What Exactly Is Game Theory?

There are three parts to any game:

 A set of players
 Moves the players can make
 Payoffs the players might receive

The players choose their moves to maximize their payoff. Each

player always assumes that other players are also trying to maximize
their score.
Game theory gets interesting, however, only when there is tactical
interaction, that is, when everyone tries to figure out their rivals’
strategy before they move.
In game theory land people always act in their own self-interest, and
consequently, everyone lies whenever lying serves their interests.

Unfortunately, game theory shows that many threats can and should
be ignored, since a man is never as good as his word in game theory
land. Game theory, fortunately, provides many means of making
credible threats.

Eliminating options can increase your payoff.

To determine truthfulness, we should often go beyond emotions

to interests. When someone makes a promise or threat, sure, use
your people skills to try to discern their honesty. Also, however,
figure out if they would be better off in the future keeping their word.
Furthermore, when competing against a rational player, remember
that she might judge your truthfulness based not upon how you
come across, but rather on whether you will serve your future
interests by keeping your threat or promise.

What should the players do in a simultaneous game? The best way

to solve a simultaneous-move game is to look for a dominant
strategy. A dominant strategy is one that you should play, regardless
of what the other player does.
A dominant strategy is a strategy that gives you a higher payoff than
all of your other strategies, regardless of what your opponent does.
A dominant strategy is a powerful solution concept because you
should play it even if you think your opponent is insane, is trying to
help you, or is trying to destroy you. Playing a dominant strategy, by
definition, maximizes your payoff.

Since coordination leads to victory (avoiding accidents)

in traffic games, you should trust your fellow drivers. In all
coordination games your fellow player wants you to know her move
and her benefits from keeping her promises about what moves she
will make. The key to succeeding in coordination games is to be
open, honest, and trusting.

In outguessing games, if your opponent figures out your strategy, he

always wins.

Fixed-Sum Games
You can characterize games by their total payoff. In a fixed-sum
game, what one player gets, another loses.
In fixed-sum games cooperation is pointless because the player’s
interests are diametrically opposed.
Fixed-sum games can get nasty because you always want to inflict
maximum pain on your opponent. Clearly, if his loss is your gain then
you want him to suffer.

Look to Interests
To win, you must know what you are playing. Different games
require different strategies. The game you’re in is determined by the
alignment of the player’s interests, so when starting a new venture
ask:
 Does everyone have the same objectives?
 Would other players benefit from lying to me about their
strategy?
 Is the game fixed or variable sum?
 Do I want my opponent to guess my future moves?
 Am I better off being perceived as rational or crazy?

The key result from this game is that when a player can’t lie, she
also can’t stay silent, for silence communicates information. Silence
signals that the situation is very bad because if it wasn’t, you would
have an incentive to say something. This result has strong
applications to consumer product markets.
 Pretend a pirate claims to know the location of a buried treasure.
You figure there’s a 1 percent chance that he is both sane and
honest. The pirate then gives you a usable map that seems to show
the exact location of the treasure. Do you still believe the pirate?
Since it’s unlikely that a sane pirate will reveal the location of
treasure, the fact that the pirate freely tells you where his treasure is
buried reduces the chance that he actually has any useful
information.
Now imagine that instead of a pirate revealing the whereabouts of a
treasure, a financial analyst reveals the name of a stock she claims
will rapidly increase in value. The analyst’s willingness to part freely
with this information should itself eviscerate the credibility of that
information. Knowledge about what stock will increase is valuable. If
the analyst was someone whom many people believed and trusted.
then the analyst would never just give away this information; she
would sell it. Might not the analyst, however, both sell this
information and freely reveal it? No. Those who paid would be upset
that they had to pay for something others got for free. Consequently,
the fact that the analyst willingly disseminates this knowledge shows
that either the analyst does not believe her own predictions or lacks
the credibility to actually get paid for this information.

Imagine investors believe that the Federal Reserve Board will cut
interest rates next week. For reasons I won’t detail, interest rate cuts
help stocks. Does this mean that next week stock prices will rise
when interest rates fall? Of course not. Say a stock is worth $58 if
interest rates are not cut and $60 if they are. If it is known that
interest rates will be cut next week, then the value of the stock will
increase to $60 today; the market won’t wait for next week. Next
week, when interest rates do change, they will not influence stock
prices. Interest rate cuts increase stock prices only when first
anticipated.

Recall, it’s the announcement of the rate cut that affects the stock
market, not the actual rate cut.