Application of Game Theory in Business

Applicationof Game Theory in Business

Applicationof Game Theory in Business

Thegame theory is one of the formal studies of conflict management andcooperation. The concepts of the game theory apply whenever theactions of all the parties involved in making a decision rareinterdependent. The parties may include groups, individuals,organizations or a combination of these parties. The concepts of thetheory provide a language to formulate structure and understand thestrategic scenarios.

Thegame theory dates back in 1838 when its concepts became applicable ina duopoly by Antoine Cournot. The theory became further developedJohn Neumann in 1928 and dubbed it as the theory of parlor games. The theory became common in the 1950s when John Nash demonstratedthat finite games always have equilibrium. The parties taking part ingame take the choices that would stand out when compared to thechoices of their opponents. The theory became a core focus in warand a political situation whereby people sought to make themselvesstronger than their enemies by first assessing the enemies’ powerand intensifying their defense mechanisms (Myerson, 2013).

Sincethe 1970s, people have applied the theory in making businessdecisions, psychology and in sociology.The t5theory arises fromthe analysis of competitive scenarios. The game refers to theproblems and the people taking part trying to solve the problem takethe name of players. The theory provides information on the mostappropriate behavior people should adopt in the game to produceoptimal results. The game has various elements that analyze andpredict human behavior. They include the players who make thedecisions, the rules of the game, the outcomes, playoffs,information, and chance. The outcomes describe the desired situationthat the actions should produce. The playoffs are the players’preferences concerning the outcomes. Information in this game refersto what the players already know when they make decisions (Myerson,2013).

Businessesencounter complex web of interactions that relate to the environmentsin which they operate. Every decision made by a businessorganization has far-reaching effects on the short-term and long-termoutcomes. Most people have the idea that a business only deliversgoods and services without making intense efforts apart fromproviding capital. However, business managers have to make criticaldecisions that determine the success or failure of the business. Oneof the theories used by the managers is the game theory (McMillan,2013).

Theinteractions in the business and the decisions made have differentoutcomes. Every business desires to gain a competitive advantage overthe other which produces close substitutes. The success of thesedecisions depends on the actions of the participants. As earliernoted, a key element of the game theory is the participants. Whenthey make decisions, they consider the potential threats of othercompanies. While doing this, they consider the possibility of thecompetitors making similar decisions. The prisoner’s dilemma is anaspect of the game theory commonly applied in businessdecision-making by the managers. The theory gives the example of twocriminal accomplices arrested and put in police custody in adifferent cell. The two of them can either cooperate or defect withthe police. Since their interrogation takes place separately, eachdoes not know what his partner will say. They can only guess theprobability of the information they are likely to give. Each of thecriminals with the struggle to give information that will result in alight penalty. However, they have to put in mind the thoughts of eachother and maximize the information that will be of advantage to them(McMillan, 2013).

Thegame theory helps to improve decision making by providing thedecision makers with valuable insights to counter the interests ofanother group that may be detrimental to the business. Itsapplication in decision making occurs in different businessstrategies like pricing, market entry and exit, capacity management,mergers and acquisitions and the R&ampD strategy (Croson, 2014).

Inpricing strategy, the game theory gives business managers a platformto set the most favorable price for their products in the industry.First, the major goal of pricing promotion is to gain a large marketshare. Businesses set the prices that attract customers usingdifferent strategies in the various industries. The price attractshigh profits from increased scale. The number of loyal customers alsoincreases and this gives the business the prospects of a good future.However, businesses put into consideration the possibility o othercompetitors providing similar products at fairly the same price. Avariety of products in the market provides customers with an array ofchoices and increase competition to the disadvantage of the company(McMillan, 2013).

Forthis reason, businesses avoid the presentation of two competingproducts simultaneously. However, this does not shut off competitorswith similar products. Businesses cannot go on with promotionalprices without going at a loss. They have therefore to developequilibrium for the rice by settling at a common price. When onlyone company is promoting its price, it will draw a large number ofcustomers and enjoy the playoffs. The none-promoting company goes ata disadvantage since it does not enjoy favorable payoffs in terms ofsales or profits. In a situation where both of them have promotionalprices there no significantly change in their profits, and they wouldnot receive significant payoffs. Therefore, the game theory depictsthat companies should not have price collision, the market throughits natural applications pushes the firms to arrive at prices thatare favorable for each of them.

Thegame theory is also applicable to the entry or exit from the market.Most of the times, people think that the entry and exit of firms inthe market are subject to the prevailing relationship between marketcosts and the average costs of a firm. However, the two can becomplex in different market situations. A firm wishing to enter themarket must make some considerations about how its actions willaffect the future of the price in the market. In doing this, the firmconsiders the possible actions of its rivals who are already strongin the business. The preliminary step might be problematicespecially a firm does not have perfect information regarding therivals in the market.

Thegame of entry stresses the importance of a firm’s strong commitmentto a specific market segment. Some of the aspects that may increasethe commitment of a firm are an investment in large capital venturesthat cannot readily shift to other markets. The entering firm willhave an option but to offer itself fully to the quest. The firm mustalso be in a position to give the sunk costs. These are costs thatwill allow it to function and produce in the new market without anyresidual value if it opts to move out. Such costs include expenditureon unique types of equipment required in the production process aswell as on the job training for its workers.

Whenentering the market, the firm can either be a leader or a followerdepending on the mechanisms put in place to enjoy the payoffs. As aleader, a firm enjoys a considerable higher level of payoffs in termsof profits that when it is a follower. The leading strategy may proveto be disastrous since it does not take the Nash equilibrium. Firmswould opt to be followers when they have the wind that their rivalsare likely to adopt the leader strategy. When both rivals take thefollower approach, t turns out to be advantageous to both of them.However, it may be unstable because it gives room for dishonesty toeither of the rivals (Colman, 2014).

Whena firm has an opportunity to move ahead of the others, it can be in aposition to dictate the equilibrium the market. It is one of themajor advantages of first movers. At times, the move may be verywell calculated and timed such that it deters the entry of otherfirms in the market. They cannot operate at a profit at the existingequilibrium set b the first mover. The economies f scale enjoyed bythe leader is enough deterrence of other firms. The leader can adopta large scale operation that limits the entry of any otherprospective firm. The new firm may experience a high average costthat would put it at the risk of running at a loss (Colman, 2014).

Thegame theory is also very imperative in mergers and acquisitions.Firms have occasional chances of entering into mergers with othersmaller or same-level firms. Sometimes, they may be strong enough toacquire other firms and integrate them in their management. Whendoing so, the firms must take into account the consequences of theiractions. In most cases, firms that give themselves for acquisitionpresent themselves to the best bidder (Coate &amp Fischer, 2012).

Afirm with an intention of acquiring the company or entering into amerger must approach the issue from a skeptical point bearing in mindthat there are other firms with similar interests. The shorter andthe long term effects o the process should prove to be advantageousfor the company. A company without enough capital at its disposalmay opt to disengage from the process and take the advantage ofoperating at minimal but sustainable profits than taking undeservedrisks. On the other hand, companies with a huge capital base may seea brighter future in the long-run when they acquire new companies(Coate &amp Fischer, 2012).

Onthe same note, the prevailing circumstances may force the companiesto enter into strategic alliances and share the benefits presented bymergers and acquisitions. The payoffs may be favorable in firms sharethe costs of acquisition or mergers. Managers get insight on thestrategies that other firms may put, and they institutecountermeasures to protect their businesses from being on thereceiving end of disadvantages. When each comes up with strongstrategies, the parties have to strike a balance in the market in oneway or the other.

Thereare various implications of the game theory in business decisionmaking. Since its adoption by economists, companies have beenutilizing it to make a complex decision that distance their businessfrom the threat of being insignificant in their respectiveindustries. For more than 50 years, the theory has proved to be idealfor generating strategic ideas for various situations. The principlesapply to the use of various strategy games. The well-defined elementidentifies the key players and the strategies they are likely toimplement as well as the prospective payoffs for their actions. Themost common in business is the prisoner’s dilemma.

Anothermajor implication of the theory in business decision making is thatit helps to form an important tool for predicting the outcomes ofinteracting groups. Taking a single action affects the payoffsenjoyed by the company as well as mother participating groups. Ittranslates into a situation where every player plays an imperativerole and cannot be ignored. The action of each player affects thepayoffs received by other participating parties. For this reason,when making decisions, firms bear in mind that other parties are alsomaking powerful strategies and at the same time thinking about howtheir rivals are approaching the issues. The form of understandingthat becomes quantified through calculation of payoffs makes itpossible for companies to formulate optimal strategies.

Thetheory also has far-reaching effects on the behavior modeled forstrategic situations. For example, entry and exit from the market,auctions, and principle agent decisions among others. The modeladopted by every player tries to ward off competitors and increasethe payoffs that a company can enjoy. Companies conceive strategiesto get desirable outcomes and recommend the best approaches to getthese desirable payoffs. The theory has helped to keep theequilibrium of various market activities at bay without the partnersengaging in dangerous egocentric competitions.

However,the theory does not come without its shortcomings. First, the theoryoperates under the assumption that all players have an egocentricmind, and they only work towards their advantage and to put theirrivals at an undesirable edge. Logically, this is not always thetruth. Sometimes, players can act for the good of the industry andnot necessary for their benefits. Secondly, the theory assumes thatthat all the firms taking part make decisions from a strategic pointof view having analyzed the power and the prospects of their rivals.However, this is not always the case since some managers may act outof this context. Finally, the theory becomes effective when managersunderstand the payoffs for their behavior. It is not always aguarantee that managers understand the consequences of their actions.Sometimes, they are so much out of context that they do not foreseethe effects that their decisions have on other companies. In such ascenario, it would be hard even to understand the payoffs of theircompetitors (Diamond &amp Vartiainen, 2012).

Inconclusion, the game theory is practical in business operations anddecision-making. Manages find it to be an important tool to consultwhenever that face sensitive issues that may be detrimental to thefuture of their companies. Using the theory helps them to scrutinizethe threats coming from their rivals and consequently institutemeasure that cushions them against the markets threats from theircompetitors.


Coate,M. B., &amp Fischer, J. H. (2012). Daubert, Science, and Modern GameTheory: Implications for Merger Analysis. SupremeCourt Economic Review,20(1),125-182.

Colman,A. M. (2014). Gametheory and experimental games: The study of strategic interaction(Vol. 4). Elsevier: New York.

Croson,R. (2014). Experimentally Testing Game Theory. In GameTheory and Business Applications(pp. 307-321). Springer: New York.

Diamond,P., &amp Vartiainen, H. (Eds.). (2012). Behavioraleconomics and its applications.Princeton University Press: New Jersy.

McMillan,J. (2013). Gametheory in international economics.Taylor &amp Francis: New York.

Myerson,R. B. (2013). Gametheory.Harvard university press: Massachusetts.