Game Theory

'Game Theory' is a concept that deals with the formulation of the correct strategy that will enable an individual or entity, when confronted by a complex challenge, to succeed in addressing that challenge. It was developed based on the premise that for whatever circumstance, or for whatever 'game', there exists a strategy that will allow one to 'win.' Any business is a game played against competitors, or even against customers. Master the rules of the business you're in and you'll win the game, so says Game Theory.

Game Theory is not a new concept, having been invented by John von Neumann and Oskar Morgenstern in 1944. At that time, the mathematical framework behind the concept has not yet been fully established, limiting the concept's application to special circumstances only. Over the past 60 years, however, the framework has gradually been strengthened and solidified, with refinements ongoing until today. Game Theory is now an important tool in any strategist's toolbox, especially when dealing with a situation that involves several entities whose decisions are influenced by what decisions they expect from other entities.

Game Theory involves the study of how the final outcome of a competitive situation is dictated by interactions among the people involved (also referred to as 'players' or 'agents'), based on the goals and preferences of these players, and on the strategy that each player employs. A strategy is simply a predetermined 'program of play' that guides a player as to what actions to take in response to past and expected actions from other players.

Game Theory has several important elements, some of which are: 1) the agent, which refers to a person or entity who have their own goals and preferences; 2) the utility, which is an abstract concept that indicates the amount of satisfaction that an agent derives from an object or an event; 3) the game, which pertains to a situation participated in by several agents (now referred to as 'players', since they're in a game), each of whom is trying to maximize his utility of the game by anticipating the actions of the other players and responding to them correctly; 4) the information, which is what a player knows about what has already happened in the game, and which can be used to come up with a good strategy; 5) the representation, which characterizes the order of play employed in the game; and 6) the equilibrium, which is an outcome of or a solution to the game.

In 1950, Albert Tucker of Princeton University invented the Prisoner's Dilemma, an imaginary scenario that is undoubtedly one of the most famous representations of Game Theory. Here, two prisoners were accused of the same crime and eventually given three possible outcomes: 1) if one confesses and the other does not, the confessor will be released and the other will be imprisoned for a long period of time; 2) if neither confesses, both will be imprisoned for a short period of time; and 3) if both confess, both will be imprisoned for an intermediate period of time. In the end, both prisoners conclude that the best decision is to confess, and are both sent to intermediate imprisonment.

A new concept related to Game Theory is the Nash equilibrium, which was developed by John Nash for his PhD thesis. In a game, players would tend to change strategies from time to time to improve their respective positions. The Nash Equilibrium is the point at which no player can improve his or her position in the game by changing strategy. In the Prisoner's Dilemma, the Nash Equilibrium is the point at which both prisoners confess, since whoever changes this strategy will be sent to a long prison term, instead of an intermediate one.

Game Theory is said to be too rational to be used in the reality of an irrational, modern business world. As such, companies that usually embrace it are those which are in a business sector where there are but a few players, and for which the rules are very tightly regulated, such as the oil industry. In such a 'playing field' where rules are to be followed and behavior can be rationalized, the best competitive moves can be formulated using Game Theory.

HOME