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Using game theory to make sensible decisions in the world of Finance

The game of dollar bill auction was invented by notable game theorist Martin Shubik and explains how a lot of financial decisions today make sense or in some cases do not make sense. Here is how the dollar bill auction works: All the players concerned agree to auction a dollar bill and the bidding takes place in increments of one cent. The auctioned dollar goes to the highest bidder but the second highest bidder has to pay as well, thereby increasing the inherent risks for the highest bidders. As you would have figured out by now, this game continues till as long as the bidders’ resources have been exhausted and the natural tendency for each of the two highest bidders is to continue with the bidding in anticipation of a win and thereby big profits. The second highest bidder in this game, however, incurs huge losses, which he could have possibly averted.

The game’s essence is to show how it might be a better idea to offer a small amount to avoid larger losses. It is for this reason that it makes sense to agree to help bail out Greece in its economic crisis than to risk the breakdown of the entire European economic integration. It is also for this reason that it might be a better decision for industrial firms to meet the demands of the strikers in its work force than to withstand the large losses due to factory shut downs. Air India, India’s premium Airlines carrier, incurred huge losses because they refused to meet the demands of its on-strike pilots. In the financial world, it would have been a better idea to bear the costs of rescuing Lehman rather than risking the collapse of the global financial system.

But here’s the drawback to this game: The underbidder always comes back to bite you again, but it is a trade-off. It still makes sense to be the smaller loser than being persistent and ending up as the bigger loser. This is why Shubik presented this game as a problem to which game theory had no solution. Something to think about..

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