GAME THEORY

GAME THEORY
 Game theory is the study of how people behave in strategic
situations
 It is a mathematical theory that deals with models of
conflict and cooperation.
 Strategic decisions are those in which each person, in
deciding what actions to take, must consider how others
might respond to that action
 Strategy is a plan for the actions that a player in a game will
take under every conceivable circumstance that the player
might face.
 If the market is composed by a small number of firms, each
firm must act strategically
 Each firm affects the market price changing the quantity
produced
GAME THEORY….
Suppose 2 firms are producing 100 units each
 If one of the firms decides to increase the production
by 10 units
 The market supply will increase from 200 to 210 and
the price has to drop to reach an equilibrium
Therefore, it also affects the profits of other firms.
 Each firm knows that its profit depends not only on
how much it produced but also on how much the
other firms produce
What is a Game?
A game is a situation where the participants’ payoffs
depend not only on their decisions, but also on their
rivals’ decisions
This is called Strategic Interactions:
 My optimal decisions will depend on what others do in the
game
Any situation in which individuals must make
strategic choices and in which the final outcome will
depend on what each person chooses to do can be
viewed as a game.
 A Game
 Four elements describe a game:
1) Player
A player is a decision maker and can be anything from
individuals to entire nations.
2) Rules
The rules of the game state who can do what, and when they
can do it. When each player moves, what are the possible
moves, what is known to each player before moving
3) Payoffs
Payoffs are the final returns to the players at the conclusion of
the game. Payoffs are usually measured in utility but
sometimes measured monetarily, how much money each
player receive for any specific outcome.
4) Strategies
Are the choices that a player is allowed to make.
Examples of strategies
 In game trees (sequential games), the players choose
paths or branches from roots or nodes.
 In matrix games players choose rows or columns
 In market games, players choose prices, or quantities,or
R and D levels.
 Classifications of Games
 Cooperative and non-cooperative games
Cooperative game: players are able to form binding commitments.
Non cooperative games: the players make decisions independently
 Zero sum and non-zero sum games
Zero sum game: one person wins, another loses. E.g., poker
Non-zero sum game: e.g., prisoner’s dilemma
 Finite game and infinite game
Finite game: the players and the actions are finite.
 Simultaneous and sequential (dynamic) games
Simultaneous game: players move simultaneously, or if they do not
move simultaneously, the later players are unaware of the earlier
players' actions
Sequential game: later players have some knowledge about earlier
actions.
 Perfect information and imperfect information games
Perfect information game: all players know the moves previously made
by all other players. E.g., chess
Presentation of Payoffs
Payoffs can be presented by a game tree or a matrix
to show the final returns to the players.
 a game tree is called the extensive form

 a matrix is called the normal form

Example 1
Matching coins
 Each player selects one side of a coin;
 If the coins match both heads or both tails player 1 wins
and gets 1 dollar from player 2;
 If the coins don’t match i.e. one heads and one tails, then
player 2 wins and gets 1 dollar from player 1.
 Matrix Representation of Matching Coins
Player 2

Head Tail

Head
1, -1 -1, 1
Player 1
Tail
-1, 1 -1, 1
Example 2
Prisoners Dilemma
Prisoners’ dilemma is a game situation in which there
is a tension between the collective interest of all of the
players and the self-interest of individual players.
Two individuals (John and Juma) have been arrested
for possession of guns.
The police suspects that they have committed 10 bank
robberies;
If nobody confesses to the police, they will be jailed for
2 years.
 If only one confesses, he’ll go free and his partner will
be jailed for 40 years.
 If they both confess, they get 16 years
Prisoners Dilemma…
There are 4 combinations of strategies and two
payoffs for each combination
 Decision Tree
There are two cases to consider

If John Confesses
If John Does Not Confess

Juma
Juma

Confess Not Confess Confess Not Confess

16 Years in 40 Years in 0 Year in 2 Years in

Prison Prison Prison Prison

Best
Best
Strategy
Strategy
The dominant strategy for Juma is to confess because no matter what John does
he is better off confessing.
Matrix Representation of Prisoners Dilemma

Juma

Confess Not confess

Confess 16, 16 0, 40

John
Not confess 40, 0 2, 2
 Boeing-Airbus game
Example 3
Boeing and Airbus have to decide whether to invest in the
development of a Super Jumbo for long distance travel;
If they both develop successfully the new plane, their
profits will drop by 50 millions a year;
If only one develop the Super Jumbo, it will make 80
millions a year in additional profits, whereas the profits of
the other firm will drop by 30 millions a year;
 If no firm develops the plane, nothing changes.
Matrix Representation of Boeing-Airbus game…

Airbus
Do not
Develop
develop
Develop -50,-50 80,-30
Boeing
Do not
-30,80 0,0
develop
 Pricing Game Between Two Firms
Example 4
 Firms price simultaneously.
 They may price High or Low
 Both Pricing High yields the highest profits.
 But each wants to cheat.
 Market-Share Game
Example 5
Two managers want to maximize market share
Strategies are pricing decisions
 S1 = {1, 5, 10}.
 S2 = {1, 5, 10}.
Simultaneous moves.
The Market-Share Game in Normal Form
 Equilibrium
Once we have described strategies and payoffs, we can
go ahead and try to predict how a player will play a
game.
But where do we start?
“Equilibrium” is the term game theorists use to
describe how the game will (likely?) be played.
We will focus on two types of equilibrium:
 Elimination of Dominated Strategies
 Nash Equilibrium
 Nash Equilibrium
Nash equilibrium is a situation in which each player in
a game chooses the strategy that yields the highest
payoff, given the strategies chosen by the other players.
If we have two individuals A and B, then
We will say that a pair of strategies is a Nash
equilibrium if A’s choice is optimal, given B’s choice,
and B’s choice is optimal given A’s choice.
A strategy profile is a Nash equilibrium if and only if
each player’s prescribed strategy is a best response to
the strategies of the others.
No player can do better by unilaterally changing his or
her strategy
Nash Equilibrium…
No individual prefers a different choice
In other words, each player is choosing the best
strategy, given the strategies chosen by the other
players.
Game theory seeks to answer the question: What is the
likely outcome of a game?
To identify “likely outcomes” of games, game theorists
use the concept of a Nash equilibrium.
In some games, there is no pure strategy Nash
equilibrium exists, players find it in their interest to
engage in mixed (randomized) strategies.
John Nash proved that every game has at least one
Nash equilibrium when a mixed strategy is allowed.
 Dominant and dominated strategies
Dominant strategy is a strategy that is better than
any other a player might choose, no matter what
strategy the other player follows.
When a player has a dominant strategy, that strategy
will be the player’s Nash equilibrium strategy.
The opposite of a dominant strategy is a dominated
strategy.
A strategy is dominated when the player has another
strategy that gives it a higher payoff no matter what
the other player does.
Dominant and dominated strategies…
When the elimination of dominated strategies leads to
a single pair of strategies, then we call this an
equilibrium of a game.
Some games, however, do not have dominated
strategies, or after elimination, do not lead to a single
pair of strategies.
For example in slide 27
Example 6
How to find: dominant strategy, dominated strategy,
and Nash equilibrium
Prisoners Dilemma

The dominant strategy here is Confess

The dominated strategy Not confess
The Nash equilibrium is (Confess, Confess), with the
payoff (16,16)
Example 7
The Market-Share Game
 Advertising Game
Example 8
Two firms managers want to maximize profits.
Strategies consist of advertising campaigns.
Simultaneous moves.
Firm B

Firm A
Problems of using elimination to attain a best strategy
Example 9
Consider the following two game games:
Player B
Left Right
Player A Up 9,4 2,8 No dominant
Down 5,6 7,3 strategy

Musa
Left Right

Willy Up 5,9 2,6 Two Nash

Down 3,5 4,7 equilibriums
Example 10
Find all the pure strategy Nash equilibria in the
following simultaneous game in which player 1 has four
strategies W, X, Y, and Z while player 2 has three
strategies as well A, B and C
Player 2
A B C
W 6,6 4,7 1,4
Player 1 X 9,3 4,1 6,2
Y 8,5 5,4 6,6
Z 4,4 8,5 4,3
 Mixed strategy
A mixed strategy exists in a strategic game, when the
player does not choose one definite action, but rather,
chooses according to a probability distribution over his
actions.
There are cases where a pure strategy equilibrium does
not exist.
Therefore, we have to find the probability for which
the player would be willing to randomise between his
actions.
This means players will “randomly” select strategies
from all available strategies.
This probability will depend on the expected payoffs of
the player for each of his actions.
 Some Applications of Game Theory

1) The study of oligopolies (industries containing only a

few firms)
2) The study of cartels; e.g. OPEC
3) The study of externalities; e.g. using a common
resource such as a fishery.
4) The study of military strategies.