Theory Log #10: Game Theory
A Summary of the Game Theory by Alyssa Maac
      Our society is composed of individuals who compete, coordinate and communicate with each other. As the concept of survival of the fittest suggest, each of us need to adapt and play by the rules of the game of life in order to survive. The concept wherein it considers society as a strategic game played by individuals is called Game Theory. Game Theory is the study of human conflict and cooperation within a competitive situation. In some respects, game theory is the science of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting.
The key pioneers of game theory were mathematicians John von Neumann and John Nash, as well as economist Oskar Morgenstern. Game theory is widely regarded as having its origins with the publication of Augustin Cournot's Researches into the Mathematical Principles of the Theory of Wealth in 1838; in which he attempted explain the underlying rules governing the behavior of duopolists. However, it was in 1944 with the publication of John von Neumann and Oskar Morgenstern's The Theory of Games and Economic Behavior that the modern principles of game theory were formulated. Â Game theory has been widely applied to the behavior of producers with a few or only one competitor (an oligopoly).
Game theory creates a language and formal structure of analysis for making logical decisions in competitive environments. The term âgameâ can be misleading. The concept of âgameâ simply means any interactive situation in which independent actors share, more-or-less, the same formal rules and consequences (although game theory also applies to recreational games).
All the games have the following: (1) Rules, which govern conduct, attitude and behavior of the players; (2) Pay-offs, such as win, lose or draw; (3) Strategies, that influences and predicts the decision making process.
The formal application of game theory requires knowledge of the following details: the identity of independent actors, their preferences, their knowledge, their possible valid strategic acts, and how their decision influences the outcome of the game. Various other requirements or assumptions may be necessary depending on the model. Finally, each independent actor is assumed to be rational.
In applying game theory to the behavior of firms, they face a number of strategic choices that govern their ability to achieve a desired pay-off, including: (1) Decisions on price and output, such as whether to: raise, lower or hold the price. (2) Decisions on products, whether to: keep the existing products or develop new ones. (3) Decisions on promoting products, whether to: spend more on advertising, spend less or keep the spending constant. From these strategy choices, firms could derive a range of possible pay-offs, including: (1) more profits for shareholders, (2) greater market share, (3) improved chances of survival, and (4) riddance of a rival or competitor.
There are three types of strategy: maximax, maximin and dominant. (1) A maximax strategy is one where the player attempts to earn the maximum possible benefit available or possible. This means they will prefer the alternative that gives the chance of achieving the best possible outcome â even if a highly unfavorable outcome is possible. This strategy, often referred to as the best of the best is often seen as ânaiveâ and overly optimistic strategy, because it assumes a highly favorable environment for decision making. (2) A maximin strategy is where a player chooses the best of the worst pay-off. This is commonly chosen when a player cannot rely on the other party to keep any agreement that has been made - for example, to deny. Take a group of prisoners as an example, the judge offers them one year of imprisonment if they confess but 3 years if none of them confessed and the worst, 10 years of imprisonment if they you denied it but they all pinpointed to you - therefore the best of the worst is to confess. (3) A dominant strategy is the best outcome irrespective of what the other player chooses, in the case of the prisoners, it is for each player to confess - both the optimistic maximax and pessimistic maximin lead to the same decision being taken. In general, game theory suggests that firms are unlikely to trust each other, even if they collude and come to an agreement such as raising price together.
Game Theory provides many insights into the behavior of an oligopolist. For example, it indicates that generating rules for behavior may take some of the risks out of competition, such as: (1) Employing a simple cost-plus pricing method which is shared by all participants. This would work well in situations where oligopolists share similar or identical costs, such as with petrol retailing. (2) Implicitly agreeing a 'price leader' with other firms as followers. A big firm may lead and raise price, with another firm passively following suit. (3) Supermarkets implicitly agreeing some lines where price cutting will take place, such as bread or baked beans, but keeping price constant for most lines. (4) Finally, generally keeping prices stable to avoid price retaliation.
Suppose executives in charge of Apple iOS and Google Android are deciding whether or not to collude and exert duopolistic power over the market for smartphone operating software. Each firm knows that if they work together and do not cheat each other, they will be able to restrict output and raise prices, thereby enjoying above-normal profits.
A great example of the game theory is the intense competition between Apple and Windows. There are a lot of computer and gadget brands out there but they are the most popular choices. People who buy their products consider a lot of things before they purchase: the price, the benefit, the function, the durability, the performance and the quality. Some people let the price suffer in exchange of durability, performance and quality. Others consider the price before the performance and quality. However, there are people who choose all of the aspects and choose the product that at least have all of these qualities.
Game theory has a wide range of applications, including psychology, biology, war, politics, economics and business. Game theory turned attention away from steady-state equilibrium and toward market process. Every decision-maker must anticipate the reaction of those affected by the decision. In business, this means economic agents must anticipate the reactions of rivals, employees, customers and investors. Despite its many advances, game theory is still a young and developing science. As the game theory suggests, lifeâs a game, be wise.
Resources:
http://www.investopedia.com/terms/g/gametheory.asp
http://www.economicsonline.co.uk/Business_economics/Prisoner's_dilemma.html















