Businesses around the world are getting smarter and smarter. Every entrepreneur pursues business progress, which is achieved by making wiser choices than competition, to name one. Defining game theory will make things overly complicated, so I will provide a basic example to help you understand.
Imagine 2 people. Apparently a crime has been committed and they both seem very suspicious.
Before making a decision the prosecution tells each player resulting years of jail as a result of their confessing/not confessing while their partner confesses/does not confess. The most ideal choice for both prisoners is to not confess. Suppose they do decide not to confess. But when they walk in and are asked, they think
“The other player is not confessing, if I confess I can go for free. If I also stay quiet, I will have to spend 1 year in jail.”
Such thoughts are inevitable and thus cooperation is not possible. This condition is called prisoners dilemma, where 2 players are in a condition that cooperation is not possible and neither can achieve the most ideal situation which is (-1, -1) in this case. This shows that not confessing can be risky, either 1 year of jail or 10 years.
What is the result?
So what will derive the conclusion? If you observe deeply, both players are better off Confessing. Confessing has become their Dominant Strategy. Dominant Strategy is when the decision one player is making is in best interest for himself and no matter what decision the second player makes, the first player will be comparative better off choosing the Dominant Strategy, rather than Dominated strategy.
Both players will feel much more safe confessing and they will end up 5 years of jail each. Now since they both choose 5,5 and could not reach 1,1 this condition is prisoners dilemma.
Now one way this is achieved among Businesses in real life is through collusion. Businesses Collude to reach optimum points like 1,1. Collusion is an illegal agreement between 2 parties, which is made under the table for their own benefits. Most of the time, collusions cause harm to consumers.
One example of collusion is a valley of hotels, 500 km away from cities, in a country side. Let’s say you also own one of the hotels there. Imagine tourists traveling long distance to enjoy a vacation in the valley, but all the hotels in the valley, including yours decide to collude. You all agree to set a price or $70 per night, instead of competing against each other. Now all consumers are forced to pay a much higher price and you can enjoy higher profits for the time being.
The reason it is bad for your businesses is that, if your business has hardworking labor, nice rooms and better quality service than all that is going to waste because you cannot charge the fair price. You basically lose the incentive to work hard, innovate and provide higher quality goods and service. Another logic is that consumers are smart enough to understand such situations. If anyone reports the case, all the hotels in the valley may be sued including your own. Even if no one is caught, the valley is likely to lose long term customers.
I would be lying if I said that Game theory should be the ultimate strategy of decision making. It has many limitations, which are very important for you know.
- Once you start comparing between more than 2 players, the idea of simplicity and logic no longer follow the example I gave. It will get overly complicated, simply put
- Most of the times, we do not know if Game theory applies or not. We can never tell If the competitor is also in the same situation as us and is making a choice between 2 options, which are the same as ours.
- Giving or predicting numerical values is too hard. Sometimes consequences deal with non-monetary factors, e.g. reputation. In such cases, giving them numerical values Is too hard. And even if you can give numerical values to your own decisions, but we cannot measure the impact on Competitor, never as exact as ours. Sometimes we do not really know how the consequence will effect competitor
- Predicting what the consequences will be and assuming that there are no variations is a huge flaw.