Why is game theory useful in business?

Original post


Game theory was once hailed as a revolutionary interdisciplinary phenomenon bringing together psychology, mathematics, philosophy and an extensive mix of other academic areas. Some 20 game theorists have been awarded the Nobel Memorial Prize in Economic Sciences for their contributions to the discipline; but beyond the academic level, is game theory actually applicable in today’s world?


Game Theory in the Business World

The classical example of game theory in the business world arises when analyzing an economic environment characterized by an oligopoly. Competing companies have the option to accept the basic pricing structure agreed upon by the other companies or to introduce a lower price schedule. Despite it being in the common interest to cooperate with competitors, following a logical thought process causes the firms to default. As a result everyone is worse off. Although this is a fairly basic scenario, decision analysis has influenced the general business environment and is a prime factor in the use of compliance contracts.

Game theory has branched out to encompass many other business disciplines. From optimal marketing campaign strategies to waging war decisions, ideal auction tactics and voting styles, game theory provides a hypothetical framework with material implications. For example, pharmaceutical companies consistently face decisions regarding whether to market a product immediately and gain a competitive edge over rival firms, or prolong the testing period of the drug. If a bankrupt company is being liquidated and its assets auctioned off, what is the ideal approach for the auction? What is the best way to structure proxy voting schedules? Since these decisions involve numerous parties, game theory provides the base for rational decision making.

Nash Equilibrium

The Nash equilibrium is an important concept in game theory referring to a stable state in a game where no player can gain an advantage by unilaterally changing his strategy, assuming the other participants also do not change their strategies. The Nash equilibrium provides the solution concept in a noncooperative game. The theory is used in economics and other disciplines. It is named after John Nash who received the Nobel in 1994 for his work.

One of the more common examples of the Nash equilibrium is the prisoner’s dilemma. In this game, there are two suspects in separate rooms being interrogated at the same time. Each suspect is offered a reduced sentence if he confesses and gives up the other suspect. The important element is if both confess, they receive a longer sentence than if neither suspect said anything. The mathematical solution, presented as a matrix of possible outcomes, shows that logically both suspects confess to the crime. Given that the suspect in the other room’s best option is to confess, the suspect logically confesses. Thus, this game has a single Nash equilibrium of both suspects confessing to the crime. The prisoner’s dilemma is a noncooperative game since the suspects cannot convey their intentions to each other.

Another important concept, zero-sum games, also stemmed from the original ideas presented in game theory and the Nash equilibrium. Essentially, any quantifiable gains by one party are equal to the losses of another party. Swaps, forwards, options and other financial instruments are often described as “zero-sum” instruments, taking their roots from a concept that now seems distant.

(For related reading, see: Game Theory: Beyond the Basics.)