*Written by: Mauricio Nakahodo, professor of Economics at ESEG College
Long before companies, markets, or economic theories existed, human beings were already playing games. The historian Johan Huizinga called this homo ludens — the human being who plays.
Games were not just for fun: they helped organize social life, create rules, test strategies, and deal with conflicts.
Over time, we realize that many real-life situations function exactly like games. Not in a playful sense, but in a strategic sense: what I do depends on what you do—and vice versa. That's precisely what game theory studies.
In this content, you will understand what game theory is in economics, learn about the concept of Nash Equilibrium, and discover who John Nash was.
Furthermore, you will see how this theory is applied in degree in economics, in the financial market and even in criminal proceedings, through practical examples.
Keep reading to learn more!
What is game theory?
Game theory is a field of economics that analyzes decisions in situations of interdependence. That is, when two or more people (or companies, governments, etc.) make decisions that affect each other.
Consider some simple examples:
- Two companies competing for the same customer;
- Two countries negotiating tariffs;
- Two drivers are deciding who goes first at an intersection.
In all these cases, no one decides alone. Every choice takes into account what the other person can do.
What does John Nash's game theory say?
Game theory gained enormous prominence with the mathematician John Nash, whose story inspired the film. “"A Beautiful Mind"”. In the film, there's a famous scene where he questions the idea that everyone should act only in their own self-interest—showing that, often, the best outcome depends on considering the group.
Nash's main contribution was the theory of Nash Equilibrium.
Simply put, this balance occurs when: No one can improve their situation by changing their decision alone.
Imagine two companies that have already chosen their strategies. If any single change worsens the outcome, then they are in equilibrium.
It's a point of stability. It doesn't mean it's the best possible outcome—just that nobody has the incentive to change on their own.
How does strategic balance work?
Thinking strategically means understanding that your decisions are part of a "game" with other people.
Imagine a simple situation: a group needs to decide how to use a resource—to spend or save/invest. If each person decides without considering others, the result is one thing. But if someone notices how the others will act and adapts their decision, the result changes completely.
This ability to anticipate the behavior of others is what differentiates ordinary decisions from strategic decisions.
The 4 pillars of a game
To understand any strategic situation, we can look at four basic elements:
- Who participates in the game?; (people, companies, countries)
- What choices are available?;
- What are the rules?; (order of decisions, available information, etc.)
- What are the results of each combination of choices?.
These results are usually organized into tables called "payoff matrices," which clearly show who wins and who loses in each scenario.
Practical examples of game theory
The examples presented below illustrate in practice how these four pillars relate to each other in different contexts. See below!
1- Prisoner's Dilemma – Game Theory
This is the most famous example of game theory.
Two suspects are interrogated separately. Each can:
- to remain silent (cooperate);
- or confess (to betray the other).
If both cooperate, the outcome is relatively good for both.
But everyone has an incentive to cheat — because it might work out better for them individually.
The problem is that when both think like that, they end up in a worse situation.
This example illustrates something very important: rational individual decisions can lead to bad outcomes for everyone.
2- Price wars: when excessive competition destroys value
Now consider two competing companies.
For a while, both maintain stable prices and make good profits. But one day, one of them decides to lower its price to attract more customers.
In the short term, it seems like a great idea.
But the competitor reacts — and also lowers the price.
In a short time, both are earning less than before. Neither wanted this outcome, but, from a strategic standpoint, not reacting would be even worse.
This type of situation happens all the time in real markets. It's a classic example of how rational decisions can lead to bad outcomes for everyone.
But what's interesting is that the game can work in the opposite direction as well.
In some markets with few companies, something different happens: one company tests a price increase. The others watch closely. If they follow suit, the entire market starts operating with higher prices. If they don't follow suit, those who raised prices can quickly retreat.
This “silent game” shows the other side of game theory: not only destructive competition, but also attempts at coordination — even without formal agreements.
3- Market entry: to enter or not to enter?
Imagine you want to start a new company in a market already dominated by a large company.
Before entering, you need to think:
“"If I join, how will the company that's already there react?"”
She can:
- accept the competition
- or react aggressively, lowering prices to drive you out.
Now comes the central point: not every threat is credible.
If reacting aggressively is too costly for the dominant company, it may threaten to do so—but in practice, it will not sustain that strategy.
If you realize this, you can decide to enter anyway.
This type of reasoning is very common in markets such as digital banks, airlines, or telecommunications companies. Companies don't just look at the present—they try to anticipate the reaction of their competitors.
4- Game Theory in Law: the incentive to confess
One of the best-known applications of game theory in criminal proceedings This involves analyzing the decisions made by those under investigation during a criminal investigation.
In the legal system, the strategic logic is clearly apparent.
When two people are under investigation, each must decide whether to cooperate with the investigation or not.
The decision depends on expectations regarding the other person.
If they both trusted each other, they could have a better outcome. But the fear of being harmed leads each to act defensively.
That's why mechanisms like plea bargaining work.
The same logic applies to leniency agreements. A company collaborates with the authorities and reveals information before others to obtain benefits—anticipating that, if it does not, another company may act first.
5- Geopolitics: the game between countries
Game theory helps us understand how countries make decisions in competitive scenarios.
Imagine two countries in a tense situation. One imposes trade tariffs; the other responds. In another context, one might advance militarily, and the other must decide how to react.
In both cases, the logic is the same: no one decides alone. Every move is made based on the question:
“"How will the other person react?"”
If both sides back down, they avoid the worst-case scenario. If one side advances and the other retreats, there is a strategic gain. But if both advance—whether through tariffs or military action—the escalation generates high costs for everyone.
Conclusion on game theory in economics
Game theory teaches us a fundamental lesson: It's not enough to make good decisions — you also need to consider how others will react.
She helps explain why:
- Companies engage in price wars;
- Cooperation agreements fail;
- Negotiations are complex;
- Rational decisions don't always lead to the best results.
More than a theory, it is a way of seeing the world as a set of strategic interactions.
For those studying economics, business administration, law, or finance, this makes all the difference. Because, ultimately, the real world functions much more like a game than an isolated problem.
And those who understand the rules of this game make better decisions.
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