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Game Theory in Business: What It Is and How to Apply it in 2020

If you’ve heard of game theory in business and you want to know what it is and how it relates to business, this post is for you.

I graduated from the University of Southern of California in 2014 having studied French and business there.

However, I discovered my interest in game theory as it relates to business years after I graduated.

I don’t have all the answers when it comes to game theory in business.

But I’m excited to share with you what I’ve learned so far.

The Definition of Game Theory

If you’ve searched the web for information about game theory, you’ve probably come across Investopedia’s definition:

Game theory is a theoretical framework for conceiving social situations among competing players. In some respects, game theory is the science of strategy, or at least the optimal decision-making of independent and competing actors in a strategic setting. The key pioneers of game theory were mathematician John von Neumann and economist Oskar Morgenstern in the 1940s. Mathematician John Nash is regarded by many as providing the first significant extension of the von Neumann and Morgenstern work.

Investopedia source linked here

My favorite part of this description is:

“…the science of strategy, or … optimal decision-making of independent and competing actors in a strategic setting.”

This part of the definition indicates game theory’s broad implications.

If you think of life as a strategic setting with independent and competing actors, then game theory has to do with optimal decision making in life.

Games: The Most Practical Part of Game Theory in Business

In the context of business, I believe the types of games in game theory have the greatest practical application.

Maybe this is why game theory’s game types have made their way into common conversation.

To distinguish game types, you will find situations in which the total of gains and losses is:

  • greater than zero in positive-sum games,
  • equal to zero in zero-sum games,
  • and less than zero in negative-sum games.

If you think of wins as +1 point and losses as -1 point, these descriptions may become clearer.

For instance, you could have:

  • both players win in a positive-sum game for a net gain of two,
  • one player win and one player lose in a zero-sum game for a net gain of zero,
  • or both players lose in a negative-sum game for a net loss of two.

Of course, in the real world, you will find greater complexity, more players, and less clear application.

However, these general concepts seem to hold true in practical application.

If the game types of game theory still aren’t clear, don’t worry.

I’ll take a deep dive into zero and positive-sum games (the most common real-world games) in the following sections.

Naval Ravikant on Game Theory and Wealth Creation

Naval Ravikant is the co-founder of AngelList and a prolific technology investor in hundreds of companies including Twitter and Uber.

Some refer to him as The Angel Philosopher because of the deep ideas he shares about angel investing and more.

In a particularly striking tweetstorm, Ravikant shared several thoughts on building wealth and game theory’s implications for this process.

This tweetstorm struck a nerve with thousands who engaged with his content.

So he expanded his tweets into a podcast episode and transcript available here.

You don’t need to listen to Naval’s podcast or read the transcript to find value in this post.

However, I recommend reading it or listening to it if you get a chance.

It’s thought-provoking and particularly relevant if you’re interested in game theory in business.

Ravikant and Zero-Sum Games

Ravikant claims people are in two major pursuits in life:

  • the pursuit (or game) of wealth
  • and the pursuit (or game) of status.

Initially, Ravikant’s use of the word “game” to describe these pursuits surprised me because I thought it downplayed their importance.

However, I now believe he refers to wealth and status pursuits as games to allude to their game theory characteristics.

Ravikant defines status as your rank in the social hierarchy.

He indicates that the pursuit of status is inevitably a zero-sum game according to game theory.

Why?

Because whatever is gained by one is lost by or taken from another.

You may be able to shuffle the order of your rank in the social hierarchy.

But your gain will always come at the expense of another’s loss.

Hunter-gatherers lived in zero-sum, status-based societies with food for some, not food for all.

Politics and sports are modern examples of these same, zero-sum, status games.

In polititcs and sports, someone’s win always comes at the expense of another’s loss.

These arenas are also examples of how players often play zero-sum games with a fixed rule-book they cannot change.

For instance, a basketball player can’t change the rules of basketball, especially not during the game.

He must play out the game according to a rulebook created by a third-party.

This rulebook acts as permission where players have permission to play the game only if according to its rules.

A fixed rulebook defined by those outside the game (permission) often indicates a zero-sum game.

You find zero-sum qualities in businesses providing commodities or products and services with effectively no differentiation.

Dental, legal, and medical practices often find themselves in zero-sum competition.

Why?

Because most dental, legal, and medical teams provide extremely similar commodity-like services.

Of course, this can lead to cutthroat competition between practices.

Each firm must often vie to provide the same services to a fixed local market.

Zero-sum competition in these fields starts before you open for business too.

Consider the path you must typically follow to succeed in dentistry, law, or medicine.

You need credentials (permission) from specific institutions throughout your entire career in these fields.

In fact, you will likely encounter zero-sum competition in many areas of life before you ever enter the business world.

How the Western School System Promotes Zero-Sum Games

University degrees operate today as status symbols, and business schools in particular teach and promote zero-sum games with fixed rulebooks.

Universities base admittance (permission to attend) based on a fixed, albeit not 100% clear, rulebook.

Accepted students likely achieve a certain undergraduate or high school GPA, participate in certain extracurriculars, and more.

Once accepted, students typically experience classes graded “on a curve,” perhaps the most obvious example of formal eduction’s zero-sum qualities.

(All my classes were graded on a curve when I was in the USC business school from 2010 to 2014.)

This means that each student’s score falls within a standard normal bell curve.

A handful of students receive an A, a few more receive an A-, a little bit more receiving a B+… The majority receive a C, a few less receive a C-, and so on. 

In short, you can shuffle your order in the hierarchy of your grade in the course.

But any gain will come at another’s loss.

The zero-sum focus of western eduction compounds in business school where most classes focus on group project work.

Group projects are another opportunity to determine your rank in the social hierarchy.

Comparison and competition happen on both a small scale within the group and a larger scale between groups.

To further excel in the zero-sum game of business school, staff and professors expect students to attend networking events and job fairs.

Group projects and networking are both fundamentally comparative and competitive.

Intense focus on comparison and competition also often indicate zero-sum games.

The Qualities of Zero-Sum Game Winners

I’m more interested in positive than zero-sum games.

But I recognize zero-sum games have immense power in society today.

So it’s worth discussing how to excel in zero-sum games in business.

Thus far, the characteristics I’ve identified common to most modern zero-sum games include:

  • a fixed rulebook (permission from a third-party)
  • intense focus on comparison and competition

Thus, those who thrive in a zero-sum game environment often:

  • have excellent rule-following ability,
  • look good on paper,
  • have strong leadership skills, charisma, and emotional intelligence,
  • and are attractive and competitive.

If this doesn’t sound like you, don’t worry.

It doesn’t sound like me either.

You can still succeed in business without these qualities despite what formal western education might have you believe.

How?

Business success is all about leverage.

And although winning zero-sum games can certainly help you gain business leverage, it’s not the only way.

I’ll address leverage and how to get it in the next sections.

Labor, Capital, Media, and Code Leverage

In the excerpt of Ravikant’s tweetstorm above, he notes that businesses must use some sort of leverage to profit.

Ravikant further defines the different types of leverage businesses can use to profit as:

  • labor – people working for you
  • capital – money working for you
  • media – media working for you
  • code – code working for you

Labor is the oldest type of leverage.

Labor leverage goes back to our hunter-gatherer origins.

In pre-history, more people below you in the social hierarchy increased your odds of survival.

People today are still hard-wired like our prehistoric ancestors.

Thus the rules of labor leverage still exist today.

This is why people typically only work under someone with status (or capital which is often a result of status).

This also seems to be why management positions typically go to MBAs, those who are masters of the zero-sum game of status.

Capital leverage also requires status.

Hedge, mutual, private equity, venture capital, and other fund managers must prove their status to investors.

They prove status with educational pedigree, financial management experience, and more.

How to Win Labor and Capital Leverage By Winning Zero-Sum Status Games

People have built massive fortunes leveraging labor and capital.

They have longer track records of building fortunes than media and especially code.

Thus, the paths to labor and capital leverage are clearer than the paths to code and media leverage.

If you want to leverage labor and have the high salary that often comes with people management,

  • work in consulting at a prestigious firm,
  • get an MBA at a top school,
  • and move on to management from there.

If you want to leverage capital,

  • work in investment banking,
  • get an MBA at a top school,
  • and transition to fund management typically in private or public equity.

Neither of these paths are necessarily easy.

But they are well established as the conventional means of obtaining labor or capital leverage.

The additional benefits of leveraging labor and capital are clear:

  • wealth,
  • and (more) status

The downsides, however, can be significant.

Winning zero-sum games in business requires permission at every turn.

As I mentioned before, zero-sum games often have a fixed rulebook that players do not define and cannot change.

There are also gatekeepers to ensure players play by the rules.

In sports, the gatekeepers are referees.

In business, the gatekeepers are admissions and human resource departments, investors, and more.

The standard path to labor and capital leverage requires permission from gatekeepers to play by the rules at every turn.

You must obtain permission from (or acceptance to):

  • a top a university,
  • a particular degree program,
  • a particular graduate program,
  • a high-status job,
  • certain investors, etc.

Gate-keepers or referees of zero-sum games can stop you from winning without reason.

How many famous sports games’ tides turned and upsets occurred as a result of a wayward call from a referee?

Likewise, if your resume lands on the desk of a potential investor or someone in admissions or human resources having a bad day, they could stop you on the path to labor or capital leverage because of their bad mood.

And if you fail to obtain permission from even one of those links in the chain, you may not ever secure the labor or capital leverage you wanted.

The Pains of Labor Leverage from People Management

If you’re trying to win zero-sum games in business to obtain labor leverage, be careful what you wish for.

Ask almost anyone who has tried to scale a service-providing business, and they will likely tell you it was/is the hardest thing they’ve ever tried.

Why is this?

Scaling labor-intensive processes through people management is spectacularly difficult because human beings are:

  • inconsistent,
  • irrational,
  • emotional,
  • and unpredictable.

Of course, to build a billion-dollar business, you’ll likely need to excel in people management (and zero-sum games).

But do you really want to build a billion-dollar business?

At the extreme opposite of people-management focused companies, there are plenty of solo-entrepreneurs (or solopreneurs) who make a great living.

In fact, Elaine Pofeldt wrote a book on just this subject called The Million Dollar One Person Business.

Tim Ferriss has even referenced this book as the case study version of the Four Hour Work Week.

I’ll discuss this more later.

For now, let’s talk about positive-sum games, my favorite part of game theory.

Positive-Sum Games

According to game theory, the total of gains and losses in a positive-sum game is greater than zero.

I think it’s important to remember that this definition indicates there are still losses in positive-sum games.

It’s just that the gains are greater than the losses.

If zero-sum games determine how to distribute a fixed amount pie, positive-sum games are about how to make the pie bigger.

The internet illustrates well the positive-sum nature of competition possible according to game theory.

Though some businesses shut down because of the internet, could anyone claim it had a net negative on global business?

You can also find many micro examples of positive-sum games within the macro example of the internet.

For instance, mobile app stores have positive-sum characteristics.

They created a new market along with new opportunities to create value.

Some apps inevitably lose out to other apps.

But the app store itself provides a significant net positive of value added and wealth generated in global business.

The internet and mobile app stores also illustrate the creation of something new as characteristic common to positive-sum games.

Peter Thiel on Positive-Sum Games in Business

PayPal co-founder and venture capitalist, Peter Thiel, explores game theory and creating new things in his book, Zero to One.

Going from zero (having nothing) to one (having something) means you create a brand new or effectively new product or service (at least 10x better than its predecessor).

Most companies focus on incremental improvements taking their product from one to two.

But Thiel encourages people and companies to pursue “zero to one” opportunities.

The net positive from creating brand new businesses and value makes the world a better place.

And he believes more entrepreneurs should pursue positive-sum business opportunities that make the world better instead of the current path.

Most high-performing students today get stuck in zero-sum business competition.

They pursue the same management consulting or investment banking jobs with predictably high salaries but low global benefit.

Positive Sum Games and Permissionless Leverage

If you don’t have the skills, personality type, or fortune to win zero-sum games, don’t worry.

You can still win at business by pursuing positive-sum games via the permissionless forms of leverage mentioned by Naval Ravikant.

Code and media leverage require minimal if any success with zero-sum games.

This is why YouTubers who take advantage of media leverage don’t need a particular degree to succeed.

This is also why there are plenty college dropouts or others with minimal status who have created fortunes from code.

Code and media are less exploited forms of leverage because they haven’t been around as long as labor and capital.

Many people don’t understand code and media leverage as well as capital and labor leverage.

Thus, they often credit success in these areas to luck.

Although code and media leverage aren’t well understood, they are the most interesting forms of leverage to me.

Code and Media Leverage Benefits

Today’s most profitable businesses are those in which you sell a fixed amount of work product, say a piece of software or hit recording, millions and millions of times at very low marginal cost.

Seth Klarman, CEO and portfolio manager of The Baupost Group, a hedge fund with $27 billion AUM

Seth Klarman is a hero in the world of high finance because of his investment success.

He also wrote the cult classic book, Margin of Safety.

Klarman has leveraged capital and labor (by winning zero-sum games) to build his wealth.

However, he acknowledges in the quote above that the most profitable businesses leverage code and/or media.

These are the forms of leverage that don’t require winning zero-sum games.

Why is this?

Code and media can be reproduced or consumed at very low marginal costs.

Low marginal costs enable those who leverage code or media to capture more of the value they create in the form of profits.

Thiel points out an example of the economies of scale uniquely available to code-based (and media-based) leverage in Zero to One.

He notes that in 2012, Google’s revenue was $50 billion, and the entire airline industry’s revenue was $160 billion.

But Google kept 21% of those revenues as profits that year, more than 100 times the airline industry’s profit margin.

How?

They leverage superior economies of scale and low marginal cost of code.

Low marginal costs and effective economies of scale enable those who leverage code or media to create highly efficient businesses with great margins.

Excellent margins enable you to create spectacularly profitable (or lean) companies.

In fact, Ravikant notes that the unicorn billion-dollar companies of today use the absolute minimum required amount of labor and capital to fully exploit media and code.

As I mentioned above, you can also choose to leverage code and media to create a super lean, one-man business (and anything in between).

These super lean businesses are the sorts of businesses this website is all about.

How to Apply Game Theory in Business

Ultimately game theory in business is just that, a theory.

Applying theories to the real world can be messy and difficult.

However, I hope this article helps you understand and apply this theory in your own life.

My personal research of game theory in business has enabled me to realize that I don’t thrive in zero-sum games.

But just because I don’t doesn’t mean I can’t be successful in business.

Rather, it means I need leverage media and code and rely less on labor and capital to succeed.

This conclusion is consistent with my skills and desires.

And it’s a big reason why I made this website.

I want readers to know that they can thrive in business without:

  • a fixed rulebook (permission from a third-party)
  • intense focus on comparison and competition
  • labor and
  • capital.

To build a lifestyle business, you don’t need any of these things.

But you may excel in zero-sum games.

If so, labor and capital could be the best forms of leverage for you in business.

What do you think about game theory and how it relates to business?

Let me know in the comments.

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