Applying game theory to business

Understanding the relative payoffs of cooperating versus defecting may stimulate you to engage in significant price negotiations before you make a big purchase.

Nash equilibrium in game theory is a situation in which a player will continue with their chosen strategy, having no incentive to deviate from it, after taking into consideration the opponent's strategy. Cournot competition, for example, is an economic model describing an industry structure in which rival companies offering an identical product compete on the amount of output they produce, independently and at the same time.

It is effectively a prisoner's dilemma game. Game theory can be used very effectively as a tool for decision-making whether in an adversarial, business, or personal setting. Princeton University Press. The Nobel Prize. Behavioral Economics. Business Essentials. Actively scan device characteristics for identification.

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Select personalised ads. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Your Money. Personal Finance. Your Practice. Popular Courses. Economics Behavioral Economics. Table of Contents Expand. Matching Pennies. Cournot Competition. Coordination Game. Centipede Game. There are several different ways to set an auction, but William Vickrey of Columbia University recommends using a second-prize auction to maximize your return.

In this auction, each participant bids in a sealed number and the highest bid wins. However, the highest bid does not pay the highest bid price, he pays the second highest bid price. This creates an incentive for participants to bid higher but they often spend more than they would like on the asset. In doing this, you are optimizing your potential return by forcing the bidders to offer more than they would in a normal, highest bid wins and pays that bid situation.

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Ben Duronio. Game Theory can also be performed in two ways: simultaneous games , where the players make their moves or actions at the same time, without waiting for information on what the other players have chosen or acted upon, and sequential games , where the moves of the players will depend on, and in response to, the previous action or choice of another player. Anyone that plays a key role in high-level and strategic decision-making in an organization should definitely consider learning about, and applying, the Game Theory.

They include, but are not limited to, executives, directors, and senior managers. The applicability of Game Theory may be in question by some pundits, but there is no denying the fact that even large and established businesses have openly discussed using Game Theory for their key strategic business decisions. Making business decisions is a daily event for managers. They are always faced with decisions on what to produce, what to procure, and what to sell, followed by decisions on how much they should spend in producing or in procuring, and what price they should set when they sell.

There are so many tools used to come up with decisions, and one of these tools is Game Theory. We can enumerate several reasons why business managers should consider using the Game Theory in its business operations. Business managers must beware, however, of how they use Game Theory. It is not a management tool that they can use as a substitute for experience in business. It is merely a tool, or a guide, for them to go about their tasks or roles as business managers.

The pricing decisions of a company can be highly influenced by the pricing choices or decisions of rival companies. One popular example was the price-chopping decisions initiated by Intel and Advanced Micro Devices AMD on their desktop and mobile processors.

Intel and AMD are considered to be competitors in a highly specialized niche, and both are in a tight race to gain a larger share of the market.

The first move was taken by Intel, who initiated a price slash on its desktop and mobile processors. AMD reacted by implementing a similar price cut, even if it meant potential losses or decrease in revenues.

This price war resulted to both companies seeing significant increases in unit sales and shipments of their products — a sign of an increase in their market potential. However, their revenues saw a drop, and so did the profits. The interrogators are not in possession of sufficient evidence or information to make a conviction, so they have to find a way to facilitate a confession.

They present each of the suspects with two choices: either defect , or confess to the crime and get a lighter punishment or jail sentence, or they could cooperate , or refuse to say anything, and suffer the punishment due them.

The interrogators make it a point to inform both suspects that the other is fully aware of the deal and its connotations. If the two suspects decide to defect and make a confession, they will both get the full brunt of the punishment and be sentenced the standard jailtime.

If, however, one suspect confesses and the other stays quiet, it is the latter who will get the jail sentence — often even longer — while the one who confessed gets off with a lighter sentence, or even walks away scot-free.

Both companies are aware of each other as long-time competitors, and that they will be playing the same game for a long time to come. Thus, they have the choice on whether to cooperate with each other and kept their prices higher, or they could engage in mutual price-chopping actions. Many assume that Game Theory applies only to getting the pulse of competitors.

However, it can also apply to the relationship of companies with their supply chain partners. Supply chain management can be facilitated by Game Theory concepts.

The game can be played in one of two ways. It helps improve the quality of strategic decisions in situations where decisions are interdependent. In oligopolistic situations where a few firms dominate the market - the prevailing condition in almost all industries - strategic decisions have an effect on other players in the market.

Any move by one company is closely followed by their competitors. Therefore, when one takes into account how other players are going to react to the boardroom metrics, action is taken. The optimum choice may lie somewhere between the best and the worst choices seen in isolation. These decisions are based on reasoning backward and thinking forward, so we are able to understand the perspective of others in order to choose the best path, considering other players are also going to choose the best course of action for themselves.

While game theory has many applications in economics, policy development and business negotiations, this article focuses on its use in the making of strategic choices by managers, when their decision will be affected by the actions of other players in the market.

Its application potential ranges from decisions about a capacity addition to market entry, and from pricing to new product launches. Capacity addition is one of the key strategic decisions managers have to make. Deciding how much capacity to add and when to add it has a bearing on industry profitability.

In such cases, adding capacity draws strong reactions from competitors. As long as supply lags market demand, incumbents can earn an economic rent and generate supernormal profits. Any challenge to this situation can generate strong reactions which need to be accounted for when taking a decision to add capacity. The decision to add capacity can be modelled by either considering two or three choices, depending on their situation.

Companies can decide to add or not to add, or make no addition, a small addition or a large addition. While modelling the game, it is possible to consider simultaneous moves; where one player does not know what others are going to do, and sequential moves; where one player has increased their capacity and competitors must decide whether to follow.

Market entry is another important area where game theory can be extremely useful in improving decision making. Understanding how incumbents would behave following the entry of a new player provides critical insights in deciding; whether to enter the market or not, when is the correct time to do so, and how one can enter in the best possible way.

If the market is new for all the players, game theory can help in deciding whether the first mover will have an advantage. In some cases, it may be worth waiting for others to test the new market in order to learn from their mistakes. In market entry decisions, there is also a possibility of changing the game being played currently. In mobile telephony, companies were playing the high-priced game until Reliance Infocom arrived on the scene.

The entry strategy of Reliance Infocom changed the mobile telephony game in India forever. Pricing is a very potent weapon for managers if used correctly. Competitors closely observe price movements, particularly in oligopolistic markets. Game theory can help when modelling the impact of pricing decisions on competitors and assist in deciding on the best choice available, given the most likely response of these competitors.

In pricing decisions, some players may emerge as leaders in the market. They first decide when, and by how much to change the price, while others follow them in a way which is aligned with their own market position and results in the best payoffs, given the move made by the leader. We have come across a number of cases where companies launch new products with great fanfare while ignoring or miscalculating the moves of other players in the market. Moreover, the response of other players to new product launches may alter projections drastically if managers do not account for their motives while making these projections.

By understanding which players will be affected by the new product and how they will react, companies can position their launch in a way that achieves their business goals.

As can be seen from the above applications, managers can make better strategic decisions by applying game theory models.