Contrary to popular opinion, game theory isn’t just used by economists and political scientists. It is a reality in our daily lives, for example, in board games or poker games, as well as in war. It can also be utilized to determine the most optimal results for every player.
In this article, ReelNat will explore some ways that individuals can utilize game theory to make better choices and meet their goals.
Table of Contents
What is Game Theory?
When we hear game, we typically begin to think of some exciting and thrilling games that players engage in; however, game theory involves the research of the scientific and mathematical model of strategic decision-making that focuses on studying the different costs and advantages of a scenario (game) and then attempting to come up with the most effective solution that gives the most significant profit and minimum or no risk.
In real life, just like in games, it is necessary to make smart choices to get the desired results.
Useful Terms in Game Theory
When we encounter an event involving two or more players that include certain payouts or quantifiable outcomes, We can apply game theory to determine which outcomes are most probable.
Let’s first define the terms we commonly use to study game theory:
A scenario that produces an outcome that is dependent on the action of two or more decision-makers (players)
A strategic decision-maker in the game
A complete plan of action that a player is expected to adopt based on the situations that could arise during the game.
The payment a participant receives after getting a certain outcome (The payout may be in any quantifiable format, such as money or utility.)
Is the information that is available at any time within the game (usually used when the game includes a sequence.)
The stage in a game in which each player has made their choices, and the outcome is determined.
If one understands the fundamentals of game theory, it is possible to create a more efficient method for dealing with life’s challenges.
Types of Game Theory Strategies
Game theory players have the option of choosing between a variety of strategies in which to approach their game. In general, every participant must determine the level of risk they’re willing to accept and the length they’re willing to go to achieve the most favorable result.
A maximax strategy doesn’t require a hedge. The gambler is either all in or all out and they’ll either be able to win huge or suffer the most severe consequences.
Think about new startup businesses that introduce new products on the market. Their new product could lead to the value of their company’s stock rising fifty times over. In contrast, an unsuccessful launch can result in the company being bankrupt. In both cases, the person intends to risk getting the best result even in the event that a negative result is possible.
A maximin strategy used in game theory leads to the player choosing the best of the
worst payoff. The participant has decided to hedge risk and give up all gain in exchange for the least damaging result. Many companies are faced with and accept this option when it comes to lawsuits.
Businesses accept a negative outcome when settling outside of court and not having the possibility of a trial in public because the outcome could have been more disastrous because of the exploits of the trial or a more damaging outcome based on a judicial ruling.
In a dominant strategy, an individual performs actions that will result in the best outcome of the play, regardless of what other players choose to take.
In the business world, this may occur when a business grows and expands into a new market, regardless of whether an opponent has decided to join the market, too.
Pure strategy requires a minimal amount of strategic decisions because it is merely a predetermined decision without regard to external forces or other people’s actions. Take an example of the game of rock-paper-scissors, in which one player decides to use the exact shape on each time; Since the outcome for this participant is known beforehand (outcomes can be either a particular shape or not a specific shape), the strategy can be described as pure.
A mixed strategy may seem like a random chance; However, a lot of thinking goes into formulating a strategy for mixing actions or elements.
Take a look at what happens between a baseball player and a batter. The pitcher cannot make the same pitch every time, or else the batter would be able to know what’s coming up. The pitcher has to blend his strategy from angle to angle in order to give a feeling of uncertainty that he hopes to gain.
Examples of Game Theory Strategies
Game theory is utilized to analyze the variety of games. Let’s look into the analyses of a few games with the help of these examples.
The Prisoner’s dilemma
The Prisoner’s Dilemma is an example of a game theory issue that is frequently used to illustrate concepts of defection and cooperation.
The game is played in the following manner:
Two prisoners, prisoner A and prisoner B, are detained and placed inside separate cells.
The police provide each prisoner with the following terms:
- If both players admit to and incriminate the other (Defect), the other is sentenced to prison for three years. — (3,3)
- If neither party admits (Cooperates), they will be sent to a two-year jail. — (2,2)
- If one of the players admits (Defects) and incriminates the other, the one who confessed (Defector) is given a one-year term of imprisonment and the other (Cooperator) is given a four-year term. — (1,4) or (4,1)
The Prisoner’s Dilemma is a non-zero-sum game where players can choose to cooperate or defect.
The Prisoner’s problem is usually solved through game theory, which is predicting the probable outcomes of the game and then deciding on the most effective strategy.
From all the offered deals, the best deal is that neither
prisoner admits guilt and receives the punishment (two years in prison) in this particular case. The problem is that since the prisoners don’t know what strategies they are using against each other, they don’t know if one will admit. Based on Nash equilibrium, prisoners are more likely to select the most beneficial strategy for their individual situation but most detrimental to both.
The phrase “tit for Tat” is considered the most effective solution in this game theory. In the prisoner’s situation, the optimal option for both parties is to deviate — confess and indict the other. This is because the most damaging scenario for both players is they both fall out, and each is sentenced to a three-year term. Suppose one player defects while another agrees to cooperate, and the defector gets an elongated sentence, while the one who cooperates will be given a shorter sentence. In the event that both parties cooperate, they’ll be sentenced less than if both defected.
The Tragedy of the Commons
The tragedy of commons is a scenario described in game theory whereby players in the shared resource system behave selfishly and ultimately deplete the resources shared by all. The term first came into use in an article written by Garrett Hardin in 1968 that described the loss of fisheries worldwide.
The plight of the commons is illustrated in this game theory model, where every player has two options:
They could either increase their profits (by making use of the common resource) Or they could collaborate with other players and work together to secure this common resource.
This game is played in a series of rounds. In every round, players may either agree or deviate.
- When all the players cooperate, they will all receive a bonus of 2.
- If all players fail the game, they will get a payout of 0.
- If players cooperate in certain rounds but fall apart in others, the payoffs will be mixed.
Similar to the prisoner’s dilemma, the Nash balance of the game is that all players defect because this will give them the highest payoff for each player. In this scenario, the common resource is diminished, and all players suffer.
In the real world, the calamity of the commons could be prevented by establishing rules or regulations that stop people from taking advantage of common resources.
Deadlocks are social problems similar to the prisoner’s dilemma, in which the participants either cooperate or don’t cooperate (defect).
- In deadlocks, if organizations X and organization Y cooperate, both organizations will get the reward of 1
- If both don’t cooperate, they will each receive a payout of 2.
- If organization X cooperates, but Y is not cooperating, the organization X will receive the payoff of 0, whereas organization Y gets the reward of 3.
In contrast to the prisoner’s dilemma, when both organizations fail to cooperate in the case of deadlock is a good method.
Let’s understand the deadlock by using an Imagination that the two countries attempt to agree that the production of nuclear weapons must be banned. In this situation, cooperation implies that both nations adhere to the agreement and do not make nuclear weapons, whereas the defections suggest that one or both nations will secretly violate the agreement and produce nuclear weapons. In this scenario, the most likely option for either nation would be to secretly break the agreement by manufacturing nuclear weapons, as it will confer a benefit over the other should war occur.
The other option is to have both countries not cooperate and continue to produce nuclear weapons.
The game is named in honor of its creator, Augustin Cournot, a French mathematician, proposed the model in 1838. The concept of the game is like the prisoner’s dilemma.
This Cournot model explains the duopoly, i.e., the rivalry between two major companies in the market. For example, suppose that firm X and Y both produce similar products, and both can produce the product in huge and small quantities.
- If both of the companies form a corporation with one another and decide to make the product in smaller quantities and have a limited quantity of the product on the marketplace, it will result in an increase in the price of the product so that both businesses will gain the benefits.
- If both companies cancel their agreement and compete against one another to make the product that is superior, which results in a lower price for this product, both businesses will face disadvantages.
- Additionally, if one of the companies collaborates and produces the product in a smaller quantity, but the other one does the opposite, i.e., make the product in huge quantities, the first is likely to lose money, and the latter company will make the highest profit.
The Nash Equilibrium
Nash equilibrium is an outcome that, once it is achieved means that no one can raise the amount of payout by making changes. It is also considered to be “no regrets,” in the sense that after the decision is taken, it is the case that the person is not able to regret decisions based on the repercussions.
The Nash equilibrium is achieved over time typically. Once you have reached the Nash equilibrium, it can not be changed. When we have learned how to locate that Nash equilibrium, we can examine how a unilateral decision could impact the situation.
In general, there are multiple equilibriums within the game, but it is more common when playing games with more complex components with more than two players. In games played repeatedly over time, one of these equilibrium can be reached through trial and error.
This type of scenario involving different options in the course of time before reaching equilibrium is often performed in business when two companies determine the prices of highly interchangeable goods.
Applying Game Theory in Everyday Life
Everyone uses game theory in their daily life, whether consciously or not. The decisions we make every day to do a task first and then complete other tasks later are based on the notion of game theory.
Let us discuss some real-life examples where game theory concepts are being used.
Game theory aids in the determination of the strategies of the customer and retail price. Retailers entice customers by appealing to customers with sales on certain products or services in order to boost their sales. You should be aware of the sale during the off-season when sellers offer their product at an incredibly low price, and this can be one of many tactics of game theory. Retailers and consumers are the two principal participants in this game of price choices. The consumers want the products at the most affordable prices, and the retailer employs the most effective pricing strategy.
Negotiations are common throughout the day, whether you’re discussing an employee’s salary or deciding on where to eat. Game theory can guide you through negotiations in a more strategic manner by considering the interests of the other side and their choices.
If, for instance, you’re trying to negotiate an employee’s salary, You could employ game theory to assess your bargaining ability and determine possibilities that could benefit both parties. If you do this, you’ll have a better chance to negotiate a contract that is agreeable to both parties.
Getting a Job
A good illustration of how a person could apply game theory in their daily lives is when deciding which job to accept. If you’re deciding between two jobs, both of which offer excellent wages and benefits. It is possible to apply game theory to decide which is the best option by studying the strategies that each employer could employ. For example, one firm might be willing to pay more money; however, the other might have a greater chance of promoting you.
Game theory will help you figure out the job that will give you the most benefits in terms of pay and advancement in your career.
Social interactions usually involve competition or cooperation between people. Game theory can assist you in examining these interactions by analyzing the advantages and the costs of various actions.
For instance, if there are already too many guests at the party, the event may not be worth it.
New Product Decision
Understanding Game theory helps businesses decide if they should launch new products. Game theory assists in understanding the actions of the competition that could launch similar products, as well as the strategies they can employ to defend.
Game theory could provide an overview of the success or failure of a new launch, so business people are able to make the best choice using game theory.
Investment decisions often require the calculation of risk versus reward. Utilizing game theory models, such as the expected utility model or decision tree, investors can assess the possible outcomes before making any investment and avoid investing too much in risky assets while maximizing the returns over the period chosen for investment.
When deciding between two different stocks, it is necessary to be aware of the potential gains and losses for each of the stocks, along with the possibility of these things happening. After that, one can evaluate them against one another by using the expected utility analysis etc.
In the end, it will allow one to make informed choices about which stock(s) most closely fits their goals for investing.
Buying Property or Gadget
The game theory concept can be employed to purchase a property for lower cost instead of visiting a dealer and bargaining with a salesperson.
Locating every dealership for the property you are seeking within a certain area would be your first move. Contacting each dealership and saying that you’ll buy from the dealer who offers you the lowest price by an agreed-upon date follows. The dealer will then try to beat other dealers by offering an amount that is lower.
Before you put any of your assets into the auction, determining the kind of auction that is most suitable for greater profits is an essential process. There are various ways in which auctions are held.
The second-prize auction was suggested by a professor of economics from Canada, William Vickery, and is among the most effective auction methods. The participants bid on the item by offering the highest amount, but the bidder who has the highest bid is not obliged to pay the highest price that won the bids; however, they are required to pay the second-highest bid.
This technique makes the bidders bid higher because they believe they’re saving money because they will have to pay the second-highest price, not the highest price.
You might not have thought of it, but game theory has applications for real estate. Most real estate transactions are recognized by agents, making it simpler to conclude the deal. However, the scenario is completely different with multi-offer transactions. Only three options are available if the bid you’ve submitted is formally announced as a multi-offer scenario by the agent representing you. Three options are available.
- The original offer will remain in force.
- By withdrawing the current offer
- Increases the price of the offer
To win the bid, the bidder must beat the one who is not winning. If game theory is followed, then the bidder must bid the amount he has estimated to be successful following their budget instead of raising the price by bidding higher than the budget. In this scenario, even if you lose your bid, you were able to make a sound decision since bidding at a price that isn’t within your budget is a poor choice that could result in an unnecessary burden for you.
Game theory helps us to understand how we make financial decisions, for example, making money or the repayment of debt; if you have high-interest debt on credit cards, you should be focusing on settling the debt as soon as possible (even when it means reducing savings) instead of investing the money elsewhere, as higher interest rates can mean more loss; on the other hand, lower interest debts could let them save or invest more money without fearing being unable to earn potential profits because of a lack of liquidity, etc.
Through the use of game theory models, one can weigh the pros and cons of a variety of financial options and make more informed decisions.
Rise and Fall of Bitcoin
Sometimes, the choices of individuals performing a task do not solely rely on their viewpoints but are dependent on the opinions of the vast majority of the population. Trading in crypto and stocks are just two examples of decisions that other people and the application of game theory influence. Imagine you’re looking to buy bitcoin. What is your first step? Of course, you’ll look at the recent changes chart to decide if you want to purchase bitcoin. You will see that many people are purchasing bitcoin and earning money, and you will purchase bitcoin. Imagine that a respected financial expert sends a tweet questioning the reliability of bitcoin. As with the large majority, you imagine selling bitcoin because an expert has expressed his opinion and the worth of the bitcoin declines. In this instance, game theory is the reason for bitcoin’s rise and fall.
Read More: Deductive and Inductive Reasoning
Limitations of Game Theory
The most significant issue in game theory is, as with many other economic theories, it is based on the assumption that individuals are rational and motivated by self-interest and maximization, we are social creatures who collaborate, often at our own expense. Game theory can’t explain how in certain situations, we could enter a Nash equilibrium, while at other times not based on the context of our social lives and who the participants are.
Furthermore, game theory often struggles to include human aspects like loyalty, honesty, and compassion. While mathematical and statistical calculations will determine the best way to proceed, we do not always follow this route due to the innumerable and intricate situations of self-sacrifice and manipulative behaviour. Game theory can examine a range of behavior but cannot predict the human component.
Ultimately, game theory isn’t just for professionals and academics; anyone can benefit from its principles in daily life. When it comes to bargaining with your employer, or deciding where to put your money, understanding the strategic decision-making process helps us all improve our decision-making skills as time passes and eventually leads us to the desired results.