Game theory and rival strategies in economic decision-making

Economics

Game Theory

Game theory is a model that can be used to examine and explain the way that different actors in a given situation may choose to act and develop strategy, using a mathematic approach. The model looks at how players will make decisions which will be based on both the firms own position and resources as well as the way their competitors are or are expected to act. Game theory can therefore be used to help try and identify the optimal course of action (McEachern, 2009).

There are many scenarios where Game Theory will be useful; in the commercial environment game theory is most applicable in oligopoly situations

To consider the application of the theory the concept needs to be described. The situation examined is a game. For there to be a game players are required; these are the firms (Nellis and Parker, 2006). For a game to commence there need to be at least two players making decision which will impact on each other. Each set of decision made by the players is referred to as the payoff (McEachern, 2009). An effective way of examining game theory is to look at an example and the way decision impact on the different players. A good example may be the airline industry, where there are only a limited number of airlines travelling each route.

In this example there will be two airlines, Airline A and Airline B, travelling the same route. It is assumed they are both flying the same route. Airline A wants to increase their profit, as they know that the passengers like the loyalty program they are considering increasing their investment. Enhancing the loyalty program will increase costs, but the firm also believes that this will also attract more customers, which will create more profit. Therefore, the decision to be made is whether or not to invest in a loyalty scheme.

If Airline A invests in their loyalty scheme it is likely they will gain more business, which will result in Airline B. loosing passengers. If this occurs Airline B. is then likely to invest in their own loyalty program to try and regain the lost customers from Airline A. The net result may be that both airlines have increased their costs by investing in the loyalty schemes, but do not have a net gain, as they have both followed the same strategy.

In game theory there is the ability to look forward at the way the game will play out, in stages, and determine the potential net result (Nellis and Parker, 2006). In this scenario it may be argued that the best course of action would be for the two airlines to reach an agreement where they can protect their profits and avoid wasteful spending. In this case the airlines may reach an agreement.

The difficulty with any game is that even where there is an agreement parties to that agreement may choose to cheat. For example, if both parties make an agreement, but each party realizes that if they cheat they have the potential to increase their profit; they may be tempted to cheat. If one party cheats, the compliant party will loose out in the short-term. However, when one airline knows the other has cheated they are likely to loose trust and follow suit. As seen above, if both parties cheat, increasing their costs, they are likely to face a net loss rather than a net gain.

This can be represented with a matrix as shown in figure 1 below. In this case it is assumed that if both companies work with each other, which may include refraining for increasing spending on loyalty scheme, but could also include other strategies such as holding up airline ticket prices, both firms will make a net gain of $5 million (box 1). However, it one cheats, the cheating firm will gain $8 million and the compliant firm will loose $2 million through the lost business (boxes 2 and 3). If both firms cheat there will be a loss of $1 million each (box 4).

The process may result in different plays for a few rounds, with first one then the other cheating, neither wanting to loose out (Nellis and Parker, 2006). Eventually, the firms will realize the best option is to comply, as this gives the potential long-term outcome for the firm for each game period.