Game Theory Economics in Business
| 7 Min Read
If you think about it, business and games have a lot in common. Both involve competitors, require smart strategies, and conclude with outcomes where people win or lose. So, it makes sense that applying game theory in business can provide a leg up when seeking a competitive advantage in the marketplace.
What is Game Theory?
With roots in applied mathematics, game theory studies connections between participants engaged in an activity and how their decisions will affect the outcome. It provides a structure for devising strategies that determine whether certain choices might lead to wins or losses.
Of course, an organization’s strategy will change depending on the type of game they’re playing. Coursera outlined five classifications for activities related to game theory:
- Cooperative vs. non-cooperative games: The participants work together to succeed or compete against each other to win.
- Perfect vs. imperfect information games: In these games, participants must act when fully informed or in the dark about some details.
- Simultaneous vs. sequential games: These games differ based on when participants can act simultaneously or by taking turns.
- Symmetric vs. asymmetric games: Participants must use the same strategies to win in symmetric games. By contrast, asymmetric games allow for personalized tactics, with one participant’s loss being the other’s gain.
- Zero-sum vs. non-zero-sum games: Zero-sum games involve finite resources, with one player taking from others. Non-zero-sum games are less competitive because everyone benefits when the game ends.
These classifications also apply to card games and board games. Poker is a zero-sum game, and chess is a sequential game. These classifications apply to real-world scenarios with higher stakes, including military conflicts, politics, and economics.
An Introduction to Game Theory Economics
Understanding game theory can help business professionals apply an economic framework to their strategies. As posed by the economist Larry Samuelson in the Journal of Economic Perspectives, game theory expanded from a minor economic theory 60 years ago to an accepted economic concept today. It’s even common for students to study economics game theory in graduate programs.
So, what is game theory in economics? It’s a tool economists can use to understand how companies and countries make decisions that affect the production of goods and delivery of services. Here are examples found in economics:
Price Wars
When prices are stable, companies can expect to profit from their goods and services. However, price wars occur when one organization slashes prices to an unsustainable level, forcing competitors to follow suit or lose customers. According to Harvard Business Review, price wars can diminish revenues industry-wide — and vast capital is needed for companies to engage in lengthy wars of attrition.
Companies that initiate price wars might be pursuing a dominant strategy. What is dominant strategy in game theory? The finance education company CFI describes the dominant strategy as “a situation where one player has superior tactics regardless of how their opponent may play.” So, if only one company has the resources to sustain a price war, its competitors might need to find an alternate strategy to stay in the game.
Trade Wars
Countries engage in these disputes by playing hardball during trade negotiations, usually instituting costly tariffs that hike the price of goods. When rival countries opt for terms that only benefit themselves and refuse to yield from fear of suffering a loss, they enter a state known in game theory as the Nash equilibrium.
Named after the mathematician John Forbes Nash, Investopedia describes the Nash equilibrium as a non-cooperative game when “players know their opponent’s strategy and still will not deviate from their initial chosen strategies because it remains the optimal strategy for each player.” Despite seeming like the optimal strategy, this equilibrium might not lead to the optimal outcome for either participant.
Matching Pennies
Matching pennies is a simultaneous, zero-sum game that sounds simple but has actual economic implications. Investopedia describes the game like this:
“Matching pennies involves two players simultaneously placing a penny on the table, with the payoff depending on whether the pennies match. If both pennies are heads or tails, the first player wins and keeps the other’s penny; if they do not match, the second player wins and keeps the other’s penny.”
According to Faster Capital, companies match pennies when completing mergers and acquisitions. For instance, a firm trying to acquire a competitor will aim to get the best deal while anticipating the lowest price the other party will accept. Botching that analysis could mean overpaying for the acquisition and, in a sense, losing the game.
Using Game Theory in Business to Manage Complexity
The complexity of business can feel overwhelming. A study by Pegasystems found that many workers feel “overloaded with information, systems, and processes” that are used to meet customer demands. That information overload could lead to stagnation when faced with decisions that lead to wins and losses.
Using game theory in business helps with organizing this complexity. A tutorial from the Santa Fe Institute describes how to use game trees to map the potential decisions available to an individual company and its competitors. As such, the company could visualize different outcomes and devise strategies for responding to them.
Other game theory examples in business include:
- Market analysis: A financial services firm could use game theory to anticipate how companies and consumers respond to various market conditions.
- Competitor analysis: After developing tactics, a business can game out potential responses from competitors to determine the best path forward.
- Negotiations: Closing a deal requires organizations to analyze the concessions another party might make while exploring ways to secure an advantageous offer.
Business leaders using game theory to make strategic decisions now have another tool at their disposal — artificial intelligence. As discussed in an article published on Medium, organizations can use machine learning, predictive analysis, and other AI-driven systems to compute massive data sets and simulate the competitive landscape. This leads to highly sophisticated business strategies that account for real-time market fluctuations.
Real-World Applications of Game Theory in Business
Practical applications of game theory can be seen throughout the business landscape. Learnsignal, an accounting and finance education company, shared three game theory examples in business to demonstrate how to use game theory to outdo the competition:
Smarter Strategies in the Smartphone Market
In June 2024, Samsung and Apple were the top smartphone manufacturers in the world, according to Statista. To gain an advantage, they could apply game theory to gauge how consumers — and one another — might respond to specific pricing models, user interface changes, and other revisions to their iPhone and Galaxy product lines.
Amazon’s Grip on Online Retail
Amazon held 37.6% of the online retail market in 2023, about six times more than its closest competitor. Applying game theory to cut into that lead would require retailers to game out tactics that play on their unique strengths. That said, encroaching on Amazon’s turf could spur the online retail giant to respond with dominant strategies. In 2020, a House subcommittee investigating competition in digital markets reported that Amazon is known for engaging in price wars that competitors cannot afford.
A Bigger Share of the Ride-Share Market
If it seems Amazon dominates online retail, Uber’s grip on ridesharing is even stronger. CNN reported that Uber controlled 74% of this market in 2023, speeding far ahead of Lyft. As Lyft plays catchup, it could use game theory when analyzing how to differentiate itself, such as by testing different pricing models or making bets on innovations in the automotive space.
The latter point is essential. Although Uber and Lyft’s business models might seem similar, neither needs to subscribe to symmetric game theory when seeking an advantage. Consider Uber’s investment in autonomous cars, which TechCrunch highlighted as offering considerable growth potential. Should Lyft follow Uber down that road? Or does it make sense to invest in other innovations? The application of game theory in business could help the company determine the best strategic decision.
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