In the previous posts, we have discussed about common narratives and publicly available knowledge about personal finance. If you have not seen those posts, you can check them out here. In this post, we will understand a lesser known theory which is commonly used by large corporations and businesses, and how you can apply it to your life. Any guesses, what we are going to discuss in this post? Yes, we are going to discuss game theory in this post.
So let’s start by understanding what Game Theory is.
What Is Game Theory?
Game Theory formally is the study of strategic interactions between rational decision-makers, called players, where the outcome for each participant depends not only on their own choices but also on the choices of others. It’s like analyzing a chess match, a business negotiation, or even a political standoff—where each move is calculated based on what the other side might do.
In summary, it is a fascinating field that blends strategy, logic, and decision-making.
Game Theory isn’t just about games—it’s about understanding how people make decisions when their outcomes depend on others. Game Theory is a powerful lens through which businesses can analyze competitive dynamics, anticipate rival moves, and make smarter strategic decisions.
Important Terminology
To understand Game Theory, we first need to get familiar with some of the terminology associated with it.
- Players: They are individuals or entities involved in the strategic interaction.
- Strategies: These are the possible actions each player can take.
- Payoffs: The outcomes or rewards resulting from the combination of strategies.
- Games: It is defined as a structured scenario where these interactions take place.
Real-World Applications
- Economics: Pricing strategies, auctions, market competition.
- Politics: Voting systems, international diplomacy.
- Business: Negotiations, mergers, competitive tactics.
- Biology: Evolutionary strategies and survival.
- Computer Science: Algorithm design, AI behavior modeling.
Types of Games
Games, as defined in the previous section, can be of different types as mentioned in the table below.
| Type | Description |
|---|---|
| Zero-Sum Game | One player’s gain is another’s loss (e.g., poker). |
| Non-Zero-Sum Game | Players can all benefit or lose together (e.g., climate agreements). |
| Cooperative Game | Players can form alliances and share payoffs. |
| Non-Cooperative Game | Players act independently, often competitively. |
| Simultaneous Game | Players make decisions at the same time. |
| Sequential Game | Players take turns, and later moves can depend on earlier ones. |
Strategic Applications of Game Theory in Business
So, how is theory applied in the world of business? What is the use of understanding game theory? Read ahead to know.
Game Theory doesn’t just help businesses react—it helps them think ahead, simulate outcomes, and craft winning strategies as described below.
1. Pricing Strategies
Companies use Game Theory to decide whether to match, undercut, or hold prices based on competitors’ likely responses. Example: Coca-Cola and Pepsi often engage in strategic pricing, knowing that a price drop by one will likely trigger a response from the other.
2. Market Entry Decisions
Firms evaluate whether entering a new market will provoke retaliation or cooperation from incumbents. Game Theory helps model scenarios like barriers to entry, predatory pricing, or collusion.
3. Product Launch Timing
Timing a product release can be critical. If two firms plan to launch similar products, Game Theory helps predict whether launching early or waiting offers a better payoff. Example: Apple and Samsung often strategize around launch dates to maximize market impact.
4. Negotiations and Mergers
In mergers or supplier negotiations, Game Theory models help firms understand bargaining power, optimal offers, and walk-away points. It’s especially useful in multi-party negotiations where outcomes depend on others’ decisions.
5. Advertising and Promotion
Firms decide how much to spend on advertising based on competitors’ expected budgets. Overspending may lead to a zero-sum game, while strategic restraint can preserve margins.
Real-World Examples
- Amazon vs. Flipkart: Strategic pricing and delivery speed competition in Indian e-commerce.
- Infosys: Uses Game Theory to optimize bidding strategies for large IT contracts.
- Coca-Cola vs. Pepsi: Classic example of advertising and pricing wars modeled through repeated games.
Key Game Theory Models Used in Business
| Model | Business Use Case |
|---|---|
| Nash Equilibrium | Predict stable outcomes where no firm benefits from changing strategy alone. |
| Prisoner’s Dilemma | Explains why firms may not cooperate even when it’s mutually beneficial. |
| Sequential Games | Useful in industries where firms take turns making moves (e.g., tech patents). |
| Repeated Games | Helps model long-term relationships like supplier contracts or brand rivalry. |
| Dominant Strategy | A strategy that always provides a better outcome, no matter what others do. |
Common Pitfalls in Applying Game Theory to Business
While Game Theory offers powerful insights for business strategy, it’s not foolproof. Misusing it can lead to flawed decisions or missed opportunities. Here are some of the most common pitfalls businesses encounter:
1. Oversimplification of Real-World Complexity
Game Theory models often rely on assumptions like perfect rationality or complete information. Real-world business environments are messy—emotions, politics, and unpredictable behavior can derail even the most elegant model.
2. Ignoring Context
Applying a generic model without tailoring it to the specific industry, market dynamics, or cultural factors can lead to misleading conclusions. For example, a strategy that works in tech may flop in retail due to different customer behaviors and competitive pressures.
3. Assuming Rational Behavior
Not all players act logically or in their best interest. Competitors may make irrational moves due to ego, misinformation, or short-term thinking. This can invalidate predictions based on Nash Equilibrium or dominant strategies.
4. Misidentifying Players and Payoffs
Failing to correctly identify all stakeholders or misunderstanding their incentives can skew the entire analysis. For instance, overlooking regulators or consumer advocacy groups in a pricing strategy could lead to backlash.
5. Static Thinking in Dynamic Markets
Many models are one-shot or static, but business is dynamic and evolves over time. Repeated games and adaptive strategies are often more realistic but harder to model.
6. Overreliance on Quantitative Models
Game Theory is mathematical, but business decisions often require qualitative judgment, intuition, and experience. Blindly following a model without considering human factors can be dangerous.
7. Failure to Communicate Strategy
Even a well-crafted strategy can fail if not communicated effectively across teams. Game Theory insights must be translated into actionable plans that stakeholders understand and support.
How to Avoid These Pitfalls
- Use Game Theory as a framework, not a crystal ball.
- Combine it with behavioral insights, market research, and scenario planning.
- Regularly update models to reflect changing conditions.
- Involve cross-functional teams to stress-test assumptions and strategies.
Let’s look at one of the famous business model Nash Equilibrium.
What Is Nash Equilibrium?
A Nash Equilibrium occurs in a strategic game when no player can benefit by changing their strategy, assuming all other players keep their strategies unchanged. In simpler terms everyone is doing the best they can, given what everyone else is doing. It’s named after mathematician John Nash, who proved that every finite game has at least one equilibrium (possibly in mixed strategies). The key characteristics of Nash Equilibrium are:
- Each player chooses a strategy that is optimal given the strategies of others.
- No one has an incentive to deviate unilaterally.
- It’s a stable state—like a truce where no one wants to make the first move.
A classic example of this is the Prisoner’s Dilemma where two suspects are arrested and interrogated separately. Each has two choices: Confess or Stay Silent.
| Prisoner B: Silent | Prisoner B: Confess | |
|---|---|---|
| Prisoner A: Silent | Both get 1 year | A gets 20 years, B goes free |
| Prisoner A: Confess | A goes free, B gets 20 years | Both get 5 years |
According to Nash Equilibrium both confess. Why? Because each prisoner fears the other will confess, so they confess to minimize their own sentence—even though mutual silence would be better.
Real-World Applications of Nash Equilibrium
- Business: Competing firms setting prices or launching products.
- Politics: Countries deciding whether to arm or disarm.
- Traffic: Drivers choosing routes based on congestion.
- Tech: Platforms deciding on standards or protocols.
Nash vs. Dominant Strategy
| Concept | Description |
|---|---|
| Nash Equilibrium | Best response given others’ strategies; no incentive to deviate. |
| Dominant Strategy | Best strategy regardless of what others do. |
Not all games have a dominant strategy, but every finite game has at least one Nash Equilibrium. Nash Equilibrium is a cornerstone of game theory, and it connects deeply with many other concepts—some build on it, some refine it, and others challenge its assumptions. Let’s explore how it fits into the broader game theory landscape:
How Nash Equilibrium Relates to Other Game Theory Concepts
1. Dominant Strategy
A dominant strategy yields the best outcome for a player, no matter what others do. If every player has a dominant strategy, the combination of those strategies forms a Nash Equilibrium. But not all games have dominant strategies—Nash Equilibrium is more general.
2. Pareto Optimality
A Pareto optimal outcome means no player can be made better off without making someone else worse off. A Nash Equilibrium is not always Pareto optimal—players may settle for less-than-ideal outcomes (e.g., Prisoner’s Dilemma).
3. Subgame Perfect Equilibrium
Used in sequential games, where players move one after another. It’s a refinement of Nash Equilibrium that eliminates non-credible threats by requiring equilibrium in every subgame. Example: In bargaining or multi-stage negotiations.
4. Mixed Strategy Equilibrium
In games with no pure strategy Nash Equilibrium, players may randomize their choices. A mixed strategy Nash Equilibrium involves players choosing probabilistic combinations of strategies. Example: Rock-Paper-Scissors has no pure strategy equilibrium, but a mixed one exists.
5. Evolutionarily Stable Strategy (ESS)
In evolutionary game theory, ESS is a strategy that, if adopted by most of the population, cannot be invaded by a mutant strategy. Every ESS is a Nash Equilibrium, but not every Nash Equilibrium is evolutionarily stable.
6. Correlated Equilibrium
A generalization of Nash Equilibrium where players can base their strategies on shared signals. Allows for coordination without direct communication. Often leads to better outcomes than the Nash Equilibrium in some games.
7. Repeated Games
In repeated interactions, players may use strategies like tit-for-tat to enforce cooperation. Nash Equilibrium in repeated games can support trust and collaboration, unlike one-shot games.
Summary Table
| Concept | Relation to Nash Equilibrium |
|---|---|
| Dominant Strategy | Leads to Nash if all players have one |
| Pareto Optimality | Nash may not be Pareto optimal |
| Subgame Perfect Equilibrium | Refines Nash for sequential games |
| Mixed Strategy | Extends Nash to probabilistic choices |
| Evolutionarily Stable | ESS ⊆ Nash Equilibrium |
| Correlated Equilibrium | Generalizes Nash with shared signals |
| Repeated Games | Nash supports long-term cooperation |
Nash Equilibrium is like the hub of a wheel—many game theory concepts either radiate from it or orbit around it.
One of the most compelling real-world examples of Nash Equilibrium comes from the oil industry, specifically the behavior of OPEC (Organization of Petroleum Exporting Countries).
OPEC is a coalition of oil-producing countries that collectively decide how much oil to produce. Each member wants to maximize its own revenue, which depends on both the price of oil and the quantity sold.
- If all members limit production, oil prices stay high, and everyone benefits.
- If one member cheats and produces more, it can sell more oil at the current high price—but this drives prices down for everyone.
The Nash Equilibrium occurs when each country chooses a production level such that no country can increase its profit by changing its own output, assuming others stick to theirs.
- If all members cooperate and stick to agreed quotas, they reach a stable equilibrium.
- But if one cheats, others may retaliate by increasing their own production, leading to a price war—a worse outcome for all.
So, the equilibrium is a delicate balance where no one has an incentive to deviate, even though the temptation exists.
So why does this matter?
This example shows how strategic interdependence plays out in global economics. It’s not just about maximizing individual gain—it’s about anticipating others’ reactions and finding a stable strategy.
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