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Game Theory

By: Manohar Gadre ITBM,

Prn: 9030241015

Introduction

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.

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.

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:

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”

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:

III

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

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.

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.

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.”

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):

Game theory

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.

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,

Game theory

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

party.

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

theory.

Game theory

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:

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.

Conclusion

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. –

Game theory

References

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.

http://www.youtube.com/user/YaleCourses#p/c/6EF60E1027E1A10B/1/qQ3kFy

dI_xQ.

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