JOIN USHave you applied Game Theory?
A few months ago, Reliance Jio supported its rivals Bharti Airtel and Vodafone Idea while demanding lower 5G spectrum prices in what was a rare display of unity in the telecom sector, against the Telecom Regulatory Authority of India. It was unusual because Reliance’s rivals had accused it of slashing prices and causing disruption in the industry. Jio had, in turn, accused them of destroying the telecom ecosystem by charging high interconnect usage charges (IUC).
Elsewhere, the Competition Commission of India (CCI) had on many occasions reprimanded and fined airlines like Indigo, Jet and SpiceJet for forming a cartel and colluding with each other on air ticket pricing.
Cut to the recent Assembly elections in Maharashtra. While forming the government in Maharashtra, the dilemma of Shiv Sena was whether to support BJP or scoot from the alliance.
Whether it is business or politics, the players always face a dilemma -- whether to cooperate or compete with each other. Cooperation, collusion, or ruthless, sometimes unethical, rivalry among these players are all examples of what economists refer to as ‘games.’
Game Theory, which is the study of how people employ different strategies in competitive situations, explains this behaviour. Game Theory is concerned with scenarios where the outcome of a participant’s action depends not only on his decisions but also on the decisions of other participants. It is used by economists in analyzing competition, bargaining, auctions and behavioural economics. It has wide applications in psychology, politics and in international relations.
Game Theory is more relevant in understanding the behaviour of firms in an oligopoly, which is a market structure where a few firms dominate and compete with each other while offering similar or identical products. Each player, while deciding what actions to take, must consider how others might respond to that action. Because the number of firms in an oligopolistic market is small, each firm must act strategically. Each firm knows that its profit depends not only on how much it produces but also on how much the other firms produce. In making its production decision, each firm in an oligopoly should consider how its decision might affect the production decisions of all the other firms.
Let us consider the airline industry. Indigo, before cutting its airfares, should know the payoffs. By cutting airfares, it expects to increase its market share and profits. The outcome of the price cut depends, however, on what decisions its rivals like Air Asia or Spice Jet may take. This may be good for Indigo, but is it good for the whole airline industry? What if they also start cutting airfares? All of them will end up cutting each other’s throats and incur huge losses. The dilemma for Indigo is: should it cooperate or compete? Cooperating with rivals would leave everyone better off. But in real life, achieving 100% cooperation is idealistic as each player is driven by self-interest.
Game Theory is better understood through a game called the Prisoner’s Dilemma. This game provides valuable insight into the difficulty of maintaining cooperation. Prisoners’ Dilemma contains a general lesson that applies to any group trying to maintain cooperation among its members. The Nash Equilibrium suggests that in a Prisoner's Dilemma, individual players will make a move that is good for them individually, but worse for them collectively.
Prisoners’ dilemma
Prisoners’ Dilemma is a game about two criminals who have been arrested for a crime. But the police do not have enough evidence to convict them. Let’s call them Bunty and Babli. The police question Bunty and Babli in separate rooms. They each have the choice to either benefit themselves by betraying the other person or cooperate with the other and remain silent.
If both prisoners betray each other, each serves three years in prison. If Bunty betrays but Babli remains silent, Bunty is set free and Babli serves five years in prison, and vice versa. If both of them remain silent, then both of them spend just one year in prison. The Nash Equilibrium in this example is when both players confess and betray each other because their decision is driven by self-interest. Even though cooperation leads to a better outcome, the dominant strategy for each of them will be to confess. By each pursuing their own interest, the two prisoners together reach an outcome that is worse for both of them.
For his work on Game Theory, mathematician John Nash won the Nobel Prize in Economics in 1994 as well as Norway’s Abel Prize for Mathematics in 2015. Nash’s two-page paper of 1950, just as era of nuclear weapons was dawning, remains a seminal contribution to Game Theory and our general understanding of strategic decision-making. Nash, on whose story was based the movie ‘A Beautiful Mind’ was killed in a car accident in New Jersey in 2015 while he was returning from Norway after receiving the Abel Prize.
Game Theory instances happen almost regularly in real life. In auctions, for example, the payoffs for a buyer depends not only on the amount he bids but also on the amount bid by other buyers.
(The writer is a CFA and a former banker and currently teaches at Manipal Academy of Banking, Bengaluru)