What Is Game Theory? How Game Theory Applies to Business

Game theory is a theoretical field of study in the social sciences that applies a mathematical model to predict the likely outcomes of a particular scenario. It is often used by people in political science, business, or poker to predict potential outcomes for scenarios in their fields. Game theory simulates a series of real-life, strategic situations through sequential games to predict how people or organizations will act. The dominant strategy is often for a player to make the choice that benefits them the most, though the best response is usually to cooperate to ensure the most advantageous, symmetric outcome for all players.

Game-theoretic mathematician John von Neumann helped formulate the idea of parties finding equilibrium through a series of two-person, zero-sum games. Along with Oskar Morgenstern, von Neumann wrote a book titled Theory of Games and Economic Behavior (1944), which is the foundational text of the field. John Nash also had a hand in developing the use of game theory through the Nash Equilibrium, which addresses non-cooperative games involving strategic interactions between players (two or more), in which neither reconsiders their decisions after hearing the other decision makers’ choice.

Game theory can be used in business by economists who are analyzing a specific economic landscape to predict the moves that companies (or players) will make. It can also be used by private companies to make business decisions, or strategically monitor and analyze the varying aspects and competitive behaviors within their relevant economy. Teachers may also use game theory models in business school to introduce their students to a set of strategies and various solution concepts that they may see reflected in the real world.

Game theory can help companies make strategic choices within or outside of their organizations, especially against competitors. Different situations are presented through simple games that set up hypothetical scenarios meant to simulate real-world conditions and predict a player’s behavior.

Game theory can be applied to political science as well as it can be applied to poker, but it is commonly used as a business strategy planning tool to try to predict different situational outcomes. A strategic game always consists of players, the scenario, and strategic decisions that can be made, followed by all the possible outcomes/payoff matrix of each decision. Below are a few types of games in game theory that can be applied to the business world.

1. 1. The Prisoner’s Dilemma. This game involves two players—or prisoners—who have been separated and asked to confess to a crime that they may have committed together. Either both parties can confess, only one party confesses, or no parties confess, all of which present different outcomes. This game assumes that the players will behave strategically out of self-interest, resulting in a less than optimal outcome for both parties. In business, you can apply this to a scenario of two businesses with competing products. If one business alters their pricing to gain a competitive advantage, the other business will be forced to as well, effectively reducing the maximum profits for both companies.
2. 2. The Centipede Game. The centipede game involves two players choosing to take or leave a sum that increases with each sequential turn. In this game, the players must trust one another and continue to pass the sum in order to increase the amount, and they will each receive the largest possible sum at the end of the game. If one player takes the sum before the end, each will end up with less than if they would have cooperated. In business, this game sets up a scenario in which two entities (which might be rival businesses) are required to trust each other. The optimal strategy requires them to deny their individual self-interest in the moment for a greater payoff for all in the end.
3. 3. The Dictator Game. The dictator game involves two players splitting a sum of cash. The first player must split a sum of cash with the second player, but the second player can’t influence their decision. This sets up a state of information asymmetry, which gives one party information that another doesn’t have. If the second player accepts the first player’s proposed split of the cash, they both get to keep their portion of the money. However, if they reject it, both parties get nothing. This is another scenario that can illustrate how different companies or individuals working together in a company can work together to devise the most beneficial outcome for both parties.

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