game-theory

Game Theory

Business / By / November 27, 2023

Game Theory is a mathematical framework that studies strategic interactions among rational decision-makers. It includes key concepts like Nash Equilibrium and encompasses various types of games, from cooperative to sequential. Game Theory finds applications in economics, political science, and biology, offering insights into decision-making and strategy in various domains.

Introduction to Game Theory

Game theory is a formalized framework for understanding how individuals or entities make decisions when their outcomes depend on the actions of others. It explores the strategic interactions between rational actors who seek to maximize their own utility or outcomes. While the term “game” might evoke thoughts of board games or sports, in the context of game theory, a “game” refers to any situation where there are multiple decision-makers, each with a set of available actions and associated payoffs.

Key components of game theory include:

  1. Players: Individuals or entities making decisions within the game. Players are often assumed to be rational, meaning they make choices that maximize their expected utility.
  2. Strategies: The possible actions or decisions that players can take within the game. A player’s strategy defines how they will act in response to different situations or choices made by others.
  3. Payoffs: The outcomes or rewards associated with different combinations of actions chosen by the players. Payoffs represent the players’ preferences over possible outcomes.
  4. Information: The level of information that players have about each other’s actions, strategies, or payoffs. Game theorists distinguish between games with complete information (where all players know everything) and games with incomplete information (where some information is hidden or uncertain).

Types of Games

Game theory encompasses various types of games, each with its unique characteristics and strategies:

  1. Cooperative Games: In cooperative games, players can form coalitions or alliances to achieve mutually beneficial outcomes. The focus is on how players can work together to maximize collective payoffs. Examples include negotiations, partnerships, and collaborative projects.
  2. Non-Cooperative Games: Non-cooperative games assume that players act independently and do not form alliances. The Prisoner’s Dilemma is a classic example of a non-cooperative game, where rational individuals may not achieve the best collective outcome due to self-interested decision-making.
  3. Zero-Sum Games: Zero-sum games are a specific class of non-cooperative games where the total gains and losses are balanced. In other words, what one player gains, another player loses. Poker is a classic example of a zero-sum game.
  4. Simultaneous Games: In simultaneous games, players make decisions simultaneously, without knowing the other players’ choices. Examples include the Prisoner’s Dilemma and the Battle of the Sexes.
  5. Sequential Games: Sequential games involve a sequence of moves, where players observe the actions of previous players before making their decisions. Chess is an example of a sequential game.

Key Concepts in Game Theory

To understand game theory, it’s crucial to grasp some fundamental concepts that underpin its analyses:

  1. Nash Equilibrium: A Nash equilibrium is a situation where no player can improve their outcome by unilaterally changing their strategy, assuming the other players’ strategies remain unchanged. It represents a stable solution to a game.
  2. Dominant Strategy: A dominant strategy is a strategy that yields the highest payoff for a player regardless of the strategies chosen by other players. In some games, one or more players may have dominant strategies.
  3. Prisoner’s Dilemma: The Prisoner’s Dilemma is a famous example illustrating the tension between individual and collective rationality. Two suspects are better off if they both remain silent (cooperate), but each has an incentive to betray the other for personal gain.
  4. Tragedy of the Commons: This concept arises in situations where individuals, acting in their self-interest, deplete shared resources, leading to a worse outcome for everyone. It underscores the challenges of collective action.
  5. Mixed Strategies: In some games, players may randomize their strategies to make them less predictable. Mixed strategies involve assigning probabilities to different actions.

Applications of Game Theory

Game theory has a wide range of applications across various disciplines:

  1. Economics: Game theory is a foundational tool in economics, used to analyze market behavior, pricing strategies, and competition. It informs economic models of oligopolies, auctions, and bargaining.
  2. Political Science: Game theory helps political scientists understand decision-making in politics, from voting behavior to international relations. It models how politicians strategize to maximize their chances of winning elections or achieving policy goals.
  3. Biology: Game theory is applied in evolutionary biology to study behaviors like altruism, mating strategies, and predator-prey interactions. It provides insights into how natural selection shapes animal behavior.
  4. Computer Science: In artificial intelligence and computer science, game theory informs the design of algorithms for decision-making in multi-agent environments. It is used in fields like robotics, automated negotiation, and game-playing AI.
  5. Social Sciences: Game theory is relevant in sociology and psychology for understanding human interactions, cooperation, and conflict resolution. It can explain phenomena such as trust, reciprocity, and social norms.
  6. Environmental Science: Environmental game theory explores the challenges of managing shared resources and addressing global issues like climate change. It helps design mechanisms for international cooperation.

Real-World Implications

Understanding game theory has important real-world implications:

  1. Business Strategy: Firms use game theory to develop competitive strategies, set prices, and negotiate contracts. It helps businesses anticipate competitors’ moves and make informed decisions.
  2. International Relations: Game theory plays a crucial role in understanding and predicting international conflicts, negotiations, and cooperation. It informs diplomatic strategies and arms control agreements.
  3. Public Policy: Policymakers apply game theory to design policies that incentivize desirable behaviors and discourage harmful ones. It is used in areas like healthcare, education, and environmental regulation.
  4. Environmental Conservation: Game theory informs conservation efforts by addressing issues of resource management and incentivizing sustainable practices among communities.
  5. Auctions and Bidding: Auction design, including online auctions like eBay, relies on game theory principles to optimize outcomes for buyers and sellers.
  6. Sports Strategy: Coaches and teams use game theory to analyze opponents’ strategies and make decisions during games. It helps formulate winning strategies in sports like basketball, soccer, and chess.
  7. Healthcare: Game theory can inform healthcare decisions, such as vaccine distribution strategies, hospital resource allocation, and medical treatment protocols.

Challenges and Criticisms

While game theory offers valuable insights, it also faces challenges and criticisms:

  1. Assumptions of Rationality: Game theory assumes that players are perfectly rational decision-makers, which may not always reflect real-world behavior.
  2. Limited Predictive Power: Predicting human behavior in complex situations remains challenging, and game theory’s accuracy depends on the quality of the assumptions and models used.
  3. Incomplete Information: In many real-world scenarios, information is incomplete or uncertain, making it difficult to apply traditional game theory models.
  4. Ethical Considerations: Some applications of game theory raise ethical concerns, particularly when modeling situations involving harm or exploitation.
  5. Behavioral Game Theory: An emerging field, behavioral game theory, incorporates insights from psychology to account for deviations from strict rationality. It seeks to bridge the gap between theory and observed behavior.

Conclusion

Game theory is a powerful tool for analyzing strategic interactions and decision-making in various domains. Its applications extend from economics and politics to biology and artificial intelligence, offering valuable insights into human behavior and cooperation. While it has limitations and challenges, game theory continues to shape our understanding of complex real-world situations, informing strategies, policies, and negotiations that impact society, businesses, and individuals alike. As it evolves and adapts to new contexts, game theory remains a fundamental framework for understanding the dynamics of strategic interactions.

Case Studies

Economics:

  • Prisoner’s Dilemma: Two suspects held in separate cells face the dilemma of whether to cooperate (stay silent) or betray (confess). Their sentences depend on their joint decision, highlighting the tension between self-interest and cooperation.
  • Oligopoly Pricing: In industries with a small number of dominant firms (oligopoly), companies must strategize their pricing decisions. If one firm lowers prices, others may follow suit or maintain higher prices.
  • Auction Bidding: Auctions involve strategic bidding strategies. For example, in a sealed-bid second-price auction (Vickrey auction), bidders aim to submit bids that reflect their true valuation while aiming to win at a lower price.

Political Science:

  • Arms Race: Nations engaged in an arms race must decide how much to invest in military capabilities. Game Theory helps analyze the decisions of countries in response to their adversaries’ actions.
  • Voting Systems: Elections and voting systems involve strategic choices. Strategic voting, where voters may not choose their preferred candidate but one they believe has a better chance of winning, is an example.

Biology:

  • Evolutionary Games: Game Theory is used to model the evolution of behaviors in species. For instance, the Hawk-Dove game explains how animals choose between aggressive (hawk) and passive (dove) strategies during resource disputes.
  • Predator-Prey Interactions: Game Theory helps study the strategies employed by predators and prey. Prey animals may adopt various evasion tactics, while predators decide when and where to hunt.

Social Sciences:

  • Social Dilemmas: In scenarios like the tragedy of the commons, individuals must decide whether to act in their self-interest or cooperate for the common good. Overfishing in shared waters is an example.
  • Peer Pressure and Social Influence: Adolescents may face a game-like situation where they decide whether to conform to peer norms or make independent choices, reflecting strategic interactions.

Key Highlights

  • Game Theory Definition: Game Theory is a mathematical and economic framework that analyzes strategic interactions among rational decision-makers.
  • Characteristics: It involves strategic interactions, rationality, and employs mathematical models to represent and analyze these interactions.
  • Nash Equilibrium: A central concept in Game Theory where no player can improve their outcome by changing their strategy, given the strategies of others.
  • Types of Games:
    • Cooperative Games: Involving collaboration among players for mutual benefit through coalition formation and negotiation.
    • Sequential Games: Games with a sequence of moves and strategic timing.
  • Applications: Game Theory finds applications in various fields, including economics, political science, biology, and social sciences.
  • Examples: Practical examples such as the Prisoner’s Dilemma, Oligopoly Pricing, Arms Race, and Evolutionary Games illustrate Game Theory’s real-world relevance.

Connected Thinking Frameworks

Convergent vs. Divergent Thinking

convergent-vs-divergent-thinking
Convergent thinking occurs when the solution to a problem can be found by applying established rules and logical reasoning. Whereas divergent thinking is an unstructured problem-solving method where participants are encouraged to develop many innovative ideas or solutions to a given problem. Where convergent thinking might work for larger, mature organizations where divergent thinking is more suited for startups and innovative companies.

Critical Thinking

critical-thinking
Critical thinking involves analyzing observations, facts, evidence, and arguments to form a judgment about what someone reads, hears, says, or writes.

Biases

biases
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.

Second-Order Thinking

second-order-thinking
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.

Lateral Thinking

lateral-thinking
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.

Bounded Rationality

bounded-rationality
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

Dunning-Kruger Effect

dunning-kruger-effect
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.

Occam’s Razor

occams-razor
Occam’s Razor states that one should not increase (beyond reason) the number of entities required to explain anything. All things being equal, the simplest solution is often the best one. The principle is attributed to 14th-century English theologian William of Ockham.

Lindy Effect

lindy-effect
The Lindy Effect is a theory about the ageing of non-perishable things, like technology or ideas. Popularized by author Nicholas Nassim Taleb, the Lindy Effect states that non-perishable things like technology age – linearly – in reverse. Therefore, the older an idea or a technology, the same will be its life expectancy.

Antifragility

antifragility
Antifragility was first coined as a term by author, and options trader Nassim Nicholas Taleb. Antifragility is a characteristic of systems that thrive as a result of stressors, volatility, and randomness. Therefore, Antifragile is the opposite of fragile. Where a fragile thing breaks up to volatility; a robust thing resists volatility. An antifragile thing gets stronger from volatility (provided the level of stressors and randomness doesn’t pass a certain threshold).

Systems Thinking

systems-thinking
Systems thinking is a holistic means of investigating the factors and interactions that could contribute to a potential outcome. It is about thinking non-linearly, and understanding the second-order consequences of actions and input into the system.

Vertical Thinking

vertical-thinking
Vertical thinking, on the other hand, is a problem-solving approach that favors a selective, analytical, structured, and sequential mindset. The focus of vertical thinking is to arrive at a reasoned, defined solution.

Maslow’s Hammer

einstellung-effect
Maslow’s Hammer, otherwise known as the law of the instrument or the Einstellung effect, is a cognitive bias causing an over-reliance on a familiar tool. This can be expressed as the tendency to overuse a known tool (perhaps a hammer) to solve issues that might require a different tool. This problem is persistent in the business world where perhaps known tools or frameworks might be used in the wrong context (like business plans used as planning tools instead of only investors’ pitches).

Peter Principle

peter-principle
The Peter Principle was first described by Canadian sociologist Lawrence J. Peter in his 1969 book The Peter Principle. The Peter Principle states that people are continually promoted within an organization until they reach their level of incompetence.

Straw Man Fallacy

straw-man-fallacy
The straw man fallacy describes an argument that misrepresents an opponent’s stance to make rebuttal more convenient. The straw man fallacy is a type of informal logical fallacy, defined as a flaw in the structure of an argument that renders it invalid.

Streisand Effect

streisand-effect
The Streisand Effect is a paradoxical phenomenon where the act of suppressing information to reduce visibility causes it to become more visible. In 2003, Streisand attempted to suppress aerial photographs of her Californian home by suing photographer Kenneth Adelman for an invasion of privacy. Adelman, who Streisand assumed was paparazzi, was instead taking photographs to document and study coastal erosion. In her quest for more privacy, Streisand’s efforts had the opposite effect.

Heuristic

heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.

Recognition Heuristic

recognition-heuristic
The recognition heuristic is a psychological model of judgment and decision making. It is part of a suite of simple and economical heuristics proposed by psychologists Daniel Goldstein and Gerd Gigerenzer. The recognition heuristic argues that inferences are made about an object based on whether it is recognized or not.

Representativeness Heuristic

representativeness-heuristic
The representativeness heuristic was first described by psychologists Daniel Kahneman and Amos Tversky. The representativeness heuristic judges the probability of an event according to the degree to which that event resembles a broader class. When queried, most will choose the first option because the description of John matches the stereotype we may hold for an archaeologist.

Take-The-Best Heuristic

take-the-best-heuristic
The take-the-best heuristic is a decision-making shortcut that helps an individual choose between several alternatives. The take-the-best (TTB) heuristic decides between two or more alternatives based on a single good attribute, otherwise known as a cue. In the process, less desirable attributes are ignored.

Bundling Bias

bundling-bias
The bundling bias is a cognitive bias in e-commerce where a consumer tends not to use all of the products bought as a group, or bundle. Bundling occurs when individual products or services are sold together as a bundle. Common examples are tickets and experiences. The bundling bias dictates that consumers are less likely to use each item in the bundle. This means that the value of the bundle and indeed the value of each item in the bundle is decreased.

Barnum Effect

barnum-effect
The Barnum Effect is a cognitive bias where individuals believe that generic information – which applies to most people – is specifically tailored for themselves.

First-Principles Thinking

first-principles-thinking
First-principles thinking – sometimes called reasoning from first principles – is used to reverse-engineer complex problems and encourage creativity. It involves breaking down problems into basic elements and reassembling them from the ground up. Elon Musk is among the strongest proponents of this way of thinking.

Ladder Of Inference

ladder-of-inference
The ladder of inference is a conscious or subconscious thinking process where an individual moves from a fact to a decision or action. The ladder of inference was created by academic Chris Argyris to illustrate how people form and then use mental models to make decisions.

Goodhart’s Law

goodharts-law
Goodhart’s Law is named after British monetary policy theorist and economist Charles Goodhart. Speaking at a conference in Sydney in 1975, Goodhart said that “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.” Goodhart’s Law states that when a measure becomes a target, it ceases to be a good measure.

Six Thinking Hats Model

six-thinking-hats-model
The Six Thinking Hats model was created by psychologist Edward de Bono in 1986, who noted that personality type was a key driver of how people approached problem-solving. For example, optimists view situations differently from pessimists. Analytical individuals may generate ideas that a more emotional person would not, and vice versa.

Mandela Effect

mandela-effect
The Mandela effect is a phenomenon where a large group of people remembers an event differently from how it occurred. The Mandela effect was first described in relation to Fiona Broome, who believed that former South African President Nelson Mandela died in prison during the 1980s. While Mandela was released from prison in 1990 and died 23 years later, Broome remembered news coverage of his death in prison and even a speech from his widow. Of course, neither event occurred in reality. But Broome was later to discover that she was not the only one with the same recollection of events.

Crowding-Out Effect

crowding-out-effect
The crowding-out effect occurs when public sector spending reduces spending in the private sector.

Bandwagon Effect

bandwagon-effect
The bandwagon effect tells us that the more a belief or idea has been adopted by more people within a group, the more the individual adoption of that idea might increase within the same group. This is the psychological effect that leads to herd mentality. What in marketing can be associated with social proof.

Moore’s Law

moores-law
Moore’s law states that the number of transistors on a microchip doubles approximately every two years. This observation was made by Intel co-founder Gordon Moore in 1965 and it become a guiding principle for the semiconductor industry and has had far-reaching implications for technology as a whole.

Disruptive Innovation

disruptive-innovation
Disruptive innovation as a term was first described by Clayton M. Christensen, an American academic and business consultant whom The Economist called “the most influential management thinker of his time.” Disruptive innovation describes the process by which a product or service takes hold at the bottom of a market and eventually displaces established competitors, products, firms, or alliances.

Value Migration

value-migration
Value migration was first described by author Adrian Slywotzky in his 1996 book Value Migration – How to Think Several Moves Ahead of the Competition. Value migration is the transferal of value-creating forces from outdated business models to something better able to satisfy consumer demands.

Bye-Now Effect

bye-now-effect
The bye-now effect describes the tendency for consumers to think of the word “buy” when they read the word “bye”. In a study that tracked diners at a name-your-own-price restaurant, each diner was asked to read one of two phrases before ordering their meal. The first phrase, “so long”, resulted in diners paying an average of $32 per meal. But when diners recited the phrase “bye bye” before ordering, the average price per meal rose to $45.

Groupthink

groupthink
Groupthink occurs when well-intentioned individuals make non-optimal or irrational decisions based on a belief that dissent is impossible or on a motivation to conform. Groupthink occurs when members of a group reach a consensus without critical reasoning or evaluation of the alternatives and their consequences.

Stereotyping

stereotyping
A stereotype is a fixed and over-generalized belief about a particular group or class of people. These beliefs are based on the false assumption that certain characteristics are common to every individual residing in that group. Many stereotypes have a long and sometimes controversial history and are a direct consequence of various political, social, or economic events. Stereotyping is the process of making assumptions about a person or group of people based on various attributes, including gender, race, religion, or physical traits.

Murphy’s Law

murphys-law
Murphy’s Law states that if anything can go wrong, it will go wrong. Murphy’s Law was named after aerospace engineer Edward A. Murphy. During his time working at Edwards Air Force Base in 1949, Murphy cursed a technician who had improperly wired an electrical component and said, “If there is any way to do it wrong, he’ll find it.”

Law of Unintended Consequences

law-of-unintended-consequences
The law of unintended consequences was first mentioned by British philosopher John Locke when writing to parliament about the unintended effects of interest rate rises. However, it was popularized in 1936 by American sociologist Robert K. Merton who looked at unexpected, unanticipated, and unintended consequences and their impact on society.

Fundamental Attribution Error

fundamental-attribution-error
Fundamental attribution error is a bias people display when judging the behavior of others. The tendency is to over-emphasize personal characteristics and under-emphasize environmental and situational factors.

Outcome Bias

outcome-bias
Outcome bias describes a tendency to evaluate a decision based on its outcome and not on the process by which the decision was reached. In other words, the quality of a decision is only determined once the outcome is known. Outcome bias occurs when a decision is based on the outcome of previous events without regard for how those events developed.

Hindsight Bias

hindsight-bias
Hindsight bias is the tendency for people to perceive past events as more predictable than they actually were. The result of a presidential election, for example, seems more obvious when the winner is announced. The same can also be said for the avid sports fan who predicted the correct outcome of a match regardless of whether their team won or lost. Hindsight bias, therefore, is the tendency for an individual to convince themselves that they accurately predicted an event before it happened.

Read Next: Biases, Bounded Rationality, Mandela Effect, Dunning-Kruger Effect, Lindy Effect, Crowding Out Effect, Bandwagon Effect.

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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
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