Game theory on everyone understanding

Game Theory is a science with a name that awakens curiosity, because it combines two words that call two opposing concepts, which apparently have nothing to do with each other. The first leads us to study, to learning, to science, to research, to a serious and difficult thing, and the second to play, to fun, to frivolity, to win, to luck (gambling).

We can even guess from the name that we have to look for a equilibrium between the two concepts and this equilibrium must be sought in the results generated by the interaction between the players.

What is actually game theory and why is it so important in business?

Far from being an easy or frivolous thing, this science of games, in business, has an essential role in assisting management in choosing the decisions that maximize the profit. It gives us clarifications about the types of interactions between players, teaches us how to identify them in our current business activity, provides us with an algorithm for search and identification of decisions that maximizes our profit and teaches us how to act in each case, influencing the decisions of others players, in order to maximize our profit.

If we take into account that game theory is a sub-branch of mathematics, what we have to do is, firstly, to define the game as interaction between the players.

The game is a succession of decisions (simultaneous or sequential, repetitive or played one-time only, etc.), which sometimes involves random events, but which all respect a certain structure of winning, given by the rules of the game. These rules of the game show how the decisions are made by the players and in which order.

As in any game, players aim to win; in business this earnings are mainly profits. So, rationally, any company on a competitive market will pursue maximizing its profit, taking into account the decisions of the other companies active on the same market.

A player's strategy is a possible (achievable) action that the player can choose in the game. So a player needs to know all possible strategies (actions) that he has, as well as those of competitors, and the results generated by each combination of strategies (actions), in order to make the decision that maximizes his payoffs in a game.

Now, for each possible strategy, each player gets a payoff, defined by a certain payoffs function. As each player has several possible strategies, there will be more payoffs functions.

For firms, the payoffs function can be given by the function of profit (or of income, or of costs); everyone knows how to calculate its profit, so we will not discuss this topic now, but I emphasize that in order to be able to choose the strategy that maximizes profit, depending on the type of the game, we need to see which optimal strategy we have taking into account the interactions with competitors, we need to learn if there is a Nash equilibrium (or more), we need to see if we can apply the trigger strategy, in what sub-game there is a perfect equilibrium. All of these things will be taught in our business strategy course - The Game Theory in Business, over the 3 days, based on examples from current activity of the firms.

In other words, we cannot talk about maximizing profits on a competitive market without applying game theory. Otherwise, our results will only depend on the chance.

We want to win, but do we know how to play?

Because game theory is little known and applied by managers, I'll take an example to help you understand its usefulness. I will not explicitly describe the algorithm of finding the optimal decision , you will learn it at the course and it is different depending on the type of the game, but it is very important to understand that making decisions without using this algorithm, even with the best intentions, you can to lose a lot of money.

Suppose we have two competing firms on the same market, Firm A and Firm B, who each sell a product and have to set up their business plan for the next year.

Firm A has two price options for its product: the price A1 of 50 Euro / unit and the price A2 of 30 Euro / unit. Firm B has, also, two pricing options for its product: price B1 of 55 Euro / unit and price B2 of 32 Euro / unit.

• If Firm A uses the A2 price and Firm B uses the B2 price, both companies get 1 million Euro profit.
• · If Firm A uses A1 and Firm B uses B1, both companies earn 5 million Euro profit.
• · If Firm A uses the A1 price and Firm B uses B2, Firm A gets 2 million Euro profit and Firm B gets 10 million profit.
• · If Firm A uses the price A2 and Firm B uses B1, Firm A gets 7 million profit and Firm B gets zero Euro profit.

Which price will be used by each firm, to establish its business plan?

I know that there are very few people considering these 4 pricing decisions and I know that most of the managers, takes into account, when establishing the business plan the highest profit resulted from calculations, without taking into account the competitor decisions. They consider it's not recommended to plan a lower profit than in the previous year, thinking that, in this way, they avoid any problems with the shareholders and they keep their jobs!

If, in our example, Firm A chooses the A2 price, this would be a wrong choice, because instead of 7 million Euro profit, it would only get 1 million Euro profit, because Firm B has a strategy that maximizes its profit, no matter what price choose Firm A of the two possible (A1 price and A2 price)- and that strategy is price B2. And if the managers of Firm B know how to apply the theory of games in business, they will choose price B2! Firm A does not have such a strategy! I think you realize what repercussions would have on business and management, such a decision, if is obtained only 1 million Euro profit, instead of the 7 million Euro profit, budgeted. You understand that will follow other decisions related to promotional campaigns based on price reductions, hoping that the 7 million Euro profit will be achieved; all of them must be established using the game theory, in order to maximize the profit, taking into account the decision of our competitor.

Think that you and your competitor make decisions to reduce the price, simultaneously and / or sequentially. Every discount made by you and your competitor reduces the price and reduces the outcome of each campaign! You get into a real price war that will reduce your profit. It is very important not to decrease, with our mistaken decisions, the ability of the company to produce profit in the medium and long term!

In our example, the set of strategies to be used to establish the business plan is price B2 for Firm B and price A1 for Firm A; and the budgeted profit for Firm B2 is EUR 10 million, while Firm A will get a profit of EUR 2 million. 

As you see, it is very important to understand how you influence each other's results (it is necessary to determine your demand function, cost function, profit function!), with the decisions you make, if you are competing on the same market! As you know, in a company, there are many decisions made in all functional departments, which are affecting the company's profit. Therefore, it is recommended that all managers, who make strategic decisions in a firm, to know and to apply the theory of games.

All the examples in our course are in this form and deal with games between competitors about pricing, simple and sequential negotiations, marketing, product warranty, regulating activity by an authority, monitoring employees, entering a market, launching a product, etc. .

I'm waiting you to the Game Theory In Business course to understand what games there are on the market where you activate and to learn to choose the strategies that maximize your profit.

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If you want to connect with me on LinkedIn you may send an Email at [email protected]. 

Accent Serv International SRL (www.accentserv.ro/en) is a business consultancy company which aims to increase the profitability of the companies. We organize our training Game Theory in Business! For more details you may contact us at [email protected] .

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