Game Theory

Game theory is a branch of mathematics that studies strategic interactions between intelligent and rational decision makers, called players. Strategic interactions take place anytime a player’s payoff depends not only on his or her own decision but also on the decisions made by the other players. Intelligent players fully understand the rules of the game and are able to assess the likely impact of their moves or actions. Given the available information, rationality simply means that players select the strategy that optimizes their payoff. Managers are regularly confronted with situations where the outcomes of their decisions are contingent on how their competitors or partners will react to those decisions. Examples include setting the price of a product, launching a new one, building an industrial plant overseas, bidding for a contract, and negotiating delivery terms with service and input providers. In these examples and in many others—indeed, the list is endless—managers must anticipate the other players’ possible decisions when formulating their own strategy, knowing that their competitors are just as sophisticated and are attempting to do the same. In a nutshell, game theory offers a model for thinking strategically in situations involving interdependent gains. As with any model, abstraction, or conceptualization, game theory represents a highly complex reality through a parsimonious model, retaining only those elements that are rationalizable determinants within the context under study. To illustrate, consider a negotiation over wages between a company’s management and union representatives. Experts agree that the outcome depends on variables such as the profitability of the firm, wages in similar firms in the industry, the state of the labor market, and both parties’ potential losses in the event of a strike. This does not imply that other factors, such as the negotiators’ ability, their past relationships, the shape of the room where the negotiations are taking place, and the time at which they start will not play a role in determining the negotiations’ outcome. Nevertheless, a game theory model typically ignores these last factors because their impact is too situation specific to be of any general interest. Also, because they are highly perceptual, they can hardly be represented in a conceptually appealing way. To give an analogy, game theory helps determine the best travel route from A to B, but it does not describe the scenery. The remainder of this entry is structured as follows: The elements of a game are defined, and a classification of games is provided; the roots of the theory and its history are discussed, and a brief assessment is given of the impact of game theory, particularly on management and managers.