Cornerstone Business Studies recently hosted Robert Hill from the University of Cape Town who delivered a fascinating lecture on the use of Game Theory in Economics and more broadly. 

At its core, game theory is all about analysing situations where multiple players, each with their own interests, interact strategically. These players could be individuals, companies, or even nations, and the decisions they make can impact not only themselves but also others involved in the “game.”

A simple example of this is the classic scenario know as The Prisoner’s Dilemma.

Imagine two suspects are arrested by the police and are being held separately. The police have enough evidence to convict both of a minor crime, but they need a confession to convict them of a more serious offense. The suspects are faced with a choice: stay silent or betray their partner.

• If both suspects remain silent, they each serve a short sentence for the minor crime.
• If one betrays the other by confessing and the other remains silent, the betrayer goes free, and the other serves a long sentence.
• If both betray each other, they both serve moderately long sentences.

Each suspect must consider not only their own interests but also what the other might do. This illustrates the tension between individual and collective interests—a fundamental concept in game theory.

One of the most influential figures in the development of game theory is John Nash, whose life and work were movingly portrayed in the film “A Beautiful Mind.” Nash challenged traditional economic theories, including those of Adam Smith, which asserted that individuals acting in their own self-interest will lead to optimal outcomes for society as a whole. Nash’s equilibrium demonstrated that this isn’t always the case. In some situations, cooperation among individuals can lead to better outcomes for everyone involved.

Nash’s contributions and those of other academics and researchers paved the way for practical applications of game theory in various disciplines, including economics, political science, biology, and even computer science.

Thinking about business, there are multiple situations where game theory could be applied:

Scenario 1: Pricing Strategy in Oligopoly

Imagine you’re the owner of a small company producing a unique product in an industry dominated by a few large firms. Each firm’s pricing strategy affects not only its own profits but also those of its competitors.

If you set your prices too high, customers might turn to your competitors. But if you lower your prices too much, you risk starting a price war that could hurt everyone’s profits. This strategic decision-making, where each firm must anticipate the reactions of others, resembles what economists call an oligopoly—a market structure where a few firms dominate.

Scenario 2: Negotiating Contracts and Alliances

When negotiating contracts or forming alliances with other companies, businesses must anticipate how their actions will influence the behaviour of their partners. Game theory provides a framework for analysing these strategic interactions and making informed decisions that align with business objectives.

Scenario 3: Strategic Investments

In industries with high levels of uncertainty, such as technology or pharmaceuticals, companies must strategically allocate resources to research and development projects. Game theory can help businesses evaluate the potential risks and rewards of different investment strategies, considering the actions of competitors and regulatory agencies.

Then of course there are everyday scenarios in life where really understanding game theory can help you be so much more successful. Think about negotiating a salary increase with your manager – what are the strategies, the information and the payoffs which you should take into consideration to get the best outcome?

So, in conclusion, game theory offers a powerful lens through which to view and manage the strategic interactions that shape our lives, whether in business, politics, or personal relationships. And for those interested in business, understanding game theory and its practical application will allow you to achieve significant leverage in the new world of work.

New knowledge and skills are the key to changing your world and the worlds of those around you. And, learning doesn’t have to be dull—sometimes, it’s just a game away.

Geoff Schreiner

HOD Business Studies

Cornerstone Institute

9/03/24

(Note: Initial aspects of this article were generated using Ai applications)