What is game theory?

Game theory is the formal study of conflict and cooperation. Game theoretic concepts
apply whenever the actions of several agents are interdependent. These agents may be
individuals, groups, firms, or any combination of these. The concepts of game theory
provide a language to formulate, structure, analyze, and understand strategic
scenarios.
OR
Game theory is a branch of applied mathematics that is used in the social science,
most notably in economics, as well as in bilogy, engineering, political science,
international relation, computer science, and philosophy. Game theory attempts to
mathematically capture behavior in strategic situations, in which an individual's
success in making choices depends on the choices of others. While initially developed
to analyze competitions in which one individual does better at another's expense, it
has been expanded to treat a wide class of interactions, which are classified according
to several criteria. Today, game theory is a sort of umbrella or 'unified field' theory
for the rational side of social science, where 'social' is interpreted broadly, to include
human as well as non!human players "computers, animals, plants##
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History and impact of game theory%
The earliest example of a formal game!theoretic analysis is the study of a duopoly by
&ntoine 'ournot in $()(. The mathematician *mile +orel suggested a formal theory
of games in $,-$, which was furthered by the mathematician .ohn von /eumann in
$,-( in a 0theory of parlor games.1 Game theory was established as a field in its own
right after the $,22 publication of the monumental volume Theory of Games and
Economic Behavior by von /eumann and the economist 3skar 4orgenstern. This
book provided much of the basic terminology and problem setup that is still in use
today. 5n $,67, .ohn /ash demonstrated that finite games have always have an
e8uilibrium point, at which all players choose actions which are best for them given
their opponents9 choices. This central concept of noncooperative game theory has
been a focal point of analysis since then. 5n the $,67s and $,:7s, game theory was
broadened theoretically and applied to problems of war and politics. ;ince the $,<7s,
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it has driven a revolution in economic theory. &dditionally, it has found applications
in sociology and psychology, and established links with evolution and biology. Game
theory received special attention in $,,2 with the awarding of the /obel prize in
economics to /ash, .ohn =arsanyi, and >einhard ;elten. &t the end of the $,,7s, a
high!profile application of game theory has been the design of auctions. ?rominent
game theorists have been involved in the design of auctions for allocating rights to the
use of bands of the electromagnetic spectrum to the mobile telecommunications
industry. 4ost of these auctions were designed with the goal of allocating these
resources more efficiently than traditional governmental practices, and additionally
raised billions of dollars in the @nited ;tates and *urope.
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Game theory and information systems%
The internal consistency and mathematical foundations of game theory make it a
prime tool for modeling and designing automated decision!making processes in
interactive environments. Aor example, one might like to have efficient bidding rules
for an auction website, or tamper!proof automated negotiations for purchasing
communication bandwidth. >esearch in these applications of game theory is the topic
of recent conference and Bournal papers "see, for example, +inmore and Culkan,
0&pplying game theory to automated negotiation,1 Netnomics Col. $, $,,,, pages $D
,# but is still in a nascent stage. The automation of strategic choices enhances the need
for these choices to be made efficiently, and to be robust against abuse. Game theory
addresses these re8uirements. &s a mathematical tool for the decision!maker the
strength of game theory is the methodology it provides for structuring and analyzing
problems of strategic choice. The process of formally modeling a situation as a game
re8uires the decision!maker to enumerate explicitly the players and their strategic
options, and to consider their preferences and reactions. The discipline involved in
constructing such a model already has the potential of providing the decision!maker
with a clearer and broader view of the situation. This is a 0prescriptive1 application of
game theory, with the goal of improved strategic decision making. With this
perspective in mind, this article explains basic principles of game theory, as an
introduction to an interested reader without a background in economics.
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Definitions of games%
The obBect of study in game theory is the game, which is a formal model of an
interactive situation. 5t typically involves several playersE a game with only one player
is usually called a decision problem. The formal definition lays out the players, their
preferences, their information, the strategic actions available to them, and how these
influence the outcome. Games can be described formally at various levels of detail. &
coalitional "or cooperative# game is a high!level description, specifying only what
payoffs each potential group, or coalition, can obtain by the cooperation of its
members. What is not made explicit is the process by which the coalition forms. &s an
example, the players may be several parties in parliament. *ach party has a different
strength, based upon the number of seats occupied by party members. The game
describes which coalitions of parties can form a maBority, but does not delineate, for
example, the negotiation process through which an agreement to vote en bloc is
achieved. Cooperative game theory investigates such coalitional games with respect
to the relative amounts of power held by various players, or how a successful coalition
should divide its proceeds. This is most naturally applied to situations arising in
political science or international relations, where concepts like power are most
important. Aor example, /ash proposed a solution for the division of gains from
agreement in a bargaining problem which depends solely on the relative strengths of
the two parties9 bargaining position. The amount of power a side has is determined by
the usually inefficient outcome that results when negotiations break down. /ash9s
model fits within the cooperative framework in that it does not delineate a specific
timeline of offers and counteroffers, but rather focuses solely on the outcome of the
bargaining process. 5n contrast, noncooperative game theory is concerned with the
analysis of strategic choices. The paradigm of noncooperative game theory is that the
details of the ordering and timing of players9 choices are crucial to determining the
outcome of a game. 5n contrast to /ash9s cooperative model, a noncooperative model
of bargaining would posit a specific process in which it is prespecified who gets to
make an offer at a given time. The term 0noncooperative1 means this branch of game
theory explicitly models the process of players making choices out of their own
interest. 'ooperation can, and often does, arise in noncooperative models of games,
when players find it in their own best interests. +ranches of game theory also differ in
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their assumptions. & central assumption in many variants of game theory is that the
players are rational. & rational player is one who always chooses an action which
gives the outcome he most prefers, given what he expects his opponents to do. The
goal of game!theoretic analysis in these branches, then, is to predict how the game
will be played by rational players, or, relatedly, to give advice on how best to play the
game against opponents who are rational. This rationality assumption can be relaxed,
and the resulting models have been more recently applied to the analysis of observed
behavior "see Fagel and >oth, eds., Handbook of Experimental Economics, ?rinceton
@niv. ?ress, $,,<#. This kind of game theory can be viewed as more 0descriptive1
than the prescriptive approach taken here. This article focuses principally on
noncooperative game theory with rational players. 5n addition to providing an
important baseline case in economic theory, this case is designed so that it gives good
advice to the decision!maker, even when D or perhaps especially when D one9s
opponents also employ it.
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Strategic and extensive form games%
The strategic form "also called normal form# is the basic type of game studied in
noncooperative game theory. & game in strategic form lists each player9s strategies,
and the outcomes that result from each possible combination of choices. &n outcome
is represented by a separate payoff for each player, which is a number "also called
utility# that measures how much the player likes the outcome. The extensive form, also
called a game tree, is more detailed than the strategic form of a game. 5t is a complete
description of how the game is played over time. This includes the order in which
players take actions, the information that players have at the time they must take those
actions, and the times at which any uncertainty in the situation is resolved. & game in
extensive form may be analyzed directly, or can be converted into an e8uivalent
strategic form. *xamples in the following sections will illustrate in detail the
interpretation and analysis of games in strategic and extensive form.
Dominance%
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Binmore, Ken (1991), Fun and Games: A Text on Game Theory. D. C. Heath,
exin!ton,
"A.
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;ince all players are assumed to be rational, they make choices which result in the
outcome they prefer most, given what their opponents do. 5n the extreme case, a
player may have two strategies A and B so that, given any combination of strategies of
the other players, the outcome resulting from A is better than the outcome resulting
from B. Then strategy A is said to dominate strategy B. & rational player will never
choose to play a dominated strategy. 5n some games, examination of which strategies
are dominated results in the conclusion that rational players could only ever choose
one of their strategies.
The following examples illustrate this idea
Nash equilirium!
5n the previous examples, consideration of dominating strategies alone yielded precise
advice to the players on how to play the game. 5n many games, however, there are no
dominated strategies, and so these considerations are not enough to rule out any
outcomes or to provide more specific advice on how to play the game. The central
concept of Nash euilibrium is much more general. & /ash e8uilibrium recommends
a strategy to each player that the player cannot improve upon unilaterally, that is,
given that the other players follow the recommendation. ;ince the other players are
also rational, it is reasonable for each player to expect his opponents to follow the
recommendation as well.
"ixed strategies%
& game in strategic form does not always have a /ash e8uilibrium in which each
player deterministically chooses one of his strategies. =owever, players may instead
randomly select from among these pure strategies with certain probabilities.
>andomizing one9s own choice in this way is called a mixed strategy. /ash showed in
$,6$ that any finite strategic!form game has an e8uilibrium if mixed strategies are
allowed. &s before, an e8uilibrium is defined by a "possibly mixed# strategy for each
player where no player can gain on average by unilateral deviation. &verage "that is,
expected# payoffs must be considered because the outcome of the game may be
random.
#xtensive games $ith perfect information%
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Games in strategic form have no temporal component. 5n a game in strategic form, the
players choose their strategies simultaneously, without knowing the choices of the
other players. The more detailed model of a game tree, also called a game in extensive
form, formalizes interactions where the players can over time be informed about the
actions of others. This section treats games of perfect information. 5n an extensive
game with perfect information, every player is at any point aware of the previous
choices of all other players. Aurthermore, only one player moves at a time, so that
there are no simultaneous moves.
#xtensive games $ith imperfect information%
Typically, players do not always have full access to all the information which is
relevant to their choices. *xtensive games with imperfect information model exactly
which information is available to the players when they make a move. 4odeling and
evaluating strategic information precisely is one of the strengths of game theory. .ohn
=arsanyi9s pioneering work in this area was recognized in the $,,2 /obel awards.
'onsider the situation faced by a large software company after a small startup has
announced deployment of a key new technology. The large company has a large
research and development operation, and it is generally known that they have
researchers working on a wide variety of innovations. =owever, only the large
company knows for sure whether or not they have made any progress on a product
similar to the startup9s new technology. The startup believes that there is a 67 percent
chance that the large company has developed the basis for a strong competing
product. Aor brevity, when the large company has the ability to produce a strong
competing product, the company will be referred to as having a 0strong1 position, as
opposed to a 0weak1 one. The large company, after the announcement, has two
choices. 5t can counter by announcing that it too will release a competing product.
&lternatively, it can choose to cede the market for this product. The large company
will certainly condition its choice upon its private knowledge, and may choose to act
differently when it has a strong position than when it has a weak one. 5f the large
company has announced a product, the startup is faced with a choice% it can either
negotiate a buyout and sell itself to the large company, or it can remain independent
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and launch its product. The startup does not have access to the large firm9s private
information on the status of its research. =owever, it does observe
whether or not the large company announces its own product, and may attempt to
infer from that choice the likelihood that the large company has made progress of
their own. When the large company does not have a strong product, the startup would
prefer to stay in the market over selling out. When the large company does have a
strong product, the opposite is true, and the startup is better off by selling out instead
of staying in.
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%ero&sum games and computation%
The extreme case of players with fully opposed interests is embodied in the class of
twoplayer !ero"sum "or constant!sum# games. Aamiliar examples range from rock!
paperscissors to many parlor games like chess, go, or checkers. & classic case of a
zero!sum game, which was considered in the early days of game theory by von
/eumann, is the game of poker. The extensive game in Aigure $7, and its strategic
form in Aigure $$, can be interpreted in terms of poker, where player 5 is dealt a
strong or weak hand which is unknown to player 55. 5t is a constant"sum game since
for any outcome, the two payoffs add up to $:, so that one player9s gain is the other
player9s loss. When player 5 chooses to announce despite being in a weak position, he
is collo8uially said to be 0bluffing.1 This bluff not only induces player 55 to possibly
sell out, but similarly allows for the possibility that player 55 stays in when player 5 is
strong, increasing the gain to player 5. 4ixed strategies are a natural device for
constant!sum games with imperfect information. Geaving one9s own actions open
reduces one9s vulnerability against malicious responses. 5n the poker game of Aigure
$7, it is too costly to bluff all the time, and better to randomize instead. The use of
active randomization will be familiar to anyone who has played rock!paper!scissors.
Hero!sum games can be used to model strategically the computer science concept of
0demonic1 nondeterminism. Iemonic nondeterminism is based on the assumption
that, when an ordering of events is not specified, one must assume that the worst
possible se8uence will take place. This can be placed into the framework of zero!sum
game theory by treating nature "or the environment# as an antagonistic opponent.
3ptimal randomization by such an opponent describes a worst!case scenario that can
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Dixit, A#inash K., and $a%e&u'', Barry (. (1991), Thin)in! *trate!i+a%%y: The
Com,etiti#e
-d!e in Business, .o%iti+s, and -#eryday i'e. $orton, $e/ 0or).
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serve as a benchmark. & similar use of randomization is known in the theory of
algorithms as >ao9s theorem, and describes the power of randomized algorithms. &n
example is the well!known uicksort algorithm, which has one of the best observed
running times of sorting algorithms in practice, but can have bad worst cases. With
randomization, these can be made extremely unlikely. >andomized algorithms and
zero!sum games are used for analyzing problems in online computation. This is,
despite its name, not related to the internet, but describes the situation where an
algorithm receives its input one data item at a time, and has to make decisions, for
example in scheduling, without being able to wait until the entirety of the
input is known. The analysis of online algorithms has revealed insights into hard
optimization problems, and seems also relevant to the massive data processing that is
to be expected in the future. &t present, it constitutes an active research area, although
mostly confined to theoretical computer science "see +orodin and *l!Janiv, #nline
Computation and Competitive Analysis, 'ambridge @niversity ?ress, $,,(#.
'idding in auctions%
The design and analysis of auctions is one of the triumphs of game theory. &uction
theory was pioneered by the economist William Cickrey in $,:$. 5ts practical use
became apparent in the $,,7s, when auctions of radio fre8uency spectrum for mobile
telecommunication raised billions of dollars. *conomic theorists advised governments
on the design of these auctions, and companies on how to bid "see 4c4illan, 0;elling
spectrum rights,1 $ournal of Economic %erspectives Col. (, $,,2, pages $26D$:-#.
The auctions for spectrum rights are complex. =owever, many principles for sound
bidding can be illustrated by applying game!theoretic ideas to simple examples. This
section highlights some of these examplesE see 4ilgrom, 0&uctions and bidding% a
primer1 "$ournal of Economic %erspectives Col. ), $,(,, pages )D--# for a broader
view of the theory of bidding in auctions.
Second&price auctions $ith private values%
The most familiar type of auction is the familiar open ascending"bid auction, which is
also called an English auction. 5n this auction format, an obBect is put up for sale. With
the potential buyers present, an auctioneer raises the price for the obBect as long as
two or more bidders are willing to pay that price. The auction stops when there is only
one bidder left, who gets the obBect at the price at which the last remaining opponent
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drops out. & complete analysis of the *nglish auction as a game is complicated, as the
extensive form of the auction is very large. The observation that the winning bidder in
the *nglish auction pays the amount at which the last remaining opponent drops out
suggests a simpler auction format, the second"price auction, for analysis. 5n a second!
price auction, each potential buyer privately submits, perhaps in a sealed envelope or
over a secure computer connection, his bid for the obBect to the auctioneer. &fter
receiving all the bids, the auctioneer then awards the obBect to the bidder with the
highest bid, and charges him the amount of the second!highest bid. Cickrey9s analysis
dealt with auctions with these rules. =ow should one bid in a second!price auctionK
;uppose that the obBect being auctioned is one where the bidders each have a private
value for the obBect. That is, eachnbidder9s value derives from his personal tastes for
the obBect, and not from considerations such as potential resale value. ;uppose this
valuation is expressed in monetary terms, as the maximum amount the bidder would
be willing to pay to buy the obBect. Then the optimal bidding strategy is to submit a
bid e8ual to one9s actual value for the obBect. +idding one9s private value in a second!
price auction is a &eakly dominant strategy.
That is, irrespective of what the other bidders are doing, no other strategy can yield a
better outcome. ">ecall that a dominant strategy is one that is al&ays better than the
dominated strategyE weak dominance allows for other strategies that are sometimes
e8ually good.# To see this, suppose first that a bidder bids less than the obBect was
worth to him. Then if he wins the auction, he still pays the second!highest bid, so
nothing changes. =owever, he now risks that the obBect is sold to someone else at a
lower price than his true valuation, which makes the bidder worse off. ;imilarly, if
one bids more than one9s value, the only case where this can make a difference is
when there is, below the new bid, another bid exceeding the own value. The bidder, if
he wins, must then pay that price, which he prefers less than not winning the obBect. 5n
all other cases, the outcome is the same. +idding one9s true valuation is a simple
strategy, and, being weakly dominant, does not re8uire much thought about the
actions of others. While second!price sealed!bid auctions like the one described above
are not very common, they provide insight into a /ash e8uilibrium of the *nglish
auction. There is a strategy in the *nglish auction which is analogous to the weakly
dominant strategy in the second price auction. 5n this strategy, a bidder remains active
in the auction until the price exceeds the bidder9s value, and then drops out. 5f all
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bidders adopt this strategy, no bidder can make himself better off by switching to a
different one. Therefore, it is a /ash e8uilibrium when all bidders adopt this strategy.
4ost online auction websites employ an auction which has features of both the
*nglish and second!price rules. 5n these auctions, the current price is generally
observable to all participants. =owever, a bidder, instead of fre8uently checking the
auction site for the current price, can instead instruct an agent, usually an automated
agent provided by the auction site, to stay in until the price surpasses a given amount.
5f the current bid is by another bidder and below that amount, then the agent only bids
up the price enough so that it has the new high bid. 3perationally, this is similar to
submitting a sealed bid in a second!price auction. ;ince the use of such agents helps
to minimize the time investment needed for bidders, sites providing these agents
encourage more bidders to participate, which improves the price sellers can get for
their goods.
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$asar, *y%#ia (1991), A Beauti'u% "ind: A Bio!ra,hy o' (ohn For&es $ash, (r.,
2inner o'
the $o&e% .ri3e in -+onomi+s, 1994. *imon and *+huster, $e/ 0or).
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