How Game Theory Works

The key pioneers of game theory were mathematician John von Neumann
and economist Oskar Morgenstern in the 1940s.1 Mathematician John
Nash is regarded by many as providing the first significant extension of the
von Neumann and Morgenstern work.

The focus of game theory is the game, which serves as a model of an

interactive situation among rational players. The key to game theory is that
one player's payoff is contingent on the strategy implemented by the other
player.

The game identifies the players' identities, preferences, and available

strategies and how these strategies affect the outcome. Depending on the
model, various other requirements or assumptions may be necessary.

Game theory has a wide range of applications, including psychology,

evolutionary biology, war, politics, economics, and business. Despite its
many advances, game theory is still a young and developing science.

According to game theory, the actions and choices of all the participants
affect the outcome of each. It's assumed players within the game are
rational and will strive to maximize their payoffs in the game.2

Useful Terms in Game Theory

Any time we have a situation with two or more players that involve known
payouts or quantifiable consequences, we can use game theory to help
determine the most likely outcomes. Let's start by defining a few terms
commonly used in the study of game theory:

 Game: Any set of circumstances that has a result dependent on the

actions of two or more decision-makers (players)
 Players: A strategic decision-maker within the context of the game
 Strategy: A complete plan of action a player will take given the set
of circumstances that might arise within the game
 Payoff: The payout a player receives from arriving at a particular
outcome (The payout can be in any quantifiable form, from dollars
to utility.)
 Information set: The information available at a given point in the
game (The term information set is most usually applied when the
game has a sequential component.)
 Equilibrium: The point in a game where both players have made
their decisions and an outcome is reached
The Nash Equilibrium
Nash equilibrium is an outcome reached that, once achieved, means no
player can increase payoff by changing decisions unilaterally. It can also
be thought of as "no regrets," in the sense that once a decision is made,
the player will have no regrets concerning decisions considering the
consequences.

The Nash equilibrium is reached over time, in most cases. However, once
the Nash equilibrium is reached, it will not be deviated from. After we learn
how to find the Nash equilibrium, take a look at how a unilateral move
would affect the situation. Does it make any sense? It shouldn't, and that's
why the Nash equilibrium is described as "no regrets." Generally, there
can be more than one equilibrium in a game.

However, this usually occurs in games with more complex elements than
two choices by two players. In simultaneous games that are repeated over
time, one of these multiple equilibria is reached after some trial and error.
This scenario of different choices overtime before reaching equilibrium is
the most often played out in the business world when two firms are
determining prices for highly interchangeable products, such as airfare or
soft drinks.

Ever seen an opposing coach call a timeout right before the other team's
kicker is to attempt a game-winning field goal? Th

Impact of Game Theory

Game theory is present in almost every industry or field of research. Its
expansive theory can pertain to many situations, making it a versatile and
important theory to comprehend. Here are several fields of study directly
impacted by game theory.

Economics

Game theory brought about a revolution in economics by addressing

crucial problems in prior mathematical economic models. For instance,
neoclassical economics struggled to
understand entrepreneurial anticipation and could not handle the imperfect
competition. Game theory turned attention away from steady-state
equilibrium toward the market process.

Economists often use game theory to understand oligopoly firm

behavior. It helps to predict likely outcomes when firms engage in certain
behaviors, such as price-fixing and collusion.
Business

In business, game theory is beneficial for modeling competing behaviors

between economic agents. Businesses often have several strategic
choices that affect their ability to realize economic gain. For example,
businesses may face dilemmas such as whether to retire existing products
or develop new ones or employ new marketing strategies.

Businesses can often choose their opponent as well. Some focus on

external forces and compete against other market participants. Others set
internal goals and strive to be better than previous versions of itself.
Whether external or internal, companies are always competing for
resources, attempting to hire the best candidates away from their rivals,
and gather the attention of customers away from competing goods.

Game theory in business may most resemble a game tree as shown

below. A company may start in position one and must decide upon two
outcomes. However, there are continually other decisions to be made; the
final payoff amount is not known until the final decision has been
processed.

Example of Game Tree.

Internet Encyclopedia of Philosophy

Project Management

Project management involves social aspects of game theory as different

participants may have different influences. For example, a project manager
may be incentivized to successfully complete a building development
project. Meanwhile, the construction worker may be incentivized to work
slower for safety or delay the project to incur more billable hours.

When dealing with an internal team, game theory may be less prevalent as
all participants working for the same employer often have a greater shared
interest for success. However, third-party consultants or external parties
assisting with a project may be incentivized by other means separate from
the project's success.

Consumer Product Pricing

The strategy of Black Friday shopping is at the heart of game theory. The
concept holds that should companies reduce prices, more consumers will
buy more goods. The relationship between a consumer, a good, and the
financial exchange to transfer ownership plays a major part in game theory
as each consumer has a different set of expectations.
Outside from sweeping sales in advance of the holiday season, companies
must utilize game theory when pricing products for launch or in anticipation
of competition from rival goods. The company must balance pricing a good
too low and not reaping profit, yet pricing a good too high may scare
customers away towards a substitute good.

Types of Game Theories

Cooperative vs. Non-Cooperative Games

Although there are many types (e.g., symmetric/asymmetric,

simultaneous/sequential, etc.) of game theories, cooperative and non-
cooperative game theories are the most common. Cooperative game
theory deals with how coalitions, or cooperative groups, interact when only
the payoffs are known. It is a game between coalitions of players rather
than between individuals, and it questions how groups form and how they
allocate the payoff among players.

Non-cooperative game theory deals with how rational economic agents

deal with each other to achieve their own goals. The most common non-
cooperative game is the strategic game, in which only the available
strategies and the outcomes that result from a combination of choices are
listed. A simplistic example of a real-world non-cooperative game is rock-
paper-scissors.

Zero-Sum vs. Non-Zero Sum Games

When there is a direct conflict between multiple parties striving for the
same outcome, this type of game is often a zero-sum game. This means
that for every winner, there is a loser. Alternatively, it means that the
collective net benefit received is equal to the collective net benefit lost.
Almost every sporting event is a zero-sum game in which one team wins
and one team loses.

A non-zero-sum game is one in which all participants can win or lose at the
same time. Consider business partnerships that are mutually beneficial
and foster value for both entities. Instead of competing and attempting to
"win", both parties benefit.

Investing and trading stocks is sometimes considered a zero-sum game.

After all, one market participant will buy a stock and another participant sell
that same stock for the same price. However, because different investors
have different risk appetites and investing goals, it may be mutually
beneficial for both parties to transact.
Simultaneous Move vs. Sequential Move Games

Many times in life, game theory presents itself in simultaneous move

situations. This means each participant must continually make decisions at
the same time their opponent is making decisions. As companies devise
their marketing, product development, and operational plans, competing
companies are also doing the same thing at the same time.

In some cases, there is intentional staggering of decision-making steps in

which one party is able to see the other party's moves before making their
own. This is usually always present in negotiations; one party lists their
demands, then the other party has a designated amount of time to respond
and list their own.

One Shot vs. Repeated Games

Last, game theory can begin and end in a single instance. Like much of
life, the underlying competition starts, progresses, ends, and cannot be
redone. This is often the case with equity traders that must wisely choose
their entry point and exit point as their decision may not easily be undone
or retried.

On the other hand, some repeated games continue on and seamlessly

never end. These types of games often contain the same participants each
time, and each party has the knowledge of what occurred last time. For
example, consider rival companies trying to price their goods. Whenever
one makes a price adjustment, so may the other. This circular competition
repeats itself across product cycles or sale seasonality.

In the example below, a depiction of the Prisoner's Dilemma (discussed in

the next section) is shown. In this depiction, after the first iteration occurs,
there is no payoff. Instead, a second iteration of the game occurs, bringing
with it a new set of outcomes not possible under one shot games.

Example of Repeated Game.

Internet Encyclopedia of Philosophy

Examples of Game Theory

There are several "games" that game theory analyzes. Below, we will just
briefly describe a few of these.

The Prisoner's Dilemma

The Prisoner's Dilemma is the most well-known example of game
theory. Consider the example of two criminals arrested for a crime.
Prosecutors have no hard evidence to convict them. However, to gain a
confession, officials remove the prisoners from their solitary cells and
question each one in separate chambers. Neither prisoner has the means
to communicate with each other. Officials present four deals, often
displayed as a 2 x 2 box.

1. If both confess, they will each receive a five-year prison sentence.

2. If Prisoner 1 confesses, but Prisoner 2 does not, Prisoner 1 will get
three years and Prisoner 2 will get nine years.
3. If Prisoner 2 confesses, but Prisoner 1 does not, Prisoner 1 will get
10 years, and Prisoner 2 will get two years.
4. If neither confesses, each will serve two years in prison.

The most favorable strategy is to not confess. However, neither is aware of

the other's strategy and without certainty that one will not confess, both will
likely confess and receive a five-year prison sentence. The Nash
equilibrium suggests that in a prisoner's dilemma, both players will make
the move that is best for them individually but worse for them collectively.

The expression "tit for tat" has been determined to be the optimal strategy
for optimizing a prisoner's dilemma. Tit for tat was introduced by Anatol
Rapoport, who developed a strategy in which each participant in an
iterated prisoner's dilemma follows a course of action consistent with their
opponent's previous turn. For example, if provoked, a player subsequently
responds with retaliation; if unprovoked, the player cooperates.

The image below depicts the dilemma where the choice of the participant
on the column and the choice of the participant in the row may clash. For
example, both parties may receive the most favorable outcome if both
choose row/column 1. However, each faces the risk of strong adverse
outcomes should the other party not choose the same outcome.

Example of Static Two-Person Game.

Internet Encyclopedia of Philosophy

Dictator Game

This is a simple game in which Player A must decide how to split a cash
prize with Player B, who has no input into Player A’s decision. While this is
not a game theory strategy per se, it does provide some interesting
insights into people’s behavior. Experiments reveal about 50% keep all the
money to themselves, 5% split it equally, and the other 45% give the other
participant a smaller share.

The dictator game is closely related to the ultimatum game, in which

Player A is given a set amount of money, part of which has to be given to
Player B, who can accept or reject the amount given. The catch is if the
second player rejects the amount offered, both A and B get nothing. The
dictator and ultimatum games hold important lessons for issues such as
charitable giving and philanthropy.

Volunteer’s Dilemma

In a volunteer’s dilemma, someone has to undertake a chore or job for the

common good. The worst possible outcome is realized if nobody
volunteers. For example, consider a company in which accounting fraud is
rampant, though top management is unaware of it. Some junior employees
in the accounting department are aware of the fraud but hesitate to tell top
management because it would result in the employees involved in the
fraud being fired and most likely prosecuted.

Being labeled as a whistleblower may also have some repercussions down

the line. But if nobody volunteers, the large-scale fraud may result in the
company’s eventual bankruptcy and the loss of everyone’s jobs.

The Centipede Game

The centipede game is an extensive-form game in game theory in which

two players alternately get a chance to take the larger share of a slowly
increasing money stash. It is arranged so that if a player passes the stash
to their opponent who then takes the stash, the player receives a smaller
amount than if they had taken the pot.

The centipede game concludes as soon as a player takes the stash, with
that player getting the larger portion and the other player getting the
smaller portion. The game has a pre-defined total number of rounds, which
are known to each player in advance.

Game theory exists in almost every facet of life. Because the decisions of
other people around you impact your day, game theory pertains to
personal relationships, shopping habits, media intake, and hobbies.

Types of Game Theory Strategies

Game theory participants can decide between a few primary ways to play
their game. In general, each participant must decide what level of risk they
are wiling to take and how far they are wiling to go to pursue the best
possible outcome.

Maximax Strategy

A maximax strategy involves no hedging. The participant is either all in or

all out; they'll either win big or face the worst consequence. Consider
new start-up companies introducing new products to the market. Their new
product may result in the company's market cap increasing fifty-fold. On
the other hand, a failed product launch will leave the company bankrupt. In
either situation, the participant is willing to take a chance on achieving the
best outcome even if the worst outcome is possible.

Maximin Strategy

A maximin strategy in game theory results in the participant choosing the

best of the worst payoff. The participant has decided to hedge risk and
sacrifice full benefit in exchange for avoiding the worst outcome. Often,
companies face and accept this strategy when considering lawsuits. By
settling out of court and avoid a public trial, companies agree to an
adverse outcome. However, that outcome could have been worse due to
the exploits of the trial or even worse judicial finding.

Dominant Strategy

In a dominant strategy, a participant performs actions that are the best

outcome for the play irrespective of what other participants decide to do. In
business, this may a situation where a company decides to scale and
expand to a new market whether or not a competing company has decided
to move into the market as well. In Prisoner's Dilemma, the dominant
strategy would be to confess.

Pure Strategy

Pure strategy entails the least amount of strategic decision-making, as

pure strategy is simply a defined choice that is made regardless of external
forces or actions of others. Consider a game of rock-paper-scissors in
which one participant decides to throw the same shape each trial. As the
outcome for this participant is well-defined in advance (outcomes are
either a specific shape or not that specific shape), the strategy is defined
as pure.

Mixed Strategy
A mixed strategy may seem like random chance, but there is much thought
that must go into devising a plan of mixing elements or actions. Consider
the relationship between a baseball pitcher and batter. The pitcher cannot
throw the same pitch each time; otherwise, the batter could predict what
would come next. Instead, the pitcher must mix its strategy from pitch to
pitch to create a sense of unpredictability in which it hopes to benefit from.

Limitations of Game Theory

The biggest issue with game theory is that, like most other economic
models, it relies on the assumption that people are rational actors that are
self-interested and utility-maximizing. Of course, we are social beings who
do cooperate often at our own expense. Game theory cannot account for
the fact that in some situations we may fall into a Nash equilibrium, and
other times not, depending on the social context and who the players are.

In addition, game theory often struggles to factor in human elements such

as loyalty, honesty, or empathy. Though statistical and mathematical
computations can dictate what a best course of action should be, humans
may not take this course due to incalculable and complex scenarios of
self-sacrifice or manipulation. Game theory may analyze a set of behaviors
but it can not truly forecast the human element.

What Are the Games Being Played in Game Theory?

It is called game theory since the theory tries to understand the strategic
actions of two or more "players" in a given situation containing set rules
and outcomes. While used in several disciplines, game theory is most
notably used as a tool within the study of business and economics.

The "games" may involve how two competitor firms will react to price cuts
by the other, whether a firm should acquire another, or how traders in a
stock market may react to price changes. In theoretic terms, these games
may be categorized as prisoner's dilemmas, the dictator game, the hawk-
and-dove, and Bach or Stravinsky.

What Are Some of the Assumptions About These

Games?
Like many economic models, game theory also contains a set of strict
assumptions that must hold for the theory to make good predictions in
practice. First, all players are utility-maximizing rational actors that have
full information about the game, the rules, and the consequences. Players
are not allowed to communicate or interact with one another. Possible
outcomes are not only known in advance but also cannot be changed. The
number of players in a game can theoretically be infinite, but most games
will be put into the context of only two players.

What Is a Nash Equilibrium?

The Nash equilibrium is an important concept referring to a stable state in
a game where no player can gain an advantage by unilaterally changing a
strategy, assuming the other participants also do not change their
strategies. The Nash equilibrium provides the solution concept in a non-
cooperative (adversarial) game. It is named after John Nash who received
the Nobel Prize in 1994 for his work.3

Who Came Up with Game Theory?

Game theory is largely attributed to the work of mathematician John von
Neumann and economist Oskar Morgenstern in the 1940s and was
developed extensively by many other researchers and scholars in the
1950s.1 It remains an area of active research and applied science to this
day.

The Bottom Line

Game theory is the study of how competitive strategies and participant
actions can influence the outcome of a situation. Relevant to war, biology,
and many facets of life, game theory is used in business to represent
strategic interactions in which the outcome of one company or product
depends on actions taken by other companies or products.