Mental Model Fundamentals: Game Theory

Use math to model the strategic interaction of rational decision-makers.

Related Examples:

• Auctions - Modeling out bidding strategies of the key competitors to optimize your bidding strategy.
• Competitive Dynamics - E.g., Pricing, market entry, product releases, capacity creation.
• Political Science - E.g., Election tactics, regulatory decisions, strategic lobbying, Duverger’s Law.
• Tragedy of the Commons - Shared resources can engender pernicious incentives encouraging individuals to take actions that spoil the shared resource and create a negative outcome for everyone.
• Gresham’s Law - Bad behavior can often dominate and drive out good behavior in the presence of meaningful ambiguity of real vs. perceived value.
• Winner’s Curse - The winner of an auction for an asset with uncertain value attributes has the most optimistic assumptions, so likely overpaid.
• The Red Queen Effect - Survival in a competitive environment usually requires adaptation and velocity, so doing nothing often means being left behind.
• Mutually Assured Destruction (Deterrence) - Making an aggressive move can cause your own destruction because of the inevitable response.

Related Quotes:

• “An equilibrium is not always an optimum; it might not even be good. This may be the most important discovery of game theory.” ~ Ivar Ekeland
• “Tis better to have loved and lost than never to have loved at all.' In other words, love is a dominant strategy.” ~ Avinash Dixit
• “You can be as morally righteous as you want—in a vacuum—but throw in a second entity and you gotta start acting in response to the other.” ~ Angry Zodd
• “If changing strategies doesn't help, you can try to change the game. And if that's not possible, you can at least exercise some control about which games you choose to play. The road to hell is paved with intractable recursions, bad equilibria, and information cascades. Seek out games where honesty is the dominant strategy. Then just be yourself.” ~ Brian Christian, Tom Griffiths

Related Concepts:

• Information Asymmetry - Situations where one party has more and/or better information.
• Marginal Utility - The value of a change in consumption often varies based on context.
• Cooperation - Humans find ways to coordinately work together toward shared goals for mutual benefit.
• Signaling - Expensive actions more credibly reveal information to others.
• Decision Trees - A tree-like decision analysis tool to elucidate key decisions and their potential outcomes.
• Scenario Analysis - Illuminate potential outcomes by thoughtfully linking discrete assumptions into specific scenarios.
• (Preserving) Optionality - There is value in keeping extra options open until there is more situational certainty.
• Zero-Sum - With a fixed amount of a scarce resource, wealth cannot be created or destroyed, just divided, so gains for one directly lead to losses for another.
• Adaptation - Organisms adapt to their environment to enhance evolutionary fitness.
• Incentives - Contingent rewards are one of the most powerful drivers of behavior.
• Feedback Loops - Reactions can loop back to automatically and continuously affect themselves, either amplifying (positive feedback) or dampening (negative feedback) the effects.
• Porter’s Five Forces - Industry attractiveness is driven by known, intelligible fundamentals.
• Strategy - “A player's strategy is any of the options which he or she chooses in a setting where the outcome depends not only on their own actions but on the actions of others.”
• Auction Theory - “Deals with how people act in auction markets and researches the properties of auction markets.”
• Prisoner’s Dilemma - “A standard example of a game analyzed in game theory that shows why two completely ‘rational’ individuals might not cooperate, even if it appears that it is in their best interests to do so.”
• Pareto Efficiency - “A state of allocation of resources in which it is impossible to make any one individual better off without making at least one individual worse off.”
• Nash Equilibrium - “In terms of game theory, if each player has chosen a strategy, and no player can benefit by changing strategies while the other players keep theirs unchanged, then the current set of strategy choices and their corresponding payoffs constitutes a Nash equilibrium.”
• Tit for Tat - “An agent using this strategy will first cooperate, then subsequently replicate an opponent's previous action. If the opponent previously was cooperative, the agent is cooperative. If not, the agent is not.”
• First-Mover Advantage - “A market participant has first-mover advantage if it is the first entrant and gains a competitive advantage through control of resources.”
• Mixed Strategy - “An assignment of a probability to each pure strategy. This allows for a player to randomly select a pure strategy.”
• Mechanism Design - “[A] field in economics and game theory that takes an objectives-first approach to designing economic mechanisms or incentives, toward desired objectives, in strategic settings, where players act rationally. Because it starts at the end of the game, then goes backwards, it is also called reverse game theory.”
• Seizing the Middle - “In chess, the winning strategy is usually to seize control of the middle of the board, so as to maximize the potential moves that can be made and control the movement of the maximal number of pieces.”

Related Resources:

• Game Theory
• Game Theory
• Competitive Solutions: The Strategist's Toolkit
• Finite and Infinite Games

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