Monday, October 24, 2005

Irrational Games

Thomas Schelling and Robert Aumann were this year's Nobel Prize winners for economics. They shared the prize for their contributions to game theory, with Aumann helping to create the theoretical foundation of the field, and Schelling using the theories to help interaction between nations.

Other than the Peace Prize, it seems that the economics prize always generates the most controversy. Typically, this is driven by a conflict in the political ideologies that support or attack the winner's economic theories. This year, the conflict was no less, but it seemed less political than usual, and more academic in nature. Several articles came out that attacked game theory as a field itself, claiming that it was too idealistic and based on too many assumptions shown to be false in real life. One such article was written by Michael Mandel in Business Week. In it, he asserts:

Instead, the real progress in economics these days is coming not from game theory, which has been around for 60 or more years, but from the much newer fields of behavioral and experimental economics. Behavioral and experimental economics don't start with the assumption of rationality used by game theory. Rather, as the name suggests, the focus is on looking at how individuals and organizations actually make decisions in practice, including systematic biases, misperceptions, and just general all-around bloody-mindedness.

The article basically states that game theory is intricately intertwined with the assumption of fully rational behavior, and that fields such as behavioral and experimental economics are simply incompatible.

With all due respect to the author's PhD (I'm just an MBA student, and not even specializing in economics), but this isn't how I've learned game theory. I have always understood game theory to be more of a framework to determine strategy, based on the analysis from all the players standpoints. It doesn't matter whether the players make rational, utility maximizing choices, or not. What does matter is that you know what drives their choices.

If you can predict other parties' action, no matter the motivation, the framework of game theory can still apply. These choices can be based on truly rational self-interest, on altruistic social conscience, or on the ego of the CEO. In determining these decisions, behavioral and experimental economics are indeed valuable, as they often predict individual behavior better than the standard assumption of purely rational value maximization.

Therefore, the important thing to learn through game theory is not the fundamental assumptions of what drives behavior. Rather, it is more important to learn how to build upon the assumptions to find the correct response to a given situation - in order to maximize whatever drives YOU.