Game Theory
Game theory models decisions whose outcomes depend on what other participants choose. By specifying players, available actions, information, and payoffs, it helps analyze conflict, cooperation, and strategic responses.
THE IDEA
Dr. Strangelove
It’s hard for a scientist to become a household name. So it shouldn’t be surprising that for most people the name John von Neumann doesn’t ring a bell.
That’s a shame because von Neumann is a hero of mine, and should be to anyone committed to making better decisions. His contributions to the science of decision-making were immense, and yet they were just a footnote in the short life of one of the greatest minds in the history of scientific thought. (And, not coincidentally, he was a poker player.)
After a twenty-year period in which he contributed to practically every branch of mathematics, this is what he did in the last ten years of his life: played a key role on the Manhattan Project, pioneered the physics behind the hydrogen bomb, helped develop early computers, figured out the optimal way to route bombers and choose targets at the end of World War II, and helped shape early debates about nuclear deterrence, later associated with mutually assured destruction (MAD). Even after being diagnosed with cancer in 1955 at the age of fifty-two, he served in the first civilian agency overseeing atomic research and development, attending meetings, though in great pain, in a wheelchair for as long as he was physically able.
Despite all he accomplished in science, somehow von Neumann’s legacy in popular culture is as one of the models for the title character in Stanley Kubrick’s apocalyptic comedy, Dr. Strangelove: a heavily accented, crumpled, wheelchair-bound genius whose nuclear strategy contributes to the film’s catastrophe.
In addition to everything else he accomplished, John von Neumann is also the father of game theory. After finishing his day job on the Manhattan Project, he collaborated with Oskar Morgenstern to publish Theory of Games and Economic Behavior in 1944. The Boston Public Library’s list of the “100 Most Influential Books of the Century” includes Theory of Games. William Poundstone, author of a widely read book on game theory, Prisoner’s Dilemma, called it “one of the most influential and least-read books of the twentieth century.” The introduction to the sixtieth-anniversary edition pointed out how the book was instantly recognized as a classic. Initial reviews in the most prestigious academic journals heaped it with praise, like “one of the major scientific achievements of the first half of the twentieth century” and “ten more such books and the progress of economics is assured.”
Though the roots of game theory can be traced to the 1930s, the field was extensively developed by scholars throughout the 1950s, and by the 1970s it had been applied to biology. Today it serves as an umbrella term for the science of logical decision-making in people, computers, and even animals, making it a vital tool across a broad range of disciplines.
Game theory revolutionized economics, evidenced by at least eleven economics Nobel laureates connected with game theory and its decision-making implications, including John Nash, whose life story was chronicled in the Oscar-winning film A Beautiful Mind. Game theory has broad applications outside economics, informing the behavioral sciences (including psychology and sociology) as well as political science, biomedical research, business, and numerous other fields.
Economist Roger Myerson (one of the game-theory Nobel laureates) defined it succinctly as “the study of mathematical models of conflict and cooperation between intelligent rational decision-makers.” This is the modern basis for studying the bulk of our decision-making, addressing the challenges of changing conditions, hidden information, chance, and multiple people involved in the decisions. Any game in this framework involves a player, the actions available to them, the information they possess, and the payoff for each action—a strategic mental view that can be internalized in countless real-world scenarios.
Von Neumann used a simplified version of poker to study strategic decisions under hidden information. It provides a useful starting point: the best action depends partly on what the other player knows and chooses.
When to use it
Negotiating a business deal with a competitor.
Deciding whether to launch a new product in a market dominated by one other player.
Understanding international relations conflicts like nuclear arms races or trade wars.
Analyzing competitive pricing strategies in an oligopoly.
Deciding whether to enter a new market where existing competitors will react to your move.
Negotiating a salary raise with a boss who has a limited budget and must balance your request with others.
Choosing a strategy in a board game that involves bluffing, cooperation, and counterplay from opponents.
Allocating resources in a team project where members have conflicting interests and must coordinate for optimal outcomes.
FROM THEORY TO EVERYDAY LIFE
In practice
Poker and Game Theory
Von Neumann studied a simplified poker game to analyze strategic interaction under hidden information. Bluffing illustrates why a decision depends on an opponent’s expectations as well as the cards.
Mutually Assured Destruction
The Cold War doctrine of mutually assured destruction (MAD) is a classic example of game theory, where both the US and Soviet Union had incentives to avoid nuclear war but also to maintain a credible threat.
Prisoner's Dilemma
Two suspects are arrested and interrogated separately. Each must decide whether to confess or remain silent. The payoff depends on the other's choice, illustrating strategic interdependence and the tension between individual and collective rationality.
Competitive Pricing
Two companies in a duopoly must decide whether to lower prices or maintain them. The outcome depends on the competitor's decision, highlighting how game theory helps analyze market strategies and potential price wars.
A MOMENT TO REFLECT
Put it to work.
How does game theory apply to a situation where you have to make a decision that depends on what someone else chooses?
What are the limitations of assuming all players are rational in game theory?
Can you think of a real-world negotiation that can be modeled using game theory?
What information does each participant have in a decision you face, and what important information is hidden?
How might your model change if the other party values a different outcome from the one you assumed?
In a competitive market, how can understanding game theory inform your pricing or product launch decisions?
References
- Theory of Games and Economic Behavior — John von Neumann and Oskar Morgenstern (1944)
- Prisoner's Dilemma — William Poundstone
CONTINUE THE CONVERSATION
Source texts
- Thinking in Systems and Mental Models Think Like a Super Thinker (Dawson, Marcus P)
- Thinking in Bets Making Smarter Decisions When You Dont Have All the Facts (Annie Duke)