Game theory emerged as a scholarly field of study in the first half of the 20th century. Since that time, it has significantly affected various academic disciplines, such as economics, political science and biology. Although the term “game theory” may suggest a certain frivolity, the concepts underlying it have many real-world applications and offer a structured and logical method of considering strategic situations. The parallels between competitive games and strategic business situations should be fairly obvious. Consider the game of chess. There are two players, each of whom makes moves in sequence.
After observing the move made by the first player, the second player makes a counter move. Then the first player, having observed the first two moves, makes the third move and so on. Compare this to the business situation of gas stations competing for customers through strategic pricing. (The players in this case are station A and station B. ) Suppose, for instance, that station A starts by choosing a new pricing strategy. Given station A’s decision, station B decides how it will set its prices. Given station B’s response, station A can choose to revise its pricing strategy and so on.
The objective of each gas station in this “game” is to maximise its own profit. For each to do so, it must be continually acting and reacting to its competitor in the market as well as anticipating competitive responses when making decisions. What does game theory have to offer? First, game theory provides a framework, or formal procedure, for analysing any competitive situation (or “game”). Specifically, it forces you to identify the players in a game (consumers, sellers, input providers, governments, foreign organisations, etc. , their possible actions and reactions to the actions of other players, and the payoffs or rewards implicit in the game. Game theory models reduce the world in which businesses operate from a highly complex one to one that is simpler but nevertheless retains some important characteristics of the original. By capturing and clarifying the most significant aspects of competition and interdependence, game theory models make it possible to break down a complex competitive situation into its key components and to analyse the complex dynamics between players.
In order for game theory to be truly useful in analysing such complex situations, certain assumptions need to be made. The most significant assumption is that the players in a game are choosing their actions optimally; that is, they are choosing their actions in the hope of maximising their ultimate payoff and they assume that the other players are doing likewise. Without this assumption, game theory cannot successfully model real-world situations. Because game theory can realistically model business situations, it helps businesses to make optimal decisions and choose optimal actions.
In other words, by “solving” a game, a business can identify its optimal actions (assuming, as always, that all the other players are also choosing their actions optimally). This is especially valuable because it helps companies choose the right business strategies when confronted with a complex strategic situation. In what types of business situations can game theory be applied? Click on the linkhere to find out. The nature of the solution(s) in game theory also motivates businesses to analyse how the structure of the game can be altered so that a different (and perhaps a more favourable) game can be played.
Because of its systematic approach, game theory allows businesses to examine the consequences of actions that they may not have considered. It is worth noting here that many games involving business are different from games in other fields. For instance, in business, many players can win (and lose) simultaneously, which obviously is not the case with chess. Additionally, because of the interdependent nature of most business relationships, these games are not always ones of direct competition. Consider a game between manufacturer and supplier — both have incentives to do well, but each also has a vested interest in the success of the other.
Furthermore, unlike some other games with fixed rules, the rules of business are continuously in flux. They may be formulated by law, by tradition or by accident. Often, however, players have an influence on how rules are decided. How does game theory differ from microeconomics? Because game theory can be used to model almost any economic situation, it might seem redundant to study both microeconomics and game theory. However, microeconomics tends to focus on cases in which there are many buyers and sellers or there is one seller (or buyer) and many buyers (or sellers). Yet here are many instances in which there are a few buyers or sellers. Markets in which more than one but still only a few firms compete are known as “oligopolies. ” Oligopolists are acutely aware of their interdependence. Each firm’s decisions in the market depend on the specific assumptions it makes about how its rivals make pricing and output decisions. In addition, there are other situations in which there is one buyer and one seller. Microeconomics without game theory does not adequately address these matters. Consider a market in which the number of producers is small.
In aircraft manufacturing, two firms, Boeing and Airbus, control 100 percent of the world market for commercial aircraft. Each firm recognises that its pricing and production decisions have important implications for its rival’s profitability. As a consequence, each firm attempts to guess which actions its rival will take. But each must also recognise that its rival will also be guessing as to what it will do. Clearly, such interactions are inadequately represented by classic microeconomic models, which assume that the firms are price takers.
In some other markets, the number of buyers is small. For instance, the wholesale market for diamonds is dominated by a small group of global firms; therefore, diamond producers may find that implicit (or explicit) collusion between buyers makes it difficult for the diamond producers to exercise market power. Once again, classic microeconomic models may be missing a very important feature of actual markets. Click on each of the links below to read a few real-world examples in which game theory is applicable.