How can you benefit from game theory?

NEW DELHI: Let’s play a game. Suppose you and your neighbour were each asked to choose a number from a given range — say, 0 to 200. You’re told that you’ll each get cash equal to the lower of the two numbers picked. What number would you pick?

Clearly, the game gives both of you an incentive to choose a high number within the range — and walk away with anything up to Rs 200.

But supposing you were told that the person who chooses the higher number would pay a penalty of Rs 20. What number would you now choose? It would still work out mutually beneficial for both of you to choose the highest allowable number.

However, if each of you were caught up in trying to get more money than the other, you would both be “playing safe” and undercutting each other and both would lose in this “race to the bottom”.

A strand of behavioural economics, called game theory, which seeks to predict outcomes in situations such as these is currently in focus: this year’s Nobel prize in economics has gone to two game theorists whose researches helped understand the rationale of conflict and cooperation between countries, individuals and organisaations.

Game theory can be applied to many situations by various entities - individuals, businesses and even governments.

Very simply put, the theory describes the strategies that people should employ to maximise their rewards by factoring in what others in a group might do. Guessing what your competitors might do is part of “the game”.

How is game theory useful to businesses? In a market where there are only, say, two firms manufacturing a particular product, both stand to gain by restricting their output.

That way, prices stay high, and both benefit - and this is a classic example of how business cartels work. But if Firm A steps up its production levels, prices would fall, impacting Firm B’s profits rather more because Firm A would benefit from the economy of scale.

In some situations, however, a large player with deep pockets may have the capacity to regulate market prices even when others in a group are not acting in tandem. Saudi Arabia’s influence within the Organisation of Petroleum Exporting Countries is a classic example of this.

Similarly, the price war in the detergent market in India in recent years was the manifestation of the game theory in full play!

Governments, too, employ game theory to figure out responses to public policy. For instance, while selling telecom and oil exploration licences, or when offloading shareholdings in public sector undertakings, a government that has an interest in maximising revenue can profit from game theory models.

Similarly, when finance minister P. Chidambaram prophesies that tax compliance will improve if he cuts income tax rates, he is only employing game theory models that can be traced to the wisdom of US economist Arthur Laffer.

However, game theory has its limitations. For instance, its predictive power is rather low: people don’t always behave the way that game theory says they ought to. But, then, no game would be exciting if it didn’t have an element of uncertainty.