Game Theory: A New Tool for Economists

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Game Theory: A New Tool for Economists

In the last 25 years, many if not most significant innovations in economics have been driven by this methodological innovation.

In the last 25 years, many and perhaps most significant innovations in economics have been driven by the use of game theory, which provides economists with a language and analytical tools to study many economic interactions that older tools, such as price theory, couldn't touch. These interactions involve dynamics, private information, small numbers, and non-market institutions. "The impact on economics has been very dramatic," says David Kreps, the Paul E. Holden Professor of Economics.

While the roots of game theory go back to the 19th century, modern developments trace largely from after World War II. Among the pioneers were business school academics John Harsanyi, now at Berkeley, and Howard Raiffa, currently at Harvard. But the explosive adoption of game theory by economists began in the early 1970s, led in particular by Stanford's Robert Wilson, the Adams Distinguished Professor of Management.

"Bob Wilson, especially in his work on competitive bidding and the winner's curse [of often bidding more than something is worth], showed how game theory can be used to analyze difficult economic problems," says Kreps. "And his students have been instrumental in extending his ideas." Wilson continues to innovate. With Business School professor John McMillan, Paul Milgrom of the Stanford Economics Department, and University of Texas professor Preston McAfee, Wilson played a leading role in the design of auctions to sell spectrum rights for U.S. wireless communication. "The spectrum auctions are a rare example of public policy flowing directly from academic research," McMillan says. "They've been a success, generating more than $20 billion. They've helped validate the idea that market incentives are an important tool of public policy."

Wilson has also been at work designing decentralized markets for electricity supply, demand, and transmission for the State of California. "Bob has been the single most influential individual in this methodological innovation in the world, as well as being one of the true intellectual leaders of the Business School," says Kreps.

The rise of game theory is an example of a match between methodology and subject matter, he says. The early 1970s was also the time when information economics was developed. This branch of economics, which focuses on topics such as incentives and market signaling, numbers among its most influential founders the School's former dean A. Michael Spence. Information economics provided the contextual puzzles, and game theory provided the key to unlock those puzzles. Much of the unlocking took place at business schools, with Stanford and Northwestern in the vanguard.

Today, these ideas permeate the curriculum of business schools: Subjects that were dramatically changed by these innovations include strategic management, human resource management, managerial accounting, and business and the environment.

Game theory also can be found outside the classroom. Regulators in the Antitrust Division of the U.S. Department of Justice, at the Federal Trade Commission, and in agencies that regulate financial markets rely heavily on game theory to frame their arguments and analyses. "We're at the point where game theory really dominates the modern analysis; it's essential in a job like mine," says Jeremy Bulow, the School's Richard A. Stepp Professor of Economics, on leave to serve as chief economist at the FTC's Bureau of Economics.

Three decades ago, the government's chief focus in antitrust policy was to preserve competitors, not competition. But things are more sophisticated now. One example, Bulow notes, is a predatory practices case being prepared by the Justice Department against American Airlines. Using game theoretic models, economists can examine to what extent taking losses in entry markets will help the airline build a reputation for toughness that will deter entry by competitors. Game theory also can assess so-called "switching costs." For example, airlines create frequent flyer programs to make switching costs high for consumers. In the case of bundling software such as Microsoft Office or packaging car options, consumers sometimes get features at lower cost, but bundling can also deter entry of worthy competitors.

Game theory also has proved useful in analyzing corporate strategy, both in terms of showing firms how to "play" the game in which they are enmeshed and how they might change the rules to their benefit. "One of the messages that game theory gives you is that you need to forecast accurately the beliefs, the expectations, and the behavior of other parties with whom you're interdependent in terms of profits and payoffs," says John Roberts, the Jonathan B. Lovelace Professor of Economics at the School.

For example, when chip maker Intel Corp. built its first microprocessor, the 086, it gave up its monopoly position and created a second source. Intel figured that customers would hesitate to develop products using the 086 if they had only one supplier. By creating a second source-its own competitor-Intel ensured demand for microprocessors would take off. "Something that's hard to understand suddenly makes sense when you think about it in game-theoretic terms," says Roberts.

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