The Economics Book

240

it was either a huge savings of
money if the other side didn’t
develop it either, or the sucker’s
payoff of a total defeat if they did.
The importance of Nash’s work
in a wider context was to show
that there could be an equilibrium
between independent self-
interested individuals that would
create stability and order. In fact
it was argued that the equilibrium
achieved by individuals trying to
maximize their own payoffs
produced safer and more stable
outcomes in non-cooperative
situations than when the players
tried to accommodate each other.
Nash shared the 1994 Nobel
Prize for economics with two other
economists who helped to develop
game theory. Hungarian-born
economist John Harsanyi showed
that games in which the players
did not have complete information
about the motives or payoffs of
the other players could still be
analyzed. Since most real life
strategic decisions are made in
the fog of uncertainty, this was
an important breakthrough. A
real life example might be when
financial markets cannot be sure of

GAME THEORY

money between them, and each

time they do so the pile of money is

increased by 20 percent. There are

two ways for the game to end: the

money is passed between them

for 100 rounds (hence the name

centipede), and then the total pot

of money is shared, or at some

stage one player decides to keep

the pile of money that he or she has

been given. Each player’s choice is

to cooperate by passing the money

on or defect and keep the money. In

the last round the player does best

by defecting and taking it all.

You know what you are

thinking, but you do

not know why you are

thinking it.

Reinhard Selten

the central bank’s attitude toward

inflation and unemployment, and

therefore cannot know whether it

will increase interest rates to

reduce inflation or reduce rates to

increase employment. Since the

profits of firms in the financial

markets are determined by the

rate of interest that the central

bank will set in the future, firms

need to be able to assess the risk

of lending more or less money.

Harsanyi showed that even if the

markets cannot tell which target

the central bank is more concerned

with, game theory can identify the

Nash equilibrium, which is the

solution to the problem.

The centipede game

Another economist responsible

for advancing game theory was

the German Reinhard Selten, who

introduced the concept of sub-

game perfection in games that are

multi-staged. The idea is that there

should be an equilibrium at each

stage or “sub-game” of the overall

game. This can have major

implications. An example of such a

game is the centipede game, where

a number of players pass a sum of

Getting to the truth

In 1960, Russian-born economist

Leonid Hurwicz began to study

the mechanisms by which

markets work. In classical theory

it is assumed that goods will be

traded efficiently: at a fair price

and to the people who want them

most. In the real world markets do

not work like this. For instance

Hurwicz recognized that both the

buyer and seller of a secondhand

car have an incentive to lie about

how much each values it.

Even if both parties revealed

how much they were willing to

buy or sell for and agreed to split

the difference in the price, it is

unlikely that this mechanism

would create an optimal

outcome. Sellers will naturally

claim to want a much higher

price than they actually require,

while buyers will offer much less

than they are willing to pay. In

such circumstances they will

fail to come to an agreement

even though they both want to

make a deal. Hurwicz concluded

that if the participants could be

persuaded to reveal the truth,

then the benefits to both parties

would be maximized.

When haggling with a buyer, a

seller may start with a price many

times what he is happy to accept,

but in doing so risks losing the sale.