How game theory can be applied to personal finance – Free Malaysia Today

If you can predict your opponent’s moves, your chances of success improve dramatically. This applies to gaming as well as business and finance. (Envato Elements pic)

Game theory was coined in 1944 to describe a mathematical theory defining the strategy of game participants, and the recognition that actions impact all game participants, for better or worse.

In economics, game theory is used to make precise decisions based on logic and reasoning, measuring certain aspects – for instance, how much money you stand to lose or gain in a particular financial endeavour.

An oil cartel engaging in price-fixing and competitive espionage exemplifies how economists employ game theory. By predicting the cartel’s possible moves, companies or countries can formulate multiple strategies based on scenarios, and make proactive decisions to reduce negative impact or even completely reverse the outcome in their favour.

By applying game theory skills and analysis to business decisions and the economy, corporations can obtain a financial advantage. It can also apply to personal financial planning and be used for managing your cash flow or improving your investment practices.

What is game theory, exactly?

Game theory can be used to effectively predict social situations among competing players. Simply put, it’s the science of strategy.

The most well-known example of game theory is The Prisoner’s Dilemma. Consider the case of two crooks who have been apprehended. Prosecutors are unable to press charges on either due to a lack of hard evidence.

Investigators isolate them into different rooms and question them individually in the hope of obtaining a confession. With neither inmate able to speak with the other, investigators offer four deals:

  • If they both confess, they will receive five years in prison.
  • If crook 1 confesses but crook 2 does not, crook 1 will receive three years and crook 2 will receive nine.
  • If crook 2 confesses but crook 1 does not, crook 1 will receive 10 years and crook 2 will receive two.
  • If neither confesses, they will each be sentenced to only two years in prison.

The Prisoner’s Dilemma is a well-known example of game theory. (Envato Elements pic)

The best tactic is for both to avoid confessing. However, neither party is aware of the other’s decision, and without a guarantee that the other will not confess, both are likely to own up and serve a five-year term.

“Nash equilibrium” is a concept within game theory where each player has nothing to gain if they change strategies based on the decisions of the other player. In a prisoner’s dilemma, the Nash equilibrium predicts both parties …….


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