INTRODUCTION TO STRATEGY AND GAME

THEORY
Introduction
Humans, cannot survive without interacting with other humans, and unluckily, it
sometimes seems that we have survived despite those interactions. Production and
exchange require cooperation between individuals at some level but the same
interactions may also lead to disastrous confrontations. Many human interactions
carry the potentials of cooperation and harmony as well as conflict and disaster.
Examples are: relationships among couples, siblings, countries, management and labor
unions, neighbors, students and professors, etc.
Game theory is used to analyze the interrelated decisions when several conditions are
met. Therefore, game theory is the process of modeling the strategic interaction
between two or more players in a situation containing set rules and outcomes. The
following conditions are critical in game theory
a) Every individual must have several alternatives to choose from.
b) Individuals must have well defined set of preferences over the outcome of their
various decisions.
c) Outcomes must depend on the actions of more than one person in this case every
one’s set is intertwined.
d) Finally, individuals must choose actions that give them the best outcome.

Basic concepts
Players
The actors or choosers in a game are usually called players for example firms,
individuals, or government that make choices in the game. In our case players could
range from ball players to spouses.
Strategies
The actions players choose like quantity of output, price, whether to go to store,
whether to get married, are called strategies. The list of strategies players can choose
from is called strategic set for example for a soldier, the strategic set can be to shoot,
hide or run away. So, the strategy set will include shoot, hide, run].
Strategy combination is the list of all possible combination of strategies that can
result in a game. In other wards a strategy combination is strategy combination of
various players in the game e.g one strategy combination can be (shoot, shoot)
implying that both soldiers can shoot at each other. Or (shoot, run) etc implying one
can shoot and the other one can run away. The central problem in game theory is to
predict the choices that players make. In other wards the central problem is to predict
the strategy combination that will be chosen by all players in equilibrium.
Payoff
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Payoff. Is the payout a player receives from arriving at a particular outcome. In
any game, payoffs are numbers which represent the motivations of
players. Payoffs may represent profit, quantity, utility etc. in one case a player may
prefer a given strategy if the payoff is higher than the other.
Strategic interdependence.
The distinguishing feature of choice problem in game theory is that player’s payoff
depends not only on his strategy but also on the strategy of other players in the game.
This is referred to as strategic interdependence. this implies that each player’s payoff
is determined by the entire strategy combination in the game. So, each player must be
concerned with strategy choice made by other players in the game. So, a player will
try to maximize her own payoff given the strategy taken by other players. Therefore,
moving from the strategy of other players to the strategy that maximizes her own
payoff is called best response function. It specifies the player’s best response to a
given strategies of other players
Example of best response
Consider a situation where two suspects are arrested on a same charge but are kept in
two separate rooms. The payoffs are number of months to be sentenced depending on
strategies they undertake.
Question

Confess Do not confess

Confess (-6, -6) (0, -8)
Do not Confess (-8, 0) (-2, -2)

The best outcome for the player 1 in this case is when he confesses and player 2 does
not. The next best outcome for player 1 is (N, N), and then (C, C) and finally (N, C).
A similar interpretation applies to player 2. Therefore, no matter what player 2 intends
to do, playing C yields a better outcome for player 1. This is so because (C, C) is a
better outcome for him than (N, C), and (C, N) is a better outcome for him than (N,
N). So, it seems only “rational” for player 1 to play C by confessing. The same
reasoning for player 2 entails that this player too is very likely to play C. A very
reasonable prediction here is, therefore, that the game will end in the outcome (C, C)
in which both players confess to their crimes.
Equilibrium strategy combination
If every player’s strategy is the best response to the strategies of all other players, the
combination is known as equilibrium strategy combination. Therefore, there is nothing
can be done by each individual player to increase her own payoff independently. In
this case, each one’s payoff is maximized.

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Nash equilibrium
Is where the optimal outcome of a game is reached such that there is no incentive to
deviate from their initial strategy. Nash Equilibrium determines the optimal solution in
a non-cooperative game in which each player lacks any incentive to change his/her
initial strategy. Under the Nash equilibrium, a player does not gain anything from
deviating from the initially chosen strategy, assuming the other players keep their
strategies unchanged. Nash equilibrium represents all dominant strategy equilibrium
of all players in the game. Therefore, A strategy combination is said to be the in Nash
equilibrium if it represents the best response to the different players’ strategies.
Example of Nash Equilibrium
Imagine two competing companies: Company A and Company B. Both companies
want to determine whether they should launch a new advertising campaign for their
products. If both companies start advertising, each company will attract 50 new
customers. If only one company decides to advertise, it will attract 100 new
customers, while the other company will not attract any new customers. If both
companies decide not to advertise, none of the companies will engage new customers.
Company A should advertise its products because the strategy provides a better payoff
than the option of not advertising. The same situation exists for Company B. Thus, the
scenario when both companies advertise their products is a Nash equilibrium. The
payoff table is below:
Advertise Do not advertise
Advertise (50, 50) (100, 0)
Do not advertise (0 100) (0, 0)

Presentation of games
Normal forms and extensive forms
An extensive form of a game is often referred to as a game tree. Each decision point or
node has a number of branches stemming from it each one indicating specific
decision. At the end of each branch is either player’s payoff or another node.
Extensive form deal with sequential games.
A normal form represents the game in form of a matrix. If Player A has m moves to
choose from and Player B has n, we can represent the game using a payoff matrix: the
m×n matrix showing the payoff resulting from each possible pair of choices of moves.
In the payoff matrix, Player A's moves, are listed on the left, while Player B's moves
are listed along the top. We call Player A the row player and Player B the column
player.

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Dominant strategies and prisoner’s dilemma .
Dominant strategies are strategies that are better than all others no matter what other
players in a game are doing. If one strategy is always worse than another for some
player, regardless the strategy of other players, then the strategy is dominated
strategy. So, a pure strategy is a specific move or action that a player will follow in
every possible attainable situation in a game in this case the dominant strategy.
Example

Advertise Do not advertise

Advertise (50, 50) (100, 0)
Do not advertise (0 100) (0, 0)

In the above case advertise is the dominant strategy while not advertising is the
dominated strategy. This is because advertising yields better outcomes than not
advertising for all players.
Question which is the dominant strategy
Testify Do not testify
Testify (0, 0) (4, -1)
Do not Testify (-1 4) (2, 2)

In the above case testify is a dominant strategy for both players

D E F G
A 2,2 6,7 1,5 4,1
B 1,2 4,3 0,0 2,2
C 0,3 1,4 0,1 3,1
In the above case dominant strategy is (A, E)

PRISONERS DILEMA
Prisoners’ dilemma situations actually arise in many interesting scenarios, such as
arms-races, price competition, dispute settlements with or without lawyers, etc. The
common element in all these scenarios is that if everybody is cooperative a good
outcome results, but nobody finds it in her self-interest to act cooperatively, and this
leads to a less desirable outcome.
Example, consider two suspects have been arrested on charges of keeping stolen
motor bike from John and they have been placed in two separate rooms. There isn’t
enough evidence to convict them. This is because the two were found immediately
taking the bike from the parking as they took off before were easily identified. Police
caught them with stolen property. The police have evidence for charge of keeping
stolen property but doesn’t have enough evidence of theft. At the same time John

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can’t easily identify them since it was at night. In this case the police are trying to get
confession out of at least one. In order to do this, they are offered the following deal.
Any prisoner who finks on his partner, will be let go if the other partner won’t
confess. If Player one remains silent, and player two finks, then player one is going to
spend 8 months in prison and player two will walk free. If they both fink then they
will both be convicted of theft and will spend 5 months in jail. If neither of them fink,
then they will only be charged of possession of stolen property and get a lighter
sentence of one month in prison. What will be the equilibrium of this game?
ILLUSTRATION

PLAYER TWO
PLAYER ONE SILENT FINKS
SILENT (-1, -1) (-8, 0)
FINKS (0, -8) (-5, -5)

In the above case the equilibrium will happen if they both finks. We can make the
following conclusions on prisoners’ dilemma which is a non-cooperative game.
a) This game has so many applications in real life like the case of oligopoly where
cooperation has better outcomes than competing like case of oil producing countries.
b) The equilibrium results from the dominant strategy for both players
c) equilibrium outcome is not pareto optimal. This is because both players would have
been better-off if they had remained silent.
Therefore, prisoner’s dilemma is a game of dominant strategies where the equilibrium
is not pareto optimal. When players are allowed to interact, in repeated prisoner
setting, the outcome is better of cooperation and pareto outcomes. However, when
there is no ability to punish opposing prayers for choosing the fink strategy, the
outcome is Nash equilibrium (Fink, fink).

Coordination games
The prisoner’s dilemma is a description of many situations in real life but it is not the
whole picture. Some games may have no equilibrium and others may have more than
one equilibrium. In this case of coordination games, there is more than one Nash
equilibrium and solving this equilibrium requires some mechanism for determining
the final outcome.
Example A: Consider a scenario where two academic tutors James and Christine are
to publish a paper together. James prefers to use word software and Tina likes Corel’s
WordPerfect. Each understands every one’s program but they prefer using their
choices. These two works in two different universities. They start on the paper and

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they email each other their drafts. The table below shows the payoffs for their
strategies.
PLAYER TWO (TINA
PLAYER ONE (JAMES) Word Word perfect
Word (2, 1) (-2, -2)
Word perfect (-2, -2) (1, 2)

There are two Nash equilibrium in this case either both players use word or word
perfect and as a result, the Nash equilibrium concept is not enough to tell us where
both players will settle. This is also called the battle of sexes game. In this case both
a man and woman are players. They are either going to a boxing match or to the
basketball. The man prefers for boxing and the woman prefers basketball but they
both want to be together. The outcomes will be the same as those above with two
Nash equilibrium but we cannot tell where they will end up.
Another scenario is chicken games where two teenage drivers are in a game of
bravery. Each of the teenager are in the car facing each other. If both players stay the
course, they both die in the crash. If only one diverges he is coward and the other one
is a brave like the previous example the person who uses other one’s prefers is
Coward and the other is a brave. The payoffs in this case are given below
PLAYER TWO
PLAYER ONE Stay Swerve
Stay (-3, -3) (2, 0)
Swerve (0, 2) (1, 1)
The Nash equilibrium in the above case is when one stay and another one swerves.
Another example is where there two lovers James and Tina who want to meet for a
love affair. If James decides to call to discuss on where to meet, just moments after
Tina picks up the phone, there is a technical problem and the connection is broken.
James’ strategy is either to call back or wait for Tina to call and Tina’s strategy is the
same. If both calls back the line just rings busy and both cannot talk and meet. If both
of them decides to wait for other’s call they will wait longer and they won’t talk and
meet. The two equilibrium in this case is (Wait, Call) and (Call, Wait). It does not
matter who calls back but only one person can call and the other must wait. In these
current situations the onus is on original caller or one who needs the other most.
One other method of solving the coordination game is to attempt to pre-empt the game
by making some type of move before the game. For example, in the previous case you
may decide to call all your friends and inform them if you make a call and it is
interrupted you will never call them back.

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Question
Consider two firms that are merging into two divisions of a large firm, and have to
choose the computer system to use. In the past the firms have used different systems, I
and A; each prefers the system it has used in the past. They will both be better off if
they use the same system than if they continue to use different systems. The payoff is
given by the matrix below
PLAYER TWO
PLAYER ONE I A
I (2, 1) (0, 0)
A (0, 0) (1, 2)

To find the Nash equilibria, we examine each action profile in turn.

(I, I) Neither player can increase her payoff by choosing an action different from her
current one. Thus, this action profile is a Nash equilibrium. (I, A) By choosing A
rather than I, player 1 obtains a payoff of 1 rather than 0, given player 2's action. Thus,
this action profile is not a Nash equilibrium. [Also, player 2 can increase her payoff by
choosing I rather than A. (A, I) By choosing I rather than A, player 1 obtains a payoff
of 2 rather than 0, given player 2's action. Thus, this action profile is not a Nash
equilibrium. [Also, player 2 can increase her payoff by choosing A rather than I.] (A,
A) Neither player can increase her payoff by choosing an action different from her
current one. Thus, this action profile is a Nash equilibrium. We conclude that the
game has two Nash equilibria, (I, I) and (A, A).

No equilibrium
Nash's theorem states that every game with a finite number of players and a finite
number of pure strategies has at least one Nash equilibrium. As a result, a game with
infinitely many strategies might have no equilibria. In some situations, there can be
players with opposing preferences and in such cases, there will be no Nash
equilibrium.
Example
An established firm and a newcomer to the market of fixed size have to choose the
appearance for a product. Each firm can choose between two different appearances for
the product; call them A and B. The established producer prefers the newcomer's
product to look different from its own (so that its customers will not be tempted to buy
the newcomer's product) while the newcomer prefers that the products look alike. The
payoffs are given below
PLAYER TWO
PLAYER ONE A B

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 A (2, 1) (1, 2)
B (1, 2) (2, 1)
The Nash equilibrium in the above case won’t exist.
Soln
To find the Nash equilibria, we examine each action profile in turn. (A, B)
Firm 2 can increase its payoff from 1 to 2 by choosing the action B rather than the
action A. Thus, this action profile is not a Nash equilibrium. (A, B). Firm 1 can
increase its payoff from 1 to 2 by choosing the action B rather than the action A. Thus,
this action profile is not a Nash equilibrium. (B, A) Firm 1 can increase its payoff
from 1 to 2 by choosing the action A rather than the action B. Thus, this action profile
is not a Nash equilibrium. (B, B) Firm 2 can increase its payoff from 1 to 2 by
choosing the action A rather than the action B. Thus, this action profile is not a Nash
equilibrium.

Game of plain substitute and plain complements

The payoffs (measured in utility) to either patterner in relationship like marriage is
jointly determined by each of the two partners put in. as you undoubtedly know one of
the more important decisions you will make in your life is how much effort you will
put into your relationship. In this relationship game the strategy space is continuous.
In fact, the strategy space is a set of non-negative real numbers.

Games in which each player’s payoff diminishes as the value of other players strategy
increases is a game of plane substitute. While game of plane complements is a game
in which each players payoff increases as the value of other players strategy increases.
With games of plain substitutes, the players impose negative externalities on each
other while the game of plain complements they impose positive externalities on each
other.
Example: two roommates who smoke in a room of common airspace are playing a
game of plain substitutes because each of them is adversely affected by the second
hand smoker their roommate vomits out. Also, two teens who competes for attention
by spending money on clothes to improve their appearance are playing a game of
plain substitutes because the more one teen spends money, the more it becomes for
other to get attention. On the other hand, game of plane complements, two roommates
who devote effort in keeping their apartments clean are playing a game of plane
complements. This is because each one’s effort positively affects the other.
Also, two firms who produce identical products are playing a game of plain
substitutes. This is because there more output is produced, the lower the price and
lower the profit that the other firm can get from the same good.

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This is also applicable in situations of bribing of government official where many
players are involved it will require a large pay off. In that case people will pay bribes
if the benefits are higher than the requested amount.

Zero sum game

This is a with two players (Player A and Player B) such that: One player's loss equals
the other's gain ("zero sum"). The outcome of the game is determined by each player's
choice from among a fixed, finite set of moves. The possible moves may be different
for the two players. This is mainly applied in duopoly firms competing for the market
share. Each duopolist attempts to maximize his market share. With the above goal,
whatever firm gains by increasing its share of the market, the other firm loses because
of decrease in the share in the market and the net gain is zero hence the zero-sum
game. Therefore, any gain of one of rival is offset by the loss of the other. This is
based on assumption that firms have predetermined goal, each firm knows the
strategies open to it and to its rivals, each firm knows the payoff of all strategies of all
combinations with certainty i.e total revenue, total costs and profit. Each action taken
by duopolist do not affect the market size and there is no incentive for collusion.

Mixed strategies and game of discoordination

Think of a game of matching pennies or tossing a coin with head or tail outcomes. In
this case if both players chose the same pure strategy, one gets a payoff of 1 and
player two gets pay off of -1. If they choose different pure strategies then one gets a
payoff of one and the other -1. In this case no Nash equilibrium.
Consider a party game where two ladies want to choose to attend one of the two
weddings. One lady (Ritah) want to attend the same party as the other (Cathy). While
Cathy want to avoid Ritah. The following is the payoff for this game. This is a game
of discoordination.
Cathy
Ritah Party A Party B
Party A (1, 0) (0, 1)
Party B (0, 1) (1, 0)
The Nash equilibrium in the above case won’t exist.
Mixed strategy will arise if strategies are chosen randomly. Whenever you are playing
a game where one party wins and other one loses, and players have an incentive to
conceal their strategies, then the equilibrium strategies will be mixed. This can be the
case of sports and terrorism prevention. If you do one thing in a consistent way you
will be known to another player and you lose.
For case of terrorist, they keep on changing their strategies such that they are not
predictable.

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Sequential games
All games we have examined were of single stage or one period game. In life many
situations involving interaction with others where there is a sequence of decision.
These interactions may involve two or more stages. A sequential game is a game
where one player chooses their action before the others choose theirs. This means that
players who move later in the game have additional information about the actions of
other players or states of the world. This also means that players who move first can
often influence the game. Each player's strategy makes the actions that he or she
chooses conditional on the additional information received during the game. A
sequential game involves: a set of actions at each stage, each player’s information at
each stage, each player’s preferences over all possible combination of actions =
payoffs
Extensive Form Representation of sequential Games
A common way of representing games, especially sequential games, is the extensive
form representation, which uses game trees. Game trees are made up of nodes and
branches, which are used to represent the sequence of moves and the available actions,
respectively. Example consider a coordination game in previous example for James
and Tina. This can be represented in the game tree as below.
PLAYER TWO (TINA
Word Word perfect
Word (2, 1) (-2, -2)
Word perfect (-2, -2) (1, 2)

Word E Word A (2,1)

G Word perfect B (-2, -2)

F C (-2, -2)
Word perfect
Word perfect
D (1,2)
If we solve the equilibrium through backward induction by beginning with the
second player and cross out the branches the player he will never choose, we find that
EB, FC Will never be chosen by the second player. Now if we turn on player one then
he will never choose GF resulting into an equilibrium path of (word, word) with
payoff (2,1). This equilibrium we find using back ward induction is called subgame
perfect Nash equilibrium. It is a refinement of Nash equilibrium and it is their
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decision nodes not just that nodes are in equilibrium. In the original simultaneous
move game, there were two Nash equilibrium i.e both word and word perfect. There is
another Nash equilibrium in the sequential game in which both players chose word
perfect but it is not subgame perfect. In the imperfect equilibrium, Tina’s strategy is to
choose word perfect at both nodes.
Applications can be in oligopoly where one firm enters first and another one has to
follow.

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