Game theory: The science of strategic decision-making

Businesses using the theory to help make pricing, product, merger and acquisition decisions

KARACHI: Consider the following scenario: You are driving on the road and another driver is driving towards you from the opposite direction. You are on a collision course; one person must swerve or both may die in the crash. But if you swerve you are called a chicken or a coward.

This scenario where both players prefer not to yield to each other but the worst possible outcome occurs if they don’t, is an important model of conflict in the game theory.

Game theory, a branch of mathematics, is the study of strategic decision-making. It is a field which affects every one of us and has wide-ranging applications in the fields of business, politics, economics, computer science, biology and even war. This discipline is used to analyse the decisions rational people make under a framework of strict rules and where each player gets a payoff based on the decisions of all other players.

Businesses are increasingly using game theory to help make pricing, product, merger and acquisition and labour negotiation decisions. The discipline came into prominence in the 1940s due to the work of John von Neumann, a mathematician and Oskar Morgenstern, an economist who wrote a book, “Theory of Games and Economic Behavior”.

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They concentrated on zero-sum games where one player’s gain is another player’s loss and cooperative ones where binding commitments can be made and enforced. Real world situations do not fall into either category.

Enters mathematician John Nash in the 1950s, who changed the world of game theory. His most important result known as the Nash equilibrium is that in any game with any number of players each player has a strategy available to him that he has no interest in changing so long as all the players stick to their choices.

Nash’s contribution provides a focus for understanding real world problems rooted in conflict and failure of cooperation.

The importance of the discipline has been recognised since Nash’s contribution to the field and since then nine game theorists inclusive of him have won the Nobel Prize. Nash became popular outside his field due to the Oscar winning movie, “A Beautiful Mind” on his life released in 2001. He recently passed away in an unfortunate car accident along with his wife in New Jersey.

Applying game theory

Big organisations such as Microsoft and Chevron reveal that they use game theoretic frameworks to help them make difficult and risky decisions. The discipline provides an insight into the strategic options available to players and the likely outcomes that they would follow. This can also help them avert outcomes that could potentially lead to conflict.

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A key example of this was US-Soviet relations during much of the cold war where both parties led to decisions that avoided any nuclear standoff. It is unfortunate that many programmes do not exist in Pakistan to teach game theory at the university level.

This is in contrast to the neighbour India which has set up game theory labs at the famed Indian Institute of Science, Bangalore. This promotes a research culture in the subject which has implications in many different fields of economics such as marketing, advertising, social networks and auction behaviour.

In fact, there is little recognition of game theory in particular and behavioural economics in general, as a taught discipline in universities teaching economics, mathematics and management courses in the country.

Behavioural economics takes into account social, psychological, cognitive and emotional factors in the economic decisions of individuals. The subject concerns itself with the idea as to why economic agents make irrational decisions contrary to the primary assumption of rational economic players.

This subject has gained particular prominence post-financial crisis of 2008 where ‘greed’ exhibited by fund managers and investors led to adverse decisions, resulting in multiple defaults and an acute crisis.

Nobel prize winner, economist and author of ‘Irrational Exuberance’ Robert Shiller says, “It should be clear that human patterns of less-than-perfectly rational behaviour are central to financial market behaviour, even among investment professionals, while at the same time there is little outright foolishness among investors.”

Although financial markets are still developing in Pakistan, the government can still apply these principles in analysing and coming up with strategic solutions to the numerous internal power struggles it faces with regard to various pressure groups.

The writer is an economist and
ex-central banker

Published in The Express Tribune, June 29^th,  2015.

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