January 12, 2006
Nobel Winner: Game Theory Can Help Market Choices
By Kevin Plumberg
NEW YORK -- Game theory, a science of solving conflicts based on individuals choosing the best outcome for themselves, may offer everyone from the hard-bitten day trader to a corporate chief executive a framework for making tough decisions.
Robert Aumann, co-winner of the 2005 Nobel prize in economics for his work in game theory, said the concept has practical applications for everything from auctions of oil leases to resolving geopolitical conflicts.
Aumann's own work on game theory concerns individuals who interact with each other over a long period of time and regularly choose the optimum outcome for themselves.
However, in a discussion with financial reporters during a visit to New York City on Thursday, Aumann was quick to point out the limits of his own knowledge on some topics to which game theory could be applied.
"I don't know anything about markets. I'm sorry," said the soft-spoken 75-year-old German native who now resides in Israel.
Game theory has gained recent popularity, particularly after the movie "A Beautiful Mind," based on the life of John Nash. Actor Russell Crowe portrayed the Princeton University mathematician who, along with two others, won a Nobel prize in 1994 for their work in game theory.
The Wall Street Journal reported on Thursday that some economists are even watching television game shows and applying game theory to find clues on how consumers react to everyday situations.
WAR AND PEACE
Aumann's comments on how game theory accounts for irrational human behavior could be applied to the quick-paced world of finance.
Asked whether game theory accounts for irrationality, Aumann said, "It does, and it doesn't."
Behavioral economics, which views human beings as rational agents trying to make rational decisions, accounts for emotional biases in decision-making more than game theory.
"People do act irrationally, but not as widely as behavioral economics would suggest," said Aumann.
He explained that irrational behavior arises when people are forced to react to events in unfamiliar situations.
Federal Reserve Chairman Alan Greenspan made irrationality a familiar concept in 1996 when he referred to "irrational exuberance" in the stock market. Game theory would explain investors' behavior as a reaction to an unfamiliar situation, in which stock prices continuously rose at an unprecedented pace.
Game theory places individual actors in situations they may encounter on a regular or everyday basis, such as driving to work in the morning, or even participating in an auction.
For example, Aumann said game theory was used to design the process by which the federal government auctioned spectrum licenses for cellular phone companies.
The theory said the highest bidder in an auction should pay the second-highest bid price, rather than the highest price, because it would motivate bidders to bid what they think is the "true" value of the object being auctioned.
In the realm of foreign policy and geopolitical risk, Aumann said game theory also has applications. He has done work in that area, and the title of his Nobel acceptance speech was "War and Peace."
One example of how game theory could help resolve international conflicts, such as between Israel and the Palestinians, is not to make the peace process a "one-shot game," he said.
"Cooperative solutions are more likely in a repetitive situation," said Aumann. "If you want peace now, you may never get it."