Chapter Five: Game Theory

 Game theory deals with decision making under conflict or competition.

 Decision making of this type appears in parlor games (from this area some
terms in game theory were adopted).
 There are many examples of real-life game theory problems: international
military conflicts, choice of marketing strategies, labor-management
negotiations, potential mergers and so on.
 Game theory has its beginning in the 1920’s, but its greatest advance
occurred in 1944.
 The main characteristic of games is that two or more decision makers with
conflicting objectives are involved and the consequences of the decisions
(payoffs) to each depend on the courses of action taken by all.
 Each decision maker is usually trying to maximize his welfare at the expense
of the others.

BY: Getachew Gobena (Asst. Prof.)

 The following basic terms are used in game theory:
Play: is a one-shot decision in a conflict situation.
Game: is a series of repetitive decisions (plays).
Player: is an active participant of the game (it may be a
single person or a group of persons with the same interests).
Strategy: is a predetermined plan for selecting a course of
action. A set of strategies for a player forms a space of
strategies for this player.
Payoff: is a numerically expressed consequence of the
decisions of the players. The payoff depends on the choice of
the strategies of all players and therefore we speak about
payoff function.
Value of a game: is an average payoff per play. A game
whose value is zero is called a fair game.
BY: Getachew Gobena (Asst. Prof.)
A solution to game problems provides us with answers
to these two questions:

 What strategy should each player follow to maximize

his/her welfare.

 What will the payoff to each player be if the recommended

strategy is followed.

BY: Getachew Gobena (Asst. Prof.)

 In game theory, two or more decision makers, called players,
compete against each other.

 Each player selects one of several strategies without knowing in

advance the strategy selected by the other player or players.

 The combination of the competing strategies provides the value of

the game to the players.

 Game theory applications have been developed for situations in

which the competing players are teams, companies, political
candidates, and contract bidders.

BY: Getachew Gobena (Asst. Prof.)

5.1. Two-person, zero-sum games

 Two-person means that two players participate in the game.

 Zero-sum means that the gain (or loss) for one player is equal
to the loss (or gain) for the other player.

 As a result, the gain and loss balance out (resulting in a zero-

sum) for the game.

 What one player wins, the other player looses.

 Let us demonstrate a two-person, zero-sum game and its

solution by considering two companies competing for market
share. BY: Getachew Gobena (Asst. Prof.)
 Suppose that two companies are the only manufacturers of a particular
product; they compete against each other for market share. In planning a
marketing strategy for the coming year, each company will select one of three
strategies designed to take market share from the other company. The three
strategies, which are assumed to be the same for both companies, are as
follows:

 Strategy 1: Increase advertising

 Strategy 2: Provide quantity discounts
 Strategy 3: Extend warranty

BY: Getachew Gobena (Asst. Prof.)

 Payoff table showing the percentage gain in market share for
company A

Company B
Increase Quantity Extend
advertizing b1 discount b2 Warranty b3
Increase Advertizing a1 4 3 2
Quantity discount a2 -1 4 1
Company A
Extend warranty 5 -2 0

• A payoff table showing the percentage gain in the market share for Company A for
each combination of strategies .
• Because it is a zero-sum game, any gain in market share for Company A is a loss in
market share for Company B.
• In interpreting the entries in the table, we see that if Company A increases
advertising (a1) and Company B increases advertising (b1), Company A will come
out ahead with an increase in market share of 4%, while Company B will have a
decrease in market share of 4%.
BY: Getachew Gobena (Asst. Prof.)
 If Company A provides quantity discounts (a2) and Company B
increases advertising (b1), Company A will lose 1% of market
share, while Company B will gain 1% of market share.

 Therefore, Company A wants to maximize the payoff that is its

increase in market share. Company B wants to minimize the
payoff because the increase in market share for Company A is
the decrease in market share for Company B.

BY: Getachew Gobena (Asst. Prof.)

 This market-share game meets the requirements of a two-person,
zero-sum game.
 The two companies are the two players, and the zero-sum occurs
because the gain (or loss) in market share for Company A is the
same as the loss (or gain) in market share for Company B.

 Each company will select one of its three alternative strategies.

 Because of the planning horizon, each company will have to

select its strategy before knowing the other company’s strategy.

 What is the optimal strategy for each company?

BY: Getachew Gobena (Asst. Prof.)

 The logic of game theory assumes that each player has the same information
and will select a strategy that provides the best possible payoff from its point of
view.
 Suppose Company A selects strategy a1. Market share increases of 4%, 3%, or
2% are possible depending upon Company B’s strategy. At this point, Company
A assumes that Company B will select the strategy that is best for it.

 Thus, if Company A selects strategy a1, Company A assumes Company B will

select its best strategy b3, which will limit Company A’s increase in market
share to 2%. Continuing with this logic, Company A analyzes the game by
protecting itself against the strategy that may be taken by Company B.

 Doing so, Company A identifies the minimum payoff for each of its strategies,
which is the minimum value in each row of the payoff table as indicated in the
following table.

BY: Getachew Gobena (Asst. Prof.)

 Considering the entries in the Row Minimum, we see that
Company A can be guaranteed an increase in market share of at
least 2% by selecting strategy a1.

 Strategy a2 could result in a decrease in market share of 1% and

strategy a3 could result in a decrease in market share of 2%.

 After comparing the row minimum values, Company A selects the

strategy that provides the maximum of the row minimum values.
This is called a maximin strategy.

 Thus, Company A selects strategy a1 as its optimal strategy; an

increase in market share of at least 2% is guaranteed.

BY: Getachew Gobena (Asst. Prof.)

Let us now look at the payoff table from the point of
view of the other player, Company B.

The entries in the payoff table represent gains in market

share for Company A, which corresponds to losses in
market share for Company B.

BY: Getachew Gobena (Asst. Prof.)

Payoff table with row minimum
Company B

Increase Quantity Extend Row

advertizing b1 discount b2 Warranty b3 Minimum
Increase 4 3 2 2
Advertizing a1 (maximum)
Company A
Quantity -1 4 1 -1
discount a2
Extend 5 -2 0 -2
warranty a3
 Consider what happens if Company B selects strategy b1.
 Company B market share decreases of 4%, –1%, and 5% are possible.
 Under the assumption that Company A will select the strategy that is best for it
 Company B assumes that Company A will select strategy a3, resulting in a
gain in market share of 5% for Company A and a loss in market share of 5%
for Company B. At this point, Company B analyzes the game by protecting
itself against the strategy taken by Company A.
BY: Getachew Gobena (Asst. Prof.)
 Doing so, Company B identifies the maximum payoff to Company A for each
of its strategies b1, b2, and b3. This payoff value is the maximum value in
each column of the payoff table.

 Considering the entries in the Column Maximum, Company B can be

guaranteed a decrease in market share of no more than 2% by selecting the
strategy b3.

 Strategy b1 could result in a decrease in market share of 5% and strategy b2

could result in a decrease in market share of 4%.

 After comparing the column maximum values, Company B selects the

strategy that provides the minimum of the column maximum values. This is
called a minimax strategy.

BY: Getachew Gobena (Asst. Prof.)

Payoff table with column maximum values
Company B

Increase Quantity Extend Row

advertizing b1 discount b2 Warranty b3 Minimum
Increase 4 3 2 2
Advertizing a1 (maximum)
Company A
Quantity -1 4 1 -1
discount a2
Extend 5 -2 0 -2
warranty a3
Column 5 4 2
Maximum (Minimum)

 Thus, Company B selects b3 as its optimal strategy in which it has

guaranteed that Company A cannot gain more than 2% in market share as
shown in the above table.
 Therefore, Company A selects the strategy of increase advertizing, while
Company B selects the strategy of extend warranty (optimal strategies).
BY: Getachew Gobena (Asst. Prof.)
5.2. Pure strategies: Game with Saddle point
 If it is optimal for both players to select one strategy and stay with
that strategy regardless of what the other player does, the game has
a pure strategy solution.

 Whenever the maximum of the row minimums equals the

minimum of the column maximums, the players cannot improve
their payoff by changing to a different strategy.
 The game is said to have a saddle point, or an equilibrium point.

 Thus, a pure strategy is the optimal strategy for the players.

 A Game has a Pure Strategy Solution if:

 Maximum (Row minimums) = Minimum (Column maximums)

BY: Getachew Gobena (Asst. Prof.)

 For the equality in the case of our example, the solution to the
game is for Company A to increase advertising (strategy a1) and
for Company B to extend the warranty (strategy b3).

 Company A’s market share will increase by 2% and Company B’s

market share will decrease by 2%.

 With Company A selecting its pure strategy a1, let us see what
happens if Company B tries to change from its pure strategy b3.
 Company A’s market share will increase 4% if b1 is selected or will
increase 3% if b2 is selected.
 Company B must stay with its pure strategy b3 to limit Company A to a 2%
increase in market share.

BY: Getachew Gobena (Asst. Prof.)

 Similarly, with Company B selecting its pure strategy b3, let us see
what happens if Company A tries to change from its pure strategy
a1.

 Company A’s market share will increase only 1% if a2 is selected or will not
increase at all if a3 is selected.

 Company A must stay with its pure strategy a1 in order to keep its 2%
increase in market share.

 Thus, even if one of the companies discovers its opponent’s pure strategy in
advance, neither company can gain any advantage by switching from its pure
strategy.

BY: Getachew Gobena (Asst. Prof.)

 If a pure strategy solution exists, it is the optimal solution to the game.
 The following steps can be used to determine when a game has a pure strategy
solution and to identify the optimal pure strategy for each player:

Step 1: Compute the minimum payoff for each row (Player A).
Step 2: For Player A, select the strategy that provides the maximum of the row
minimums.
Step 3: Compute the maximum payoff for each column (Player B).
Step 4: For Player B, select the strategy that provides the minimum of the
column maximums.
Step 5: If the maximum of the row minimums is equal to the minimum of the
column maximums, this value is the value of the game and a pure strategy
solution exists.

 The optimal pure strategy for Player A is identified in Step 2, and the optimal
pure strategy for Player B is identified in Step 4.

BY: Getachew Gobena (Asst. Prof.)

 If the maximum of the row minimums does not equal the
minimum of the column maximums, a pure strategy solution
does not exist.
 In this case, a mixed strategy solution becomes optimal.

 In the following discussion, we define a mixed strategy

solution and show how linear programming can be used to
identify the optimal mixed strategy for each player.

BY: Getachew Gobena (Asst. Prof.)

 5.3 Mixed strategies: Game without saddle point
 A mixed strategy game occurs when each player selects an
optimal strategy and they do not result in an equilibrium .
 The following example will demonstrate a mixed strategy game. The Colorid
camera company (company I) is going to introduce a new instant camera in to
its product line and hopes to capture large market share as possible. In
contrast, Camco Camera company (Company II) hopes to minimize Coloroid’s
market share increase.
 The strategies for each company are based on their promotional
campaigns, packaging, and cosmetic differences between the
products. Each player will first determine an optimal probability
distribution for selecting whether to increase promotion,
packaging or cosmetic differences.
 Then, when the game is played, each player will use his
probability distribution to randomly select one of his three
strategies.
BY: Getachew Gobena (Asst. Prof.)
 Payoff Table for Camera Companies
Company II
Camera Company I Strategies
Strategies
Promotion Packaging Cosmetic (b3)
(b1) (b2)
Promotion (a1) 9 7 2
Packaging (a2) 11 8 4
Cosmetic (a3) 4 1 7

 The values in the table are the percentage increases or decreases in market
share for Company I and II.
 The first step is to check the payoff table for any dominant strategy. Doing
so, we find that strategy a2 dominates strategy a1, and strategy b2 dominates
strategy b1.
BY: Getachew Gobena (Asst. Prof.)
 Thus, strategies a1 and b1 can be eliminated from the pay off
table and the following new payoff table will be formed.

Company II
Company I strategies
Strategies Packaging (b2) Cosmetic (b3)
Packaging (a2) 8 4
Cosmetic (a3) 1 7

 We apply the maximin decision criterion to the strategies for Company A

(offensive player).
 The minimum value for strategy 2 is 4% and the minimum value for strategy 3
is 1%.
 The maximum of these two minimum values is 4%, thus, strategy 2 is the
optimal strategy for company I.

BY: Getachew Gobena (Asst. Prof.)

 Payoff table with Maxmin Criterion

Company I Company II strategies

Strategies
b2 b3

a2 8 4
Maximum of the minimum values

a3 1 7

BY: Getachew Gobena (Asst. Prof.)

 Now the minimax decision criterion is applied to the strategies
for company II ( defensive player).

 The maximum value for strategy b2 is 8%, and the maximum

value for strategy b3 is 7%. Of these two maximum values, 7% is
the minimum; which is the optimal strategy for Company II.

Company I Company II strategies

Strategies b2 b3
a2 8 4
a3 1 7
Minimum of maximum values

BY: Getachew Gobena (Asst. Prof.)

 Company I and II combined strategies
Company I Company II strategies
Strategies
b2 b3

a2 8 4 (Company I)

a3 1 7 (Company II)

 The strategies selected by the companies do not result in an

equilibrium point. Therefore, this is not a pure strategy game.
 In fact this condition will not result in any strategy for either
firm.

BY: Getachew Gobena (Asst. Prof.)

 The companies come back where they started and they complete a
closed loop which could continue indefinitely if the two
companies persisted.

Company I Company
Strategies II
strategies
b2 b3
a2 8 4
a3 1 7

 The most common methods for solving mixed strategy games are
the expected gain and loss method (analytical) and linear
programming.

BY: Getachew Gobena (Asst. Prof.)

Expected Gain and Loss method

 It is based on the principle that in a mixed strategy game, a plan

of strategies can be developed by each player so that:

 the expected gain of the maximizing player or the expected loss of the
minimizing player will be the same, regardless of what the opponent
does.
 In this method the player is indifferent to the opponent’s action.

 This method is based on the concept of expected values.

BY: Getachew Gobena (Asst. Prof.)

 The mixed strategy for the two camera companies will be used
to demonstrate the expected gain and loss method.

 First we will compute the expected gain for company I.

 Company I arbitrarily assumes that Company II will select

strategy b2.

 Given this condition, there is a probability of p that Company I

will select strategy a2 and 1-p that company I will select strategy
a3. Thus, if Company II selects b2, the expected gain for
Company I will be:
8p+1(1-p) = 1+7p

BY: Getachew Gobena (Asst. Prof.)

 Next, Company I assumes that Company II will select strategy b3.

 Given strategy b3, there is a probability of p that Company I will

select strategy a2 and a probability of 1-p that company I will
select strategy a3.

 Thus, the expected gain for Company I given strategy b3 is:

4p+7(1-P) = 7-3p

BY: Getachew Gobena (Asst. Prof.)

 If company I is indifferent to whether Company II selects
strategy b2 or b3, we can simply equate the expected gain from
each of these strategies:
1+7p = 7-3p
10p= 6
P=6/10=0.60
 Recall that p is the probability of using strategy a2 or the
percentage of time strategy a2 would be employed.

 Thus, company I’s plan is to use strategy a2 for 60% of the time
and to use strategy a3 the remaining 40% of the time.

BY: Getachew Gobena (Asst. Prof.)

 The expected gain (market share increase for company I) can be
computed using the payoff of either strategy b2 or b3 since the
gain will be the same regardless.
EG (Company I)=0.60(8)+0.40(1)
= 5.2 % market share increase

 In order to check this result, we will compute the expected gain

if strategy b3 is used by Company II.
EG (Company I) = 0.60 (4) +0.40(7)
= 5.2% market share increase

BY: Getachew Gobena (Asst. Prof.)

 We must also repeat the above process for Company II to develop its mixed
strategy (Company II’s expected loss).
 First, we assume that company I will select strategy a2.
 Thus, company II will employ strategy b2 for p probability (percentage of the
time) and b3 for the remaining 1-p probability( percent of the time). Thus, the
expected loss for company II is:
8p+4(1-p) = 4+4p
 Next, we compute the expected loss for company II given that Company I
selects strategy a3.
1p + 7(1-p)= 7-6p
By equating the two expected losses for strategies a2 and a3, the
result of p and 1-p will be
4+4p= 7-6p
10p = 3
P= 3/10
P= 0.30 and 1-p = 0.70
BY: Getachew Gobena (Asst. Prof.)
 Since p is the probability of employing strategy b2, Company II
will employ strategy b2 for 30% of the time and thus strategy b3
will be employed 70% of the time.

 The actual expected loss given strategy a2 (which is the same as

that for strategy a3) is computed as:
EL(Company II) = 0.30 (8) +0.70 (4)
= 5.2% market share loss.
 The mixed strategies for each company are summarized as
follows:
Company I
Strategy a2: 60% of the time
Strategy 3: 40% of the time
Company II
Strategy b2: 30% of the time
Strategy b3: 70%
BY: Getachew Gobena of the
(Asst. Prof.)time
 5.4. Dominant Strategy
 Dominance of strategy occurs when all the payoffs for one
strategy are better than the corresponding payoffs for another
strategy.
 Let’s see the following table:
Athlete /agent
Strategies General manager strategies
A B C
1 $50,000 $35000 $30,000
2 $60,000 $40,000 $20,000
 In the above table, values $30,000 and $20,000 are both lower than the
corresponding payoffs of $50,000 and $60,000 for strategy A and the
corresponding payoffs $35,000 and $40,000 for strategy B.
 Since strategy C dominates A and B, these two latter strategies can be
eliminated from consideration in case of payment to be made by general
manger to the athlete/agent.
BY: Getachew Gobena (Asst. Prof.)
 If this approach had been done, strategy C could have been
selected automatically without applying the minimax criterion.

 Thus, the most efficient approach is to first examine the payoff

table for dominance in order to possibly reduce its size.

Athlete/agent General Manager Strategies

Strategies

C
1 $30,000
2 $20,00

BY: Getachew Gobena (Asst. Prof.)

 The optimal strategy for each player in this game resulted in the
same payoff game value of $30,000 which is classified as a pure
strategy game.

 Since the outcome of a $30,00 results from a pure strategy, it is

referred to as an equilibrium point or saddle point. A point of
equilibrium is a value that is simultaneously the minimum of a
row and the maximum of a column as $30,000 indicated above.

BY: Getachew Gobena (Asst. Prof.)