APPLICATION OF GAME THEORY IN BUSINESS

GAME THEORY

Game theory is the branch of decision theory concerned with interdependent decisions. The problems of interest involve multiple participants, each of whom has individual objectives related to a common system or shared resources. Because game theory arose from the analysis of competitive scenarios, the problems are called games and the participants are called players. But these techniques apply to more than just sport, and are not even limited to competitive situations. In short, game theory deals with any problem in which each player. strategy depends on what the other players do.

The field of game theory began around 1900 when mathematicians began asking whether there are optimal strategies for parlor games such as chess and poker, and, if so, what these strategies might look like. The first comprehensive formulation of the subject came in 1944 with the publication of the book Theory of Games and Economic Behavior by famous mathematician John von Neumann and eminent economist Oskar Morgenstern. As its title indicates, this book also marked the beginning of the application of game theory to economics. Since then, game theory has been applied to many other fields, including political science, military strategy, law, computer science, biology and business, among other areas. In 1994 three pioneers in game theory were awarded a Nobel Prize, marking the arrival of the field.

CHARACTERISTICS OF GAME THEORY

The mathematical analysis of games begins by recognizing certain basic characteristics of all conflict situations. First, games always involve at least two people or two groups of people. In most cases, the game results in a win for one side of the game and a loss for the other side. Second, games always begin with certain set conditions, such as the dealing of cards or the placement of soldiers on a battlefield. Third, choices always have to be made. Some choices are made by the players themselves ("where shall I place my next X"?) and some choices are made by chance. Chess is considered a game of perfect information because both players know exactly

where all the pieces are located and what moves they can make. Finally, the game ends after a set number of moves and a winner is declared.

TYPES OF GAMES

Games can be classified in a variety of ways. One method of classification depends on the amount of information players have. In checkers and chess, for example, both players know exactly where all the pieces are located and what moves they can make. There is no hidden information that neither player knows about. Games such as these are known as games of perfect information.

The same cannot be said for other games. In poker, for example, players generally do not know what cards their opponents are holding, and they do not know what cards remain to be dealt. Games like poker are known as games of imperfect knowledge. The mathematical rules for dealing with these two kinds of games are very different. In one case, one can calculate all possible moves because everything is known about a situation. In the other case, one can only make guesses based on probability as to what might happen next. Nonetheless, both types of games can be analyzed mathematically and useful predictions about future moves can be made. Games also can be classified as zero-sum or nonzero-sum games. A zero-sum game is a game in which one person wins. Everything lost by the loser is given to the winner. For example, suppose that two players decide to match pennies. The rule is that each player flips a penny. If both pennies come up the same (both heads or both tails), player A wins both pennies. If both pennies come up opposite (one head and one tail), player B wins both pennies. This game is a zero-sum game because one player wins everything (both pennies) on each flip, while the other player loses everything. Game theory often begins with the analysis of zero-sum games between two players because they are the simplest type of conflict situation to analyze.

Most conflict situations in real life are not zero-sum games. At the end of a game of Monopoly, for example, one player may have most of the property, but a second player may

still own some property on the board. Also, the game may involve more than two people with almost any type of property distribution.

GAME THEORY & ITS BRANCHES

There are two main branches of game theory: cooperative and non-cooperative game theory. Non-cooperative game theory deals largely with how intelligent individuals interact with one another in an effort to achieve their own goals. In addition to game theory, economic theory has three other main branches: decision theory, general equilibrium theory and mechanism design theory. All are closely connected to game theory.

DECISION THEORY

Decision theory can be viewed as a theory of one person games, or a game of a single player against nature. The focus is on preferences and the formation of beliefs. The most widely used form of decision theory argues that preferences among risky alternatives can be described by the maximization of the expected value of a numerical utility function, where utility may depend on a number of things, but in situations of interest to economists often depends on money income. Probability theory is heavily used in order to represent the uncertainty of outcomes, and Bayes Law is frequently used to model the way in which new information is used to revise beliefs. Decision theory is often used in the form of decision analysis, which shows how best to acquire information before making a decision.

GENERAL EQUILIBRIUM

General equilibrium theory can be viewed as a specialized branch of game theory that deals with trade and production, and typically with a relatively large number of individual consumers and producers. It is widely used in the macroeconomic analysis of broad based economic policies such as monetary or tax policy, in finance to analyze stock markets, to study interest and exchange rates and other prices. In recent years, political economy has emerged as a combination of general equilibrium theory and game theory in which the

private sector of the economy is modeled by general equilibrium theory, while voting behavior and the incentive of governments is analyzed using game theory. Issues studied include tax policy, trade policy, and the role of international trade agreements such as the European Union.

MECHANISM DESIGN

Mechanism design theory differs from game theory in that game theory takes the rules of the game as given, while mechanism design theory asks about the consequences of different types of rules. Naturally this relies heavily on game theory. Questions addressed by mechanism design theory include the design of compensation and wage agreements that effectively spread risk while maintaining incentives, and the design of auctions to maximize revenue, or achieve other goals.

APPLICATION AND CHLLANGES

Game theory has been used to study a wide variety of human and animal behaviors. It was initially developed in economics to understand a large collection of economic behaviors, including behaviors of firms, markets, and consumers. The use of game theory in the social sciences has expanded, and game theory has been applied to political, sociological, and psychological behaviors as well.

Game theoretic analysis was initially used to study animal behavior by Ronald Fisher in the 1930s (although even Charles Darwin makes a few informal game theoretic statements). This work predates the name "game theory", but it shares many important features with this field. The developments in economics were later applied to biology largely by John Maynard Smith in his book Evolution and the Theory of Games.

In addition to being used to predict and explain behavior, game theory has also been used to attempt to develop theories of ethical or normative behavior. In economics and philosophy,

scholars have applied game theory to help in the understanding of good or proper behavior. Game theoretic arguments of this type can be found as far back as Plato.

ECONOMICS AND BUSINESS

Economists have long used game theory to analyze a wide array of economic phenomena, including auctions, bargaining, duopolies, fair division, oligopolies, social network formation, and voting systems and to model across such broad classifications as behavioral economics and industrial organization. This research usually focuses on particular sets of strategies known as equilibria in games. These "solution concepts" are usually based on what is required by norms of rationality. In non-cooperative games, the most famous of these is the Nash equilibrium. A set of strategies is a Nash equilibrium if each represents a best response to the other strategies. So, if all the players are playing the strategies in a Nash equilibrium, they have no unilateral incentive to deviate, since their strategy is the best they can do given what others are doing.

The payoffs of the game are generally taken to represent the utility of individual players. Often in modeling situations the payoffs represent money, which presumably corresponds to an individual's utility. This assumption, however, can be faulty.

A prototypical paper on game theory in economics begins by presenting a game that is an abstraction of some particular economic situation. One or more solution concepts are chosen, and the author demonstrates which strategy sets in the presented game are equilibria of the appropriate type. Naturally one might wonder to what use this information should be put. Economists and business professors suggest two primary uses:

a) Descriptive b) Prescriptive

BENEFITS OF GAME THEORY

Game theory was once hailed as a revolutionary interdisciplinary phenomenon bringing together psychology, mathematics, philosophy and an extensive mix of other academic areas. Eight Noble Prizes have been awarded to those who have progress the discipline.

The classical example of game theory in the business world arises when analyzing an economic environment characterized by an oligopoly. Competitive firms are faced with a decision matrix similar to that of a Prisoner's Dilemma. Each firm has the option to accept the basic pricing structure agreed upon by the other companies or to introduce a lower price schedule. Despite that it is in the common interest to cooperate with the competitors, following a logical thought process causes the firms to default. As a result everyone is worse off. Although this is a fairly basic scenario, decision analysis has influenced the general business environment and is a prime factor in the use of compliance contracts.

Game theory has branched out to encompass many other business disciplines. From optimal marketing campaign strategies, to waging war decisions, ideal auction tactics and voting styles, game theory provides a hypothetical framework with material implications. For example, pharmaceutical companies consistently face decisions regarding whether to market a product immediately and gain a competitive edge over rival firms, or prolong the testing period of the drug; if a bankrupt company is being liquidated and its assets auctioned off, what is the ideal approach for the auction; what is the best way to structure proxy voting schedules? Since these decisions involve numerous parties, game theory provides the base for rational decision making.

There are a lot of benefits to game theory and gaming mechanics, depending on how they are organized, the intention behind them, and how well they fit in with the corporate strategic plan and culture. They can improve engagement, relatedness, productivity, efficiency, consistency, effectiveness, employee performance, client satisfaction, employee retention, the bottom line, and probably more.

A well-organized game can be a source of influence - as a motivator, a resource to increase

ability, or both. A game that is well planned usually is tied in with the strategic plan and culture, and may either generate innovation or tighten up a system. The most engaging games involve some way of keeping score. Feedback that helps people improves. Games generally focus on rewarding strengths or something that is done well, and can provide objective and consistent feedback, therefore making a good option for training and focus.

LACKINGS OF GAME THEORY IN BUSINESS

Game theory presents the only current approach to determine logically/scientifically what will happen in response to changes in a complex environment. It is far from perfect and cannot possibly deal with all the variables, but at least it's an attempt to make reasoned decisions.

CONCLUSION

Game theory studies competitive and cooperative behavior in strategic environments, where the fortunes of several players are intertwined. It provides methods for identifying optimal strategies and predicting the outcome of strategic interactions.

Game theory helps us model, analyze, and understand the behavior of multiple self-interested agents who interact while making their decisions. In particular, it is a powerful tool for analyzing situations where the agents strive to maximize their (expected) payoffs while choosing their strategies, and each agents final payoffs depend on the profile of strategies chosen by all agents. Most business situations can be modeled by a game, since in any business interaction involving two or more participants the payoffs of each participant depend on the other participants actions.

The general methods and concepts offered by game theory, such as strategies and equilibrium, can be applied and provide useful insights in many applications of business and social sciences. In this chapter we provided an introductory overview of basic concepts in game theory and gave examples of their applications in supply chain management and other business settings.

There are many powerful tools, such as simulation, optimization, and decision analysis, which could aid managers in their decisions. We believe the use of game theory along with these other tools and the managers business experience could significantly improve the managers understanding of the dynamics in business interactions and lead to higher quality and more informed decisions.