What is Game Theory?
In most business situations, managers and organizations make a variety of decisions that directly or indirectly affect each other. Such situations are called "games". Because these decisions are taken by taking into account the moves that other players and opponents can make. In this sense, Game Theory provides a framework for predicting and analyzing behavior and possible outcomes in strategic interaction situations.
Game theory is a field of theoretical study in the social sciences that applies a model to predict the possible outcomes of a given scenario. Game theory is essentially a discipline or method of strategic thinking in which players have to make decisions from different perspectives, basically putting themselves in the shoes of other players and anticipating their possible actions and reactions. Game theory can also be thought of as a modeling technique used to predict and explain the actions of all players involved in competitive situations and to test and determine the relative optimality of different strategies.
So what are the elements that make up game theory? There are three key components at play here:
- A number of players involved. In business, these often relate to individual business managers and firms or companies.
- A set of strategies that players can use at certain points during the game. This also includes the rules of the game, which are set to determine the order of all possible moves and actions. Information that is effective in creating a strategy is also covered here.
- Strategies are the expected returns as a result of actions. These returns are assumed to be known to all parties or players involved.
Principles (Conditions) of Game Theory
Most game theory models include these conditions:
- Every decision maker has two or more options or choice sequences. All possible combinations of decisions or games result in a clear outcome: win or lose.
- Scenarios have a well-defined outcome and decision makers receive a “payment (the value of the outcome to the participants). That is, participants gain or lose something depending on the outcome.
- Decision makers know the rules of the game and the payoffs of other decision makers.
- Decision makers are rational: when faced with two alternatives, players will choose the option that provides the greatest benefits.
- While decision makers know the rules and their opponent's options, they do not know in advance the actual decisions of their opponents. Therefore, decision makers must choose options based on assumptions about what their competitors will choose.
- Some game theory scenarios are also zero-sum games, meaning one decision maker wins what the other loses. But others allow for mutual gains and losses.
- Scenarios or games involve various strategies such as minimizing the maximum losses that another decision maker can cause and making decisions based on probability.
- Games and scenarios can have varying degrees of move and strategy content. Excellent trivia games such as chess and checkers do not contain surprises: each player has a limited number of moves, and each player can see his opponent's moves and instantly respond to them. But other games and scenarios such as the prisoner's dilemma (given below) involve surprises and more guesswork.
Example of Game Theory
A strategic game always consists of the players, the scenario and the strategic decisions that can be made, and then all the possible consequences/cost matrix of each decision. A type of game that can be applied to different fields in game theory and, of course, to the business world is called the "Prisoner's Dilemma".
This game features two players (or prisoners) separated and asked to confess to a crime they committed together. In the game, there are two suspects who are questioned at the same time in separate rooms. The suspects taken into custody by the police are placed in two separate rooms, where they are interrogated and an agreement is made. Because the police have no evidence and need a confession.
According to the agreement, the same conversation is given to both suspects and the suspects are given three options. Admitting that they committed the crime together, confessing to having committed the crime, or denying the crime. Either both parties can confess, only one can confess, or neither side confesses, all with different consequences. They do not communicate with each other, do not cooperate, and are not aware of each other. So each will make a decision without knowing what the other will do.
According to the agreement, if one of the suspects tests against the other and the other remains silent, the suspect who testifies will be released, and the suspect who chooses to remain silent will be sentenced to ten years in prison. If both do not testify against the other and remain silent, both will be sentenced to one year in prison. If both testify against each other, both suspects will each be sentenced to five years in prison. In this context, both suspects have to choose between testing or remaining silent. Since both suspects are not given the opportunity to learn the other's decision until the end of the investigation, the player who is unaware of the other side's decision will not remain silent, not risking the possibility of serving ten years in prison. Testify against the other party and consent to a shorter prison sentence of five years or be released. Here the player will aim to minimize his loss (maximize his win). Of course, it will be inevitable that the other party will testify by acting rationally under the same conditions.
The suspect in the other room makes a logical confession, since confession is the best option. Thus, this game has a single Nash equilibrium where both suspects confess to the crime. The prisoner's dilemma is an uncooperative game as the suspects are unable to communicate their intentions to each other.
The point is, if both confess, they get a longer sentence than if neither of the defendants said anything. Thus, the decision taken by the two parties, who do not communicate with each other, by acting rationally rather than in good faith will actually increase the prison sentence, which they will serve less.
This game assumes that players will act strategically out of self-interest, resulting in less-than-optimal outcomes for both sides. In business, you can apply this to two business scenarios with competing products. If one business changes its pricing to gain a competitive advantage, the other business will be forced to do so, effectively reducing the maximum profit for both companies.
Examples of Game Theory from Business Life
Game theory simulates a set of real-life strategic situations through sequential games to predict how people or organizations will behave. While the best response is usually to cooperate to ensure the most advantageous outcome for all players, the dominant strategy is usually for one player to make the choice that benefits him the most. In other words, while the players' acting together and acting collectively towards the desired goal actually benefits all parties, it can actually harm itself in the long run if one of them thinks for his own benefit and acts separately, wants to come forward with another strategy or harm his opponents. The best example of this situation is considered to be OPEC(Organization of Petroleum Exporting Countries).
In its official statement, OPEC's purpose is to coordinate and unify oil policies among member states to ensure fair and stable prices for oil producers; an efficient, economical and regular supply of oil to consuming countries; and to provide a fair return on capital to those who invest in the sector. In fact, there is an aim to prevent oil producing countries from acting on their own and harming the entire market.
In fact, countries may expand their oil production limits to increase supply and earn more income than others, or they may want to get ahead of rival countries by lowering prices. But countries actually gain more by not doing both. Game theory helps explain this, too.
For an independent country focused on income maximization, producing as much oil as possible is often the dominant strategy. But when everyone increases production, it puts downward pressure on prices. In game theory, this is an example of the prisoner's dilemma. Everyone acting in their own best interests results in a much worse scenario than when players cooperate. This is where the OPEC collusions come into play. Member countries – Algeria, Angola, Ecuador, Equatorial Guinea, Gabon, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia and the United Arab Emirates – act as a single supplier. But as prices rise, it creates more incentives for members not to cheat and produce more.
Another example is the giant IT companies Intel and Advanced Micro Devices (AMD). In such a duopoly market, a company's pricing decisions can be greatly influenced by the pricing choices or decisions of competing companies. A popular example is the price reduction decisions initiated by Intel and AMD on their desktop and mobile processors. Intel and AMD are considered competitors in a highly specialized niche, and both are in a tight race for a larger share of the market. Desiring to gain a competitive advantage, Intel made a move by launching price reductions for its desktop and mobile processors. AMD has responded by applying a similar price cut, even if it means potential losses or a reduction in revenue. However, the ensuinghowever, there have been a series of price reductions that can be described as “repeats of interactions”. This price war has caused both companies to see significant increases in unit sales and shipments of their products, marking an increase in their market potential. However, their revenues and profits have also declined in the long run.
Both companies realize that they have been rivals for a long time and will be playing the same game for a longer period of time. Therefore, they can choose between cooperating with each other and keeping their prices high, or engaging in mutual price-cutting actions.
How is Game Theory Applied in Business Life?
Game theory has branched out to encompass many other business disciplines. From optimal marketing campaign strategies to battle decisions, ideal auction tactics and voting styles, game theory offers a hypothetical framework with substantive implications.
Game theory can be used in business by managers who analyze a particular economic environment to predict the moves that rival companies will make. It can also be used by companies to make business decisions or strategically monitor and analyze changing aspects and competitive behavior in relevant economic conditions and industry-related attributes.
When used in a business context, game theory is mostly used by business managers to understand what their collaborators and competitors are thinking or planning. For example, pharmaceutical companies are constantly faced with decisions whether to market a product immediately to gain a competitive advantage over competitors or to extend the testing period of a drug. Here, it has to act according to the position of its competitors and take the decision to maximize its profit.
Game theory can help companies make strategic choices within or outside their organizations, especially against their competitors. Different situations are presented through simple games that create hypothetical scenarios to simulate real-world conditions and predict a player's behavior.
Here are the most common situations where Game Theory becomes most useful:
- Auctions: Particularly useful when it comes to the analysis of first price closed bid auctions. A first price closed bid auction is a type of auction in which bidders submit their bids – sealed and secured – and the highest bidder wins. What is examined are the behavior of the bidders and the factors that come into play when making decisions while preparing their bids. In this case, the bids are independent of each other and are submitted simultaneously by the bidders.
- Bargaining activities: Game theory comes into play when it comes to bargaining between parties, such as revenue sharing negotiations, as well as negotiations between management and the labor union.
- Product decisions: This is the most important area where businesses can generate scenarios using game theory. In fact, it is most often used by businesses to decide whether to enter or exit a market. Businesses deciding whether to introduce a new product can also use game theory.
- Supply chain decisions : The majority of decisions made by businesses involve the supply chain, and some of the more common decisions made include capacity management, manufacturing or purchasing, outsourcing, etc.
The Importance of Applying Game Theory in Business
Although game theory models have been applied to numerous disciplines, they were originally developed to explain economic phenomena. Therefore, most of the previous discussions are directly related to business and economics.
Making business decisions is a daily occurrence for managers. They are always faced with decisions about what to produce, what to supply, and how to sell what and at what price. This is followed by decisions about how much they should spend on production or supply, how much they should or can afford to incur, and what price they should set when selling (taking into account competitors, consumer preferences, economic conditions, etc.). Game theory is an important tool used for decision making.
It is possible to list a few reasons why business managers should consider using game theory in their business operations:
- To reduce business risk : Simulations are used by business managers in risk analysis methodologies. The application of game models is effective in determining the equilibrium in the market. Risk analysis uses game theory to determine the optimal price strategy, expected market shares, expected revenue, and number of customers while gaining insight into the company, market, competitors and technologies used, among others.
- Learn about the business and industry's competition and the overall competitive landscape: One of the best ways to stay competitive is to know your competition. Using game theory is very effective in gaining insight into various factors related to the competitiveness of the business. Core asks, “What do my competitors think?” she addresses the question. Businesses naturally want to know what their competitors' next move is, their motivations, strategies, strengths and weaknesses, and they use all this information to change the game and increase the value of their business proposition. Game theory is an important tool in this sense.
- Improving internal decision-making processes: By simulating business scenarios, companies are more confident in their decisions and management is more likely to be more involved in internal decision-making processes.
It should be noted, however, that business managers should be mindful of how they use game theory. It is not a management tool that they can use as a substitute for work experience. It is simply a tool or guide for them to fulfill their duty or role as business managers . Also, game theory provides the most satisfying and precise information and analysis in simpler games or scenarios with fewer decision makers and fewer options. Because of the inherent complexity of more complex games with more than two decision makers, game theory becomes more speculative when applied to such games. In these scenarios, decision makers are confronted with forces they cannot control, making it difficult to monitor and define rational behavior.