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  • Writer's pictureMihir Shahi

Game Theory: A Must-Know for Entrepreneurs

Game theory, while appearing to be a purely theoretical framework for academics to tinker with, provides a strategic tool which budding entrepreneurs can harness to gain a competitive advantage.

Firstly, what is game theory?

Game theory is a method of strategic thinking where the players will have to make decisions by looking from different perspectives, basically putting themselves in the shoes of the other players and anticipating their possible actions and reactions.

Why is this relevant in business?

At the heart of business are interactions. Whether that be with colleagues, competitors, suppliers or customers, interacting is key. Superstar firms, such as Amazon, Facebook and Apple have reached their dizzying heights of success through mastery of the art of interaction.

This is where game theory steps in.

Game theory is a powerful tool for predicting outcomes of a group of interacting firms where an action of a single firm directly affects the payoff of other participating players. Firms are strategically interdependent. The fate of countless small businesses rests in the hands of Amazon. Conversely, what brings so many customers to Amazon are the seemingly endless array products provided by those small businesses.

Given that each firm functions as part of a complex web of interactions, any business decision or action taken by a firm impacts multiple entities that interact with or within that firm, and vice versa.

In our Amazon analogy, this manifests itself through the relationship between Amazon and its third-party sellers. Amazon, in structuring its referral fee system, takes around 10-15% of the sales price. Small businesses must then decide how to act in this ‘game’.

Within this ‘game’ numerous self-interested parties must interact to succeed. Amazon must decide how high a price they can charge businesses. Businesses must decide whether or not to market on Amazon, choosing to sacrifice market access in order to retain profit margin. On top of this, game theorists would acknowledge the actions of competitors within this interaction, whether the presence of a competitor on Amazon means that the business must be on Amazon themselves.

Therefore, when making a decision or choosing a strategy firms must take into account the potential choices and payoffs of others, keeping in mind that while making their choices, other players are likely to think about and take into account your strategy as well.

Game theory can also be applied to interactions within firms. Shareholders are at the mercy of management decisions which affect the performance of firms, and therefore affect the value of their shares.

There have been numerous incidents where executives have chosen to maximise their compensation at the detriment of shareholders. During the height of the financial crisis, AIG executives paid themselves $218 million of taxpayer money following the 3rd largest federal government bail out.

In this interaction, it is clear that in constructing the terms of the bailout game theory could have been instrumental in predicting and stopping such a flagrant waste of taxpayer money.

How has Game Theory been used?

Game theory, through improving strategic decision-making by providing valuable insights into the interactions of multiple self-interested agents, is increasingly being used in business interactions.

Regarding the shareholder-manager problem, game theory can be leveraged to align the interests of the differing ‘players’ in this ‘game’.

Frequently, the compensation packages of executives include numerous stock options. This creates a situation in which executives are incentivised to maximise shareholder value. Whilst this supposedly could come at the expense of long-term strategic vision, this example illustrates the fact that insights provided by game theory can overcome the problem of multiple self-interested agents.

Game theory is increasingly becoming ingrained in business decision making. The pandemic has accelerated technological uptake across the globe, broadening the scope for interactions between businesses. To succeed, businesses must appreciate and utilise game theory to master the complex web of interactions which they face every day.

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