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Game theory

Game Theory
By: Manohar Gadre ITBM,

Prn: 9030241015

Game theory is the study of conflict & cooperation and how people behave in
strategic situations. The Strategic term here refers to a situation in which each
person when deciding on what action to take must consider how others might
respond to that action. Game theory 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.

History of Game theory

The earliest work on game theory can be related to study of duopoly by Antoine
Cournot in 1838. However it was Von Neumann and Oskar Morgenstern in their 1944
publication „Theory of Games and Economic Behaviour‟ who established game
theory as a field in its own right. It primarily focussed on method for finding
mutually consistent solutions for two persons zero sum game. The research work
over the years focussed on developing several types of games and game theory has
evolved from cooperative games to zero sum games and symmetric and asymmetric
games. There have been eight economists who have been awarded Nobel Prize for
their work in the field related to game theory & its applications. One of the
remarkable work has been of John Nash, who propounded Nash Equilibrium that
talked about developing criteria for mutual consistencies of players‟ strategies.

Game theory: Basics

One of the most common & easiest ways of explaining the basics of game theory is
using the Prisoners‟ Dilemma. Lets us explain how the prisoners‟ dilemma works
and understand few concepts pertaining to game theory:

Consider there are two Prisoners caught by the police namely James and Steve.
Police have enough evidence to convict James & Steve of the minor crime of
carrying an unregistered gun which would result in each of them spending 1 year in
Jail. The police as well suspect that the two criminals have committed a bank
robbery together, but they lack hard evidence to convict them of this major crime.
The Police offers to question each of the criminals in separate rooms and offer
them following deal:

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Game theory

“Right Now we can lock you up for 1 year. If you confess to the bank robbery and
implicate your partner, however we will give you immunity and you can go free.
Your Partner will get 20 years in jail. But if you both confess to the crime, we
won‟t need your testimony and we can avoid cost of trial, so you will each get an
intermediate sentence of 8 years”

This situation is perfect strategic situation (as defined in introduction) where

choice of the alternative/ action is highly dependent on the choice of alternative /
action of some other person. Let us represent this peculiar situation in an
appropriate form:

The deal For John The Deal for Steve


The Outcome of Payoff Matrix

Figure 1: Illustration of Prisoners Dilemma

Let us try and understand thought process of the prisoners:-

John would clearly think that “I don‟t know what Steve will do. If Steve remains
silent and I confess then I will be free. However if I confess and Steve also

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Game theory

confesses we both will spend 8 years in prison, which is much better that spending
20 years or 1 year in prison”. So regardless of whatever Steve does I am better of
Confessing to the crime. The thought process for Steve is also similar.

In terms of game theory, it‟s termed as dominant Strategy: It is the best strategy
for a player to be followed regardless of strategies pursued by other players.

Now, both the prisoners were selfish and played to maximise their Payoffs, both of
them ended up in prison for 8 years.

Payoffs are numbers which represent the motivations of players. It may represent
profit, quantity, utility or may simply rank the desirability of outcomes (ordinal
payoffs). In all cases, the payoffs reflect the motivations of the particular player.

Moving on, this strategy of both the players to Confess has yielded them a jail
term of 8 years each. This is said to be the Nash equilibrium to this game because
given that the other player has testified/confessed, each individual regards his
own choice (Confessing) as optimal. At Nash Equilibrium no player has an
incentive to independently change his own strategy and get better payoff.

Prisoners Dilemma: The game of Non Cooperation

Now suppose John and Steve before getting caught decide to cooperate i.e. they
decide that they are not going to confess. In such a scenario both of them remain
silent and hence end up spending just one year in prison, which is the best option
in the given scenario.

Once they are being questioned separately, the logic of self-interest takes over
and leads them to confess. Cooperation between the two prisoners is difficult to
maintain, because cooperation is individually irrational.

Here comes the concept of Rationality, which is defined as “A player is said to be

rational if he seeks to play in a manner which maximizes his own payoff. It is often
assumed that the rationality of all players is common knowledge.”

Application of Game theory to business scenarios

The game theory applications can be easily related to Oligopolistic markets.
However it has general application in all the various business scenarios in all other
market types. Let‟s take an example of a real life scenario explaining how the
game theory concepts can be applied. Let us discuss two classic cases of Game
theory application to real world scenarios. Case 1: Crude oil production levels
control by OPEC, Case2: Arms race between US and Soviet Union during the cold
war. Let‟s discuss these in detail:

1. OPEC, Saudi Arabia Iraq & Iran (Enforcing a cartel, Cooperative games):

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Game theory

OPEC (Organization of Petroleum Exporting Countries) is a cartel consisting

of 13 world‟s most important oil producing nations. Oil ministers of each
member organization meet on regular basis with the objective of of
influencing world oil prices by establishing maximum production quotas for
the cartel and for each country.
But history of OPEC suggests that agreements on production levels have
often been difficult to formulate. Barring few exceptions it has been seen
that countries like Iran and Iraq have advocated for lower production quotas
that would result in high world prices, however Saudi Arabia has been know
for supporting moderate prices. These differences have several times led to
major fluctuations in crude oil prices. Let‟s see one such scenario between
Iraq and Iran.
After prolonged negotiation, the countries agree to keep oil production low
in order to keep the world price of oil high. After they agree on production
levels, each country must decide whether to cooperate and live up to this
agreement or to ignore it and produce at a higher level. The payoffs in each
case are displayed in Figure 2.

Figure 2: Payoff Matrix for Iraq & Iran

After the agreement is signed each “I could keep production low as we

agreed, or I could raise my production and sell more oil on world markets. If
Iran lives up to the agreement and keeps its production low, then my
country earns profit of $60 billion with high production and $50 billion with
low production. In this case, Iraq is better off with high production. If Iran
fails to live up to the agreement and produces at a high level, then my
country earns $40 billion with high production and $30 billion with low
production. Once again, Iraq is better off with high production. So,

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Game theory

regardless of what Iran chooses to do, my country is better off reneging on

our agreement and producing at a high level. Same is the case with Iraq.
So both Iraq and Iran breach the agreement and produce high resulting in
lower prices for both of them.
2. Arms Race between United States and Soviet Union:
Post World War II and up to 1990s when Soviet Union got disintegrated the
period is known as Cold war period. It saw an arms race between the two
super powers with possibilities of war looming high during several instances.
Each country preferred to have more arms than the other because a larger
arsenal gave it more influence in world affairs. But each country also
preferred to live in a world safe from the other country‟s weapons. The
payoffs from the scenarios can be represented in Figure 3.

If the Soviet Union chooses to arm, the United States is better off doing the
same to prevent the loss of power. If the Soviet Union chooses to disarm,
the United States is better off arming because doing so would make it more
powerful. For each country, arming is a dominant strategy. Thus, each
country chooses to continue the arms race, resulting in the inferior outcome
in which both countries are at risk.

Thus, in both arms races and crude oil prices, the relentless logic of self-interest
drives the participants toward a non-cooperative outcome that is worse for each

Other applications of the game theory involve launching decisions on launching

advertising campaigns, product launches, determining production levels, autions
etc. In fact many decision in day to day life are can be analysed using the game

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Game theory

Game theory: Advance Concepts

There are several types of games that have evolved over the years that can be
used in various strategic situations. Let us describe the various concepts and types
of games:

 Sequential Games (The Advantage of being first): A sequential game is a game

in which players make at least some of their decisions at different times. Entry
into a new market is an example of a sequential game. The new firm decides
whether or not to enter and existing firm then decides whether to ignore the
new firm of try to prevent entry.
 Repeated games (Dealing with Cheaters): A repeated game is a game that the
same players play more than once. Repeated games differ from one-shot games
because people's current actions can depend on the past behavior of other
players. In such games Cooperation is encouraged.
 Zero Sum Game: A game is said to be zero-sum if for any outcome, the sum of
the payoffs to all players is zero. In a two-player zero-sum game, one player‟s
gain is the other player‟s loss, so their interests are diametrically opposed.
 Coordination games: They are games where the "diagonal" cells (top left or
bottom right) have the essentially identical payoffs which are greater than
those of the off diagonal payoffs.
 Mixed Strategies: In several scenarios simple pure strategies may not work
effectively. Consider simple cricket case where the pace bowler must bowl
both Fast and swinging delivery to get the batsmen out. So there is not pure
strategy, but a combination of two things that would give a maximum payoff.

Game theory is exciting because although the principles are simple, the
applications are far-reaching. Interdependent decisions are everywhere,
potentially including almost any endeavour in which self-interested agents
cooperate and/or compete. Probably the most interesting games involve
communication, because so many layers of strategy are possible. Game theory can
be used to design credible commitments, threats or promises or to assess
propositions and statements offered by others. Concepts of game theory can find
application in at the heart of foreign policy and nuclear weapons strategies. –

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Game theory

 Mankiw Economics Principles and Applications,Cengage Learning 2007
 HC Petersen, W. Cris Lewis Manegerial Economics (4th Edition) (pp 370-397)
 TL Turocy, BV Stengel Game theory Research Report CADM (2001)
 Yale university course on Game Theory retrieved September 5, 2010.

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