What is Game Theory?
Game theory is a mathematical and economic field that studies how strategies and decisions are made between individuals. Every decision we make can be classified as a game. In life, there are collaborative and competitive games. Businesses who fail to recognize this difference operate inefficiently and eventually fail. By understanding the fundamentals of game theory, you will be able to consistently make correct decisions and have a new awareness of how strategies are used.
Modern game theory was developed by John Von Neumann and Oskar Morgenstern. After trying to apply concepts from physics to human behavior, Von Neumann began developing another field of mathematics called game theory, which effectively modeled for decision making. Coming from an economics background, the researchers quickly realized that firms operate in a game, which is an interactive situation between rational players. Furthermore, they realized that games also model well for the different types of interactions firms can have with each other. Games can either be competitive or collaborative. In business, firms operate in the same way. To succeed in business, firms must collaborate with one another in order to succeed against their competitors. It is also important to note that business is not the only practical application for game theory; it can also be used for politics, war, law, psychology, and biology.
How is Game Theory Applied?
Although the mathematics behind game theory are thorough and theoretically valuable, oftentimes, it is more important to analyze the status of the game, rather than the mathematical nuances of rational decision making. Some key factors to identify when analyzing a situation through a game theory lens include: the level of cooperation in the game, the players in the game, potential payoffs of all players, the constraints of the game, possible net results of the game (i.e. zero-sum game vs. non-zero-sum game). By understanding all of these variables, you will be able to understand what each stakeholder/ player wants out of the game, and how you can use the structure of the game to your advantage.
A common economic example of a game theory application is actually the basis for our logo at Parametric Pro Consulting - the Edgeworth box (see Figure 1). The box builds off of the basic microeconomic concept of marginal utility. The “exchange lens” is built by the intersection of two parties’ marginal utility curves. Oftentimes, the Edgeworth box is used to illustrate a market with two consumers and two goods, where the “exchange lens” identifies an appropriate production region of the two goods. However, a more relevant application of the model for game theory is negotiation. The Edgeworth box in a negotiation context illustrates the window in which the two parties may land. Negotiation is one of the most dynamic games that we can play. By understanding the limits of the other player and the constraints that they face, you will be able to maximize your marginal utility, while still being able to “play” with the other player. It is actually possible to test where the limits of another player’s Edgeworth box lies. By reading into social signals and cues, you can tell which clauses or amounts push players to the edge of their exchange lens. Gathering this information is crucial to winning a game.
Expanding the pie is one of Parametric’s favourite negotiation strategies. By enlarging the potential benefits for all parties involved and changing the underlying structure of the game being played, you can control the direction of negotiation and turn the negotiation from a competitive game into a collaborative one, where both players work together to structure a non-zero-sum game. This strategy is successful because of an effective application of game theory. The player analyzes the game to understand the constraints before entering into negotiation. By building a new game, you can control the game.
Another famous example of a game theory application is the prisoner’s dilemma game. The setup of the game is the following:
“Two prisoners accused of the same crime are kept in separate cells. Only a confession by one or both can lead to conviction. If neither confesses, they can be convicted of a lesser offense, incurring a penalty of one month in prison. If both plead guilty of the major crime, both receive a reduced sentence, five years. If one confesses and the other does not, the first goes free (for having turned State’s evidence), while the other receives the full sentence, ten years in prison. Under the circumstances is it rational to admit guilt or to deny it?”
Although it seems like not confessing is the most rational decision, confessing is actually the safest strategy a player can use. Funnily enough, this game structure has been used for a dating show called Temptation Island, where couples split apart for a month and live with singles of the opposite sex. Once again, the most rational strategy for the contestants is to cheat on their partner, which makes for some dramatic TV.
At the heart of all strategy development is game theory. All business decisions are made based on the expected actions and reactions of other players/firms. By understanding how to analyze games and exploit games to your advantage, you will have a competitive advantage over the players that you engage with.
Game Theory is an extremely in-depth topic, so if you would like some further reading, check out the Stanford entry for Game Theory.
To check out a real world example of how Game Theory is used, see Parametric Properties' post about it here.
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