Game theory has won 7 Noble prizes for its contribution to society. I hope you are aware of Game theory but it is always a good idea to refresh memory. So, allow me to explain it in an easy way illustrating prisoner’s dilemma. Game theory is basically a psychological phenomenon which prepares the opponent for/against the proponent’s moves. The probability of breakeven is 0.25% for two prisoners in consideration, and same probability is shared for evasion for both sides, but .75% probability to get caught. For most of the people this proves to be the real proof of trust, and many interesting TV programs are based on the notion of this phenomenon.
It wouldn’t be too late to discuss its implication in business world. We know oligopoly; competitive firms mostly are in association with prisoner dilemma. Cartels, pricing and market dominance from few larger organizations can be somehow being explained using game theory. Firms always try to anticipate competitors move, for pricing, launching products and other plenty of reasons. Sometimes companies delay their launch of the product or model anticipating no benefits, or sometime they launch at the same time for share profit, which might also result in gain/loss. It works on the phenomena of Zero-sum that what you lose is the gain for someone embodying evenness. There are many financial instruments working on game theory principle – swap, forward and options and they are also called Zero-sum instruments. In options long call – short call, long put – short put can be referred for Zero-sum.
Suppose company X offers to swap one of its shares for every two shares of company C. X’s stock is selling for $100 per share and Y’s stock was selling for $40 per share before the offer. Therefore, C’s shareholders should all accept the deal, and the value of Y’s stock should rise to $50. If C’s shares rise only to $48, it presents a merger arbitrage opportunity. Investors can buy two shares of company C for $96, short one share of company X to get $100. They can then swap their two C shares for one X share, use that to cover their short, and have $4 risk-less profit.
It is also used in negotiations and auctions. When a company is bankrupted, Game theory can be used to manage auctions, setting prices in the interest of both the parties for fair settlement. Game theory doesn’t give too many options, but provides a base for rational decision.