Game Theory, From Academic Research To The Academy Awards

The recent success of the Oscar-winning Hollywood movie, “A Beautiful Mind,” has made game theory extremely popular, even outside the academic and the business community. The movie is about the controversial life of one of game theory’s pioneers, John Forbes Nash who gave an enormous contribution to the theory, introducing, in his Ph.D. thesis for Princeton in 1949, the concept of Nash Equilibrium. This is the position in which no player, participating in a non-cooperative game, can benefit by changing strategy if all the other players don’t change their strategies as well and this position translates into a stable equilibrium.

This simple concept, of which Nash gave a detailed mathematical description, boosted the subsequent development of game theory and has been applied in an amazing range of different fields, from business to intelligence and even biology.

However, in an article on the Financial Times of March 26, the author, Simon London, relates a study conducted by Kesten Green, a researcher at the Victoria University of Wellington, New Zealand, which questions the applicability of game theory to predict the outcomes of real life situations. The point of Green’s research is that a person equipped with a sound theoretical knowledge of game theory is not able to predict the outcome of a real life situation better than a person who applies simple common sense. The reason for this is that real life is too complex to be able to perfectly apply game theory concepts, even though their theoretical base is perfectly proven.

Every business school student has applied game theory at least once in a Strategy class, and in many business schools, there is an elective course based on game theory. HBS is no exception in this regard; we apply some ideas from game theory in the RC C&S class and, among the EC classes, we have “Changing the Game,” which deals with game theory concepts. So are the major business schools teaching something which is not applicable in real life?

My answer is no. As a consultant at McKinsey, I have applied game theory in a project about regulatory issues. Based on my experience, I agree with Simon London when he says that the great value of game theory is not in its mathematical application to predict the outcome of a situation. The real value is in making managers think about complex situations from different points of view.

I know the analogy can be considered stretched but I believe game theory can be used in a similar way as another popular mathematical model, the real option valuation. We study the basic concepts of real option valuation in many finance classes at HBS and this year, for the first time, it is possible to take an EC class, “Corporate Financial

Flexibility,” which is completely based on the study of Real Options and it is taught by one of the pioneers of this theory, Prof. Copeland.

Game theory and real options are mathematical models, which may become unmanageably complex if we want to apply them to real life situations. On the other hand, just keeping the underlying concepts in mind can provide a manager with great insights about the behavior of competitors, in the case of game theory or about the value of an asset, in the case of real options.

Much research is still being conducted on game theory and its applications to business and other problems and, even though, like many other mathematical or quasi-mathematical theories, game theory has its drawbacks when applied to real life, we cannot confine it to the field of pure speculation. This popular theory, which has earned Nash a Nobel Prize and Robert Altman an Academy Award, can also help many managers make better-informed business decisions.

April 22, 2002
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