What is Game Theory ?

Game Theory is nothing new to students of economics. It is a study of the thinking process that takes place to maximize a person's outcome in situations.

For example, bidding for an item. Each bidder will have to decide on the value of the item, without knowing what the other bidders are quoting. If they bid too low, they will not get the item. If they bid too high, they might have very little profit from winning the bid.

Say 2 bidders, A and B. The market price for the item is $25 and bids must be in multiples of $10. The bidder with the highest bid price wins. The outcome table is as follow:

                           B
                 Bid10  Bid20
     Bid10  10,10   10,20

A

     Bid20  20,10   20,20

Payout table as follow:
                B
        0,0       0,5

A

        5,0       0,0

What strategy should A choose in this situation?
If A's bid is $10, and B's bid is $10, then A's outcome is 0.
If A's bid is $10 and B's bid is $20, then A's outcome is 0.
If A's bid is $20, and B's bid is $10, then A's outcome is +$5.
If A's bid is $20 and B's bid is also $20, then A's outcome is 0.

Unfortunately, the same reasoning also applies for B. Hence, the most likely situation is both A and B bidding at $20, with no one winning the bid.

It is very important to figure out what are your payouts, and your opponents' payouts before considering what strategy to adopt in any situation.