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An Introduction to Game Theory

Game theory is a mathematical theorem with a huge range of applications. It is essentially the science of strategy, and can be applied to everything from poker games to business, economics, psychology and even warfare. It’s about understanding how our strategies and actions are interdependent on the strategies and actions of other “players”, be they prospective customers, competitors or legislative bodies.

But what exactly is game theory? And how does it apply to you and your business? We’ll look at some of the fundamentals of game theory, and how it can inform your strategic decision-making in business.

What is game theory?

Game theory was developed in the mid 1940s by mathematician John von Neumann and his Princeton University colleague, the economist Oskar Morgenstern. It aims to identify, through mathematics and logic, the interdependent actions that players take in order to secure the best outcomes for themselves in different games. The “games” in question could be anything from a chess match to a business duopoly. 

Game theory explores the interdependence of player’s actions, and how they dictate other players’ decision-making. Whatever the nature of the “game”, game theory explores the intended outcomes of different players. 

These may be:

  • Mutually beneficial for themselves and other players (positive sum)

  • Detrimental for all players (negative sum)

  • Beneficial for one player at the ultimate expense of others (zero sum)

Warfare, for instance, is described as a zero-sum game, as the ultimate outcome can only be the defeat of the other “player”. Likewise, if a company aims to put competitors out of business, this could also be considered a zero-sum game. 

Different types of game theory

There are lots of different types of game theory. However, the most common, and pertinent for business owners, are cooperative and non-cooperative. 

Cooperative game theory explains how cooperation and coalitions interact when they pursue a common incentive. It might explore how, for instance, a co-branding venture might be beneficial for two non-competing businesses, and how the gains may be divided between players. 

Non-cooperative game theory explores how competitors deal with one another in the pursuit of their own goals. For instance, how competing businesses might vie for the attention of fickle consumers. 

Business applications of game theory

There are lots of hypothetical examples of game theory. The “prisoner’s dilemma” is one of the most widely-known examples. This is where two prisoners are detained and questioned in separate cells, and the outcome of their sentencing will be influenced by the unseen and unknown actions of the other prisoner. This is also a good example of how behavioural science can influence the mathematics of game theory.

But how can we apply game theory practically in a business context?

Economists use game theory to better understand the behaviour of oligopolies, where large businesses share a common market, but because the barriers to entry are very high, they typically don’t need to worry about the threat of competition. As such, oligopolies are usually a positive-sum game. 

Market research and competitive analysis are also practical applications of game theory. When researching the competitors with whom you share your market, you’re looking at how their actions (i.e. marketing, branding, promotions, etc.) influence the behaviours of consumers. This in turn will influence your own strategy as you appropriate your competitor’s actions and make them your own in order to engage their customers. 

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If you’re interested in finding out more about game theory, strategy, or any other aspect of your business and its finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.

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