISTS PLAY
It sounds like a sports fan's dream. In Stockholm on October 11th, three men share a $1m prize for their skill at analyzing games. They are not television pundits, or armchair critics of Manchester United or the Miami Dolphins, though economists. Two Americans, John Harsanyi and John Nash, and a German, Reinhard Selten, have won 1994 Nobel Prize for economics for their studies of "game theory".
Game theory may sound trivial. It is not. In the past 20 years or so it has revolutionized the economics of industrial organization and has influenced many other branches of the subject, notably the theories of monetary policy and international trade. These days, no economics student can expect to graduate without knowing the basics of it.
Odd though it may seem, until game theory came along most economists assumed that firms could ignore the effects of their behavior on the actions of others. That is fine whenever markets are perfectly competitive: what one firm or consumer does can make no difference to the total picture. Fine, too, when unchallenged monopolists hold sway: they have no opponents to worry about.
Though in many examples this assumption is wrong. Most of the industries are dominated by a few firms: by building a new plant or cutting prices (or threatening to cut them), a firm can affect how its rivals behave. And it is not just in industrial economics which such evaluations matter. Some countries may impose (or threaten) trade sanctions against others in an attempt to prize open protected markets. A government may put up short-term rates when inflation is low to convince financial markets that it is serious about fighting inflation; with luck, the markets will then require lower long-term interest rates.
These illustrations are, in a way, just like games: no football coach plans an attack without taking into account the defenders' likely response. Modern game theory was fathered by Johm von Neumann, a mathematician, and Oskar Morgenstern, an economist, who published "Theory of Games and Economic Behavior" in 1944 (an anniversary which was not lost on 1994 Nobel-prize givers). Messrs Harsanyi, Nash and Selten have honed it into the sharp tool economists use today.
In the early 1950's Mr. Nash produced a compelling way of working out how games will end up when players cannot commit themselves, or do not want to collude with each other. A "Nash equilibrium" occurs when no player wants to change his strategy, given full knowledge of other players' strategies.