Game Theory is the study of strategic decisions: situations where the outcome of my choice depends not only on what I do, but also on what others do, and where they are thinking about me in the same way. It is one of the mental models I find most useful, because so much of life, from negotiations and business competition to friendships and family life, is a game in this sense.
The essence of Game Theory is to stop thinking only about my own best move and start asking: “Given what the others want and how they will likely respond, what is my best move, and what kind of game are we really playing?“
Origin: von Neumann, Morgenstern and Nash
Modern game theory was founded by the mathematician John von Neumann, who published a paper on the theory of parlor games in 1928, and then with the economist Oskar Morgenstern wrote Theory of Games and Economic Behavior (1944). Their focus was mainly on zero-sum games, where one player’s gain is the other’s loss.
In 1950, the young mathematician John Nash extended the theory to games of any kind, and proved that every finite game has at least one equilibrium, if players are allowed to mix their strategies at random. He shared the 1994 Nobel Memorial Prize in Economic Sciences with John Harsanyi and Reinhard Selten for this pioneering work, and his life was later portrayed in the film A Beautiful Mind (which is on my recommended movie list).
Key Concepts
- Nash Equilibrium
A Nash equilibrium is a set of choices where no player can do better by changing only their own strategy, given what the others are doing. It is a stable point, but not necessarily a good one for anyone. - The Prisoner’s Dilemma
The most famous game was designed by Merrill Flood and Melvin Dresher at the RAND Corporation in 1950, and later named by Albert Tucker. Two suspects are questioned separately. If both stay silent, both get a short sentence. If one betrays the other, the betrayer goes free and the other gets a long sentence. If both betray, both get a fairly long sentence. Betraying is the best choice for each individually, whatever the other does, so the equilibrium is that both betray, even though both would have been better off staying silent. I have written more about it in What is the Prisoner’s Dilemma? - Repeated Games and Tit-for-Tat
Most real relationships are not one-off. Around 1980, the political scientist Robert Axelrod invited experts to submit strategies for a computer tournament of the repeated prisoner’s dilemma. The winner, in both rounds, was the simplest program: tit-for-tat, submitted by Anatol Rapoport. It cooperates on the first move and then copies whatever the other player did last. In The Evolution of Cooperation (1984), Axelrod described why it works: it’s nice (never the first to defect), retaliatory, forgiving and clear. - Zero-sum vs. Positive-sum
In a zero-sum game, like poker or a single sports match, the total is fixed, and my win is your loss. In a positive-sum game, like trade, friendship or building a company together, cooperation can make the total larger, so both sides can win. One of the most common mistakes I see is treating positive-sum situations as if they were zero-sum.
Some Examples
- Business Pricing
Two competing companies could both stay profitable with stable prices, but each is tempted to cut prices to win market share. When both do, they end up in a price war where both lose, a classic prisoner’s dilemma. - Negotiations
Thinking in games helps me look for outcomes where both sides gain, rather than just splitting a fixed pie. See Pareto Optimal Outcomes for more. - Shared Resources
When many people share a resource, each has an incentive to take a little more, and together they deplete it. This is the Tragedy of the Commons, a many-player version of the prisoner’s dilemma. - Coordination in Everyday Life
Many games are about coordination rather than conflict, like which side of the road to drive on or where to meet a friend without a phone. The economist Thomas Schelling showed in The Strategy of Conflict (1960) that people often converge on an obvious focal point, such as noon at the main train station. - Relationships and trust
In friendships, families and long-term business relationships, the game is repeated, so reputation and reciprocity matter more than any single win. See The Anatomy of Trust for more.
Applying Game Theory
When I face a decision that involves other people, this is the simple process I follow:
- Identify the Players
Ask who else is involved and whose decisions affect the outcome. - Understand What Each Player Wants
Look at their incentives, not just what they say. People respond to how they are rewarded. - Determine What Kind of Game It Is
Is it zero-sum or positive-sum? One-off or repeated? Is the main problem conflict or coordination? - Think One-Two Steps Ahead
Ask how the others are likely to respond to each of my options, and how I would then respond. See Second-Order Thinking for more info. - Look for Ways to Change the Game
Instead of only playing the game as it is, I look for ways to make cooperation pay off: communicating, building trust, creating repeated interactions, making commitments credible or changing the incentives. - Play the Long Game
In repeated games, I follow the lessons from tit-for-tat: start by cooperating, respond to defection, forgive quickly, and be clear and predictable.
Pitfalls and Limitations
- Real people are not perfectly rational. Emotions, fairness, habits and limited information all affect choices, which is why behavioral economics often finds results that differ from the theory. See my notes on the book Predictably Irrational, for more info and examples.
- The models are simplifications. Real situations rarely come with clear players, known payoffs and fixed rules, so the conclusions are only as good as the assumptions.
- Seeing everything as a game can make me cynical and calculating. Treating every relationship as a contest risks destroying the trust that makes positive-sum outcomes possible.
- A Nash equilibrium is stable, not good. Knowing where a game will likely end up does not mean that outcome is desirable, and many games have several equilibria.
Related Mental Models
- The Prisoner’s Dilemma
- The Tragedy of the Commons
- Pareto Optimal Outcomes
- The Coase Theorem
- Second-Order Thinking
- Inversion
Game Theory reminds me that I am rarely deciding alone. By understanding the players, their incentives and the kind of game we are in, and by looking for ways to turn zero-sum contests into positive-sum cooperation, I make better decisions and build relationships that pay off over time.
To learn more about economics and how key parts of our world work,
check out: Wise: How to Attain a Deep Understanding of the World, History, Our Place in It, and How to Live Well
📚 Sources and References
- Theory of Games and Economic Behavior (1944) by John von Neumann and Oskar Morgenstern
- Equilibrium Points in n-Person Games, Proceedings of the National Academy of Sciences (1950) by John F. Nash
- The Strategy of Conflict (1960) by Thomas C. Schelling
- The Evolution of Cooperation (1984) by Robert Axelrod
- Game Theory, Stanford Encyclopedia of Philosophy