Application of Game Theory in Business Model Development!

The application of game theory helps to develop business models to manage interactions of decision makers either in a scenario of cooperative or competitive approaches to behavior for conflict resolution.

A conflict occurs when paths are crossed. It means when one decision making entity perceives the influence of others actions on its own achievement. When there is a conflict of interest, it is generally resolved through cooperative or competitive styles. A collaborative method is a win-win approach for a problem-solving while; competitive style is a win-lose way.

Let’s take a short example:

The application of game theory outside of a firm – An Example

A mathematical application of game theory for business decisions can be described in a table form. It’s also known as the Game’s Normal Form in mathematics.

The diagram below shows a simple matrix containing various sets of strategies. A set contains two approaches, one from you (in black) and the other by your competitor (in blue). While other factors are assumed constant and negligible, suppose both you and your only competitor decide to spend money on advertisement campaigns. This results, in relatively modest payoffs of $400,000 for each (see the payoff pattern 4, 4).

Such set of decision strategy is known as Nash Equilibrium which implies neither entity can improve its profit, by changing its own strategy alone involving an interdependence of actions. Jon Forbes Nash explained this concept in 1950’s. Furthermore, it’s visible in the famous Prisoners’ Dilemma.

As another strategic possible measure, you and your competitor do not decide to advertise, get a payoff of $600,000 (see the pattern 6, 6). Remember that in some situations, no advertisement policy may result in reduced expenses, and that’s why more profit.

In the case, when, either you or your competitor alone decide to advertise, earn $500,000 payoff on it. If you don’t promote, you have to bear a loss of -$500,000, assuming your competitor utilizes your decision consequence as his/her opportunity (see the pattern -5, 5). In the very same way, if you advertise but your competitor does not, he/she has to suffer a loss of -$500,000 (see the pattern 5, -5).

application of game theory

The application of game theory inside a firm – An Example

For a layman, the initial concept of the game theory might look like just as a strategic tool to boost competitive abilities of a firm against its competitors only. Actually, it can also be successfully applied inside a firm, in the perspective of considering various internal stakeholders of a firm as players. One playing against another!

Here is an exciting example of an application of game theory where two internal entities of a firm “playing” the game against each other. Remember, the purpose of each player is to “win” against the other. The strategies adoption to bring down the rival player is purely motivated because of a simple fact if one wins the other loses; (nobody wants to lose).

Let’s get back to the example.

We have two players in this game. The player A, a manager and the player B, workers. The manager’s objective is to increase workers efficiency. His gain lies in the better productivity of the workers. On the other hand, workers “gain” is in reduced efficiency assuming a lower efficiency level benefits them.

The manager wants to make workers more efficient without monitoring them because it incurs cost as well as it’s a necessary evil. However, the workers perceive monitoring threat as it compels them to work more along knowing, it’s also a weakness of the manager due to its extra costs.

The probability of opting monitoring depends upon the “gains” of workers in the form of reduced efficiency. In the same way, the likelihood of reduced effectiveness depends on how much it costs to the manager to monitor the workers. If the workers’ gains are greater, or if the expenses for the manager for monitoring them are great, the probability of reduced efficiency will increase as well. The game begins!

The possible results can be in the following four situations of:

Win-Win

Win-Lose

Lose-Win

Lose-Lose

game theory application

Note: For the sake of simplicity take the table above as a scoreboard; black digit representing manager achievement and blue ones as workers’. The purpose is to understand comparative advantage or disadvantage through quantitative approach.

In the case of no Monitoring:

If the manager does not monitor and workers reduce efficiency, manager get -2 and workers gains by +8. This is win situation for the player B i.e. the workers and a loss for the manager.

Suppose workers remain efficient even without monitoring, their gain reduce to +4 from +8. Don’t confuse yourself here by thinking, why the heck they remained efficient without monitoring. Take it just as a possibility (even if there is 0.000001% chance of such occurrence). It’s a lose situation for the workers and a winning for the manager.

In the case of Monitoring:

If the manager monitors but still workers don’t perform well, he faces a colossal loss as he has not only suffered monitoring cost, but also the reduced efficiency of the workers expressed as -8 for manager and 0 for workers.

The win-win situation lies in +4, +4. The manager monitors and the workers perform their duties well.

The effective Application of game theory concepts

You can use its concepts to develop effective and optimal competitive strategies for setting your product/service prices, the level of product quantity and quality, capital budgeting, auctioning, public policy making, research and development, cost management and advertising.

How can you develop game theory approaches?

First, what you need is to:

Asses the magnitude of the problem i.e. the cost-benefit aspect of the solution of a particular problem. If it’s worth bothering about

Then…

Recognize your specific business type i.e. a production firm, consultancy, real estate etc. along the area of application i.e. inside or outside of organization. The purpose is to avoid wandering in the vast subject of the game theory and shooting the bulls’ eye for time and money saving.

Most of the generally used tools and techniques are available for learning through general books on application of game theory like "Game Theory with Economic Applications (2nd Edition)".  Various case studies and examples illustrate strategic business problems with solutions.

Customized solutions are only required, if problems are quite peculiar and are not of general nature, however most of issues are dealt with general understanding of basic game types mentioned in the articles. The related problems are also discussed under the umbrella of strategic management.

Game theory and managerial decisions

Game theory definition


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