Think ahead, try to outsmart your opponents, and come out on top. This is Game Theory. This powerful mathematical tool allows us to analyse and predict strategic decision-making in various scenarios from psychology to politics, business, finance and more.

Understanding Game Theory will help you understand the art of decision-making in any kind of field. Want to learn how to outsmart, outplay, and outlast your opponents? Read on!

What is Game Theory?

Game theory is a theoretical framework that simplifies and helps understand the strategic decision-making of independent actors in a competitive setting by analysing social interactions among multiple players. In simple terms, it is a way of studying how people make decisions in situations where their choices affect others. 

Using Game Theory, one can understand how to make the best decisions in competitive situations. The intention behind this theory is to produce optimal decision-making of independent and competing individuals, businesses, or corporations in a strategic setting.

What is this theory based on?

• It is based on the assumption that players are rational and try to maximize their own benefits.

• The main goal is to help players identify the best strategies to use after analysing other players' strategies.

• This theory helps us understand how players will behave in different scenarios and how different scenarios will play out.

The Nash Equilibrium

Nash Equilibrium is like the sweet spot in a game where every competitor is playing their best move and no one has any reason to change their strategy. It is the ideal outcome where all players know what other players are doing, and they still stick to their original plan because it is the best one for them.

The Nash Equilibrium is a "win-win" situation for both the competitors as they both are playing their best strategy and cannot improve their outcome by changing it. In this equilibrium, every player wins as everyone gets the outcome they desire.

Example of Nash Equilibrium

Imagine a game between Ron and Sam. In this simple game, both players have to choose either one of two strategies. Strategy A is to receive $5. Strategy B is to lose $5. Logically thinking, both players would choose Strategy A and receive a payoff of $5. 

If you revealed Ron's strategy to Sam and vice versa, there will be no impact on either one's decision and both will still stick to the same choice, that is to receive $5. Knowing other players' moves means little and doesn't change either player's behaviour.

The Prisoner's Dilemma

The Prisoner's Dilemma is another classic example of the Game Theory in which two individuals are arrested and charged with a crime. Each one is given the option to betray the other (defect) or remain silent (cooperate). If one betrays the other, they will be released while the other will be given a harsher sentence. If both betray each other, they will both receive a moderate sentence. If both remain silent, they will both receive a light sentence.

The Nash equilibrium is for both players to betray each other even though mutual cooperation leads to a better outcome for both players. However, if one player chooses to cooperate and the other does not, the player who cooperated will have a worse outcome, this fear of being betrayed is what leads both players to betray each other and results in a worse outcome for both.

The Airline Pricing Dilemna

One example of game theory in action between two companies in real life is the pricing strategy of airlines. Airlines often engage in price wars, where they lower the prices of their tickets in order to attract more customers and gain market share. This is an example of a game theory concept called price competition.

In the 1990s, American Airlines and United Airlines were engaged in a price war on routes between New York and Los Angeles. American Airlines lowered its prices in order to attract more customers and gain market share, while United Airlines responded by also lowering its prices. This led to a decrease in the profit margins of both companies, as they were both selling tickets at a lower price.

In this scenario, both companies are trying to anticipate each other's moves and adjust their own pricing strategy accordingly. Both companies are trying to outcompete each other by lowering prices, but in the end, it leads to a decrease in profit margins for both of them. This is a real-world example of a Prisoner's Dilemma, where the rational decisions of two or more players lead to an outcome that is worse for all of them.

In the end, The Game Theory may seem complex, but it's all about making the best move in any given situation. From the high-stakes world of economics and politics to the simple game of rock-papers-scissors, the principles of this theory can be applied everywhere.

So, don't be afraid to play the game, and always remember to think strategically!

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