Download Game Theory and Business Practice

Game Theory and Business Practice∗
Alex Dickson†
September 24, 2013
We are forever called upon to make decisions in our private, social and professional
lives. The essence of decision-making lies in evaluating a menu of options, each of
which leads to a different outcome, and choosing the most preferred of these according
to some criteria. Sounds simple, and sometimes it is: should I go to the opera or to the
soccer match? Decision making can also be very complex. For example, outcomes may
be subject to risk, uncertainty or a lack of knowledge and may be difficult to objectively
evaluate. But so far what we have in mind is that a decision-maker is making a choice
and this choice determines her own fate: she is not affected by the choices of others,
and neither does she affect them.
Game Theory adds an additional element to decision-making by accounting for this
“social dimension”. Game Theory is concerned with decision-making environments in
which more than one person is making a decision and the outcome for each decisionmaker depends not only on her own choice but also on the choices of others. Such
“strategic interdependence” pervades decision-making scenarios; it doesn’t take many
moments of thought to realize that most of the typical decisions we make on a daily
basis – big or small, in whatever walk of life we inhabit – have the feature that the
outcome of that decision depends on the choices of others around us. Whether driving
to work this morning was my best travel option depends heavily on the decisions of
other commuters, since these determine the level of congestion. We typically do not
act in isolation, and neither are we so insignificant that we have no effect on others
around us.
Nowhere is this more true than in business. There is perhaps no better example of
the ubiquity of strategic interactions than the business environment. Whether intraor inter-organization, decisions made throughout the hierarchy of organizations exhibit the interdependence we have been discussing. For example: the outcome for an
employee of her chosen work ethic within a team depends on the actions of the other
∗ Forthcoming in the MBA Roundtable series of the Education Supplement of the South China Morning
Review.
† Economics, University of Strathclyde, Glasgow, G4 0GE, UK. Email: alex.dickson:@strath.ac.uk; tel:
+44(0)141 548 3849.
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team members; the outcome of a pricing decision for a product depends on the pricing
decisions of firms that offer close substitutes; the outcome from a particular corporate
strategy depends on the strategies followed by competitors; and the profitability of a
firm entering a market depends on how the incumbent firms react to the newcomer.
Does the fact that a decision-making environment exhibits strategic interdependence matter? In the terminology of Game Theory let us talk of decision-makers as
“players”, decisions as “actions”, competitors as “adversaries”, outcomes as “payoffs”
and multi-player decision-making scenarios as “games”. In a game the payoff a player
receives from a particular course of action is conditional on the actions of her adversaries. An action for a player that might seem optimal may not actually be the best
choice once her adversaries’ reactions are taken into account, since it might lead to
a worse payoff than could otherwise be achieved. As such, ignoring strategic interactions, if they are present, means decisions might be taken that lead to sub-optimal
outcomes: treating adversaries as passive decision makers, rather than cunning strategic decision makers, can have serious consequences. Of course, experienced decisionmakers in business are no stranger to “thinking outside the box” in order to consider
the ultimate consequences of their actions. Game Theory provides a set of tools and a
language to objectively analyze these decision-making environments in which strategic thinking about adversaries is necessary, in order to: determine how best to play a
game; make predictions of the outcome; explain why events happen; and understand
how decision-making environments might be manipulated to secure more favorable
outcomes.
Students of Game Theory learn lots of things. The “Games of Strategy” elective on
the MBA programme at Strathclyde Business School teaches students about a bunch
of analytical tools in the context of some simple stylized games, chosen because they
have features that pervade the real world. Learning and understanding these tools is,
if you like, the “science” of Game Theory. Students also learn to master the process of
abstraction – distilling the key features of real world decision-making environments
so that they can be represented as games – following which the tools can be applied to
analyze the scenario at hand. This process of abstraction is the “art” of Game Theory.
By learning and understanding the tools in this “abstract” way students are equipped
with “portable” knowledge that they can apply whenever they recognize the key features of the strategic environments studied. Moreover, this process of abstraction from
the real world – modeling, if you will – helps to make the decision-making process
emotionless, allowing an objective analysis and discussion of the available alternatives.
Game Theory is not, of course, without its critics. A practical criticism is that
analysts of decision-making scenarios must distill the key features of the scenario to
model it as a game, and also be confident that all players being represented have a
similar idea in mind of the game they are playing. A modeling criticism is that assumptions must be made about how players make decisions. The classical assumption
is that players are self-interested and rational: given their belief about other players’
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actions, each player will choose the option that gives them the best payoff. This is
not so contentions, but what is actually required is “common knowledge of rationality”: all players are rational; all players believe all other players are rational; all
players believe all players believe all players are rational; etc. If I think that you think
I am stupid, this assumption breaks down. It is, however, an exciting time for Game
Theory. Scholars of Behavioral Game Theory are working hard on investigating the
plausibility of alternative behavioral assumptions that depart from self-interested rationality and align better with the way people have been observed making choices in
real decision-making environments, which will only serve to improve the theory.
Game Theory provides an incredibly useful way of thinking that allows us to
objectively and constructively structure and analyze multi-person decision-making
problems in which there is strategic interdependence, that might otherwise seem intractably complicated. It is a key component in the decision-maker’s toolkit that allows a better and more complete understanding of the world around us in which we
inevitably make important decisions, and so want to fully comprehend the ultimate
consequences of our actions.
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