What Is Game Theory?

Key takeaways

Game theory explains the logic behind strategy and competition when multiple players influence outcomes. Here are some important things to know:

• Game theory originated in the 1940s as a mathematical framework for analyzing how people and organizations make decisions that depend on others.

• Game theory helps economists and strategists understand competition, cooperation, and conflict in fields like business, politics, and biology.

• You can start learning game theory by examining how your own choices depend on others' decisions.

Learn how game theory explains real-world decision making and the motivations behind it. Build your analytical and strategic skills by enrolling in Stanford’s Game Theory course, where you can practice modeling interactions and explore how different choices shape results.

What is game theory?

Game theory is a mathematical discipline you can use to study strategic decision making. It examines how you and others (players) behave when the outcome (risk or reward) of a situation (game) depends on more than your choices. What you gain or lose depends on what everyone else involved decides to do, too.

The field dates back to the 1940s, when mathematician John von Neumann and economist Oskar Morgenstern published The Theory of Games and Economic Behavior [1]. Their work showed economists a new way to analyze how people and companies make decisions when they're trying to anticipate what others will do.

In the following decade, mathematician John Nash introduced the idea that in certain situations, no player can improve their outcome by changing strategy while others stick with theirs [2]. Known as the Nash Equilibrium, this idea made game theory useful for analyzing everyday business competition, not just situations with definite winners and losers.

What is game theory used for?

You can use game theory to understand competition, cooperation, and conflict across many fields. Applications span business, politics, law, sports, biology, and even everyday decision making.

• Business: Set prices against competitors, choose locations, and design compensation systems for employees.

• Sports and competition: Vary strategies to keep opponents guessing.

• Public policy: Predict coalitions among voters and select people for a jury.

• Biology: Analyze animal and plant survival behavior.

• Negotiation: Build credible positions in bargaining and diplomacy.

Read more: How to Improve Your Negotiation Skills

What is a dominant strategy in game theory?

A dominant strategy is the choice that gives you the best possible outcome, no matter what the other side decides to do. In the classic Prisoner's Dilemma game, each player's dominant strategy is to confess, as it always yields a better payoff than staying silent. Not every game has a dominant strategy. In rock-paper-scissors, no single move can guarantee a win, since each choice can be beaten by another.

Why game theory matters in economics

Since nearly every market exhibits some degree of interdependence, game theory provides economists with a unified framework for analyzing how individuals, companies, and countries make decisions that influence one another. By modeling these relationships mathematically, you can predict behavior, understand competition and cooperation, and evaluate how strategic choices affect the production of goods and the delivery of services.

Beyond prediction, game theory reveals the tension between individual and collective outcomes. It shows that rational decisions can still lead to inefficiency when each player pursues their own best interest. These insights can help you design incentives, contracts, and policies that encourage cooperation, improve market performance, and explain why similar environments can produce very different results.

Examples of game theory for economics

Game theory is a lens for understanding how real markets behave. It explains why companies react to each other's prices, why some partnerships thrive while others fail, and why rational people sometimes make choices that ultimately work against them. The examples below show how these ideas play out in everyday economic situations.

Oligopolies and pricing decisions

Oligopolies, or markets dominated by a few large firms, offer one of the clearest examples of game theory in action. In this scenario, each company's pricing and production decisions directly affect the others, so no firm can act in isolation.

For example, when an airline lowers fares, competitors must decide whether to match the price or risk losing passengers. While it may seem rational for firms to cooperate and maintain high prices, game theory explains why this rarely lasts. If one airline cuts prices while others hold steady, the airline with discounted fares gains more customers and profits. This creates constant pressure for everyone to undercut each other, which ultimately leads to lower prices and thinner margins across the market.

Economists distinguish between collusive and competitive oligopolies. In a collusive market, firms coordinate to behave like a monopoly by maintaining high prices and limiting output. In a competitive oligopoly, firms act independently, using pricing and innovation to win customers. These opposing dynamics show how easily cooperation can shift to competition when individual incentives change, and how strategic decisions shape overall market behavior.

Incentive design and corporate governance

Game theory also helps explain how companies create systems that motivate people to act in the organization's best interest. In large corporations, shareholders own the company but rely on managers to make key decisions. Since effort and judgment are challenging to measure, it can be hard to ensure managers are truly working toward shareholder goals. By using tools like performance-based pay, stock options, and profit sharing, you can align incentives across levels of the organization, reducing conflict and encouraging cooperation toward shared success.

Price competition and market dynamics

Game theory also sheds light on why competitors often end up in price wars. When two stores continually lower prices to attract customers, both would earn more if they maintained higher prices. However, each has a short-term benefit that undercuts the other, leading both to lower profits. This mirrors the Prisoner's Dilemma: individually rational decisions can lead to worse outcomes for everyone involved. Game theory helps explain why these patterns emerge and how businesses can design strategies to mitigate them.

What is pure strategy in game theory vs. mixed strategy?

A pure strategy is a single, definite action a player chooses every time, while a mixed strategy involves randomizing among several possible actions. In a pure strategy, players make their decisions by selecting one available move and committing to it without variation. If you always choose paper in rock-paper-scissors, you are using pure strategy. This approach requires minimal strategic adjustment because you make the same choice regardless of how others act.

A mixed strategy introduces deliberate unpredictability. Players assign probabilities to different moves and use those probabilities to decide which action to take. If you choose rock 50 percent of the time, paper 25 percent of the time, and scissors 25 percent of the time, you are using mixed strategy. Though it may appear random, developing a mixed strategy requires careful analysis to balance outcomes and make opponents uncertain about your next move.

What is a Nash equilibrium in game theory?

The Nash Equilibrium is a point in a game when all players have chosen their best possible actions given everyone else's strategies. When you reach this balance, no one can improve their outcome by changing course alone. It doesn't always produce the best results for everyone, but it helps explain why you may agree to settle.

Getting started with game theory

You can start learning game theory by noticing how your choices depend on others' decisions. Note the players, their options, possible outcomes, and actions, and track what happens. With this information, you can create a simple payoff table to visualize how one decision affects another.

You don't need advanced math to begin. Curiosity and logical thinking are enough. If you want to explore further or prefer a more structured learning environment, enroll in an online game theory course.

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