Introduction to Game Theory

What is Game Theory?

Game theory is a branch of applied mathematics and economics that studies
strategic situations where there are several stakeholders, each with different goals,
whose actions can affect one another.
Although it has been applied to complex business issues and military strategy,
game theory reveals its card-game origins through its name and terminology. For
example, a game is any situation where multiple players can affect the outcome, a
player is a stakeholder, a move or option is an action a player can take and, at the
end of the game, the payoff for each player is the outcome.
In general, the value of game theory lies in understanding the interactions and
likely outcomes when the end result is dependent on the actions of others who have
potentially conflicting motives. Game theory’s value to business lies in allowing
structured analysis of complex multi-player issues including the identification of a
business’ best attainable outcome, threats and promises available to different
players and the prediction of the likely actions and reactions of other players.

History of Game Theory

Game theory is a well developed field of study that has attracted some of the
world’s greatest mathematicians, won two Nobel Prizes and is even credited with
winning the Cold War.
The origins of game theory go far back in time. Recent work suggests that the
division of an inheritance described in the Talmud (in the early years of the first
millennium) predicts the modern theory of cooperative games and, in 1713, James
Waldegrave wrote out a strategy for a card game that provided the first known
solution to a two player game.
History of Game Theory Timeline
Second Nobel
Marketplace Acceptance

Prize Awarded

First Nobel
Prize Awarded
Business
Talmud Applications
anticipates Prisoner’s
Game Theory Dilemma
Cold War
John von Neumann
First Minimax Oskar Morgenstern
mixed strategy 2 x 2 games
solution created

0 1713 1940 1950 1960 1970 1980 1990 2000 2005

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Despite these early efforts, the book The Theory of Games and Economic Behavior
by John von Neumann and Oskar Morgenstern (published in 1944) is usually
credited as the origin of the formal study of game theory. This pioneering work
focused on finding unique strategies that allowed players to minimize their
maximum losses (minimax solution) by considering, for every possible strategy of
their own, all the possible responses of other players. Building upon von
Neumann’s earlier work on two player games where the winnings of one player are
equal and contrary to the losses of his opponent (zero-sum) and where each player
knows the strategies available to all players and their consequences (perfect
information), von Neumann and Morgenstern extended the minimax theorem to
include games involving imperfect information and games with more than two
players.
The golden age of game theory occurred in the 1950s and 1960s when researchers
focused on finding sets of strategies, known as equilibria, to “solve” a game if all
players behaved rationally. The most famous of these is the Nash equilibrium
proposed by John Nash, later made famous in the film “A Beautiful Mind” starring
Russell Crowe. A Nash equilibrium exists if no player can unilaterally move to
improve their own outcome. In other words, they have no incentive to change,
since their strategy is the best they can do given the actions of the other players.
Nash also made significant contributions to bargaining theory and examined
cooperative games where threats and promises are fully binding and enforceable.
In 1965, Reinhard Selten introduced the concept of subgame perfect equilibria,
which describes strategies that deliver Nash equilibrium across every sequential
subgame of the original game. Such subgame perfect equilibria may be found by
first determining optimal action of the player who makes the last move of the
game. Then, the optimal action of the next to last moving player is determined
assuming the last player's action as given. The process, known as backward
induction, continues until all players’ actions have been determined.
In 1967, John Harsanyi formalized Nash’s work and developed incomplete
information games. He, along with John Nash and Reinhard Selten, won the Nobel
Prize for Economics in 1994.
Another important contribution to game theory during the 1950s and 1960s was
Luce and Raiffa's book, Games and Decisions. The Prisoner's Dilemma, introduced
by the RAND Corporation and very familiar to any MBA student, is also a product of
this period.
Further adding to the acclaim of game theory, another Nobel Prize was awarded to
game theorists, Robert Aumann and Thomas Schelling, in 2005. Schelling used
game theory in his 1960 book The Strategy of Conflict to explain why credible
threats of nuclear annihilation from the U.S. and the former Soviet Union were
counterbalancing through mutually assured destruction and therefore were not

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likely to be used. He also argued that the ability to retaliate was more useful that
the ability to withstand an attack.
Aumann's work was mathematical and focused on whether co-operation increases if
games are continually repeated rather than played out in a single encounter. He
showed that co-operation is less likely when there are many participants, when
interactions are infrequent, when the time horizon is short or when others' actions
cannot be clearly observed.
Throughout the years, game theory has been applied to many different fields of
study including auction of underused radio spectra, artificial intelligence,
bargaining, evolutionary biology, political science and real world business decisions.

Application of Game Theory in Business

Game theory with its focus on the interactions of multiple players, each trying to
maximize their own rewards, is a natural fit for many types of business issues.
From labor negotiations to competitive pricing, game theory provides a structured
way to analyze the set of possible strategies and recommend an optimal strategy
for each player.
However, real business decisions have significant complications that are often
ignored by abstract, academic game theory. First, real business decisions almost
always have many players, a challenge for classical game theory. Second, there can
be complex relationships among the players. For example, business issues are
usually mixed-motive games in which the players have some common interests and
some competing ones. Third, business outcomes are often not easy to reduce to a
common measure for value such as dollars or expected utility. Rather, strategic
interests, long term relationships and the personal goals of the CEO or founder can
be critically influential.
In the 1980s, Niall Fraser (founder of Open Options) studied how threats can
constrain other players and create stable outcomes in multiple player games.
Building upon the academic work of Dr. Fraser, and verified over a decade of real
world cases across a wide range of industries, Open Options has developed a
unique modeling method and proprietary software tools to analyze complex, multi-
player business issues.
In game theory terminology, Open Options uses n-player, non-cooperative,
nonzero-sum, non-simultaneous, asymmetric, ordinal game theory. This allows the
modeling of very complex issues involving many players with distinct goals and
multiple distinct options. Each business issue is modeled as a single encounter over
the time frame specified, rather than many repeated games, but does not assume
players act simultaneously or without the knowledge of other players’ actions.
Furthermore, rather than estimating the expected utility of each outcome for each
player as usually required in game theory, Open Options asks the client to rank
each possible action of all players from most important to least important from each

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player’s perspective. By the principle of lexicography, this permits the calculation of
the rank ordering of all outcomes for each player, even where millions of outcomes
are possible. Consequently, many of the classical difficulties associated with
developing utility functions are eliminated, and credible preference information can
be gathered for a large number of outcomes in a practical manner.
Building upon a solid theoretical foundation, the Open Options Process has dealt
with real world business problems for many Fortune 500 companies and has helped
achieve favorable outcomes worth billions of dollars by allowing management teams
to better understand the implications of the preferences and actions of other
players.

Further Reading
Books
Fraser, N.M. and K.W. Hipel (1984). Conflict Analysis: Models and Resolutions. New
York: North-Holland.

Harsanyi, J.C. (1977). Rational Behavior and Bargaining Equilibrium in Games and
Social Situations. Cambridge: Cambridge University Press.

Luce, R.D. and H. Raiffa (1957). Games and Decisions: Introduction and Critical
Survey. New York: John Wiley & Sons.

Raiffa, H. (1982). The Art and Science of Negotiation: How to Resolve Conflicts and
Get the Best Out of Bargaining. Cambridge, Massachusetts: Harvard University
Press.

Synder, G.H. and P. Diesing (1977). Conflict among Nations: Bargaining, Decision
Making and System Structure in International Crises. Princeton, New Jersey:
Princeton University Press.

von Neumann, J. and O. Morgenstern (1944). Theory of Games and Economic

Behavior, Princeton, New Jersey: Princeton University Press.
Journals
Games and Economic Behavior
International Game Theory Review
International Journal of Game Theory

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