how game theory works
the goal of game theory is to explain the strategic actions of two or more players in a given situation with set rules and outcomes any time a situation with two or more players involves known payouts or quantifiable consequences we can use game theory to help determine the most likely outcomes the focus of game theory is the game which is an interactive situation that involves rational players the key to game theory is that one player s payoff is contingent on the strategy implemented by the other player the game identifies the players identities preferences available strategies and how these strategies affect the outcome depending on the model various other requirements or assumptions may be necessary game theory has a wide range of applications including psychology evolutionary biology war politics economics and business despite its many advances game theory is still a young and developing science according to game theory the actions and choices of all the participants affect the outcome of each it s assumed players within the game are rational and will strive to maximize their payoffs in the game 1useful terms in game theoryhere are a few terms commonly used in the study of game theory the key pioneers of game theory were mathematician john von neumann and economist oskar morgenstern in the 1940s 2 mathematician john nash is regarded by many as providing the first significant extension of the von neumann and morgenstern work 3the nash equilibriumnash equilibrium is an outcome reached that once achieved means no player can increase payoff by changing decisions unilaterally 3 it can also be thought of as a no regrets outcome in the sense that once a decision is made the player will have no regrets about it considering the consequences the nash equilibrium is reached over time normally however once the nash equilibrium is reached it will not be deviated from in such a case consider how a unilateral move would affect the situation does it make any sense it shouldn t and that s why the nash equilibrium outcome is described as no regrets 4generally there can be more than one equilibrium in a game however this usually occurs in games with more complex elements than two choices by two players in simultaneous games that are repeated over time one of these multiple equilibria is reached after some trial and error this scenario of different choices over time before reaching equilibrium is most often played out in the business world when two firms are determining prices for highly interchangeable products such as airfare or soft drinks impact of game theorygame theory is present in almost every industry or field of research its expansive theory can pertain to many situations making it a versatile and important theory here are several fields of study directly impacted by game theory game theory brought about a revolution in economics by addressing crucial problems in prior mathematical economic models for instance neoclassical economics struggled to explain entrepreneurial anticipation and could not handle the imperfect competition game theory turned attention away from steady state equilibrium toward the market process economists often use game theory to explain oligopoly firm behavior it helps to predict likely outcomes when firms engage in certain behaviors such as price fixing and collusion 5in business game theory is beneficial for modeling competing behaviors between economic agents businesses often have several strategic choices that affect their ability to realize economic gain for example businesses may face dilemmas such as whether to retire existing products and develop new ones or employ new marketing strategies businesses can often choose their opponent as well some focus on external forces and compete against other market participants others set internal goals and strive to be better than their previous versions whether external or internal companies are always competing for resources attempting to hire the best candidates away from rivals and dissuade customers from choosing competing goods game theory in business may most resemble a game tree as shown below a company may start in position one and must decide on two outcomes however there are continually other decisions to be made the final payoff amount is not known until the final decision has been processed 1internet encyclopedia of philosophyproject management involves social aspects of game theory as different participants may have different influences for example a project manager may be motivated to successfully complete a building development project meanwhile the construction worker may be motivated to work slower for safety or to delay the project to add more billable hours 