228. Game Theory: Behavioral Economics Foundations (Refreshed Episode)

Welcome to episode 228 of the Brainy Business Understanding the Psychology of why People Buy Today's episode is all about game theory. Ready? Let's get started.

You are listening to the Brainy Business Podcast where we dig into the psychology of why people buy and help you incorporate behavioral economics into your business, making it more brain friendly. Now, here's your host, Melina Palmer. Hello.

Hello everyone. My name is Melina Palmer and I want to welcome you to the Brainy Business Podcast. Today's episode is all about the fascinating world of game theory. This episode originally aired August 23, 2019 and was number 62 of the podcast. There are a couple of reasons I've selected this to be our refreshed episode this week. For one, with last Friday's episode featuring Annie Duke talking about her new book, quit, you can't think about Annie without thinking about poker, and game theory is so related to that. One of my favorite insights from game theory, which you'll hear me talk about more during the episode, particularly toward the end, is the difference between playing to win and playing not to lose. As you'll hear today, these two things may seem similar, but they're actually very different. And as you reflect upon the episode today, whether it's your first time or something you're revisiting, consider your own life and work. And let's build upon the lessons from Friday's episode with Annie about quitting and how winners need to quit in order to win versus our skewed perspective that winners never quit, which is flat wrong. You just need to know when to be gritty and when to quit. So as you are approaching the episode, look at something you've been struggling with recently, maybe something you've been trying to side if it's worth sticking with or not. And ask yourself first, what game are you playing? Don't look at the hand you've been dealt in the long term. What game do you want to be playing? Where do you want to end up now to this point? Have you been playing to win or playing not to lose? How has that been serving you? What do you need to change moving forward? Where are you hurting yourself despite others and letting maybe emotions get the best of you in the moment? Is it time to quit? What will quitting free you up to do? And don't worry, I will definitely tell you the difference between playing to win and playing not to lose. You just have to hang out and listen to know what that means. But keep it in mind as you go. In case you haven't yet listened to Annie's episode 227. You don't have to listen to it before this one, though you can if you want. There's a link for it and many other past episodes and related books and articles within the show. Notes for the episode, which are waiting for you in the app you're listening to. And@the brainybusiness.com 228. There's also a free worksheet on game Theory to help you take notes as you listen. All right, with that, let's jump into the episode and learn all about game theory. You may have heard the title for this episode and thought, sure, I like to play games, but what does that have to do with business? A lot, as it turns out, and I'm going to get into all that with you in today's episode. If you've been listening to the podcast for a while, you probably know that humans aren't rational. And honestly, you probably know that just from being a human person too. And the base of economic theory would often incorrectly predict behavior because it assumes logical people making rational choices. Because humans do not behave this way in practice, new theories needed to be developed which accounted for these irrational choices. And in game theory, it's exactly the same as with behavioral economics. We humans don't always make choices that are fully rational. We try to game the system or play the odds and choose routes that are not in our best interest, especially when we think someone may be treating us unfairly. I'm very late to the party, I know, but I have just recently started watching Downton Abbey and I am totally hooked. I'm enthralled by the interactions and how one person's choice to say a few words to the right person can have a ripple effect that impacts the entire house and beyond. Sometimes they regret the actions and sometimes they hurt themselves to prove a point. This entire show is truly game theory in action. If you haven't watched it yet and like this sort of interaction, it's worth some binge time. Another show that's a great example of game theory is Survivor. You can see the thought process and how people act when they only have part of the story. You, as the observer have all the information. So you may be screaming at your television that they should not do or say something, but if you were in their shoes, would you have done the same thing? How often are you making choices based on game theory in your life and business without even realizing it? A lot, as it turns out. In behavioral game theory, we need to consider how revenge, fairness and personal gain all play into the outcomes in the episode. I'm going to tell you about three main games that are often used in game the Ultimatum game, the Prisoner's Dilemma, and the Dictator game. We're going to start with the Dictator game. As will be the case in each of these games, there are two people playing the game. In the Dictator game, they do not know each other and will never encounter one another. They are randomly assigned a role where one person is given some money or bonus points or something of value and told they have a choice for how much they want to keep and how much to give to their partner. Remember, they will never meet that person and don't have to give anything or keep anything. Let's say the dictator was given $10 and then told they have the option to decide how much to keep for themselves and how much to give to their partner. They could keep the full $10 for themselves. Since they'll never meet this person and give them nothing, they could give away all of it and keep nothing. They could go with fairness, keeping five and giving away the other five or some other random split. What would you do? What do you think most people do? In purely rational economic terms, it's best to keep the full $10 for yourself. There's no consequence for keeping it. No one will know, so why give any away? In reality, people would give away an average of $3, keeping seven for themselves. When I said that, did you think, wow, people are really generous giving away $3. They didn't have to. Or did you think, gee, people are so selfish that they didn't give half? They could have just as easily been randomly assigned to be the recipient than the chooser. And how does this line up with what you said or thought you would do? Also, now that you've thought about what you think you would do, how might the situation change your choices? Let's say in one scenario you're behind a partition where no one can see you and you have two envelopes, one for you to keep and one to seal and give to the moderator to give to the other participant. How would this change your behavior? Or if you have to hand back physical cash to the moderator to give to the next person, or write it down with an explanation of your choice. How does the scenario and your perceived guilt or social fear impact your decision? Think about tipping in a restaurant. Do you tip more when you have to hand the money to someone? Does the amount you tip change when you're writing it onto the line in a folder you can close versus when you're using an electronic system where it feels like others can see see you tap the percentage you want or press the big red X that says no tip. This is game theory in action as well. You're playing the odds of being seen or feeling guilty or whether or not that person will resent you. And whether or not you see each other or will see them again plays a big part in your behavior. So what about our next game? This is called the ultimatum game and it's very similar to the dictator game with one important difference. There are still two people. One is still given $10 and selecting how much each person gets. But the other person, the responder, has the option to respond to the offer in this situation. So if the first person is given $10 and says they want to keep 9 for themselves and give the responder only $1, that person can either accept the dollar and be glad to have more than they would have if not playing the game, or they can reject it and in that case they both get nothing. As the one proposing how much to give and keep, you might want to play the odds. Give something, but not more than you have to so you can win as much as possible. How do you think the responder will feel about that? And how does the expectation change the way the person feels about the offer? Lets think back to the average in the dictator game and how you felt when hearing that people would keep seven and give three away. You may have thought that was generous in the first game, but if that same offer was made in the ultimatum game, how many responders would accept? And how many would punish their partner for being greedy and trying to keep an extra $2? What would you do? Would your behavior change if you were partnered against a stranger or your best friend or your ultimate frenemy or your bully from high school? What if you were partnered against a computer? History has a lot to play in. The actions people take and existing relationships help determine actions. You have to put trust in the other person that they will play nice in many cases and in others you may be likely to reject anything offered to punish the other person, even though you're effectively punishing yourself. Also think about how your behavior would change if you were playing once versus playing 10 times in a row. If you were offered $3 repeatedly, would you ever retaliate and reject an offer to encourage your partner to play more fairly? What if you had to look them in the eyes when you made the offer and or choose to accept or reject? What if you never saw their reaction? The human component knowing you're playing against a person who is profiting from your situation has a big impact on the way people respond when told they're playing against a computer. People are more likely to forgive and be more rational accepting any offer they're given than if they think they're playing against another person, and they're less likely to hold a grudge through the rest of the game or after. Some people still get frustrated and retaliate against the computer, but for the most part you figure it's better to get something than nothing. When you don't think your partner is a person trying to take advantage of you and your good nature, as with the first game, what do you think you would do if you were making the offers? How would you try to win? Or would it be all about fairness? Think about how the anchor shifts when you have power versus when you don't. And I have linked to the episode on anchoring and adjustment in the show notes in the world where you have no power, you have the anchor of not expecting any of the $10. So anything is likely to be felt as a kind and generous gesture. In the flip when you have power, even though they have the full $10 to start with, you come from a point of fairness, $5 each, so the starting anchor is completely different. This is so evident in business negotiations, and it's important to understand who has what power in each situation when you determine what to offer and think about how they might react. If you remember back to episode seven on Change Management, I talked about how even when money is not changing hands, the process of buying and selling is exactly the same as when there's money moving back and forth. You are trying to sell someone in buying in on whatever you're offering them. There might be other things that are bartered that are of value, like time, honor, integrity, and a feeling of fairness. And the way people react will change based on the power they have or believe they have. This is worth considering as you put offers out to people and you're wondering how they may respond or act, are you putting power in their hands that makes a generous offer seem stingy? How could you reframe or change the context so it feels the way you want it to? And if you've ever been shown an offer and had a gut reaction that it seemed amazing or like they're trying to take advantage of you? Try to tweak the variables a bit in the future, considering how you would feel if the Ultimatum game became the dictator game or vice versa for that specific situation in your business, you aren't limited to the lab style test. Your clients know who you are and what you're offering them so you can make an extra gesture like I talked about in the episode on Surprise and Delight to make a big impact. For example, in either game, did you consider offering more than half of the money? You can of course do that at any time. And as the responder, would you ever expect the other person to offer more than half? Would you be surprised and delighted and very likely to say yes if they do? What if that was the first offer they made and then they changed it up? So if I offered to give you $8 in the first round and then I did fives or giving you only four in a future round, did I get some extra favor from being very generous in the first offer versus trying to add that in later on? That first interaction lays a foundation for what people expect and how they feel about you in all of your future interactions. So if you lead with something really selfish, they will always consider you to be selfish or it'll be really difficult to turn it around. Whereas if you start in a more generous way and they're surprised, they would be less likely to think of you as selfish in any of your subsequent offers. Of course, reciprocity plays a big part in this if you give people something they want to give back to you. But as you can see and know from your own experience, when people feel like they might be being taken advantage of, they may rather burn the house down than let you have a place to live. As I'll talk about later in the episode, you shouldn't let people walk all over you or always give more than you keep. But it's important to understand all the options and variables before taking an action or making an offer. Our last game is called the Prisoner's Dilemma. If you've ever watched any sort of cop or legal drama, you likely know this scenario. Two criminals have been arrested for a petty theft. The cops are pretty sure they're part of a much bigger crime, but they don't have enough evidence for that conviction. They would need one or both of the criminals to confess to get the bigger conviction. Let's say both people are facing a one year sentence if they choose to cooperate with each other and not give the other away for the larger crime. If one turns on the other, he will get off with no jail time and the other will serve three years. Conversely, the other is given the same deal and if they both confess and turn the other one in, they both get a two year sentence. Alright, let's break it down. As a group, they're better to both not say anything and take the one year sentences for the petty theft. However, if they look at their individual personal gain or potential loss, they're of course better off with no prison time than one year motivating them to say something, especially if the other person talks. They are of course separated into different rooms so they don't know what the other one is doing. If your partner talks and you stay quiet, you look like a fool and have triple the sentence. Again, can you see how the shifting anchor impacts the position someone is likely to take? So saying something may feel like a win win. You're hoping they will keep quiet so you get off scot free. But if they do say something, you at least have less than the three years you would have had if you said nothing. And in this case, you may never even consider saying nothing if you don't trust them to do the same. Assuming you don't have the option to consult an attorney, what would you do in this situation? Similarly, how would your behavior change if it was a one time game versus playing 20 times in a row? And what if you think you're playing 20 times but the person you're playing with believes it's a one time thing or they know it's their last time? As in an actual prisoner's Dilemma, if you suspect them of wanting to leave the game, do you act differently? I've linked to some videos that explain each of the games, but there's a very interesting one on the extended Prisoner's Dilemma, which uncovered the best strategy when playing 200 or so rounds against someone. In that case, you get points for every round. If you both cooperate, you each get three points. If you defect and they cooperate, you get five points and they get zero and vice versa. If you both defect, you each get one point. If there are 10 rounds and you both cooperate every time, you get 30 points each. But what if you play the odds and defect once or twice? Depending on who you're playing against, you may get a few extra points and be more likely to win. But if they hold a grudge and continue to punish you, the sort of fool me once strategy, then you may both end up with less total points than if you had merely cooperated. Many strategies were suggested for this test and they were all played against each other for 200 rounds to determine which was best. As it turns out, a tit for tat strategy consistently did best overall. In this way you cooperate until someone defects, in which case you respond in kind. If they decide to cooperate the next time after their punishment, then you do too. You don't hold a grudge longer than one round, but show that you aren't going to be taken advantage of either. Blind cooperation leads to being walked all over and lots of rounds of getting no points. Continually defecting may get five points here and there, but you likely end up with quite a few one point rounds, which is what happens if you both choose to defect. Again, a quick response and a short memory tit for tat was the best strategy. They also get into a modified version which was more successful some of the time, but I won't get into that here because we are more about the general idea than the specifics and the mathematics of it all. As I said, there are links for you in the show notes and they're all pretty interesting little videos of less than five minutes apiece with some really helpful illustrations of the concepts. I mentioned a few practical applications for game theory earlier on in the episode, and you likely see lots of other places where this would apply to your life and business already. I mean, if this doesn't make it obvious why they call it the game of life, I don't know what else would. In most real life scenarios, most of us would likely choose to play fair until given a reason not to. But we all know that person that you wouldn't trust to play fair no matter what. And while you know your policy would be to play fair, usually do you expect this same kindness and fairness in others? And how does your expectation change the way you actually play versus what you think you would do or hope you would do? How does the story you tell yourself about what you think they will do influence your actions before they've had a chance to play around? How much would your strategy be influenced by the look of the other person? What stereotypes are in your mind that would make you think someone would be more likely to cooperate, or would make you more likely to want to cooperate with them than not. I've linked back to the episodes on biases toward novelty and stories and our biases toward others. In case you want a refresher on just how quickly our brains lean on these biases. And how much more angry would you be if someone went against a stereotype in your brain? Say someone who looked like your grandmother who was always incredibly generous, if they decided to play aggressively and swipe to all your winnings? As much as we may wish it would be, dealing with other people is never black and white. There's so much gray impacting every situation and decision and game theory applies in all sorts of business situations. Obviously this applies in negotiations with potential partners. What do you give away in hopes they will give back? How do you behave differently on the first time around than on the 10th? How much does a relationship influence your actions and make you think that verbal agreements are enough because you're starting the business with your brother, mother, sister, best friend, significant other, only to have them go back on their word later on? How much more does it hurt when they betray you instead of a faceless corporation? When do you blame them and hold a grudge even if it hurts you too, instead of letting it go and moving on? Humans are emotional and it's not just in the after the fact stuff. The thoughts and what ifs before a negotiation starts can always influence actions much more than we may think. The best advice I can give in negotiations is to always have written contracts and agreements document to avoid getting burned, sure, but also to ensure clarity. You may think you're speaking the same language and that you know where they're coming from, but the stories in your head and theirs can unintentionally create a situation where you're setting everything up for failure. Making sure you're on the same page and negotiating terms in a cold state is so much better than not doing the due diligence and having contracts signed and agreed to in advance. And it can keep you from having to play some of these games where you're set up to lose. One other example of how this impacts business is in advertising. Let's say you're in a small town and selling apples. There are only two apple sellers in town and your items are basically identical. If there are 100 people in town and neither of you advertise, you will each sell 50 apples. If you make $2 per apple sale, then you each make $100. If one of you chooses to advertise, it will cost that person $30, but the advertiser will now end up having 80 of the hundred people buy from them, leaving the unadvertising competitor to only 20 customers. They will then make $40 since they still don't have advertising costs and you make $130 since you have the expense of advertising. So you're better off if you advertise and they don't. But if you both decide to advertise, then you both still end up with half of the customers buying from you. But Instead of making $100 each, you only make $70 since you now have an advertising expense. If you and your competitor could Trust each other to not advertise, then you would both be better off. But do you really trust them? Should they trust you? This is business, after all. It's not personal, and there's a chance you could win big. What if you got all the customers and then you wouldn't have to advertise at all? In the real world, we're too far down the line to not advertise in some fashion. There's so much out there that you need to break through the clutter, and you likely don't know many of your competitors to make this sort of deal with them. But how does your strategy change throughout the game? There are countless examples of game theory. It's truly around us all the time. Pretty much anytime you interact with another person or business or entity, game theory comes into play. We play the odds whether we realize it or not. When a boss is out on vacation, how do their employees behave the same or differently? If someone has a strict supervisor who's constantly micromanaging, they their employee may slack off and choose to take long lunches if their supervisor isn't there to see it. Betting on the odds that it won't come back to bite them later. Think of the way you drive when you see a cop behind you and when you don't. They might still be there or ahead of you with a scanner, but you're playing the odds and choosing how to act based on what you think will happen. If you were betting on when to invest in the housing market after a recession, trying to time it perfectly so you buy in at the absolute bottom, that is game theory in action. Or betting on a hashtag to use, or what software to buy or what social channel to invest your time in. It's all based on what you expect other people will do and how you choose to react to it before and after and after the fact. These choices and actions are all versions of the Prisoner's Dilemma ultimatum game and the dictator game. What about all the businesses that have chosen a buy one, give one model like Tom's or Warby Parker? Why would they advertise it instead of just doing it? Is it because they believe people will buy differently if they have this different story about the company? That customers will play more fairly with the business if they believe it's charitable and generous? Is this giving some power back to the customer that they wouldn't have otherwise? What if they could choose the charity or location for their donation to be made? How would that impact their buying behavior? Now think about this. If you invested your money and bought from a brand and later found out they had bad business practices? How angry would you be? What if that company had earned your business by saying they were donating proceeds to charity and then you found out it was a lie? How much more would you want revenge against them than if it was a company that didn't make those claims? Have you ever been so appalled by service you received or an interaction you went through that you felt the need to complain about it to other people that you wanted to share with as many people as possible to make sure that company paid for what they did? Yelp reviews and Twitter have made it much easier to vent this frustration, and it keeps many people and companies honest. Shifting from the dictator game to the ultimatum game, companies used to be able to take advantage of customers much more if they wanted to. There wasn't an easy mechanism for them to be punished. But now customers can reject your offer and put your dirty laundry out for everyone to see. And often the punishment hurts much more than if you did the right thing in the first place. One of my favorite examples I give when speaking on this concept is a YouTube video called United Breaks Guitars. There is of course a link in the show notes, but the short story is a band was flying on United Airlines to play a show and during a connection they looked out the window to see the agents on the tarmac throwing the guitars instead of handling them with care. They told lots of agents and representatives and didn't get much attention or care. When they landed the guitar was broken a tailor which is about a three thousand dollar guitar and so they asked for the company to pay and replace it but were given the runaround for a year before getting the final response that United refused to pay for the incident or fix the guitar. The guy whose guitar was broken threatened that he would write three songs about the experience and put them on YouTube and not rest until they got a million views. He was laughed off as this was back in 2009 and then he and several friends of his who had also been wronged by United states spent about $100 to make their first video which went viral pretty much immediately. Today the video has nearly 20 million views. He was asked to be on talk shows and they've created a book and he's now a professional speaker in addition to being a singer. United tried to undo the damage after the fact and give him the money for the guitar, but in the too little too late response he he said it wasn't about that anymore and to donate the money to charity instead. Ouch. That is a prime example of a business playing the odds and losing big time in a company. The same tit for tat scenario I talked about already is still usually the best policy. You should go out with kindness and a positive cooperative approach, but still be smart and put things in writing and do your due diligence. If someone wrongs your company, you don't have to take it lying down and be taken advantage of, but have a short memory. Show where the lines are, but don't be spiteful. Don't go out of your way to wreak havoc and seek revenge against others because you're likely hurting yourself in the long run. And don't be the first to defect and make a bad choice against your customers or employees because you may never regain their trust. When emotions take hold, it can cause people to make bad decisions that they may regret in the long run. So try and get some distance and perspective before acting, especially if you feel really betrayed and angry. Consider why you feel that way. Is it because you were close? Because of your expectations? How would you feel different if a computer had made the decision? Again, don't be a pushover, but use this to be empowering. Perspective lets you look at the game in a whole different way and play by the real rules. Think back to that Survivor example I gave you where the viewer knows the whole story and has a completely different expectation than the players themselves. If someone else reacts emotionally, you can know why and expect it and know how to react or perhaps even frame the experience before they ever get to that point. The last thing I want to talk about is this. When it comes to games, many people are playing not to lose instead of playing to win. These may sound the same or similar, but they're really not. I want you to think about how they differ. Playing not to lose can mean hedging your bets and taking risks at the wrong times simply to avoid being taken advantage of or made to look a fool. When you play to win in games, life or business, you have a calmer approach. You understand the rules backward and forward. You consider what each choice you make will mean for your opponent and vice versa. Winning is a long game, investing in building a solid reputation and understanding how each decision plays to the end result. Playing not to lose is shortsighted, reactive and emotional, and it's equivalent to building a house of cards that could tumble at any moment. It's not worth the stress and anxiety to have it all crash down for not understanding the real game. With any luck, this episode has helped you to understand some of the games we play and how irrational reactions and emotions the life beyond economics impact the way the games in all their forms can impact your life and business. So what did you think of Game Theory? What got your brain buzzing during today's episode? Was it the Ultimatum game? The Prisoner's Dilemma? The dictator game? The difference between playing to win and playing not to lose? Some combination of all of them. Me too. As we wrap up and you go about your day, I want you to think about time pressure that's caused by stress. Yes, there is a whole episode about that on the podcast I'll link to in the show notes and I talk about it a lot in my book what your employees need and can't tell you. When our brains are stressed, we're more likely to revert to the status quo. That subconscious elephant may throw a fit and act in a way that's causing us harm in the long run because it feels better and safer in this one moment right now. Narrowing your priorities so you aren't spread so thin and you can know exactly what's most important to you and what's extra so you can see the longer game when you're presented with options and evaluate them more calmly instead of emotionally can make a huge difference in your outcomes in life. Don't play not to lose, play to win. And as Annie Duke talked about in Friday's episode 226 when we were discussing her book Quit, it isn't that winners quit too. Winners quit. Winners quit a lot of stuff because they know what winning looks like. They know the rules, they know the game, and they can see what's helping them to reach their goals. And what's a hindrance? What's your top takeaway from this episode? Tweet it to me hebrainybiz B I Z. And don't forget to pick up your free worksheet on Game Theory, which is waiting for you in the show notes@thebrainybusiness.com 228 and just like that, episode 228 on game theory is done. Join me Friday for a brand new Behavioral Economics Foundation's episode on Vulnerability Loops. It's it's going to be a lot of fun. You don't want to miss it. Until then, thanks again for listening and learning with me. And remember to be thoughtful.

Thank you for listening to the Brainy Business podcast. Melina offers virtual strategy sessions, workshops and other services to help businesses be more brain friendly. For more free resources, visit thebrainybusiness. Com.