What Is Game Theory?

Movie Case Study

The above scene is from the movie, ‘A beautiful mind’. This movie is based on the life of mathematician John Nash. In this particular scene, John Nash’s four friends are eyeing the beautiful blonde girl.

While the blonde girl is looking at Nash, at that moment Nash observes and contradicts Adam Smith’s Neoclassical theory and figures that if two rational people were to collaborate with each other, they have a win-win situation (in this case getting the blonde girl). If they operate from a self-centered perspective, they won’t reach an optimal outcome. This theory is based on logical deduction and emotions don’t play a role here. John Nash had a breakthrough in this theory and wrote a 32-page paper when he was 21. Learning Perspectives in this blog explores the meaning of game theory.

What Is Game Theory?

Game theory, today forms part of the curriculum, it is an integral part of Economics, Operations research, Business administration, Mathematics, Psychology, and many other management subjects. Game theory deals with making optimal decisions and choices based on relationships with others.

Game theory is the science of decision-making. It is used in International relations and Military training as well. Professor John Von Neumann and Oscar Morgenstern published their book ‘The Theory of Games and economic behavior’ developing game theory. John Nash developed Nash Equilibrium. He was awarded Nobel Prize in 1994 for his work. Nash Equilibrium is a concept in game theory, It suggests that no decisions are taken in isolation and a player cannot change their decision without being in agreement with the other player.

Prisoner’s Dilemma:

Typical example to understand game theory is Prisoner’s dilemma. It states that if two prisoners think to protect themselves at the expense of the other, an optimal solution wouldn’t be reached. However, if these prisoners use the idea of collusion and collaboration, they can reach a solution that’s beneficial to both parties.

Similarly in businesses, two related companies in the same industry might follow the collaboration strategy while fixing their prices so that each can share margins, without this, both firms stand to lose

.Think of Burger King and McDonald’s in the food and beverage industry, they both fix prices for their products which are in close range to each other.

Real-Life Example:

Let’s understand this through a real-life example of the Airline industry. The aviation industry is an industry that has high barriers to entry and is highly regulated by the government. In 2003, Air Deccan, a low-cost carrier came into being. It started offering approximately 30% lower fares compared to other airline fare tickets. It had reduced its operational costs by simplifying its operations led by Dr. Gopinath. His vision was to target the growing middle-class population of India. Reducing turnaround time, dynamic pricing, additional revenues, and unconventional distribution system were some of the strategies that the airline resorted to. As Deccan offered lower airfares, big players (Jet Airways and Indian Airlines) were forced to bring down their prices to retain market share. More low-cost careers rose such as Indigo, Spice Jet, etc, and started following similar strategies such as Air Deccan. This led to everyone losing market share including Air Deccan. The airline industry was fast losing its pricing war.

Nash equilibrium occurs when players in the industry work together and each earns their market share following a similar pricing strategy, if one player does not act in accordance everyone tends to lose. In 2007, Kingfisher took over Air Deccan. All other players were happy with this takeover as equilibrium had to be restored in the Airline industry.

Understand Game Theory with a Video