Game theory brings together several sciences, including psychology, philosophy, and mathematics. Historians credit Hungarian-American mathematician John von Neumann with introducing modern game theory in the 1940s. Brilliant minds from across the world have contributed to the advancement of the theory, with eight of them winning Nobel prizes. Game theory has many uses outside of the classroom and understanding its principles can help you make better business decisions.
The Basics of Game Theory
Game theory uses mathematical models to look at how conflict and cooperation work together. It can help you make decisions when dealing with incomplete information and when the decisions of others, often unknown to you, affect the outcome of a situation. Using game theory involves setting up formulas to figure out which course of action provides the best chance for a favourable outcome. A classic example of game theory is the prisoner’s dilemma. Suppose you and a friend are arrested for a crime, and the police separate you to try and extract confessions. You’re told that if you rat your friend out and your friend stays silent, you receive no jail time while your friend gets 10 years. However, if you stay silent and your friend rats you out, then your friend walks and you get 10 years. A jail sentence of seven years results if you both rat each other out, while you get two years if you both remain silent. Game theory helps you make sense of a confusing mass of information and make rational decision as to what to do. The formula that solves the problem looks like this:If your friend stays silent and:You stay silent: Two years. You rat your friend out: Zero years. If your friend rats you out and:You stay silent: 10 years. You rat your friend out: Seven years. The game theory formula presents an easy solution: Rat your friend out, no matter what. As the formula illustrates, ratting your friend out always results in less jail time for you, regardless of the action your friend takes.
Game Theory Example
People can use game theory in business decision making to stay a step ahead of their competitors. Everything from bidding for a job to determining ad spend on a marketing campaign is enhanced by the use of game theory. In a job bidding war, you want to give yourself the best chance of winning the job without being underpaid for it. In a marketing campaign, your goal is to anticipate what your competitors are doing, and use your ads to position your company as the superior brand. Game theory improves your decision-making process in both situations and countless other business scenarios. As with the prisoner’s dilemma, in involves constructing a matrix, populating it with each possible decision on the table, and then filling the other side of the matrix with the potential actions your competitor or adversary might take. From there, fill in the matrix with the most likely outcome of each combination, and use the results to arrive at the most sensible decision.
Game Theory Example
Bidding on a client project provides a fantastic example of game theory at work. Suppose your business offers to do a job for $20,000, and the client tells you that a competitor has offered to do it for the same price. You’re willing to do the job for as low as $17,000, but you don’t know what your competitor is going to offer going forward. At this point, you have two options: Lower your bid, or hold firm at $20,000. Your competitor has the same options. Your game theory formula looks like the following:Lower bid to $17,000:Competitor bids less than $17,000: You lose the job, but your competitor is underpaid. Competitor bids more than $17,000: You win the job at a fair price. Hold firm at $20,000: Competitor bids less than $17,000: You lose the job, but your competitor is underpaid. Competitor bids between $17,000 and $20,000: You lose the job, and the competitor is paid a fair price. Competitor holds firm at $20,000: Stalemate, and repeat the process. Assuming you want the job as long as you’re paid $17,000 or above, game theory shows you the correct decision: Lower your bid to exactly $17,000. If your competitor bids less than $17,000, either way you lose the job, but that’s okay, because you would have had to lowball to win. However, if your competitor bids under over $17,000, you win the job and get a fair price for it, whereas you might lose out on a good deal by staying firm at $20,000. Whether you work in a small business or a large one, mastering the principles of game theory can give your company a competitive advantage.