Why is Game Theory useful in business?

By Arthur Pinkasovitch AAA
A:

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 progressed the discipline; but beyond the academic level, is game theory actually applicable in today's world?

Yes!

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.

Another important concept, zero-sum games, also stemmed from the original ideas presented in game theory and the Nash Equilibrium. Essentially, any quantifiable gains by one party are equal to the losses of another party. Swaps, forwards, options and other financial instruments are often described as "zero-sum" instruments, taking their roots from a concept that now seems distant. (For an in depth explanation about game theory, check out Game Theory: Beyond the Basics.)

This question was answered by Arthur Pinkasovitch.

RELATED FAQS

  1. What are the most common momentum oscillators used in options trading?

    Read about some of the most common technical momentum oscillators that options traders use, and learn why momentum is a critical ...
  2. What are the major differences between a monopoly and an oligopoly?

    The major differences between a monopoly and an oligopoly include the number of firms in the market, type of barriers to ...
  3. How effective is creating trade entries after spotting an Exhaustion Gap pattern?

    Understand the components of the exhaustion gap pattern, how and why it occurs, and how it can be used to create an effective ...
  4. How are Bollinger Bands® used in options trading?

    Use Bollinger Bands to identify volatility changes and place options trades at the right time; profit in bull or bear markets ...
RELATED TERMS
  1. Premium to Surplus Ratio

    Net premiums written divided by policyholders’ surplus. The premium ...
  2. Current Liquidity

    The total amount of cash and unaffiliated holdings compared to ...
  3. Developed To Net Premiums Earned

    The ratio of developed premiums to net premiums earned over a ...
  4. Return On Policyholder Surplus

    The ratio of an insurance company’s net income to its policyholder ...
  5. Absolute Percentage Growth

    An increase in the value of an asset or account expressed in ...
  6. Capital Loss Coverage Ratio

    The difference between an asset’s book value and the amount received ...

You May Also Like

Related Articles
  1. Entrepreneurship

    The Best (And Worst) Countries To Be ...

  2. Investing News

    Looking to Open a Franchise? These Topped ...

  3. Not every new company or product makes it, but many successful startups share the following characteristics.
    Entrepreneurship

    6 Characteristics Of Successful Apps

  4. When it comes to managing finances and tracking the markets on the go, there are a number of excellent apps that can be downloaded and installed onto your mobile device.
    Entrepreneurship

    Top Stock Market Apps For News Or Trading ...

  5. A brief overview of the top apps that help forex traders with on time information, charts and more.
    Entrepreneurship

    Top Forex Trading Apps

Trading Center