The concept of of game theory involves recognising all available options to you, analysing those that are available to the other participants, and deciding on the option that produces the best outcome. In essence, game theory is a strategic component for uncovering and leveraging the behaviour and patterns of other “game” participants to generate the best possible outcome in any competitive circumstance.

Game theory was coined in 1944 by John Von Neumann and Oskar Morgenstern to describe a mathematical theory that aimed to define and explain the strategic conduct of game participants who are aware that actions made in the competition have an impact on all game participants, for better or worse.

Game theory in economics has its uses in making precise decisions based on logic and reasoning. It can be used to measure certain aspects – for instance, how much money you stand to lose or gain in a particular financial endeavour.

Think of an oil cartel engaging in price-fixing and competitive espionage as an example of how economists employ game theory in real-world applications.

Knowing the cartel’s possibilities can assist companies or countries that may be badly impacted by the cartel’s decisions in better understanding their options and, hopefully, changing unfavourable outcomes into positive outcomes.

Here’s another example. The goal, according to game theory, would be for companies like Ford and General Motors for instance, to precisely estimate how much money the other is spending on vehicle advertising and then match that spending in the most efficient, effective, and cost-effective way possible.

If one party knows how much the other is spending, they can spend a little more – but not the entire budget – to gain market share while keeping a close watch on the bottom line.

As a result, by applying game theory skills and analysis to business decisions and the economy, a corporation can obtain a financial advantage by playing the game theory successfully, or at least better than their rival.

Apart from corporate strategies, game theory can also be used for certain aspects in personal financial planning. If you’re an individual looking to manage your cash flow or investment practices a little better, then consider the benefits that can be gained by game theory.

What is Game Theory?

Game theory is a theoretical framework based on precise mathematical models that follow the strategic interactions of rational agents. It can get quite complicated, but at its core the theory is used to effectively predict social situations among competing players. Put simply, it’s the science of strategy.

The most well-known example of game theory is The Prisoner’s Dilemma. Consider the case of two crooks who have been apprehended. Prosecutors are unable to convict due to a lack of hard evidence.

Officials, on the other hand, take the convicts from their solitary cells and question them individually in different chambers in order to obtain a confession. Neither inmate is able to speak with the other. Officials present four deals, usually in the form of a 2 x 2 box.

  • If they both confess, they will both be sentenced to five years in prison.
  • Prisoner 1 will receive three years and Prisoner 2 will receive nine years if Prisoner 1 confesses but Prisoner 2 does not.
  • If Prisoner 2 confesses but Prisoner 1 does not, Prisoner 1 will be sentenced to ten years in prison and Prisoner 2 to two years in prison.
  • If neither of them confesses, they will each be sentenced to two years in prison.

The best tactic is to avoid confessing. However, neither party is aware of the other’s approach, and without a guarantee that one will not confess, both are likely to confess and serve a five-year term. In a prisoner’s dilemma, the Nash equilibrium predicts that both parties will choose the decision that is best for them individually but worst for them collectively.

Nash equilibirum is a state where each player has nothing to gain if they change strategies based on the decisions of the other player.

Classifications in Game Theory

Game theory classifications can be applied to a variety of situations. The following are some of the scenarios considered:

#1. Cooperative/Non-Cooperative

The most prevalent form of the game discussed in game theory is the cooperative/non-cooperative elements. In cooperative games, players can create legally binding agreements with one another, and decisions are determined by a coalition (a group of players).

A coalition’s decision determines the payment that should be dispersed among the players. A non-cooperative game, on the other hand, explores circumstances in which players are unable to create legally binding agreements. To find a Nash equilibrium, non-cooperative game theory examines various tactics and payoffs of individual players.

#2. Symmetric/Asymmetric

A symmetrical game is one in which the payoffs are mostly determined by each player’s strategy, rather than by the choices of other players. The payoffs in an asymmetric game differ depending on who is playing. As a result, even if the players use the same technique, their payoffs will vary.

#3. Zero-Sum/Non-Zero-Sum

The gains/losses of one player are balanced by the losses/gains of other participants in a zero-sum game. The gains/losses of one player do not result in the losses/gains of other players in non-zero-sum games. To put it another way, a non-zero-sum game can lead to a win-win outcome.

#4. Simultaneous/Sequential

In a simultaneous game, all of the players make their decisions at the same time, or they make their decisions without knowing what the other players are doing. In a sequential game, players take turns making decisions or receiving information about other players’ decisions.

#5. Perfect Information/Imperfect Information

The perfect information game considers the circumstance in which all participants have access to the same data from which to make judgments. In an imperfect information game, on the other hand, the information available to one player is unavailable to the other participants.

Make Your Life Easier With Game Theory

How exactly does game theory apply to someone looking to improve their personal finance management? Here are a few ways:

#1. Make Money In The Markets

Using risk arbitrage to generate a profit is one technique to take advantage of game theory in the markets.

Assume that company A (the “acquirer”) proposes to exchange one of its shares for two of company T’s (the “target”). Before the offer, A’s stock was selling for RM50 per share and B’s stock was selling for RM20 per share.

As a result, all of T’s shareholders should accept the deal, and B’s shares should climb to RM25. If T’s stock only rises to RM24, a merger arbitrage opportunity arises.

For RM48, investors can acquire two shares of company T and sell one share of company A for RM50. They can then exchange their two T shares for one A share, cover their short, and make a risk-free profit of RM2.

Risk arbitrage or merger arbitrage is the simultaneous purchase of shares in a company that has declared that it will be acquired, as well as the selling of the company that has announced the acquisition.

#2. Save Money When Buying A Car

Game theory can be utilised to get a car for a far lower price than going to a dealership and bargaining with a salesperson, and thus help in personal financial planning.

The first step is to locate each dealership within a specified radius that has the car you want. The next step is to phone each and tell them you’ll buy from whichever dealer offers you the best bargain at a specific time.

The dealer will then state that he does not negotiate over the phone, to which you will respond that you are aware that negotiations are conducted over the phone because you are aware of numerous transactions that have been reached over the phone. He will then try to outbid the other dealers by offering a lower price than he would normally.

#3. Real Estate Negotiations

Even if you aren’t aware of it, game theory is frequently used in real estate transactions. In real estate talks, the majority of negotiating moves are already known, making the game a little clearer than in other scenarios.

In multi-offer transactions, however, the situation is drastically different. You have three options if you have submitted a bid and the real estate agent subsequently informs you that you are in a multi-offer situation.

You can choose to keep your prior offer, withdraw it, or increase your price. The latter alternative is essential to win because the winner of the bid will almost likely have to overbid to win.

Then, in order to win the house bid, you must bid exactly what you estimated it would cost. You have done your research and calculated that you made the right decision if someone outbids you and wins. In other words, even if you didn’t win, you did everything right and shouldn’t be unhappy because you didn’t make any mistakes during the process.

Conclusion

Games are well-known as diversions in various contexts, making it simple to persuade people to play them. Games are known for involving goal-oriented activity that follows a set of rules. In chess, for example, the objective is to checkmate the opponent’s king.

The participants are given certain resources (chess pieces) and regulations on how to move the pieces during the game. Each player seeks to win the other’s pieces tactically by moving them correctly within the resources available.

When you make a move in the game, you forfeit the ability to make another move. This is when the concept of opportunity cost enters the picture.

Games can assist players in better comprehending abstract concepts and themes. In games, players can use what they’ve learned in class and break things down into smaller chunks. Teaching through play is a joyful and engaging approach to doing so. Learning happens almost by accident as a result of engaging with others while playing.

Games are strikingly comparable to how we think about the structure of the economy in economics. Choices are made in an economy when resources are scarce, according to one concept of economics.

Within institutional limits, each actor tries to make the best decisions feasible with the resources available to them. It’s important to remember, however, that while the economy is a complex entity, it’s best to focus on a limited and relatively straightforward theme in finance (including personal finance) when applying Game Theory.

 

Interested in gamifying your financial goals? Let us know in the comments down below.

 

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