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 / Spring 2003 / Issue 30(originally published by Booz & Company)


Finding Sanity with Game Theory

John Nash had a beautiful mind. These books showcase beautiful implications for companies.

Knowledge Review

Photograph by Matthew Septimus
A Beautiful Mind is a great tale of love and madness. But John Nash’s biography engages us for another reason: He developed game theory.

Why should game theory be of interest to anyone other than theorists? For executives, game theory matters because we live and do business in an interactive world. We need to anticipate the results of those interactions. In almost every kind of business, we need to negotiate deals, prepare for future negotiations, identify what our trading partners and our competitors are likely to do next, and position ourselves accordingly. We need to get ready for market conditions that haven’t arisen yet, which we can influence by our participation.

Game theory allows us to deal with these interactions in a clear, and often quantitative, way. Business leaders have been gradually waking up to this. Publishers have reported a growing demand for game theory books for lay readers. A Beautiful Mind has given game theory an additional push.

There isn’t yet one book that will teach an executive all the game theory concepts needed in business. Worse, most of the existing game theory texts are littered with mathematical formulas that even mathematically literate physical scientists and engineers find confusing. Thus, putting together a “virtual text” by dipping into several introductory books is probably the best approach to exploring this exciting, expanding field.

One of the best places to get a general sense of game theory is a work in progress by Roger A. McCain, available free on the Internet. It’s currently titled Strategy and Conflict: An Introductory Sketch of Game Theory and runs to about 75 pages. Using only simple arithmetic, Professor McCain introduces a significant portion of the concepts, definitions, and examples that have been central to game theory. More important, he helps readers get a feel for the kind of analysis game theory provides.

But to understand game theory’s business applications requires a deeper dive. We’ve recently experienced something of a revolution in business thinking. Instead of isolated companies producing stand-alone products, we now think in terms of business networks producing product systems. Instead of individual exchanges of brief duration with little sharing of information, we now think in terms of sustained relationships with extensive sharing of information. Game theory enables us to investigate these increasingly interactive and complex relationships.

Consider these four basic principles of business:

  1. In business, we interact not just with a large, cumulative market, but with small numbers of other players whose specific strategic choices directly affect the payoffs we will receive from our choices.
  2. We make choices that not only affect the outcome of our activities within an existing market, but also have the ability to affect the kind of market we are in.
  3. We have the option of creating alliances and partnerships, with binding agreements on joint actions and on the sharing of profits.
  4. We don’t just allocate existing value or create value by means of assets that produce a set return. We are able to create new value at new rates of return by putting together new combinations of assets.

Conventional economics without game theory is generally of little help in these matters. This is because conventional economists tend to assume that a company is interacting with the market as a whole, rather than with other individual companies or combinations of companies. In other words, conventional economics essentially leaves out the entire realm of intermediate interactions where most business activity actually takes place. Game theory, in contrast, tackles this realm head-on.

The field of game theory, in practice, divides into two main branches. The first two principles listed above give rise to one branch, known as noncooperative game theory. The latter two principles give rise to the other branch, cooperative game theory. It’s very important to be aware of the ways in which these two main branches of game theory have diverged because each branch is built on different concepts and has different uses. When businesspeople become frustrated with game theory, or feel it doesn’t meet their needs, it is often because they are trying to solve the problems addressed by one branch with concepts from the other.

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