International Baccalaureate Math HL

IA Exploration
 
 
 
 
 
Application of Probability in Economics: The
Game Theory

 
 
 
 
 
 

Student B

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Table of Contents

 
Introduction............................................................................................................ 3 
The game theory was first officially introduced by John von Neumann, although a
sense that some strategies exist in decision making was perceived by many before
him. In his book Theory of Games and Economic Behavior, published in 1944,
Neumann brought out scientific and mathematical methods of making optimal
choices in real-world phenomena............................................................................. 3 
The Prisoner’s Dilemma .......................................................................................... 4 
Modeling of Agent’s Behavior................................................................................. 4 
The Probability Rules in Game Theory.................................................................... 7 
The Range of Usages in Mathematical Economics.................................................. 7 
The Limitations of Game Theory............................................................................. 8 
Conclusion ............................................................................................................... 8 
Bibliography ............................................................................................................ 9 

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Introduction
Nothing seems more irrational than making decisions based on predictions. Counting too much
on the probability of an event always involves a great risk. However, in free market economy,
producers do have to make choices without penetrating the minds of their competitors. This
might include occasions in which only one opportunity is allowed or a single action decides the
gain or loss of a huge fortune. Particularly, if only one chance were given to make a decision, the
result seems even more random and by mere luck, as the probability only stabilizes in the long
run, shown by the graph below1. Despite these skepticisms that would come across the minds of
many, economists have developed a method of study of strategic decision making, known as
‘game theory’.

The game theory was first officially introduced by John von Neumann, although a sense that
some strategies exist in decision making was perceived by many before him. In his book Theory
of Games and Economic Behavior, published in 1944, Neumann brought out scientific and
mathematical methods of making optimal choices in real-world phenomena2.
This exploration will closely examine the methods of decision-making for the purpose of
applying the skills of solving the probability, acquitted in IB Mathematics HL, and critically
reflecting on the reliability of the game theory.

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Image from http://www.moserware.com/
2
P.86, The Mathematics of Games and Gambling, Edward Packel, MAA, 1981
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The Prisoner’s Dilemma
The most fundamental and widely-known reasoning behind the game theory can be represented
by the Prisoner’s Dilemma. Although this does not fall directly into the field of economics, as it
is also widely studied in politics, psychology and philosophy, the prisoner’s dilemma illustrates
the basic structure of how the game theory works. One version of it is introduced below:

‘Two suspects are taken into custody and separated. The District Attorney is certain that they
are guilty of a specific crime, but she does not have enough evidence to convict them at a trial.
She explains to the suspects that they each have two alternatives: they can confess to the crime,
or not confess. In neither confesses, then she will charge them on some trivial offense, and their
punishment will be relatively minor – one year in jail. If one of them confesses, then he will get
off scot-free, while the other will serve ten years in prison. If both confess, then they will both be
prosecuted, but the District Attorney will recommend a less severe sentence – eight years each3.”

It is obvious that the utility of the two prisoners would be maximized if both of them choose not
to confess. However, there are two reasons why each would choose to tell on another. First, there
is an incentive for convicting the other of the crime, for one could be set off free without any
punishment. Another, the more likely, reason is the fear that the other person might tell on
oneself, resulting in ten-year sentence.

At first sight, this decision seems extremely unreasonable, since such behaviour leads to both
receiving eight-year sentence when they can choose for one-year each. Nevertheless, the
uncertainty of the situation makes it unavoidable to select the unfavourable choice.

Modeling of Agent’s Behavior

In real economy, decision-making becomes much complex due to a number of different factors:
the unpredictability of social and financial policies, interruptions of other individuals or
businesses, or the issues of morality and social norms. However, the following examples cut
down all the other factors in order to illustrate how the behaviors of individuals and businesses
can be modeled in a simple chart.

Example 1: Iraq and Iran are the only suppliers of petroleum. Throughout a contract, they
decide to cut down petroleum supply in order to raise the price. If the both nations keep up the
contract, each gains fifty-million dollars. If one nation decides to betray and increases the
production, it gains sixty-million dollars while the other gains only thirty-million. Without any
contract and keeping the high supply of petroleum, each nation gains forty-million dollars. What
would Iraq and Iran do?

3
P.70, A Mathematical Mosaic: Patterns and Problem Solving, Ravi Vakil, Brendan Kelly Publishing Inc., 2008
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 Iraq’s
Decision

Maintain the high level of production Decrease the supply

Maintain Iraq: 40 Iraq: 30

the high Million Million
level of Iran: 40 Iraq: 60
production Million Million
Iran’s
Decision Iraq: 60 Iraq: 50
Decrease Million Million
the Iran: 30
Iran: 50
Supply Million
Million

The chart can be further simplified as shown below, and is called the normal form of modelling:

High Low

40, 40 60, 30
High

Low 30, 60 50, 50

In this case, the total profit of Iraq and Iran becomes greater when they both conform to the
contract. However, the dominant strategy, or the advantageous strategy regardless of the
opponent’s decision, is to break the treaty. There is a clear incentive for maintaining the supply
high, since one can maximize its profit when the other still keeps the low supply. On the other
hand, it is hard to neglect the possibility that the other will break the contract to maximize its
profit. Then one can only gain thirty-million dollars. At least, if they both break the contract,
each can gain forty-million dollars.

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Example 24: Calvin and Klein have been arrested for theft of good taste in fashion. They are
being held in separate cells in the jail with no way to communicate with one another. In their
interrogation they have been presented with the following table:

Klein
Confess No Confession Partly
Confess 2, 2 0, 5 1, 3
Calvin No Confession 5, 0 1/2, 1/2 4, 1/4
Partly 3, 1 1/4, 4 1, 1

If they both confess to the crime then they will both go to jail for 2 years. Calvin can cut a deal:
If he confesses and Klein does not, then Calvin's confession can be used to sentence Klein to five
years in jail and Calvin will walk. If Calvin gives a full confession but Klein only admits
complicity then Calvin gets a year and Klein is sentenced to three. The rest of the table is read
the same way.

In a case where there are more than two options, it would be easier to use branches to represent
the situation, as shown below:

In the diagram, the first three branches represent the choices Calvin can make. Then from every
branch emerges the branches of the three choices Klein can take. By using different colors or
coordinates, the results of each choice are shown at the end of the branches.

The advantage of using branches, or the extensive form of modeling, is that one can easily
figure out the probability of each situation. For instance, if Klein chooses not to confess, the

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http://isc.temple.edu/economics/Econ_92/Game_Lectures/1st-Look/introduction_to_game_theory.htm
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Image from http://isc.temple.edu
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possibility of being put in jail for less than one year is P(less than 1
D_Dd__________ðáϨϨ________________ D_Dd__________ðáϨϨ________________
()()()()D_Dd__________ ĎϨϨ________________ D_Dd__________ʔĎϨϨ___________

The Probability Rules in Game Theory 
The use of probability is essential in the game theory. Therefore, it is important to clarify the
premises of the probability distribution. The followings are the basic probability rule6s:

1. For n events, P(A B C

2. For all events, P(i)

From these two rules, there are several assumptions we can make. First, from rule 1, each event
in the game theory is mutually exclusive of one another. This means, the events cannot occur
together. Second, rule 2 shows that the probability of each event is a number equal to, or between
0 and 1. These, however, account for some limitations of the game theory, which will be
explained later.

The Range of Usages in Mathematical Economics

Game theory is broadly used in economics. By modelling the behaviours of individuals and
businesses, economists can predict the decisions of the competitors and sort out the choices they
have. There are numerous viewpoints about the possible fields of application:

“The two principal areas of application have been war and economics. For the military it has
been applied to tactical decision-making (in particular via the theory of differential games) and
in studying global nuclear strategies such as deterrence. In economics, game theory has been
used in studying competition for markets, advertising, planning under uncertainty, and so forth.
These primary areas of application - war and economics - are where one would expect game
theory to be applied, given the values reflected in its concepts7.”

-Journal of Artificial Societies and Social Simulation vol.4, no.2-

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http://gametheory101.com/Probability_Rules.html

7 Journal of Artificial Societies and Social Simulation vol. 4, no. 2, http://jasss.soc.surrey.ac.uk/4/2/2.html

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 “Applications include a wide array of economic phenomena and approaches, such as auctions,
bargaining, fair division, duopolies, oligopolies, social network formation, agent-based
computational economics, general equilibrium, mechanism design, and voting systems, and
across such broad areas as experimental economics, behavioral economics, information
economics, industrial organization, and political economy8.”

-http://en.wikipedia.org/wiki/Game_theory-

The possible application of game theory is unlimited. By aiming the psychological and
behavioral nature of every social phenomenon, prediction of certain action of opponents can be
done with rational and scientific reasoning. Nevertheless, this leads to another important
concern: the reliability of game theory.

The Limitations of Game Theory 

Conclusion 
Throughout this exploration, I could understand the basic concepts of the game theory by
investigating the results of given examples and eventually creating one with a chart by myself.
The different formats of modelling helped realized the effectiveness of simplifying a situation
and sorting out the best model that facilitates calculation and prediction.

It is undeniable that game theory cannot be the cure-all for every economic problem. Cheating
or striving to maximize one’s own profit without the care for the others can have damaging
effects on the long-term relationship with either individuals or the society.

However, in urgent situations, one has to figure out the best option allowed. In such cases,
rational and strategic decision making is crucial. I do believe that an optimal decision exists in
every phenomenon, no matter how controversial or dilemmatic it is. Therefore, a wise
application of game theory will pay off in some way or another.

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http://en.wikipedia.org/wiki/Game_theory
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Bibliography 
Book Resources

— The Mathematics of Games and Gambling, Edward Packel, MAA, 1981

— P.70, A Mathematical Mosaic: Patterns and Problem Solving, Ravi Vakil, Brendan Kelly
Publishing Inc., 2008

Online Resources

— http://isc.temple.edu/economics/Econ_92/Game_Lectures/1st-
Look/introduction_to_game_theory.htm
— http://gametheory101.com/Probability_Rules.html
— Journal of Artificial Societies and Social Simulation vol. 4, no. 2,
http://jasss.soc.surrey.ac.uk/4/2/2.html
— http://en.wikipedia.org/wiki/Game_theory

Image/Graphic Resources

— http://www.moserware.com/
— http://isc.temple.edu