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Game Theory

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Game theory models are used by managers in taking better decisions regarding price and output. As managers work in interactive payoff environments, they need a framework that anticipates the actions of others.

Game theory was developed in the early 40s in connection with war strategies. Now it is used by managers in respect of rational decisions in strategic situations. As the payoffs are dependent on the actions (behavior) of all players, managers must form expectations about the behavior of others. Specifically, because payoffs are interactive, a manager’s optimal decision depends on what he expects others to do. This means that others are similarly guided so all are aware that each must form beliefs about what others believe you believe and you believe others believe and so forth. This is called chain of reciprocal expectations. Good managers attempt to influence the behavior of others by systematically evaluating the variables subject to their control and using these variables to influence expectations.

Game theory is extremely helpful for making competitive sense of some of the most common strategic situations in the business world- situations where conflict interfaces with mutual dependence. Such games are common both within the organization and in market actions between firms, for example, in price wars, new product introductions, strikes, negotiations and divisional relationships. In these situations players having conflicting objectives but also share a mutual dependence.

Two –Person Games:
Each player- a player may be a single player or an organization- is a decision making unit with a certain amount of resources. The rules of the game describe how these resources can be utilized. For ex: the President of a corporation wants his R&D program to start and what should be done at subsequent times in response to various actions of competing firms. The game’s outcome clearly depends on the strategies used by each player.  In these Two-Person games, there is dominant strategy for each player.

Nash Equilibrium:
Nash equilibrium uses solution concept, where two or more players are involved. In the game all the players are assumed to know the equilibrium strategies of other players and no player gains anything by changing his or her own strategy unilaterally. One player if he changes his strategy while others keep their strategies unchanged, then the current set of strategy choices and corresponding payoffs constitute a Nash equilibrium. For ex: If A and B are in Nash equilibrium, A makes the best decision, taking into account B’s decision and B is taking a decision taking into account A’s decision. 

Prisoner’s Dilemma:
A specific type of game called Prisoner’s Dilemma is particularly useful in oligopolistic competition. To illustrate this type of game, consider a situation where two people A and B get arrested for doing some illegal activity. The police question them separately saying, if you confess and your friend does not then you will get 2 years and he will get 8 years.  If they both confess, they will get 8 years because they have cooperated with the police. If neither confesses, then they will both get only four years as evidence against them is weak. Both A and B have two possible strategies: to confess or not to confess. The four possible outcomes, depending on which strategy each person chooses are shown in the table below. Since A will serve less time than he would if he did not confess. If B confesses, the better strategy for A is to confess, since A will serve 8 years than he will serve 10 years. Thus, regardless of which strategy B adopts, A is better off to confess than not confess. Similarly, B will also confess regardless of which strategy A adopts, B is better off to confess than not to confess. Consequently, both A and B will confess. This is the dominant strategy for both players. However, it is important to understand that both are doing worse if neither of them is confessing. Even if they were to meet and decide on something, they would still go ahead and break the agreement. 

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