Kamal Shah Optimization & Game Theory

A Case Study on the Application of Game Theory to Business Strategy in

Underdeveloped Nations: Pakistan
By: Kamal Shah
1. Introduction
Game theory has been one of those disciplines that have reached phenomenal status because
it has introduced concepts and methodologies that are deemed by many to be “game-
changers”. It first came about in the 1900s, and has been expounded on and progressed since
then. However, there are still some questions and doubts on its applicability, especially in the
real world and in real-life situations, particularly in daily business operations.
1.1 Game theory in Business
But first, let us discuss what Game Theory is all about. It is essentially a discipline or a
method of strategic thinking where the players will have to make decisions by looking from
different perspectives, basically putting themselves in the shoes of the other players and
anticipating their possible actions and reactions. The results of playing out these scenarios
will be used to make decisions or choices.
When used in the context of business, Game Theory is most often used by business managers
to figure out what their collaborators and competitors are thinking or planning. It has become
a very powerful tool for predicting the outcomes or results of interactions or transactions
among a group of players or competitors, where the action of one will have direct effects or
impact on the others, and the others will react according to those actions.
What are the elements that compose Game Theory? There are three basic components at play
here:
A set of players who are involved. In business, these often pertain to individual business
managers and firms or companies.
A set of strategies which are available for use by the players at specific points during the
game. This also encompasses the rules of the game, which are set in order to specify the
sequence of all possible moves and actions. The information that are instrumental in
strategizing are also covered here.
The outcomes for each possible set of strategies or actions, and the expected payoffs based on
these outcomes. These payoffs are assumed to be known by all the parties or participating
players.
Strategizing through the use of Game Theory requires several assumptions to be made. These
assumptions are not fool-proof, however, since there are many arguments that could be made
against them.
Assumption #1: All the players act and think rationally, making choices and performing
actions that are in their self-interest. The weakness of this assumption lies on the fact that
human nature does not often permit rational thinking, and humans tend to make decisions for
reasons other than their own interests.
Kamal Shah Optimization & Game Theory

Assumption #2: All the players act strategically, while taking into consideration the responses
of their competitors to their actions. This is also not always the case, because there are other
drivers to players’ decisions, not necessarily the actions of others. In fact, many business
managers even do not make decisions within the strategic context.
Assumption #3: The effectiveness of Game Theory is fully realized when all the players are
fully aware of, and understand clearly, the payoffs – both the negative and positive ones – of
their choices or actions. It is a fact that most players make decisions even without having all
the information. Many even do not care to know the full story behind some actions or
responses before deciding on a specific course of action themselves.
Game Theory can also be performed in two ways: simultaneous games, where the players
make their moves or actions at the same time, without waiting for information on what the
other players have chosen or acted upon, and sequential games, where the moves of the
players will depend on, and in response to, the previous action or choice of another player.
1.2 Game theory and Business Strategies background
There is no need to discuss the necessity of business strategy for companies in developing
nations like Pakistan. A business strategy is the policy adopted by a corporation after
considering the policies its rivals may adopt (Jehle and Reny 2000).
Business strategy may also be described as "the decision of how a firm will compete in a
certain industry and position itself relative to its rivals." Therefore, company strategy refers to
the competitive strategy of a certain business unit (Hamermesh 1992).
A good summary of the expected benefits of a business strategy includes: (1) increased
profitability; (2) a procedure for analysing and rules for dealing with competitors; (3)
assistance in the management of environmental issues confronting an origination; and (4) the
inclusion of specific policies that could be adopted to achieve organisational objectives.
In companies, business strategy is a fundamental activity. According to Hamermesh (1992),
the strategy wheel is a good tool for displaying the required level of specialisation and
consistency in a corporate strategy. At the basis of the company strategy are the firm's
objectives and the principles behind how it will compete (Hamermesh 1992). Equally
important are the specific definitions of major functional policies and the consistency of these
rules with each other and the business's mission.
A major challenge is the method to comprehending how the implementation of business
strategy affects organisational performance. For these and other reasons, the theory of games
has been established to analyse business strategies in which the results rely on the actions of
all competitors (Gough and Hill 1979). Although this model was established by John Von
Newmann (Mathematician) and Oskar Morgenstem (Mathematical Economist) in 1953 and is
widely used in the area of Economics, it has been criticised for its lack of accuracy. On the
other hand, empirical research by Ledberbetter (1997), Cox (1972), Effiraim (1971), and
Waton (1971) indicate that game theory will be used seldom by corporate managers in
industrialised nations (Gough et al. 1991).
In contrast, according to polls conducted in developing nations such as Pakistan, corporate
managers do not employ the theory at all, and the vast majority of managers are unfamiliar
with it. Rather, framework-less techniques such as (1) intuitive, (2) anticipatory, (3)
Kamal Shah Optimization & Game Theory

opportunistic, (4) formal –structured, (5) incremental, and (6) adaptive. In addition, it should
be noted that these procedures are utilised in combination or separately (Osaze 1998).
Consequently, the primary purpose of this study is to describe some of the many ways in
which the use of game theory may make corporate planning more successful and efficient.
Particular attention will be paid to theoretical/conceptual difficulties, and a simplified
hypothetical case will be provided to illustrate the use of game theory for business
management. This document is separated into four parts.
The part that follows this introduction will explore theoretical/conceptual difficulties. In part
three, a simplified hypothetical case will be offered to show the use of game theory, and
section four will finish the study.
Literature Review
2.1 Current Approaches in Analyzing and Making Decisions in a Competing Environment
in Pakistan
A producer/seller (party) in a competitive market must continually consider the anticipated
responses of their competitors. The problem is the strategy each party employs to gain a
competitive edge. The procedures listed above are currently used in developing nations such
as Pakistan. According to Osaze (1998), some of the strategic management styles now used in
developing countries include hunch, intuitive and anticipatory, opportunistic, formal –
structured, incremental, and adaptive. These techniques are explained in further detail below.
(i) Approach Based on Hunch, Intuition, and Anticipation: In this method, the executive team
employs any strong intuition (variable) and educated estimate. This approach's lack of
impartiality and adaptability to changing situations is its greatest drawback.
(ii) Opportunistic Method: This method is very speculative. This tactic employs a passive
stance. The company's upper management is always awaiting an opportunity before replying
to its competitors.
(iii) Formal–structured: This strategy adheres to a predetermined set of organisational
bureaucratic processes. The senior management use the organization's defined processes to
deal with competitors. This method is quite rigid and time-consuming.
(iv) Incrementing: The incrementing technique is essentially a democratic corporate strategy.
Here, the stakeholders determine a company unit's market competition strategy.
(v) Adaptive: In an adaptive strategy, decision makers identify the changing environmental
factors and use any of the aforementioned strategies. Consequently, it can be extrapolated
that the methodologies may be used individually or together.
Without a doubt, depending on the user, the aforementioned methodologies have provided
appropriate determinations on how a company unit should compete in its market. However,
important drawbacks include: One, the techniques often involve intangible, difficult-to-
quantify considerations that correspond to individual preference and disposition. The second
shortcoming is that the techniques have few or no goals and limits. They lack both
dependability and legitimacy. The third deficiency is that, with the exception of the adaptive
strategy, other contemporary systems use mental variables rather than environment. Mental
Kamal Shah Optimization & Game Theory

aspects are often not apparent, making it harder to critique, debate, or support such
techniques, since they might be confusing.
2.2 Game Theory: Concepts and Rationale
As previously stated, game theory is a probabilistic model used for assessing and
determining decision-making rules when two or more individuals compete for the same
goals. The objective of game theory is to examine the interactions between the players in a
given model and anticipate their best choices (Investopedia 2010). Wikipedia (2010) states
that economists and business experts recommend two basic applications of game theory:
descriptive and prescriptive. In its descriptive application, game theory has been used to
examine a broad range of human and animal behaviours; thus, by determining the equilibrium
of games, we may forecast how true human prediction can be comprehended. The Nash
equilibrium is an often cited example of the descriptive application of game theory (see
Investopedia 2010; Stanford Encyclopaedia 2010). Game theory has also been used to try to
build theories of ethical or normative conduct.
This is an effort to examine economic and human behaviours as they should be, discussing
judgement and examining what is good and wrong. The prisoner's dilemma is an often cited
example of the descriptive application of game theory (see Investopedia 2010; Stanford
Encyclopaedia 2010). Modelling conflict between two or more rational decision-makers,
game theory blends mathematics, statistics, economics, and psychology (Google 2004). There
are countless instances of such competitive scenarios in the corporate world. In a perfectly
competitive market with numerous buyers and sellers, each seller formulates his own strategy
based on what he anticipates others would do. Consequently, game theory was established to
deal with such competitive circumstances.

2.3 THE GAME THEORY IN DAY-TO-DAY BUSINESS

Anyone that plays a key role in high-level and strategic decision-making in an organization
should definitely consider learning about, and applying, the Game Theory. They include, but
are not limited to, executives, directors, and senior managers.

The applicability of Game Theory may be in question by some pundits, but there is no
denying the fact that even large and established businesses have openly discussed using
Game Theory for their key strategic business decisions.

The most common situations where Game Theory becomes most useful include:

 It is especially useful when it comes to analyzing first price sealed bid auctions. A

first-price sealed bid auction is a type of auction where the bidders submit their bids –
sealed and secured – and the highest bidder wins. What is analyzed are the behaviors
of the bidders, and the factors that come into play when they make the decisions while
preparing their bids. In this case, the bids are independent of each other, and are made
by the bidders simultaneously.

 Bargaining activities. Game theory also comes into play when bargaining takes place
between or among parties. Examples include negotiations between management and
the workers’ union, as well as revenue-sharing negotiations.
Kamal Shah Optimization & Game Theory

 Product decisions. This is the quintessential area where businesses can “play games”
or play out scenarios using the Game Theory. It is actually most frequently used by
businesses in making decisions on whether to enter a market or to exit it. Businesses
deciding whether to introduce a new product or not may also use a Game Theory.

 Transactions between Principal and Agent. Principal-Agent decisions can also apply

the Game Theory when tackling compensation negotiations as well as incentives to
suppliers and business partners.

 Supply Chain decisions. A huge bulk of the decisions made by businesses involves the
supply chain, and some of the more common decisions made involve capacity
management, make or buy, and build or outsource.

2.3.1 Importance of Applying Game Theory in Business

Making business decisions is a daily event for managers. They are always faced with
decisions on what to produce, what to procure, and what to sell, followed by decisions on
how much they should spend in producing or in procuring, and what price they should
set when they sell. There are so many tools used to come up with decisions, and one of these
tools is Game Theory.

We can enumerate several reasons why business managers should consider using the Game
Theory in its business operations.

 To reduce business risk. Simulations have been employed by business managers in

their risk analysis methodologies. Applying game models is effective in determining
equilibrium within the market. Risk analysis makes use of Game Theory in
determining optimal price strategy, expected market shares, expected income and
number of customers, while obtaining information about the company, the market, the
competitors, and the technologies in use, among others.

 To obtain insights regarding the competition and the overall competitive landscape of

the business and the industry. One of the best ways to be competitive is to know your
competition. Using Game Theory is very effective in getting information on the
various factors related to the competitiveness of the business. The core addresses the
question “what are my rivals or opponents thinking?” They want to know what their
competition’s next move is – their motivations, their strategies, their strengths and
their weaknesses, and use all this information to change the game and increase the
value of their own business proposition.

 To improve internal decision-making processes. By playing out business scenarios,

companies become more confident in their decisions, and management is more
inclined to have greater involvement in the internal decision-making processes.
Business managers must beware, however, of how they use Game Theory. It is not a
management tool that they can use as a substitute for experience in business. It is merely a
tool, or a guide, for them to go about their tasks or roles as business managers.

2.3.2 Game Theory applied in Pricing Decisions

Kamal Shah Optimization & Game Theory

The pricing decisions of a company can be highly influenced by the pricing choices or
decisions of rival companies. One popular example was the price-chopping decisions initiated
by Intel and Advanced Micro Devices (AMD) on their desktop and mobile processors.

Intel and AMD are considered to be competitors in a highly specialized niche, and both are in
a tight race to gain a larger share of the market. The first move was taken by Intel, who
initiated a price slash on its desktop and mobile processors. AMD reacted by implementing a
similar price cut, even if it meant potential losses or decrease in revenues.

This price war resulted to both companies seeing significant increases in unit sales and
shipments of their products – a sign of an increase in their market potential. However, their
revenues saw a drop, and so did the profits.

The concept of ‘Prisoner’s Dilemma’ is apparent in this example. Prisoner’s dilemma is best
represented by a situation where two criminals, who are accomplices, are interrogated in two
separate rooms. The interrogators are not in possession of sufficient evidence or information
to make a conviction, so they have to find a way to facilitate a confession. They present each
of the suspects with two choices: either defect, or confess to the crime and get a lighter
punishment or jail sentence, or they could cooperate, or refuse to say anything, and suffer the
punishment due them.

The interrogators make it a point to inform both suspects that the other is fully aware of the
deal and its connotations. Thus, each of them will make a decision without knowing what the
other’s actions will be.

If the two suspects decide to defect and make a confession, they will both get the full brunt of
the punishment and be sentenced the standard jailtime. If, however, one suspect confesses
and the other stays quiet, it is the latter who will get the jail sentence – often even longer –
while the one who confessed gets off with a lighter sentence, or even walks away scot-free.

In the AMD and Intel example, AMD reacted with a price slash of its own after Intel made
the move first. But what followed was a series of price cuts that could only be described as a
“repetition of interactions”. Both companies are aware of each other as long-time
competitors, and that they will be playing the same game for a long time to come. Thus, they
have the choice on whether to cooperate with each other and kept their prices higher, or they
could engage in mutual price-chopping actions.

2.4 The Development of Game Theory

In 1713, James sent a letter in which the earliest documented discussion of game theory
appeared. Waldegrave gives a minimax mixed solution to a two-player version of the card
game Wikipedia in this letter (2010). During World War II (1942-1945), when the
management school started to study the application of quantitative approaches to military and
logistical challenges, game theory played a pivotal role in the substantial research performed
by the management science school. Among the initiatives were ways for boosting the
precision of bombing, the creation of search processes to find enemy submarines, and the
delivery of necessary supplies and equipment. The majority of research projects were done by
multidisciplinary teams comprised of experts in engineering, mathematics, statistics,
economics, psychology, and political science, among others (Richard et al. 1982;
Aigbokhaevbolo 2006). Many individuals felt after Globe War II that the newly industrialised
world had enormous possibilities (Seilagyi 1981). John Von Newmann (mathematician) and
Kamal Shah Optimization & Game Theory

Oskar Morgens- tern (mathematical economist) proposed the application of Game Theory to
deal with choices involving two or more intelligent opponents with conflicting agendas, as
indicated above (Mcain 2004). According to Mcain (2004), game theory has been used in the
area of bankruptcy since the work of John Von Newmann; barbarians at the gate, battle of the
network, caveat emptor, recruitment, coordination, escape, majority rule, market niche,
mutually defensive, prisoner's dilemma. Subsidized small enterprise, tragedy of the commons
ultimatum, and coordination of the video system.
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