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what they thought the other firm
was going to do, but this was an
isolated case of analyzing
strategic interactions.
In 1944, US mathematicians
John von Neumann and Oskar
Morgenstern published the
groundbreaking work, Theory of
Games and Economic Behavior.
They suggested that many parts
of the economic system were
dominated by a small number of
participants, such as large firms,
trade unions, or the government.
In such a situation economic
behavior needed to be explained
with reference to strategic
interactions. By analyzing simple
two-person games that are “zero-
sum” (one person wins and the
other loses), they hoped to create
general rules about strategic
behavior between people in every
situation. This became known as
game theory.
Von Neumann and
Morgenstern looked at cooperative
games in which players were
given a number of possible
actions, each with its own
particular result, or payoff. The
players were given the opportunity
to discuss the situation and come
to an agreed plan of action. A real
example of such a game was
provided by US mathematician
Merrill Flood, who allowed his
three teenagers to bid for the
right for one of them to work as
a babysitter for a maximum
payment of $4. They were allowed
to discuss the problem and form
a coalition, but if they were unable
to agree between themselves then
the lowest bidder would win. To
Flood, there were easy solutions
to the problem, such as settling
by lot or splitting the proceeds
equally. However, his children were
unable to find a solution and
eventually one of them bid 90 cents
to do the work.Nash equilibrium
In the early 1950s a brilliant
young US mathematician named
John Nash extended this work to
look at what happens when players
make independent decisions
in non-cooperative situations—
where there is no opportunity for
communication or collaboration.
Cooperation is a possible outcome
but only if each player seescooperation as maximizing
their own individual chances
of success. Nash identified the
state of equilibrium in such
games where neither player
wants to change their behavior.
Players are choosing their best
strategy on the basis that their
opponents are also selecting their
best strategies. Nash identified
the state in such games where
neither player wants to change
their behavior as “each player’s
strategy is optimal against
those of the others.” This is now
known as the Nash equilibrium. ❯❯See also: Economic man 52–53 ■ Cartels and collusion 70–73 ■ Effects of limited competition 90–91 ■
Economic equilibrium 118–23 ■ Behavioral economics 266–69 ■ The winner’s curse 294–95
POST-WAR ECONOMICS
Rock-paper-scissors is an example of a simple zero-sum game in
which if one player wins, then the other loses. The game is played by two
players. Each player must make one of three shapes with their hand at the
same time. The shape one player makes will either match, beat, or lose
to their opponent’s shape: rock beats scissors, scissors beats paper, and
paper beats rock. Game theorists analyze games such as this to discover
general rules of human behavior.ScissorsBeatsRockPaperBeatsBeats