What is Zero-Sum Game?
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Zero-sum is a situation, often cited in game theory, in which one person’s gain is equivalent to another’s loss, so the net change in wealth or benefit is zero. A zero-sum game may have as few as two players or as many as millions of participants.In financial markets, options and futures are examples of zero-sum games, excluding transaction costs. For every person who gains on a contract, there is a counter-party who loses.
Definition
A zero-sum game refers to a situation, often cited in game theory, where one person's gain is equivalent to another's loss, resulting in a net change of zero in wealth or benefit. Zero-sum games can involve two participants or millions. In financial markets, options and futures are examples of zero-sum games, excluding transaction costs. For every person who profits from a contract, there is a counterparty who incurs a loss.
Origin
The concept of a zero-sum game originates from game theory, a mathematical discipline that studies strategic decision-making. Game theory was developed by John von Neumann and Oskar Morgenstern in the 1940s, who systematically introduced the concept in their 1944 book, "Theory of Games and Economic Behavior."
Categories and Features
Zero-sum games can be divided into two categories: complete information zero-sum games and incomplete information zero-sum games. In complete information zero-sum games, all participants are aware of all the information and rules of the game; whereas in incomplete information zero-sum games, participants may lack full information about other participants' strategies or the rules of the game. A notable feature of zero-sum games is the adversarial nature between participants, often used to describe competitive markets or adversarial negotiations.
Case Studies
A typical example of a zero-sum game is the futures market. For instance, in a wheat futures contract, if one investor profits from the contract, another investor must incur a loss on the same contract. Another example is currency pair trading in the forex market, where if one trader profits on the EUR/USD pair, another trader will incur a corresponding loss.
Common Issues
Investors often misunderstand the scope of zero-sum games when applying the concept. A common misconception is that all financial transactions are zero-sum games, whereas many financial market transactions are non-zero-sum because they can create value or wealth. Another issue is overlooking transaction costs, which can affect the net outcome of a zero-sum game.
