GAME THEORY CHAPTER SIX

20/05/2022 GAME THEORY 1

INTRODUCTION

Decision theory studies individual decision-making in

situations in which an individual’s choice neither affects
nor is affected by other individuals’ choices; while
game theory studies decision-making in situations
where individuals’ choices do affect each other.

20/05/2022 GAME THEORY 2

THE PRISONER’S DILEMMA
The Prisoner’s Dilemma is a classic case in games. It tells of the
police arresting two suspects A and B but without sufficient
evidence to prosecute the two.
Prisoners Dilemma
B Denies B Confesses
A Denies Serve a 1 year sentence, Serve a 10 year sentence,
serve a 1 year sentence Immediately released
A Confesses Immediately released, Serve an 8 year sentence,
Serve a 10 year sentence Serve an 8 year sentence

20/05/2022 GAME THEORY 3

GAME THEORY
▪ Defined as a body of knowledge that deals with
making decisions when two or more opponents are
involved under conditions of conflict and
competition.
▪ A competitive situation exists when two or more
opposing parties are making decisions involving
conflicting interests and wherein the action of one
depends on the action which the opponent takes.
▪ It seeks to provide a rational course of action in a
conflicting situation.
20/05/2022 GAME THEORY 4
CONT’D
▪ Instead of making inferences from the past behavior of
the opponent, the approach of game theory is to seek
to determine a rival’s most profitable counter-strategy
to one’s own best moves and to formulate the
appropriate defensive measures.
▪ Game theory helps to determine the best course of
action for a firm in view of the expected countermoves
from the competitors. The competitors in the game are
known as players. Game theory deals with competitive
situations of decision-making under uncertainty.
20/05/2022 GAME THEORY 5
CONT’D
▪ There can be several types of games, e.g., two
person and n person games, zero-sum and non-zero
sum games. Constant sum game, cooperative and
non-co-operative games, pure strategy games and
mixed strategy games, etc.
▪ When there are two competitors playing a game, it
is called Two Person Game.
▪ If the number of competitors are N (where N > 2), it
is known as an N person game.
20/05/2022 GAME THEORY 6
CONT’D
▪ Where the sum of amounts won by all winners is
equal to the sum of the amounts lost by all losers, we
call it a Zero Sum Game.
▪ In a non-zero sum game there exists a jointly
preferred outcome, i.e., in a zero sum game or a
constant sum game the sum of gains and losses of
the game is zero. As opposed to this if the sum of
gains or losses is not equal to zero, we call it a Non-
zero Sum Game.
20/05/2022 GAME THEORY 7
CONT’D
▪ When the best strategy for each player is to play one
particular strategy throughout the game, it is known as a
Pure Strategy Game.
▪ In case the optimum plan for each player is to employ
different strategy at different times, it is called a Mixed
Strategy Game.
▪ When there is communication between the participants
they may reach agreement and increase their payoff
through some forms of Co-operative Game, otherwise
it is a Non-cooperative Game.

20/05/2022 GAME THEORY 8

UNDERLYING ASSUMPTION/RULES OF GAME
• The number of competitors is finite
• The players act rationally and intelligently.
• Each player has available to him a finite set of possible
courses of action
• There is a conflict of interests between the participants.
• The player makes individual decisions without direct
communication.
• The players simultaneously select their respective courses of
action.
• The payoff (outcome) is fixed and determined in advance.
20/05/2022 GAME THEORY 9
BASIC TERMINOLOGIES
▪ Strategy: a set of rules or alternative courses of
action available to the decision maker in advance.
✓ Pure strategy. If the players select the same
strategy each time, then it is referred to as pure-
strategy. In this case each player know exactly
what the other is going to do i.e., there is a
deterministic situation and the objective of the
players is to maximize gain or to minimize losses.

20/05/2022 GAME THEORY 10

CONT’D
✓ Mixed strategy. When the players use a combination of
strategies and each player always kept guessing as to
which course of action is to be selected by the other
player at a particular occasion then this is known as
mixed- strategy. Thus, there is a probabilistic situation
and objective of the player is to maximize expected
gains or to minimize losses. Thus, mixed strategy is a
selection among pure strategies with fixed probabilities.
▪ Optimum strategy. A course of action or play which puts the
player in the most preferred position, irrespective of the
strategy of his competitors is called an optimum strategy. Any
deviation from this strategy results in a decreased pay-off for
the player.
20/05/2022 GAME THEORY 11
CONT’D
▪ Value of the game. It is the expected pay-off of play
when all the players of the game follow their optimum
strategies. The game is called fair if the value of the
game is zero and unfair if it is non-zero.
▪ Two-person zero-sum game. There are two types of two
person zero-sum games. In one, the most preferred
position is achieved by adopting a single strategy and
therefore the game is known as the pure strategy game.
The second type requires the adoption by both players a
combination of different strategies in order to achieve
the most preferred position and is, therefore, referred to
as the mixed strategy game.
20/05/2022 GAME THEORY 12
CONT’D
▪ Pay-off matrix. A two-person zero-sum game is
conveniently represented by a matrix. The matrix,
which shows the outcome of the game as the players
select their particular strategies, is known as the
payoff matrix. It is important to assume that each
player knows not only his own list of possible courses
of action but also of his opponent.

20/05/2022 GAME THEORY 13

 CONT’D
Let player A have m course of action (A1, A2, …,Am) and player
B has n course of action (B1,B2, …, Bn). The number n and m need
not be equal. The total number of possible out came is, therefore
(mxn). These outcomes are shown in the following table.
A’s pay-off matrix
Player B
B’s pay-off matrix
 B1 − B 2 − − − Bn  Player B
 A1     B1 − B 2 − − − Bn 
a11 a12 − − − a1n 
 A2  Player A
   
 _ a11 a12 − − − _ a1n 
 A1 
Player A   _
a21 a22 − − − a2 n 
   A2 
     
 Am 
a a − − − a     _ a21 _ a22 − − − _ a2 n 
 m1 m 2 mn 
   
 Am
 _ am1 _ am 2 − − − _ amn 
 

20/05/2022 GAME THEORY 14

 PURE STRATEGIES (GAMES WITH SADDLE POINT)
▪ The minimum value in each row represents the least gain (payoff)
guaranteed to player A, if he plays his particular strategy. These are
indicated in the matrix by row minima. Player A will then select the
strategy that maximizes his minimum gains. player A’s selection is
called the maxi-min strategy and his corresponding gain is called the
Maxi-min Value of the Game.
▪ Player B, on the other hand, likes to minimize his losses. The maximum
value in each column represents the maximum losses to player B, if he
plays his particular strategy. These are indicated in the matrix by
column maxima. Player B will then select the strategy that minimizes
his maximum losses. Player B’s selection is called the mini-max
strategy and his corresponding loss is called the Mini-max Value of
the Game.
20/05/2022 GAME THEORY 15
CONT’D

➢ If the maxi-min value equals the mini-max value,

then the game is said to have a saddle point and
the corresponding strategies are called Optimum
Strategies.
➢ The amount of payoff at an equilibrium point is
known as the value of the game. It may be noted
that if player A adopts maxi-min criterion, then
player B has to adopt mini-max criterion as it is a
two-person zero-sum game.

20/05/2022 GAME THEORY 16

DETERMINATION OF SADDLE POINT
1) Select the minimum (lowest) element in each row of the
payoff matrix and write them under row minima heading.
Then select a largest element among these elements and
enclose it in a rectangle.
2) Select the maximum (largest) element in each column of the
payoff matrix and write them under column maxima
heading. Then select a lowest element among these elements
and enclose it in a circle.
3) Find out the element which is same in the circle as well as
rectangle and mark the position of such element in the
matrix. This element represents the value of the game and is
called the saddle (or equilibrium) point.
20/05/2022 GAME THEORY 17
RULE (PRINCIPLE) OF DOMINANCE
▪ The concept of dominance can be applied to any
two-person zero-sum game with any number of
strategies for each player. For a payoff matrix of
large size, the rule of dominance can be used to
reduce its size by carefully eliminating certain rows
and/or columns prior to final analysis to determine
the optimum strategy selection for each player. In
general the following rules for properties of
dominance are used to reduce the size of pay-off
matrix.
20/05/2022 GAME THEORY 18
RULE OF DOMINANCE
✓Rule 1. If all the elements in a row (say ith row) of a pay-off
matrix are less than or equal to the corresponding elements of
the other row (say jth row) then the player A will never choose
the ith strategy or in other words the ith strategy is dominated
by the jth strategy.
✓Rule 2. If all the elements in a column (say rth column) of a
pay-off matrix are greater than or equal to the
corresponding elements of the other column (say sth column)
then the player B will never choose the rth strategy or in the
other words the rth strategy is dominated by the sth strategy.
✓Rule 3. A pure strategy may be dominated if it is inferior to
average of two more other pure strategy.
20/05/2022 GAME THEORY 19
CONT’D
Example 1. A company management and the labor union are
negotiating a new 3 years settlement. Each of these has 4 strategies.
I: hard and aggressive bargaining. II: reasoning and logical
approach. III: legalistic strategy. IV: conciliatory approach. The costs
to the company are given for every pair of strategy choice

Company Strategy
I II III IV
I 20 15 12 35
II 25 14 8 10
Union Strategy
III 40 2 10 5
IV 5 4 11 0

What strategy will the two sides adopt? Also determine the value of the game?

20/05/2022 GAME THEORY 20

 CONT’D
Company Strategy
I II III IV RM
I 20 15 12 35 12
II 25 14 8 10 8
Union Strategy III 40 2 10 5 2
IV 5 4 11 0 0
CM 40 15 12 35

Maxi-min = Mini-max = value of game = 12.

The company incurs and hence its strategy is mini-max (i.e.,) minimizing
maximum losses for the union, negotiation results in gain, hence union
strategy will be maxi-min, i.e. maximizing minimum gains. Since there exists
a saddle point, strategies are pure and the strategies adopted are:
company will always adopt strategy III- legalistic strategy and union will
always adopt strategy I- hard and aggressive bargaining.
20/05/2022 GAME THEORY 21
CONT’D
Example 2. Two competitive manufacturers are producing a new toy under
license from a patent holder. In order to meet the demand they have the
option of running the plant for 8, 16 or 24 hours a day. As the length of
production increases so does the cost. One of the manufacturer, say A, has
set up the matrix given bellow, in which he estimates the % of the market
that he could capture and maintain the different product schedules:

Manufacturer B
Manufacturer A C1: 8 hrs. C2: 16 hrs. C3: 24 hrs.

S1: 8 hrs. 60% 56% 34%

S2: 16 hrs. 63% 60% 55%
S3: 24 hrs. 83% 72% 60%
At which level should each produce? What % of the market will A have?
20/05/2022 GAME THEORY 22
CONT’D
Solution
Percentage of market captured by A
Manufacturer B
Manufacturer A C1 C2 C3 Rmi
S1 60 56 34 34
S2 63 60 55 55
S3 83 72 60 60
CMA 83 72 60

The saddle point occurs at the S3-C3 position. Thus a maximin-minimax

solution is obtained:
• Both A and B should produce at the level of 24 hours per day.
• At the optimum level of 24 hours per day, A will have 60% of the
market and B will have 40% of the market.
20/05/2022 GAME THEORY 23
EXERCISE

Determine the Optimum Strategy?

Player B
Player A I II III IV
I -5 3 1 20
II 5 5 4 6
III -4 -2 0 -5

20/05/2022 GAME THEORY 24

SOLUTION METHODS OF GAMES WITHOUT
SADDLE POINT
▪In certain cases when there is no pure strategy
solution for games, i.e., no saddle point exists; both
the players must determine an optimum mixture of
strategies to find a saddle (equilibrium) point.
▪The optimum strategy mixture for each player may
be determined by assigning to each strategy its
probability of being chosen. Since strategies so
determined are probabilistic combination for
available choices of strategy, they are mixed
strategies.
20/05/2022 GAME THEORY 25
ARITHMETICAL METHOD
For a zero-sum two-person game in which each of the
players. Say A and B, has a strategies A1 & A2 and B1
& B2 respectively, and the payoffs as given below,
then if p1 is the probability with which A choose
strategy A1 and if q1 is the probability that B plays
strategy B1, the payoff matrix for player A is given
by:

20/05/2022 GAME THEORY 26

CONT’D A’s pay-off matrix
Player B’s strategy
 
 B1 − B 2 
 
 A1   a11 a12   p1 
   
Player A    
 A2  a 21 a 22   p 2
q1 q2
Then following formula are used to find the value of the game and the
probability of using optimum strategy:
a22 − a21
𝑝1 = , p2 = 1 − p1
a11 + a22 − a12 + a21
a22−a12
q1 = , 𝑞2 = 1 − 𝑞1
a11+a22 − a12+a21
a a −a a
20/05/2022 𝑉 = a +11a 22− a21 +12 , GAME THEORY 27
11 22 12 a21
EXAMPLE
Solve the following game and determine the value of the
game:
Player Y
Strategy 1 Strategy 2
Player X Strategy 1 4 1
Strategy 2 2 3

Solution. Clearly, the pay-off matrix does not possess any saddle point. The
two players, therefore, use mixed strategies. Let
p 1= probability that player X uses strategy 1
q 1 = probability that player Y uses strategy 1

then 1-p1 = probability that player X uses strategy 2

1-q1 = probability that player Y uses strategy 2
20/05/2022 GAME THEORY 28
CONT’D
The optimum mixed strategy for player X is determined by:
a22 − a21 3−2 1
𝑝1 = ,= =
a11 + a22 − a12 + a21 4+3 − 2+1 4
a22−a12 3−1 1
q1 = = =
a11+a22 − a12+a21 4+3 − 2+1 2

a11a22 − a21a12 4 𝑥3 − 2 𝑥 1 10
𝑉= = =
a11 + a22 − a12 + a21 4+3 − 2+1 4

Hence the optimum strategies for the two players are:

1  1 2 
2
Sx =   Sx = 



  1 / 4 3/ 4 
1 / 4 3/ 4 
and the value of the game = 10/4
20/05/2022 GAME THEORY 29
CONT’D
✓ If player Y selects strategy 1 and player X selects the options with
probabilities p1 and 1-p1, then expected pay-off to player X will
be:
✓ 4(probability of player X selects strategy 1) + 2 (probability of
player X selecting strategy 2) = 4p1+2(1-p1)=2p1+2
✓ If player Y selects strategy 2 then expected pay-off to player X will
be:
1p1+ 3(1-p1) = -2p1 + 3
✓ The probability p1 should be such that expected pay-offs under
both conditions are equal, i.e., 2p1+2 = -2p1 + 3 or p1 = ¼
✓i.e., player X selects strategy 1 with a probability of ¼ or 25% of
the time and strategy 2, 75% of the time. Similarly expected pay-
offs player Y can be computed as follows:

20/05/2022 GAME THEORY 30

CONT’D
✓Expected pay-offs from player Y when player X selects
strategy 1 = expected pay-off from player Y when player X
selects strategy 2
Or 4q1 + 1 (1-q1) = 2q1 + (1-q1) or q1 = ½ and 1-q1 = ½
✓This implies that player y selects each strategy with equal
probability, i.e., 50% of the time he choose strategy 1 and
50% of the time strategy 2.

20/05/2022 GAME THEORY 31

CONT’D
Value of game = (expected profit to player X when
player Y uses strategy 1) x prob. (player Y using
strategy 1) + (expected profits to player X when player
Y uses strategy 2) x prob. (player Y using strategy 2).
Value of game = [4*p+2(1-p)]q +[1*p + 3 (1-p)](1-q)
= [4*1/4 +2(1-1/4)]1/2 + [1*1/4 +
3(1-1/4)] (1-1/2)= 10/4

20/05/2022 GAME THEORY 32

 END

20/05/2022 GAME THEORY 33