Game Theory for Business: A Simple Introduction
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About this ebook
Game Theory for Business: A Simple Introduction offers an accessible guide to the central ideas and methods of business game theory, with over 35 diagrams to support the analysis.
Understand a business’s role, goals and incentives. Examine adverse selection, moral hazard, and a bait and switch strategy, see how a firm may secure long-run gains, and learn what the show business industry can teach other businesses.
Evaluate duopoly price competition, prospects for collusion, and industry entry deterrence using credible commitments and asymmetric information. Look at strategic behaviour with top dog, fat cat, puppy dog ploy, or lean and hungry strategies, Cournot output competition and Bertrand price competition.
See what a business can learn from evolutionary biology, and how a firm may differentiate itself from its rivals.
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- Rating: 5 out of 5 stars5/5Excellent for beginners. given well detailed and very clear explanation for topics
Book preview
Game Theory for Business - K.H. Erickson
Game Theory for Business: A Simple Introduction
By K.H. Erickson
Copyright © 2013 K.H. Erickson
All rights reserved.
No part of this publication may be reproduced, stored in or introduced into a retrieval system, or transmitted in any form or by any means, including electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the author.
Also by K.H. Erickson
Simple Introductions
Choice Theory
Financial Economics
Game Theory
Game Theory for Business
Investment Appraisal
Microeconomics
Table of Contents
Introduction
Business Goals
The Business’s Dilemma
Adverse Selection and Moral Hazard
Repeated Gains
The Business of Show
Business Competition
Tacit Collusion
Entry Deterrence
Strategic Behaviour
Firm Survival
Niche Businesses
Introduction
Game theory is a useful tool to model interactions and gain insight into what may appear to be unpredictable or unsatisfactory outcomes. The theory sees every interaction as a game, where the players involved aim to select the best strategy available to achieve the highest possible payoff on offer. In practice this simplifies to a choice of just two strategies for a player, as they either act a certain way or they don’t. But a game never contains only one participant, and those involved must take account of the presence of those in a similar position or risk being played. A game can force a poor payoff on a player if they only look at the game as a whole and ignore the individual incentives facing others, although trying to outmanoeuvre a rival can also backfire as both players rush to the bottom and end up worse than they started.
The characteristics of game theory make it especially relevant to the business world, and in a more general sense to all those trying to buy or sell something. A business manager may wonder why profits and sales are lower than expected, despite selling a desirable product and using a well thought out pricing strategy to appeal to customers and outmanoeuvre competitors. And a buyer may feel unsatisfied with their interactions with a business, despite paying large sums of money and being a likeable customer. Game theory can offer insights into all of these scenarios and more, to look in depth at the incentives facing the other side and suggest strategies to take advantage of them.
This book offers a simple and accessible introduction to the central ideas and principles of game theory for business. The games are illuminated with over 35 diagrams used throughout to show business theory and games in action, as both forward and backward induction are utilised to predict a business’s payoffs. Dominance and the Nash equilibrium are explained and illustrated to show how business strategies may be formulated in practice.
First the main wealth seeking priorities for a business are put forward and justified, to lay the foundations for the prisoners’ dilemma game a business or seller of any product must face. Several possible solutions to the game are explained, as a business may operate a bait and switch strategy as a short-run tactic, or build trust with a customer in an attempt to create long-run gains. The case of show business is also investigated, where a business may be able to escape the prisoners’ dilemma game other firms struggle against and create a game built around their own best interests.
Rival businesses are the focus for the remainder of the analysis, looking into a firm’s pricing incentives and at the prospects for collusion to achieve higher profits, before turning to the strategies available to repel new competitors planning to enter a firm’s industry. A business’s situation is compared to similar scenarios in evolutionary biology and lessons are drawn for what this can teach sellers competing for sales, and some specific strategies for a business trying to stay ahead of the competition are explained.
Business Goals
The goal of any business is first and foremost to maximize its wealth. This is true across all cultures worldwide, in every business sector, and holds irrespective of the current financial status of a firm, no matter if it’s close to bankruptcy or at the very top of its field. A large corporation is focused upon creating wealth for the shareholders who own it, while a small one person business based around self-employment is also primarily concerned with wealth maximization. Even if a business’s interests are focussed in the charity sector, the most important goal has to be to increase its own wealth, as without it the economic future and survival of the firm is at risk, and they may not be around to work on their mission to help others.
Just as a business intends to gain wealth to assure its own survival as a prerequisite for going after its goals, each and every individual is trying to achieve the same thing. In a world where money doesn’t grow on trees one person can only gain it by taking it from someone else, and this creates a stalemate situation where a business aims to take money from individuals, while they all target the opposite and plan to hold onto their cash. But this doesn’t have to result in an armed fight to the death, where the winner claims the money needed to assure their own long-run survival, and the loser lies motionless in a heap. Instead it’s possible for a fair exchange to take place, where a sum of money is swapped for something of value, which is worth more to the potential buyer than the money that would be given up. And of course it follows that the business will only part with the product or service if it believes that the money on offer is more valuable.
As the two different sides in any