You are on page 1of 18

[Game theory in business]

GAME THEORY APPLICATIONS, STRATEGIES IN THE BUSINESS


FIELD OF OPERATIONS RESEARCH

A TERM PROJECT

Submitted to

Ms. Fatma Galatyali

of

Eastern Mediterranean University

by

Ilkin Jafarov

in partial fulfillment of the requirements for the course

ENGL201 Technical Report Writing

in

School of Foreign Languages

Modern Languages Division

Gazi Magusa, Turkish Republic of Northern Cyprus

05.30.2017

[Industrial Engineering], Eastern Mediterranean University 1


[Game theory in business]

ABSTRACT

In this report I will talk about why game theory is important and how it is effective in

business field. To do this I will write about the role of game theory in history of economic and

information systems. Then I will show how game theory works in business field and which game

forms it is divided into. The report will give definition of the game forms which most used in

business and show dominance of the strategies and show how game theory is important in

identifying, understanding and developing the strategies adopted by companies.

[Industrial Engineering], Eastern Mediterranean University 2


[Game theory in business]

TABLE OF CONTENTS

LIST OF FIGURES .......................................................................................................... 4

LIST OF TABLES ............................................................................................................ 5

INTRODUCTION............................................................................................................. 6

1. Game theory in the business field of operations research ................................... 8

1.1. History and impact of game theory................................................................ 8

1.2. Game theory and information systems .......................................................... 9

1.3. Definition of games ........................................................................................ 11

2. Game forms ........................................................................................................... 12

2.1. Strategic (normal) form of games and payoff ............................................. 12

2.2. Extensive form (game tree) of games ........................................................... 13

CONCLUSION ............................................................................................................... 17

REFERENCES ................................................................................................................ 18

[Industrial Engineering], Eastern Mediterranean University 3


[Game theory in business]

LIST OF FIGURES

Figure 1. [The advertisements recommended by the YouTube and the websites gain.] ..... Error!

Bookmark not defined.

[Industrial Engineering], Eastern Mediterranean University 4


[Game theory in business]

LIST OF TABLES

Table 1. [Game theory timeline] .................................................................................................... 9

Table 2. [Decisions and results in strategic form] ....................................................................... 13

Table 3. [Order of decisions and results in extensive form] ........................................................ 14

Table 4. [Internet service provider strategies and payoff].. 16

[Industrial Engineering], Eastern Mediterranean University 5


[Game theory in business]

INTRODUCTION

In an interactive world, everybody wants to be successful in any business and make

money. But the decision made by each individual and company that wants to succeed in such an

environment determines whether other individuals will also be successful. Game theory, created

by Austrian economists Oskar Morgenstern and Hungarian John Von Neumann in 1944,

according to Wikipedia, analyzes all the possibilities and mathematically reveals how successful

each individual or company will be and how it will affect other individuals. Game theory

characterizes individuals and companies as players, assuming that such competitive

environments are "games". The theory divides the games into groups such as strategic, extensive

etc. to analyze the strategies and results of the players. And it predicts the successes and gains of

individuals and companies and their good or bad effects on other individuals and companies.

This report will be about game theory in business field of operations research. Its purpose

is to present the relationship between game theory, business and operation research. The report

will explain how important game theory is in business and how companies set their own

strategies. Although game theory is a mathematical theory and contains a lot of complex

formulas, these aspects have been avoided in the report. Only introductory information about

game theory will be provided. This report will be beneficial for industrial and management

engineering students.

The parts of the report discuss history, impact and definition of game theory, the

relationship between information systems and the theory, definition of games, strategic form of

games and payoff, extensive form of games, dominance of strategies and quality choice. The

sections on game theory and information systems, explains what is game theory and

its importance. The sections on game forms describe how the theory analyzes the strategies of

[Industrial Engineering], Eastern Mediterranean University 6


[Game theory in business]

the companies.And the final section on strategies and quality describes how companies need to

choose strategies and the relationship between companies and the customers, depending on the

quality of company's products.

[Industrial Engineering], Eastern Mediterranean University 7


[Game theory in business]

1. GAME THEORY N THE BUSNESS FELD OF OPERATONS RESEARCH

Under this heading I am going to explain what game theory is and talk about its history

and the impact of game theory in information systems and general game forms.

1.1. History and impact of game theory

Game theory is a field used in statistical science, social sciences, biology, engineering,

political sciences, computer science and philosophy. The concept of game theory is used when

agents interact with one another. These agents can be individuals or companies. Even if the

theory was originally developed to solve contests where an individual's earning is at the expense

of the other, he has begun to examine a vast field of interaction based on many aspects. Aumann

(1981) states Game theory is a sort of umbrella or "unified field" theory for the rational side of

social science, where "social" is interpreted broadly, to include human as well as non-human

players (computers, animals, plants).(p. 460).

Although some progress has been made earlier, game theory began with the book Theory

of Games and Economic Behavior written by John von Neumann and Oskar Morgenstern in

1944. The theory was developed by many academics in the 1950s. Game theory has been

accepted as an important tool in many fields. In the economy, eight game theorists received the

Nobel Prize. Game theory has recently been used in artificial intelligence and cybernetics as well

as in the field of computer science.

[Industrial Engineering], Eastern Mediterranean University 8


[Game theory in business]

Table 1. Game theory timeline

History of game theory. Retrieved May 08, 2017 from World Wide Web

http://cassmba8.weebly.com/john-nash-a-beautiful-mind.html

1.2. Game theory and information systems

Coherence of game theory and mathematical foundations are the most important tools for

modeling and designing an automated decision-making process in environments where

individuals interact. For example, you might want to have active bidding rules for the auction on

any web site.

For any decision-maker, game theory is a methodology for analyzing and determining the

problems of strategic choices as a powerful mathematical tool. The process of modeling a

situation as a game requires the ordering of decision makers and their strategic options, taking

[Industrial Engineering], Eastern Mediterranean University 9


[Game theory in business]

into account the preferences and reactions of the players. The discipline used to create such a

model has the potential to provide a clearer and broader perspective on the situation to a decision

maker player.

For example, if a decision maker watches a few videos on YouTube website, he will see

the website recommends some videos. YouTube creates a strategy by understanding which

videos the decision-maker watches, and according to this strategy, the website will recommend

videos to the decision-maker in his area of interest. Also, when decision maker use other internet

sites, YouTube can recommend the ads of internet sites in the same and similar categories and

internet sites can earn money by clicking on the ads.

Figure 1. The advertisements recommended by the YouTube and the websites gain.

James, M. (2015). Facebook to take on YouTube with its new video ad feature. Retrieved May

08, 2017 from World Wide Web http://marketrealist.com/2015/07/facebook-take-YouTube-new-video-

ad-feature/

[Industrial Engineering], Eastern Mediterranean University 10


[Game theory in business]

1.3. Definition of games

The goal in game theory is to describe each interactive situation as a game. Game theory

analyzes all players' preferences, knowledge, strategic activities and shows how players are

influenced. Games are divided into two groups as cooperative and non-cooperative. Cooperative

games determine the profits that any individual group can achieve through cooperation. Games

that host non-cooperating individuals are called non-cooperative games. Hahn (1992) states that

in such games, individuals make decisions according to their interests (p. 214). If we think of

companies as non-collaborators, we can see that cooperative games are valid in business.

Because in the real world all companies are in competition with one another, and the decisions

they make, and the strategies they follow, determine their winnings. Non-cooperative games are

divided into two groups as strategic form and extensive form. A game in strategic form

determines the strategies and possible options of the players. The extensive form is more detailed

than the strategic form.

[Industrial Engineering], Eastern Mediterranean University 11


[Game theory in business]

2. GAME FORMS

Under this heading Im going to explain about game forms and dominance of strategies.

2.1. Strategic (normal) form of games and payoff

In game theory, strategic form is a way of defining a game. Strategic form is generally

used for simultaneous games and allows to analyze the results of decisions made at different

times in a game. Hussein states (2008) An outcome is represented by a separate payoff for each

player, which is a number that measures how much the player likes the outcome. (p. 26)

For example, suppose there is a strategic game between two players. These players are

two companies that produce shoes in a city with a penetration of 100,000. Each player has two

strategies: "cooperation" and "defect".

Assume the price of each shoe are 10 dollars. And these two companies have the same

capacity to produce products. But each company lacks a material for production. If the

companies cooperate, the shoe they produce together can make them the same amount of profit.

For example, if each person purchases a pair of shoes, companies will earn $ 1 million. Each

company's earnings will be $ 500,000.

But if the companies do not cooperate they will not have the earnings because they can

not produce shoes. In other words, the decision to cooperate or not cooperate determines the

amount of their earnings.

[Industrial Engineering], Eastern Mediterranean University 12


[Game theory in business]

Table 2. Decisions and results in strategic form

Robert J. Aumann. (1995). Repeated Games of Incomplete Information, Cambridge:

M.I.T. Press

2.2. Extensive form (game tree) of games

The extensive form is more extensive than the strategic form in game theory. Kim (2014)

states that, in strategic games, players will make simultaneous decisions, but in extensive games

the decisions of the players are given over time. And the conclusions of the decision lead to other

decisions being made at the time.

Unlike the strategic form, the order of decisions making and taking actions is important

in the extensive form. At the same time, the information that the players have at these stages and

the time to solve the problems are very important.

Assume that two competing companies are players in a extensive form. The decisions of

these companies will affect one-on-one. If the first company decides on a certain issue and

[Industrial Engineering], Eastern Mediterranean University 13


[Game theory in business]

makes a profit, the second company will make a decision based on the result of the decision of

the first company. If the first company makes too much profit as a result of the decision, the

competitor may decide to produce a better quality but cheaper product to protect its place in the

market. On the other hand, the first company may offer to cooperate. If the rival company does

not will to make a business alliance, then their decisions will determine their market gains.

Table 3. Order of decisions and results in extensive form

Robert J. Aumann. (1995). Repeated Games of Incomplete Information, Cambridge:

M.I.T. Press

[Industrial Engineering], Eastern Mediterranean University 14


[Game theory in business]

2.3. Dominance and quality choice

In game theory, all players make rational decisions. Thus, the players make new

decisions by analyzing the results of one's decisions and the decisions they make. Or it is

possible to have two strategies, A and B for each player. Compared to the combinations of other

players' strategies, the result of this player's strategy A may be better than the result of strategy

B. Then strategy A is said to dominate strategy B. A next game example shows how the

strategies of the players influence their winnings.

Suppose a web devoloper needs to buy a service from an internet service provider to

build a website. Suppose the Internet service provider is the first player and the devoloper is the

second player. The Internet provider offers two different quality services, high and low. High

quality service is more expensive than low quality service. But in fact, the quality of the high

quality service is not as high as expected. But since the customer does not know it, there are two

choices: to buy and not to buy.

[Industrial Engineering], Eastern Mediterranean University 15


[Game theory in business]

Table 4. Internet service provider strategies and payoff

K. Hussein. (2008). A Novel Interactive Computer-Based Game Framework: From

Design to Implementatio, 32(5), 22-30. Doi: 10.1109/VIS.2008.29

Although the customer prefers to buy high quality service, the provider prefers to sell low

quality service because it attracts more customers. Therefore, the low quality service strategy Is

dominant strategy for the provider. Also the customer chooses to buy low quality service because

he thinks the provider is rational.

[Industrial Engineering], Eastern Mediterranean University 16


[Game theory in business]

CONCLUSION

In this report, I tried to explain what game theory is and the impact of game theory in

information systems. I have shown that how is important game theory in business field of

operations research and how companies set their own strategies and why it is important.

I emphasized that game theory have two important game forms in business field: normal

and extensive forms. Normal form games uses for normal and simple games and that game form

are generally used for simultaneous games and allows to analyze the results of decisions made at

same times by players in a game.

Then I explained what are the differences between normal form and extensive form and

showed that in extensive game forms the decisions of the players are given over time and the

order of decisions making and taking actions are important.

At the end I showed that companies strategies how important and what are the effects of

the strategies on quality of companies products and customer choices.

[Industrial Engineering], Eastern Mediterranean University 17


[Game theory in business]

REFERENCES

Binmore, K., Vulkan. (1999). Applying game theory to automated negotiation.

Netnomics, Vol. 1, 55, doi:10.1023/A:1011489402739

Kagel., Roth. (Eds.). Handbook of Experimental Economics. New Jersey: Princeton Univ.

Press.

K. Hussein. (2008). A Novel Interactive Computer-Based Game Framework: From

Design to Implementatio, 32(5), 22-30. Doi: 10.1109/VIS.2008.29

Game theory. Retrieved May 08, 2017 from World Wide Web

https://en.wikipedia.org/wiki/Game_theory

P. Dasgupta, D. Gale, O. Hart, E. Maskin. (Eds.). (1992). Irrationality in Game

Theory", in Economic Analysis of Markets and Games, Essays in Honor of Frank Hahn.

Cambridge: MIT Press.

Robert J. Aumann. (1995). Repeated Games of Incomplete Information, Cambridge:

M.I.T. Press

S. Kim (2014). Game Theory Applications in Network Design. Seoul: Information

Science Reference

[Industrial Engineering], Eastern Mediterranean University 18