GAME THEORY

Game Theory
• Neumann and Morgenstern presented first-time “Theory of Games
and Economic Behavior” in 1944.
• Later it was regarded as a “rare event” in the history of ideas.
• Game theory attempts to find the solution to problems of duopoly,
oligopoly, and bilateral monopoly.
• In all these market situations, it is very difficult to arrive at a
determinate solution due to the conflicting interests and strategies of
the participants.
 The objective of Game Theory
• The theory of games attempts to arrive at various equilibrium
solutions based on the rational behavior of the market participants
under all possible situations.
• Each participant in a game is confronted with a situation whose
outcome depends not only upon his own strategies but also upon the
strategies of his opponent.
• For example: Chess, Poker Games, Military Battles, and Economic
Markets.
• Mainly for duopoly problems.
 Definition of Game Theory
• Game theory is the study of strategic behavior—behavior that
recognizes mutual interdependence and takes account of the
expected behavior of others.

• Any exchange or interaction among individuals that involves the

possibility of strategic behavior can be analyzed as a game. In a
game, the outcome for each individual depends not only on that
individual’s decisions but also on the decisions of other
individuals.

• Game theory is the mathematical modelling of strategic

interaction among rational (and irrational) agents.
 Fundamentals of Game Theory
• A game has set rules and procedures which two or more participants
follow.
• Players: The individuals or participants involved in the exchange or
interaction.
• A strategy is a particular application of the rules leading to specific
result. The possible decisions or choices made by each person.
• Payoffs: The gain or loss to each individual. The various strategies
followed by each player in relation to the other is called his pay-off.
• A move is made by one player leading to a situation having alternatives.
• A choice is the actual alternative chosen by a player.
• Optimal strategy that maximizes a player’s expected payoff.
 Fundamentals of Game Theory
• The saddle point in a game is the equilibrium point.
• There are two types of games:
• constant sum and non-constant sum
• In a constant sum game what one player gains the other loses. The
profits of the participants remain the same.
• Whereas in a non-constant sum game, profits of each player differ
and they may cooperate with each other to increase their profit.
• The pay off matrix of a firm is a table showing the payoffs accruing to
this firm as a result of each possible combination of strategies
adopted by it and by its rival.
 Non-cooperative versus Cooperative
Games
Cooperative game
It is a game in which participants can negotiate binding contracts that
allow them to plan joint strategies.
Example: Buyer and seller negotiating the price of a good or service or a joint
venture by two firms (i.e., Microsoft and Apple)
Binding contracts are possible
Non-cooperative Game
Negotiation and enforcement of binding contracts between players is not
possible
Example: Two competing firms, assuming the other’s behavior, independently
determine pricing and advertising strategy to gain market share
Binding contracts are not possible
 Gaming and Strategic Decisions
An Example: How to buy a dollar bill
Auction a dollar bill
The highest bidder receives the dollar in return for the
amount bid
The second highest bidder must pay the amount he or
she bid but gets nothing in return
How much would you bid for a dollar?
Typically bid more for the dollar when faced with loss as the
second highest bidder
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 Acquiring a Company
Scenario
Company A: The Acquirer
Company T: The Target
A will offer cash for all of T’s shares

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 Acquiring a Company
Scenario
A must submit the proposal before the exploration outcome is
known
T will not choose to accept or reject until after the outcome is
known only to T
Company T will accept any offer that is greater than the per share
value of the company under current management
How much should A offer?

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 Dominant Strategies
A dominant strategy is optimal no matter what an opponent
does
An Example:
A and B sell competing products
They are deciding whether to undertake advertising
campaigns

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 Dominant Strategies

A strategy is dominant if, regardless of what other players do, the

strategy earns a player a more enormous payoff than any other.
Hence, a strategy is dominant if it is always better than any other
strategy for any profile of other players' actions.
Whether "better" is defined with weak or strict inequalities, the
strategy is strictly dominant or weakly dominant.
 If one strategy is dominant then all others are dominated. For
example, in the prisoner's dilemma, each player has a dominant
strategy.
 Dominant Strategies
A dominant strategy is known as optimal no matter what an opponent does.
Suppose Firms A and B sell competing products and decide whether to
undertake advertising campaigns. Each firm will be affected by its competitor’s
decision for its profit. A&B with advertising (10,5)
Payoff Matrix for Advertising Game
 Payoff Matrix for Advertising Game
Observations Firm B Don’t
Advertise
A: regardless of B, Advertise

advertising is the
best Advertise 10, 5 15, 0
B: regardless of A,
advertising is best Firm A

Don’t
Advertise 6, 8 10, 2

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 Payoff Matrix for Advertising Game

• Observations Firm B Don’t

• The dominant Advertise Advertise
strategy for A and B is
to advertise
• Do not worry about Advertise 10, 5 15, 0
the other player
• Equilibrium in Firm A
dominant strategy Don’t
Advertise 6, 8 10, 2

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 Dominant strategies

Equilibrium in dominant strategies: The outcome of a game

in which each firm does the best it can, regardless of what its
competitors are doing.
The optimal strategy is determined without worrying about
the actions of other players.

Advertising is a dominant strategy for Firm A. The same is

true for Firm B: No matter what firm A does, Firm B does
best by advertising.
The outcome of this game is that both firms will advertise.
 Dominant Strategies
Game Without Dominant Strategy

The optimal decision of a player without a dominant

strategy will depend on what the other player does.

Revising the payoff matrix, we can see a situation where

no dominant strategy exists.

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 Modified Advertising Game
Firm B Don’t
Advertise Advertise

Advertise 10, 5 15, 0

Firm A

Don’t
Advertise 6, 8 20, 2

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 Modified Advertising Game
Firm B Don’t
Observations Advertise Advertise

A: No dominant strategy;

depends on B’s actions Advertise 10, 5 15, 0
B: Dominant strategy is to
Firm A
advertise
Don’t
Firm A determines B’s Advertise 6, 8 20, 2
dominant strategy and
makes its decision
accordingly.

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 The Nash Equilibrium
Nash Equilibrium is a term used in game theory to describe an equilibrium
where each player's strategy is optimal given the strategies of all other
players.
In other words, no player in the game would take a different action as long as
every other player remains the same.
Nash Equilibrium is self-enforcing; when players are at a Nash Equilibrium,
they have no desire to move because they will be worse off.
Nash Equilibrium: I’m doing my best, given what you are doing. You’re doing
the best you can, given what I am doing.
Dominant Strategy: “I’m doing the best I can no matter what you do. You’re
doing the best you can no matter what I do.”
A dominant strategy is a special case of Nash equilibrium.
 Nash Equilibrium
• In game theory, the Nash equilibrium, named after the mathematician
John Nash, is the most common way to define the solution of a non-
cooperative game involving two or more players.
• The principle of Nash equilibrium dates back to the time of Cournot,
who in 1838 applied it to competing firms choosing outputs.
• If each player has chosen a strategy – an action plan based on what
has happened so far in the game – and no one can increase one's
expected payoff by changing one's strategy while the other players
keep theirs unchanged, then the current set of strategy choices
constitutes a Nash equilibrium.
The Nash Equilibrium :The Product Choice Problem
• Two cereal companies face a market in which two new types of cereal
can be successfully introduced, provided each type is introduced by
only one firm
• Product Choice Problem
• The market for one producer of crispy cereal
• Market for one producer of sweet cereal
• Each firm only has the resources to introduce one cereal
• Non-cooperative
The Product Choice Problem
 Product Choice Problem
Firm 2

If Firm 1 hears that Firm 2 is Crispy Sweet

introducing a new sweet

cereal, its best action is to Crispy -5, -5 10, 10
make crispy Firm 1
The bottom left corner is the
Sweet 10, 10 -5, -5
Nash equilibrium
What is another Nash
Equilibrium?

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 Beach Location Game
• Scenario
• Two competitors, Y and C, selling soft drinks
• Beach is 200 yards long
• Sunbathers are spread evenly along the beach
• Price Y = Price C
• Customer will buy from the closest vendor

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 Beach Location Game
Ocean
C

0 B Beach A 200 yards

• Where will the competitors locate (i.e., where is

the Nash equilibrium)?

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 The Prisoner’s Dilemma

• The prisoner’s dilemma, one of the most famous game theories, was

conceptualized by Merrill Flood and Melvin Dresher at the 
Rand Corporation in 1950.
• It was later formalized and named by Canadian mathematician Albert
William Tucker.
• The prisoner’s dilemma provides a framework for understanding how
to strike a balance between cooperation and competition and is a
valuable tool for strategic decision-making.
• Application in business, finance, economics, and political science to
philosophy, psychology, biology, and sociology
 The Prisoner’s Dilemma
• The prisoner’s dilemma scenario works as follows: Two suspects have
been apprehended for a crime and are now in separate rooms in a police
station, with no means of communicating with each other. The prosecutor
has separately told them the following:
• If you confess and agree to testify against the other suspect, who does not
confess, the charges against you will be dropped and you will go scot-free.
• If you do not confess but the other suspect does, you will be convicted
and the prosecution will seek the maximum sentence of three years.
• If both of you confess, you will both be sentenced to two years in prison.
• If neither of you confesses, you will both be charged with misbehavior
and will be sentenced to one year in prison.
 Prisoner’s Dilemma –Payoff Matrix

   Suspect B
 

     Doesn’t Confess  Confess

 Suspect A  Doesn’t Confess  (a) -1, -1  (c) -3, 0

   Confess  (b) 0, -3  (d) -2, -2

 Possible Outcomes/Dominant Strategy

• The dominant strategy for a player produces the best payoff for that
player regardless of the strategies employed by other players.
• The dominant strategy here is for each player to confess since
confessing would minimize the average time spent in prison.
 Possible Outcomes

• If A and B cooperate and stay mum, both get one year in prison—as shown in
cell (a).
• If A confesses but B does not, A goes free, and B gets three years—
represented in cell (b).
• If A does not confess, but B confesses, A gets three years, and B goes free—
see cell (c).
• If A and B confess, both get two years in prison—as a cell (d) shows.
• So if A confesses, they either go free or get two years in prison. But if they
do not confess, they get one year or three years in prison. B faces the same
dilemma. The best strategy is to confess, regardless of what the other
suspect does.
 Applications to Business

• A classic example of the prisoner’s dilemma in the real world is encountered

when two competitors are battling it out in the marketplace.
• Often, many sectors of the economy have two main rivals.
• In the U.S., for example, there is a fierce rivalry between Coca-Cola (KO) and
PepsiCo (PEP) in soft drinks and Home Depot (HD) versus Lowe’s (LOW) in
building supplies.
• This competition has given rise to numerous case studies in business schools.
• Other fierce rivalries include Starbucks (SBUX) versus Tim Horton’s (THI) in
Canada and Apple (AAPL) versus Samsung in the global mobile phone sector.
• Albert Tucker first presented the Prisoner's Dilemma in 1950 to a group of
graduate psychology students at Stanford University, as an example of game
theory
 Maximax Strategy

• A maximax strategy is one where the player attempts to earn the maximum

possible benefit available.
• This means they will prefer the alternative, which includes the chance of
achieving the best possible outcome – even if a highly unfavorable outcome
is possible.
• This strategy, often referred to as the best of the best, is seen as ‘naive’ and
overly optimistic in that it assumes a highly favorable environment for
decision-making.
• The best pay-off for Suspect A from confessing is zero years (with Suspect B
denying), and the best pay-off from denying is one year (with Suspect B
denying) – so the best of the best is to confess.
 Maxmin Strategy
• A maximin strategy is a strategy in game theory where a player makes
a decision that yields the ‘best of the worst outcome.
• All decisions will have costs and benefits, and a maximin strategy
seeks the decision that yields a minor loss.
• It is also referred to as a pessimistic or conservative strategy.
 Maxmin Strategy
• A maximin strategy is where players choose the best of the worst pay-
off.
• This is commonly chosen when a player cannot rely on the other
party to keep any agreement made –
• For example, to deny.
• In the Prisoner’s Dilemma, the worst pay-off to Suspect A from
confessing is to get two years (with Suspect B confessing), and the
worst pay-off from denying is three years (with Suspect B confessing)
– therefore, the best of the worst is to confess.
 Maximax and Maximin
Strategy
• In this case, both the maximin and maximax strategies would be to
confess. When this occurs, it is said to be the dominant strategy.
• Dominant strategy
• A dominant strategy is the best outcome irrespective of what the
other player chooses; in this case, it is for each player to confess –
both the optimistic maximax and pessimistic maximin lead to the
same decision being taken.
 Minimax Strategy
• In game theory, minimax is a decision rule used to minimize the
worst-case potential loss;
• In other words, a player considers all of the best opponent responses
to his strategies and selects the strategy such that the opponent's
best strategy gives a payoff as large as possible.
• The name "minimax" comes from minimizing the loss involved when
the opponent selects the strategy that gives maximum loss and is
useful in analyzing the first player's decisions both when the players
move sequentially and when the players move simultaneously.
• In the latter case, minimax may give a Nash equilibrium of the game if
some additional conditions hold.