The MBA's Guide to Game Theory

You may have heard something about "game theory" from the movie "A Beautiful Mind." Game theory is a method through which businesses make decisions when the outcomes are dependent upon outside factors such as the decisions that others make. For example, businesses can use game theory when determining how to set the price of a product, knowing that the competition's decision will affect the overall outcome.

In game theory, it is important to note the order through which decisions are made (i.e. do competitors make decisions at the same time, or does one competitor make a decision before or after another. Also, it must be distinguished whether a "game" is played only once (a one-shot game) or is played more than once (a repeated game). Games can also be considered to multistage games, in which "new games" are dependent upon the outcomes of previous games.

The most known concept of game theory is the Nash Equilibrium discussed in the "A Beautiful Mind" movie. Nash Equilibrium refers to the situation in which, because of the strategies opted on by the competitors, no competitor can improve his or her outcomes by changing his or her own strategy. In this case, every competitor has the optimum outcome given their own individual situation and the situations of all of the competitors.

Game theory states that in some cases, one competitor will have a dominant strategy, or one in which they will have the highest payoff no matter what their competitor does. For example, a business may have a lower cost structure and thus may be able to offer lower prices than the competition. In a case such as this, you will have to assume that your competition will use this advantage if they have it (and of course you should use this to your advantage if you do have a dominant strategy).

Some competitors will use a mixed or randomized strategy approach to game theory. This means that they will mix their actions so as to keep their competitors from being able to guess what their next step will be. While it is to a company's benefit to keep their strategies unknown, businesses will always want to act in their best interests unless they are completely irrational.

Game theory can be a complicated way to look at a company's competitive situation. While it may not be necessary to use all of its tenets, game theory can be useful in predicting the outcome of a decision when that outcome depends upon how the competition will act in return.