Presentation Speech by Professor Karl-Göran Mäler of the Royal Swedish Academy of Sciences
Translation of the Swedish text
Your Majesties, Your Royal Highnesses, Ladies and Gentlemen,
Many situations in society, from everyday life to high-level politics, are characterized by what economists call strategic interactions. When there is strategic interaction, the outcome for one agent depends not only on what that agent does, but also very largely on how other agents act or react. A firm that decreases its price to attract more customers will not succeed in this strategy if the other major firms in the market use the same strategy. Whether a political party will be successful in attracting more votes by proposing lower taxes or increased spending will depend on the proposals from other parties. The success of’ a central bank which is trying to fight inflation by maintaining a fixed exchange rate depends – as we know – on decisions on fiscal policy, and also on reactions in markets for labor and commodities.
A simple economic example of strategic interaction is where two firms are competing with identical products on the same market. If one firm increases its production, this will make the market price fall and therefore reduce profits for the other firm. The other firm will obviously try to counteract this, for example by increasing its production and so maintaining its market share but at the cost of further reduction in market price. The first company must therefore anticipate this countermove and possible further countermoves when it makes its decision to increase production. Can we predict how the parties will choose their strategies in situations like this?
As early as the 1830s the French economist Auguste Cournot had studied the probable outcome when two firms compete in the same market. Many economists and social scientists subsequently tried to analyze the outcome in other specific forms of strategic interaction. However, prior to the birth of game theory, there was no toolbox that gave scholars access to a general but rigorous method of analyzing different forms of strategic interaction. The situation is totally different now. Scientific journals and advanced textbooks are filled with analyses that build on game theory, as it has been developed by this year’s Laureates in economics, John Nash, John Harsanyi and Reinhard Selten.
Non-cooperative game theory deals with situations where the parties cannot make binding agreements. Even in very complicated games, with many parties and many available strategies, it will be possible to describe the outcome in terms of a so-called Nash equilibrium – so named after one of the Laureates. John Nash has shown that there is at least one stable outcome, that is an outcome such that no player can improve his own outcome by choosing a different strategy when all players have correct expectations of each other’s strategy. Even if each party acts in an individually rational way, the Nash equilibrium shows that strategic interaction can quite often cause collective irrationality: trade wars or excessive emission of pollutants that threaten the global environment are examples in the international sphere. One should also add that the Nash equilibrium has been important within evolutionary ecology – to describe natural selection as a strategic interaction within and between species.
In many games, the players lack complete information about each other’s objective. If the government, for example, wants to deregulate a firm but does not know the cost situation in the firm, while the firm’s management has this knowledge, we have a game with incomplete information. In three articles published toward the end of the 1960s, John Harsanyi showed how equilibrium analysis could be extended to handle this difficulty, which game theorists up to that time had regarded as insurmountable. Harsanyi’s approach has laid an analytical basis for several lively research areas including information economics which starts from the fact that different decision makers, in a market or within an organization, often have access to different information. These areas cover a broad range of issues, from contracts between shareholders and a company’s management to institutions in developing countries.
One problem connected with the concept of Nash equilibrium is that there may be several equilibria in non-cooperative games. It may thus be difficult – both for the players and an outside analyst – to predict the outcome. Reinhard Selten has, through his “perfection” concepts, laid the foundations for the research program that has tried to exclude improbable or unreasonable equilibria. Certain Nash equilibria can, in fact, be such that they are based on threats or promises intended to make other players choose certain strategies. These threats and promises are often empty because it is not in the player’s interest to carry them out if a situation arises in which he has threatened to carry them out. By excluding such empty threats and promises Selten could make stronger predictions about the outcome in the form of socalled perfect equilibria.
Selten’s contributions have had great importance for analysis of the dynamics of strategic interaction, for example between firms trying to reach dominant positions on the market, or between private agents and a government that tries to implement a particular economic policy.
Professor John Harsanyi, the analysis of games with incomplete information is due to you, and it has been of great importance for the economics of information.
Dr John Nash, your analysis of equilibria in non-cooperative games, and all your other contributions to game theory, have had a profound effect on the way economic theory has developed in the last two decades. Professor Reinhard Selten, your notion of perfection in the equilibrium analysis has substantially extended the use of non-cooperative game theory.
It is an honour and a privilege for me to convey to all of you, on behalf of the Royal Swedish Academy of Sciences, our warmest congratulations. I now ask you to receive your prizes from the hands of his Majesty the King.