Well, it's good to be with you now to talk about game theory.
This is a particularly exciting topic for me.
This is an area that I've done research in, some of my published papers.
I don't necessarily recommend that you read them but
some of my published papers are in game theory and price competition.
So it's a topic I just really enjoy talking about.
What is game theory?
It's really not restricted to pricing or business in any significant way.
Game Theory is the formal analysis of conflict and
cooperation among intelligent and rational agents.
So you might think, well, there might be a lot of applications of that in the world.
And in fact, there is.
So people interested in business use this to model price competition and
price discounting competition.
But people that study things like war, they use game theory,
too, to try to analyze the possible behaviors of opponents in battles.
So it was developed by a mathematician but it has a wide
array of applications both in economics and in all kinds of human endeavors.
So, what's true about game theory is it works best if there are a limited
number of competitors.
Better if you know who those competitors are and
you know that the alternatives that they're facing.
And people know each other's objectives and payoffs.
That means, kind of, there aren't crazy people out there.
It's one business going up toe-to-toe with another business.
And they can assume that other business is probably trying to make as much money
as they can.
They're rational profit-maximizing agents.
Or, that army is really trying to win the battle.
They are rational agents.
In those situations, game theory, and the mathematical modeling that flows from it,
can give us a lot of insight into different strategic alternatives.
Now, there are many different types of games and I'm going to a few of them here.
Particularly the ones that are important for analyzing price competition.
So there are single-period simultaneous-move games,
multi-period repeated games.
You might think in the real world, some of these games might be repeated over and
over, and that would be correct.
And you also have sequential games and what that means is that one player or
one agent moves, and
the next player gets to see what they do before they make their decision.
So all of these are different types of games.
Now I want to start with a classic single move game.
It's called a Prisoners' Dilemma.
Maybe some of you have heard about this before but
I suspect a lot of you haven't heard about it before.
So think about this kind of intuition.
You've got two people that have been apprehended for a crime.
And the police take them and they put them in separate rooms, and
they're questioning them separately.
And what these two individuals know that is if they keep their mouths shut,
if they don't rat on each other, if they don't tell on each other,
they're likely to get off pretty free.
They won't be punished too much.
However, if they tell on each other,
they'll likely have a more severe punishment.
But the worst situation possible is that one of them cooperates with the police,
tells on the other person and the other person keeps their mouth shut.
That person that keeps their mouth shut, they may be going to jail for a long time.
So if you look at some basic math around this, this is a two-by-two matrix
that's often used to describe these kind of single move games and
can be used to describe a prisoner's dilemma game.
So over here we have Prisoner B and over here we have Prisoner A, and
they can make a decision.
Each one of them can decide not to cooperate or cooperate.
And depending on the different combinations of cooperation or
non-cooperation, that's going to govern how much time they get in jail.
It's sort of a macabre example, right?
But this is the classic prisoners' dilemma game.
So if they don't cooperate,
if they keep their mouths shut, they only get 1 Year in prison.
Now that may seem pretty harsh, but
this may have been a very heinous crime of some kind.
So if they keep their mouth shut,
1 Year in prison, after that, they walk scot-free.
If they both cooperate with the police and
tell on each other, then they don't get 1 Year, they each get 2 Years in prison.
But the interesting thing happens when one tells on the other.
So, if prisoner B decides that they are going to cooperate, they're going to tell,
and prisoner A says, I'm not going to tell, I'm going to keep my mouth shut.
What happens is Prisoner B gets off with nothing.
They walk out of that police detainment room scot-free, but
Prisoner A gets 3 Years in prison.
Now if you look at this, and it's symmetric on this side,
so it's exactly the same as for A and B.
Jean Manuel IzaretSenior Partner and Managing Director, Leader of BCG’s Global Pricing Practice
Ronald T. WilcoxNewMarket Corporation Professor of Business Administration & Senior Associate Dean for Degree Programs
Thomas KohlerAssociate Director, Pricing
