What is Backward Induction?

Backward induction is a reasoning process that is rooted in game theory. It is a repetitive reasoning process that involves reasoning backward in time. An individual or a player reasons from the end of a problem to determine sequential optimal actions in games. This process of reasoning allows a player to think of the end of a problem and then apply the sequence of happenings to decide what to do at a particular stage. Backward induction has been used as far back as 1944 when John von Neumann and Oskar Morgenstern published a book Theory of Games and Economic Behavior. This process of reasoning was also used by Selten in 1965 in his versions of game.

How does Backward Induction work?

Backward induction is used by a player to decide on what move to make at a particular stage by a process of reasoning backward in time. The player considers the end of a problem and makes current decisions based on this. According to rational behavior highlighted in this theory sometimes reflect in real life but the theory does not precisely predict humans. In this theory, a player that makes the last move in a game uses an optimal strategy determined by this theory. Thereafter, the action of the player before the last one is determined by the last players action. The gaming process moves backward until the best optimal action for each subgame is determined.

Example of Backward Induction

This illustration is important for a better understanding of how a backward induction works. Player X plays first in the game and he needs to decide whether to take the stash worth $4 or pass it. If Player X takes it, the $4 will be shared between him and Player Y ($2 each), if he passes it, Player X will also need to decide whether to take or pass the stash. If Player Y passes, he gets an extra amount added to the existing $2 while Player X gets no amount. However, if both players cooperate and keeps passing, they receive an equal payoff at the end of the game, but the reverse is the case if they do not cooperate.

Related Topics

• Market Structure
• Perfect Competition
• Bidding War
• Complements & Substitutes
• Substitution Effect
• Imperfect Competition
• Market Power
• Price Takers
• Price Makers 
• Perfect Competition and Decision Making
• X-Efficiency
• Captive Market
• Contestable Market Theory
• Highest Profit Point in a Perfectly Competitive Market
• Marginal Revenue
• Using Marginal Revenue and Marginal Costs to Maximize Profit
• Marginal Revenue Curve
• Profit Margin and Average Total Cost
• Break Even Point - Cost Curve
• Shutdown Point - Cost Curve
• Short-Run Decisions Based Upon Costs in a Perfectly Competitive Market
• Marginal Costs and the Supply Curve for a Perfectively Competitive Firm
• Long-Run Average Supply (LRAS)
• Decisions to Enter or Exit a Market in the Long Run
• Long-Run Equilibrium in a Perfectly Competitive Market
• Constant, Increasing, and Decreasing Cost Industries
• Productive and Allocative Efficiency in Perfectly Competitive Markets
• Market Efficiency
• Market Inefficiency
• Pareto Efficiency
• Market Failure 
• Search Theory
• Monopoly
• Natural Monopoly
• Legal Monopoly
• Bilateral Monopoly
• Promoting Innovation through Intellectual Property
• Predatory Pricing
• How Monopolists Set Price with the Demand Curve
• Total Cost and Total Revenue for a Monopolist
• Marginal Revenue and Marginal Cost for a Monopolist
• Inefficiency of Monopoly
• Perfectly Competitive Market
• Monopolistic Competition
• Duopoly
• Oligopoly
• Differentiated Products
• Perceived Demand for a Monopolistic Competitor
• Monopolistic Competitors Choose Price and Quantity
• Monopolistic Competitors and Entry
• Monopolistic Competition and Efficiency
• Cartel (Economics)
• Game Theory
• Traveler's Dilemma
• Prisoner's Dilemma
• Iterated Prisoner's Dilemma
• Nash Equilibrium
• Diner's Dilemma
• Trembling Hand Perfect Equilibrium
• Gambler's Fallacy
• Arrows Impossibility Theorem
• Backward Induction
• Tournament Theory
• Oligopoly and the Prisoner’s Dilemma
• Forcing Cooperation in a Prisoner’s Dilemma
• Cooperation and the Kinked Demand Curve
• Corporate Merger or Acquisition
• Antitrust Laws
• Herfindahl-Hirschman Index
• Concentration Ratio
• Other Approaches to Measuring Monopoly Power in an Industry
• Restrictive Practices under Antitrust Law
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• Cost-Plus Regulation
• Price Cap Regulation
• Regulatory Capture