Choices and decisions are a very important part of our daily lives. Our decisions have consequences, and thus, we think carefully before landing on any decision to follow through with. The logic and reasoning we often use in making a decision are somewhat embedded in our behavioural characteristics. And this is where Game Theory comes in, without us actively knowing about it.
Now, as much fun as it sounds, it is not a theory about a particular game, but rather an approach that can be made use of in business, war, life, and strategy.
But what is Game Theory?
History of Game Theory
In the year 1944, a mathematician by the name of John von Neumann, along with his colleague Oskar Morgenstern, originally developed the Game Theory and mentioned it in their book: The Theory of Games and Economic Behaviour. They believed that economics is much like any other game, wherein the outcomes are generally inter-dependent on the decisions of other players.
Game Theory has been applied to a range of situations in which the players’ interactions determine the impact of the outcome.
Example of Game Theory: Prisoner’s Dilemma
Let us look at one of the easiest examples to understand this theory.
2 crooks (let us call them A and B) are arrested for a robbery. They have not worked together before but had decided to join forces only for this one job.
Once caught, they are placed in two different rooms and are made offers.
- If you confess, but your partner does not, you go free, and your partner gets 10 years in prison
- You both confess, and each gets 5 years in prison
- If neither of you confess, then each gets 2 years in prison
Now they are split up and left to decide.
This is what the decision matrix shall look like:
Since neither knows the other person well, trust is a big issue. Both will have significant doubts about the other. In an ideal situation, both must remain silent and not confess. In this case, both get 2 years. But what if A remains silent but B confesses? That leaves A in prison for 10 years. And vice versa for B. This is a highly unstable situation, even if it is ideal.
Now, what if both confess? Both have 2 scenarios before them – either 5 years in prison or go free. This seems quite lucrative to them. This is the best choice no matter what the other one chooses. This choice is called a “Nash Equilibrium”, wherein both choose what is best for them (confess), irrespective of what the other chooses.
In a competition, it is advised to opt for the choice that benefits you the most, irrespective of what the other player(s) choose to do. This is what we call a Non-Cooperative competition, where players are working their own agendas.
On the other hand, in a Cooperative competition, the concerned players have agreed to work together towards a common goal. Each one’s contribution is determined by Shapley Value (a method used to determine individual contribution’s worth in the absence of a coalition, which helps in the pay-out at the end).
Relation to Business and Economics
Businesses around all economies are run by decisions. These decisions differ from situation to the next, depending on the type of competition involved. In a cooperative situation, outcomes largely depend on the decisions of the other players, while in a non-cooperative situation, independent decisions lead to the Nash-Equilibrium outcomes.
But there are various overlaps within economies. And thus, come in Monopolies and Oligopolies.
Monopoly
A market condition with a number of producers, each having similar (but not exactly the same products), while the barriers to entry are low. An example could be fast food chains. Their product line-ups are, more or less, similar. Thus, if one increases prices, consumers have the choice of going to the other. And thus, monopolies are ruled by understanding.
An understanding that the changes must occur simultaneously, to benefit all of their businesses. This indicates that a hike in price of one’s products will be followed by the hike in prices of the other players in the market too. In a monopoly, the competition is purely based on customer segmentation. This is generally a non-cooperative game, where the individual players decide on what’s best for them, irrespective of the choices of the other players.
Oligopoly
On the other hand, is a market where the number of players is lesser, but the barriers to entry are higher. This is a rather cooperative game, where players are in somewhat of a coalition. They depend on the other’s decisions, and thus are able to control markets. One of the best examples is Coca-Cola and Pepsi – two companies who have created a global oligopoly on an unsaid common goal. If one was to lower their prices, the other would follow. And if this continued for too long, neither would be able to make profits.
Hence, in an unsaid mutual understanding, they do not engage in price competitions, but ensure that the barriers to entry in the market remain high and controlled by both of them. A non-price competition includes brand value, quality, and customer loyalty, all of which serve as large barriers to new entrants in the market.
Conclusion
Game Theory is not just one theory, but a pool of smaller theories, each for a situation of itself. The way it is used, depends greatly on the understanding of the situation, type of game and the players involved. Unknowingly, we all use Game Theory in our daily lives. Decision-making as a skill is quite critical, and aa major component that needs to be learnt is devising pay-off matrices and the concerned Game Theory.
If you had to make a choice, chances are you are using a version of this theory. How do you hone your decision-making skills? Contact us to find out.