Game Theory

Game theory

We love playing games. We are very well acquainted with the rules of the games we play because we play to win. Minus the cheesy stuff from Romcoms where someone else’s Win gives a different high, is there someone who does not enjoy winning? I think not.

While we play games, the moves are outright stimulated by our brains, routing for our win. It is as though our systems are programmed that way. Dopamine kicks in, eyes on the prize, our motor behaviour is all set to act in the best interest of ourselves. Geniuses like John Nash and Lloyd Shapley, excavate further by analysing the entire design of the game. Strategising and reverse-engineering the games is as rewarding as winning them. Game theory is the ultimate science and the beginning of it all.

‘Game’ is nothing but the interaction between multiple players in which each player’s pay-off (event of winning or losing) is affected by the decision made by other players. So, while competing with others, it only makes sense to choose a course of action that benefits you the most, regardless of what the other players’ decisions are. Even better, if you can proliferate your success rate through their moves.

But Game theory is not about winning or losing alone. Take a step back and  analyse your routine: People you talk to, the items on your to-do list, the way you plan your day, your regular reactions to a pattern of situations. All these are attributed to feeding your ‘feel-good’ hormone. There are many names to it: the dopamine effect, happiness quotient, etc. I usually call mine a Happiness project.

It is a project because I design my day the way I react to situations, the way I respond to people, the goals I want to complete or succeed at. In a larger picture, I am playing a game with an ulterior motive to stay happy and content. Success here is directly equated to happiness. 

In financial markets, you invest to make money. The companies capitalise on your money to manufacture and supply the products. If the product is a success, there is a demand created to facilitate supply. If one or more things are unique about the business, they have competitive advantage over that. If the competitive advantage period is extended (longer the durability of business, larger the gains), the growth slowdown is delayed. The entrepreneurs then know that their business is here for the long haul. More on this is explained in our article on economic moat.

In the context of games, you have a motive to play, which is usually different from others. You ought to play your hand when it’s your turn. We are all Market participants as far as we are buying, selling, creating, distributing or exchanging something. But it takes active participation and contribution to master any game. Most of the times, it is the amount of contribution that determines the level of success for a player. Gauging individual contribution against other players’ gives ‘Marginal contribution’. 

For example, If you subscribe and receive an allotment of 100 units for a fully subscribed IPO whose lot size is 100,000, your marginal contribution is 100. If the shares are further listed at premium, you receive ‘reward’ amongst other investors based on your marginal contribution (initial investment). Dummy players who didn’t participate in the IPO receive no reward. And investors who subscribed for the same lot size (100) receive a value that is the same as yours. This is what Shapley’s value is all about.

Shapley’s value is a type of co-operative game based on coalition where every player is rewarded based on their contribution and there are hardly any conflicts of interest because everyone has a vested interest in not going home empty-handed. This is a type of game where nobody has an incentive to deviate from their course of action based on other players’ decisions as they receive payments or shares proportional to their marginal contribution.

Game theory is explained based on the motives of players. Cooperative and Non-cooperative are the two major kinds. Some brilliant strategies are further classified under these topics. Nash equilibrium is a classic example of non-cooperative games as Shapley’s value is to Cooperative games.

John Nash is one of the pioneers in the study of Game theory where he explains the true competitive nature of games. A player is said to have arrived at Nash equilibrium when they make a choice that is superior to what others decide because all they want is to compete and win.  Nash equilibrium’s basic idea of competitive social interactions where there are definite winners and losers is explained through the experiment called ‘Prisoner’s Dilemma’.

In Prisoner’s Dilemma, Laura and Paola are caught for having done a criminal act and the cops investigate one another in isolation. Neither Laura nor Paola committed any crime and they don’t know anything about one another. But they are going to jail for two years no matter what. However, if one confesses about another, the one who confessed is let free for cooperating and the other goes to jail for 10 years. If both of them testifies against one another, then both go to jail for 5 years. And if neither cooperates to testify against another, they both serve two years. In a situation like this, no best response is ideal for either of them. 

Such a situation is termed as being at Pareto optimality. Both of them will likely be serving prison and it is only a matter of how many years. Pareto optimality is such a state where no-one person or scenario can win without the other having to lose. It is a definite scenario of winning and losing.

When you go long on a stock anticipating that the value of the stock will increase, someone else will short the stock, strongly predicting a fall in the future so they can buy it at a lower price. In the end, only one ends up making money at that future point in time. The one who makes returns on their investment is at Pareto optimality in comparison to the other.

Simply put, Game theory teaches you to be smart in a competitive situation and to be fair in a cooperative situation.

Various factors determine the game structures like, equilibrium notion, availability of information, player moves and their timing, expected utility function, motives of the game, etc., that helps in determining the game strategy and it’s paradoxical properties. More on games, strategies and successful players in the market will be explained in the upcoming articles.

Here’s a short narrative on the nature of Game theory explained by Simon Sinek to get you started well on this topic:

4 Responses

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  2. whoah this blog is wonderful i really like reading your articles. Keep up the great paintings! You realize, a lot of people are hunting round for this info, you could help them greatly.

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