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Real Life Applications of Game Theory in Economics Term Paper


Introduction

Game theory is a model for investigating how multi-person decisions affect various parties in relation to the payoff one agent garners from the decision of another. In the course of game theory, several decision factors are analyzed, including conflict, communication, and cooperation. Consequently, game theory has found relevance in various practical fields, including politics, law, economics, computer science, and biology.

This theory consists of various basic tools, including information economics, mathematics, and conceptual analysis. Originally, game theory was meant to address the element of game-competitions where the gains of one person often resulted in a loss for the others who were involved. However, intense studies on game theory have extended its application to cover any form of logical decision-making that involves computers, human beings, and animals. For instance, a total of eleven game theorists have won the economics Nobel Prize as a result of their breakthroughs in game theory (Dresher et al. 18). There are several real-life applications of game theory, and they used in relation to decision-making management and within the context of competition. This paper explores various real-life applications of game theory of information economics.

Manager versus Workers

One real-life application of game theory has to do with handling competition within an organization. Although the theory is often used to harness competition between organizations, it can also be applied within an organization whereby different members of one firm are considered as independent players. The information economics in this scenario mostly applies to the players within an organization, but the competitive advantage applies to the whole firm. In this real-life example, there are two individuals within an organization who are competing against each other, with their main intention being to win.

The first entity in this case scenario is a manager in the organization, and he is competing against his workers. His main objective is to increase workers’ productivity. In the course of the game, the manager wins when the workers become more efficient. On the other hand, the workers win if they do not necessarily have to work extra hard to raise their efficiency.

The manager will promise an incentive to the most productive worker/s over a certain period of time. If the workers decide to pursue a win, it also translates into a gain for the manager because he will spend less time and resources monitoring the employees. In this scenario, it is likely for the workers to decide to subject themselves to either monitoring or pursue the prize for efficiency. Nevertheless, this decision might depend on whether to consider the manager’s constant monitoring more of a burden to them or to their manager.

For instance, the workers can recognize that their manager is obviously overwhelmed by the monitoring, and if they improve their efficiency, it is more of a win to him than to them. The game is most efficient if the workers perceive the incentive to be a bigger gain for them and a bigger loss for the manager. On the other hand, the manager should perceive the incentive that he gives to the workers to be smaller than the cost he incurs when he is monitoring the workers.

According to game theory, there are four possible outcomes in this internal competition. First, the employees can pursue the incentive leading to a win for both them and their manager. Second, the employees can pursue the incentive without achieving it, leading to a win for the manager and a loss for them. The third outcome involves a scenario where the employees take up the opportunity of reduced monitoring to relax more and reduce efficiency leading to a loss for the manager and a win for them. The fourth possible outcome is when the manager still monitors the workers, and the employees pursue the incentive without getting it, leading to a loss for both players.

Mergers and Acquisitions

In this scenario, game theory is applied to Company A’s pending decision to acquire a similar private entity (Company B) using complementary assets. Company B had been floated in the market due to its continued poor financial performance. Consequently, Company A hired consultants to assist them in making this decision. The consultants were asked to decide whether Company A was more of a buyer or a mere bystander. Therefore, the consultants applied game theory in regards to the existing competitive parameters, the possible implications of the acquisition, the amount of money to bid, and the appropriate time for bidding. In the course of the acquisition, there was a possibility of a foreign company making a bid for the firm and subsequently adding to the competition.

Most merger and acquisition transactions are tricky in regards to their relation to game theory because they mostly involve a significant loss or win element for both companies (Gibbons 45). For instance, in the course of economic practice, some acquisitions can either be a wildly successful undertaking for Company A, or a disastrous purchase. It is important to note that the unpredictable nature of mergers and acquisitions prompts companies to employ a series of games in order to entice profitable deals. In the case of Company A, any of the decisions that it might make can result in several possible outcomes, which the consulting company is tasked with exploring.

The consulting company set out for the task in hand by putting together a computer algorithm in a bid to model all possible decisions that A can make, the possible behaviors of B or A’s competitors, and the easiest way for A to achieve its goals (Peters 87).

Therefore, the collection of information was the first activity for the consultants. This information could reveal a number of game theory parameters, including the possible number of players, the intentions, and aims of every player, and the imaginable moves of these players. The aim of the consultants was to try to perceive all the players’ objectives, economic motivations, and possible modes of action. The information was collected and digested through the computer algorithm, and it finally produced a number of potential outcomes in regards to game theory.

Through the results of the analysis, the consulting company was able to offer Company clear perspectives regarding the acquisition. First, the consultants enable A to consider possible outcomes from both a competitive and a stakeholder-alignment.

This analysis included the most viable course of action and the possible wins from this decision. The consultants also gave Company A the option of cooperating with other competitors or collaborating with third parties in an effort to foster a win-win scenario. Furthermore, the data that was provided to Company A gave the firm’s management useful insights into how negotiations for Company B would probably transpire. In the end, game theory was applied in the decision to have Company A ensure that there was executive buy-in for the merger and acquisition idea and ensure no oversights were made in the course of the process.

Impact of Advertising between Competitors

The game theory’s Normal Form is a mathematical application that is mostly used during business decision-making. This application involves a matrix that contains various aspects of decision-making. The decisions are grouped in sets of two in order for the analysis to show how a strategy affects opposing competitors. A real-life application of this aspect of the game theory involves a scenario where two competing companies are seeking to reap the benefits of a marketing campaign. Consequently, the matrix that is used in this case works under the assumption that all factors are constant, and outside influences have a negligible impact. In this scenario, game theory is used to determine the impacts of a $500,000 payoff for each of two competing companies after the completion of an advertisement campaign.

Analyzing the issue from the outset indicates that this scenario results in a situation that is known as Nash Equilibrium, whereby both organizations have not improved their capital performances. For instance, when the two companies achieve equal amounts of payoffs, the implication is that there is an interdependence of strategies by the competing organizations because individual decisions do not appear to change the outcome of the theory. Jon Nash, one of the most renowned game theorists further explained the concept of interdependence of actions using the example of two prisoners (Gibbons 72).

In the famous example, two prisoners commit a similar crime but they are held up in different cells. The interrogators tell both lawbreakers that they will offer amnesty to the one who confesses to the crime first. However, there is no way of any prisoner knowing if the other has already confessed and if any confession is too late. In this real-life scenario, the two companies have no way of finding out if launching an advertisement campaign leads to an obvious advantage over their competitors.

There are several sets of outcomes in this scenario. First, if one of the companies decides not to commit $500,000 for advertisement, it could still win the game if it ends up earning a higher net profit. Second, if one of the companies does not advertise it could end up losing the extra net revenue that comes from the marketing exercise (Myerson 29). The other outcome occurs if one competitor does not take advantage of the company that does not advertise leading to a scenario where the two companies lose.

Conclusion

All the explored real-life applications of game theory indicate that this concept can be used to come up with effective and adequate competitive strategies using information economics. Furthermore, game theory is applicable to various economic scenarios including allowing its users to come up with competitive prices for various products, during auctions, mergers and acquisitions, research and development, advertising, and budgeting.

The main purpose of game theory is that it enables economists to assess the scope of any challenge and determine if the trouble of solving it is worth it. There are various real-life applications of the theory including consultancy, real estate, marketing, and overall management. Game theory is most effective when a solution to a problem is found during the first try, without having to go through a series of attempts and failures.

Works Cited

Dresher, Melvin, et al. Advances in Game Theory. Princeton University Press, 2016.

Gibbons, Robert. Game Theory for Applied Economists. Princeton University Press, 2012.

Myerson, Roger. Game Theory. Harvard university press, 2013.

Peters, Hans. Game Theory: A Multi-leveled Approach. Springer, 2015.

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IvyPanda. (2020, August 3). Real Life Applications of Game Theory in Economics. Retrieved from https://ivypanda.com/essays/real-life-applications-of-game-theory-in-economics/

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"Real Life Applications of Game Theory in Economics." IvyPanda, 3 Aug. 2020, ivypanda.com/essays/real-life-applications-of-game-theory-in-economics/.

1. IvyPanda. "Real Life Applications of Game Theory in Economics." August 3, 2020. https://ivypanda.com/essays/real-life-applications-of-game-theory-in-economics/.


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IvyPanda. "Real Life Applications of Game Theory in Economics." August 3, 2020. https://ivypanda.com/essays/real-life-applications-of-game-theory-in-economics/.

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IvyPanda. 2020. "Real Life Applications of Game Theory in Economics." August 3, 2020. https://ivypanda.com/essays/real-life-applications-of-game-theory-in-economics/.

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IvyPanda. (2020) 'Real Life Applications of Game Theory in Economics'. 3 August.

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