Game Theory is referred to as one of the most significant theories not simply within any particular field but in the number of sectors, namely economics, mathematics, biology, ecology, political science, and philosophy. Since the term was first introduced by John von Neumann and Oskar Morgenstern in 1944, it has undergone many developments over the years. Game theory was technically used to “understand the strategic behaviour of decision makers who are aware that their decisions affect one another.” In easy words, it is the process of determining the strategic interaction between two or more people, companies or nations in a situation that contains set rules and outcomes. It is most prominently applied to economics for the fundamental analysis of industries, sectors or firms.
Let us take a look at some of the strategies that have been given by game theory and are applied to real life. Here we go:
The most popular and basic strategy of game theory is Prisoner's Dilemma. It involves the decision-making when two individuals acting in the best interest for themselves, end up with worse results as compared to what they had opted when cooperated with each other. For example, two prisoners, apprehended for a crime are kept in two separate rooms and are not allowed to communicate with each other. The prosecutor informs them individually that if Suspect 1 confesses and testifies against the other, he can be free to go, but if he doesn’t do that and Suspect 2 does the same, the former will be sentenced to three years in prison. However, if both choose to confess, then they will get imprisonment for two-years. Also, if neither confesses the crime, each will get one-year sentence in prison. This situation to ‘confess’ or ‘don’t confess’ without knowing other person’s choice is called prisoner’s dilemma. It aims at how people might behave in tricky situations.
Coordination involves higher outcomes when players select the same course of action. Let’s take an example; two big technology companies are planning to introduce a new memory chip that has potential to earn huge profits or a revised version of an already existing technology that may not earn as much as the previous option. If only one of the two companies decides to go with the first option, then market adoption by consumers would be lower, and it will not earn as much as what both companies might have from the same course of action.
In this strategy, each individual just focuses to maximize their own payoff without giving any thought to another person. It was introduced by economist Kaushik Basu in 1994. Suppose, an airline agrees to pay compensation for same damaged items to two travelers. So company asks them separately to estimate the value of that product with the minimum amount of $2 and a maximum of $100. The conditions are- a) if both write down the same value, both will get that amount. b) if the values differ, the airline will reimburse the lower value, with a bonus of $2 to the traveler who wrote the lower amount, and will charge a penalty of $2 from the traveler who mentioned the higher value.
Volunteer’s dilemma includes undertaking a job for the common good. But if nobody volunteers, then it is considered as the worst possible result. For example, accounting fraud is rampant in a company, but top management is not aware of it. A junior level staff member in the department knows about the fraud but hesitates to inform the seniors. It may be because the accused employees can be fired or most probably prosecuted. Also, being tagged as a “whistleblower” have its repercussions too. But if nobody will raise the matter, it may eventually result in the company’s bankruptcy and the loss of everyone’s jobs.
It is a variation of the Prisoner’s Dilemma, and replaces the “Cooperate or Defect” decisions with the “Peace or War.” We can take an example of two companies that are engaged in a price war. If both abstain from price cutting, then they would enjoy relative prosperity, but this price war would obviously reduce profits. However, in case one opts for price cutting while other does not, the former would have a higher payoff as it will be able to capture substantial market share, and the higher share would offset lower prices.
Hopefully, this blog would help you to get a better understanding of the game theory and clear your doubts related to it.
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