ELE5211: Advanced Topics in CE

Module Five
Game Theory

Tutor: Hassan A. Bashir 1

 Game Theory
Definition: Game Theory is the study of strategic decision making.

More formally, it is the study of mathematical models of conflict

and cooperation between intelligent rational decision-makers.

Strategic decisions are those in which each person, in deciding

what actions to take, must consider how others might respond to
that action. 2
 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.

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 Elements of a Game
Four elements to describe a game:
Players;
Rules: when each player moves, what are the
possible moves, what is known to each player
before moving;
Outcomes of the moves;
Payoffs of each possible outcome: how much
benefit/money each player receive for any
specific outcome.

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 Game Theory Terminologies
Simultaneous Move Game – Game in which each player
makes decisions without knowledge of the other players’
decisions.

Sequential Move Game – Game in which one player makes a

move after observing the other player’s move.

Strategy – In game theory, a decision rule that describes the

actions a player will take at each decision point.

Normal Form Game – A representation (matrix) of a game

indicating the players, their possible strategies, and the
payoffs resulting from alternative strategies.
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 Game Theory - Applications
Game Theory is used to analyze how firms interact but has
many other applications.

•National Defense – Terrorism and Cold War

•Movie Release Dates and Program Scheduling
•Auctions http://en.wikipedia.org/wiki/Spectrum_auction
• http://en.wikipedia.org/wiki/United_States_2008_wir
eless_spectrum_auction
•Sports – Cards, Cycling, and race car driving
•Politics – positions taken and $$/time spent on campaigning
•Nanny Monitoring
•Group of Birds Feeding
•Mating Habits, etc... 6
 Game Theory - Applications
Example in Economics

•If the market is composed of a small number of firms,

each firm must act strategically.

• Each firm affects the market price changing the

quantity produced.

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 Game Theory - Applications
Example in Economics
•Suppose 2 firms are producing 100 units.
• 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.
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 Example Games
1. Matching pennies
Each player selects one side of a coin;
if the coins match player 1 wins and gets 1
dollar from player 2;
if the coins don’t match player 2 wins and
gets 1 dollar from player 1.

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Matrix Representation of Matching
Pennies

Player 2

Head Tail

Head 1,-1 -1,1

Player 1
Tail -1,1 1,-1

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 2. Boeing-Airbus game
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. 11

Matrix Representation of Boeing-
Airbus game

Airbus

Do not
Develop
develop

Develop -50,-50 80,-30

Boeing
Do not
-30,80 0,0
develop

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 3. Pie making game
Game Theory is the study of rational behavior among
interdependent agents

Agents have a common interest to make the pie as

large as possible,

But Agents have competing interests to maximize

their own share of the pie.

An agent’s rational decisions require anticipating

rivals’ responses

These expectations are not perfect, so uncertainty is

a necessary feature of games
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 4. Battle of Sexes

A couple deciding on how to spend the evening

Wife would like to go for a movie
Husband would like to go for a cricket match
Both however want to spend the time together
Scope for strategic interaction
Husband
Movie Cricket
Movie 2,1 1,1
Wife
Cricket 0,0 1,2
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 Solutions of the Games

To predict what will be the

solution/outcome of the game we need
some tools:
dominated and dominant strategies;
Nash equilibrium.

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 Prisoner’s Dilemma
Two individuals 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, she’ll go free and her partner

will be jailed for 40 years.

if they both confess, they get 16 years

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Matrix Representation of Prisoners
Dilemma

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
40,0 2,2
Confess

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 We want to predict the outcome of the game
Suppose that Clyde decides to confess. What is the best decision for Bonnie?

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
40,0 2,2
Confess
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 We want to predict the outcome of the game
Suppose that Clyde decides to remain silent. What is the best decision for Bonnie?

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
40,0 2,2
Confess
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Dominated and Dominant Strategy
Dominant Strategy:
a strategy that gives higher payoffs no matter what
the opponent does;

Dominated Strategy:
a strategy is dominated if there exists another
strategy that is dominant.

So far we have only assumed that each player is

rational to determine the outcome of the game.
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 We want to predict the outcome of the game
Suppose that Bonnie decides to confess. What is the best decision for Clyde?

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
40,0 2,2
Confess
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 We want to predict the outcome of the game
Suppose that Bonnie decides to remain silent. What is the best decision for Clyde?

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
40,0 2,2
Confess
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 Outcome of the Game

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
40,0 2,2
Confess
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 Solution
Confess is a dominant strategy for both. If
both Deny they would be better off. This is the
dilemma.
This can describe a lot of situations. E.g. :
cartels,
arms control,
competition between municipalities (Child care
fees and fiscal competition).

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A Modified Prisoners Dilemma:
Clyde is proud of not confessing

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
36,0 -2,2
Confess

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 We want to predict the outcome of the game
Suppose that Bonnie decides to remain silent. What is the best decision for Clyde?

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
36,0 -2,2
Confess
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 We want to predict the outcome of the game
Suppose that Bonnie decides to confess. What is the best decision for Clyde?

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
36,0 -2,2
Confess
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Dominated and Dominant Strategy
In this case there is no dominant strategy for
Clyde.

But, for Bonnie confess is still a dominant strategy.

Suppose that Clyde knows that Bonnie is rational

and will choose to confess.

Since Clyde knows that Bonnie will choose to

confess, can we determine the outcome of the
game?

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 We want to predict the outcome of the game
Bonnie will decides to confess because it is a dominant strategy. What is the best
decision for Clyde?

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
36,0 -2,2
Confess
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 Outcome of the Game

Bonnie

Do not
Confess
Confess

Confess 16,16 0,40

Clyde
Do not
40,0 2,2
Confess
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 No Dominant Strategies

In most games there are no dominant

strategies for all players.
We cannot use this method to predict the
outcome of the game.

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 No Dominant Strategies
Player 2

L C R

T 0,7 7,0 5,3

Player 1 M 7,0 0,7 5,3

B 3,5 3,5 6,6

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 Equilibrium
Nash Equilibrium: Neither player has an incentive to
change strategy, given the other player’s choice

A player’s best option may be dictated by anticipating the

rival’s best option

The decisions of the players are a Nash Equilibrium if no

individual prefers a different choice.

In other words, each player is choosing the best strategy,

given the strategies chosen by the other players.
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 Repeated Games
Repeated Games
• The game can be played repeatedly by the same
players; repeated games.

• Player has the opportunity to establish a reputation

for cooperation and thereby encourage other players
to do the same. Thus, the prisoner’s dilemma may
disappear.

• For egoists to play cooperatively the game has to be

played an infinite number of times; there may not be a
known last round of the game.

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 Repeated Games
Repeated Games
• If there is a last round in the game, Confess is a
dominant strategy in that round. This will also be
true in the next to the last round, and so on.

• Players cooperate because they hope that

cooperation will induce further cooperation in the
future, but this requires a possibility of future play.

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 Example – Climate
Repeated Change
Games
Climate change and the Kyoto protocol in light of the
prisoner’s dilemma

• All countries will enjoy the benefits of a stable climate

whether they have helped bring it about or not
• USA and Australia chose not to put a limit on their
emissions, also many poor countries
• Everyone is counting on others to act; so no one will
• This is a prisoner’s dilemma!
• Rational leaders will neglect the problem and global
warming can not be stopped
• Is this true?

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 Example – Climate
Repeated Change
Games
Climate change and the Kyoto protocol in light of the prisoner’s
dilemma

• The implications are very different if we see it from the one shot
game perspective or the repeated game perspective

• If the game is repeated the players have an incentive to

cooperate so to not get punished by the opponents in the
following rounds

• Rational countries will not be deterred by free riders but

continue to curb emissions and devise sanctions for those who
do not

• Needed is more sanctions and negotiations more frequently

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 Mixed Strategy
Repeated Game
Games
• A game in strategic form does not always have a Nash
equilibrium in which each player deterministically chooses
one of his strategies.

• However, players may instead randomly select from among

these pure strategies with certain probabilities.

• Randomizing one’s own choice in this way is called a mixed

strategy.

• As before, an equilibrium is defined by a (possibly mixed)

strategy for each player where no player can gain on average
by unilateral deviation.

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 Mixed Strategy
RepeatedGame - Example
Games
Compliance Inspection
• Suppose a consumer purchases a license for a software
package, agreeing to certain restrictions on its use.
• The consumer has an incentive to violate these rules.
• The vendor would like to verify that the consumer is
abiding by the agreement, but doing so requires
inspections which are costly.
• If the vendor does inspect and catches the consumer
cheating,
• the vendor can demand a large penalty payment for the
noncompliance.

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 Mixed Strategy
RepeatedGame - Example
Games
Compliance Inspection

Inspection game between a software vendor (player I) and

consumer (player II).
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 Mixed Strategy - Example
Repeated Games
Compliance Inspection
• The circular arrow structure in this Figure shows that this
game has no equilibrium in pure strategies.
• If any of the players settles on a deterministic choice (like
Don’t inspect by player I),
• the best response of the other player would be unique (here
cheat by player II),
• to which the original choice would not be a best response
(player I prefers Inspect when the other player chooses cheat,
against which player II in turn prefers to comply).
• Remember: The strategies in a Nash equilibrium must be best
responses to each other,
• so in this game Nash equilibrium fails to hold for any pure
strategy combination. 41
 Mixed Equilibrium
Repeated Games
What should the players do in the game?

Option One
• One possibility is that they prepare for the worst, that is,
choose a max-min strategy.
• A max-min strategy maximizes the player’s worst payoff
against all possible choices of the opponent.

• The max-min strategy for player I is to Inspect (where the

vendor guarantees himself payoff € -6), and
• for player II it is to comply (which guarantees her payoff 0).

However, this is not a Nash equilibrium and hence not a stable

recommendation to the two players, since player I could switch
his strategy and improve his payoff. 42
 Mixed Equilibrium
Repeated Games
What should the players do in the game?

Option Two
• A mixed strategy of player I in this game is to Inspect
only with a certain probability.
• Even if an inspection is not certain, a sufficiently high
chance of being caught should deter from cheating,
at least to some extent.

How to find the probability of inspection that will lead

to an equilibrium?
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 Mixed Equilibrium
Repeated Games
What should the players do in the game?

• If the probability of inspection is very low, player II will still cheat:

• If the probability of inspection is very high, player II will prefer to

comply:

If the inspection probability is either too low or too high, then player II
has a unique best response.
As shown above, such a pure strategy cannot be part of an equilibrium.
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 Mixed Equilibrium
Repeated Games
Solution
When is player II indifferent???
• Player II is indifferent iff player I inspects with
probability 0.1

• With this mixed strategy of player I (Don’t inspect

with probability 0.9 and Inspect with probability 0.1),
• Player II is indifferent between her strategies.
• Player II can mix them (that is, play them randomly)
without losing payoff
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 Mixed Equilibrium
Repeated Games
Solution cont’d

• Player I is indifferent iff player II complies with probability 0.8

• The expected payoffs to Player I are then:

• for Don’t inspect

• and for Inspect

• Player I is indeed indifferent, and his mixed strategy is a best

response to the mixed strategy of player II.

The above defines the only Nash equilibrium of the game.

• It uses mixed strategies and is therefore called a mixed equilibrium.
• The resulting expected payoffs are 2 for player I and 0 for player II.
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 Extensive games with perfect
Repeated Games
information
• In a game in strategic form, the players choose their
strategies simultaneously, without knowing the choices
of the other players.

• The more detailed model of a game tree, also called a

game in extensive form, formalizes interactions where
the players can over time be informed about the actions
of others.

• In an extensive game with perfect information, every

player is at any point aware of the previous choices of all
other players.
• Furthermore, only one player moves at a time, so that
there are no simultaneous moves.
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Extensive games with perfect
Repeated Games
information

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 Extensive games with perfect
Repeated Games
information
• There is a unique solution to the game, as
determined by backward induction,
• player I offers high quality service, and player II
responds by buying the service.

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 Extensive games with perfect
Repeated Games
information
• A game tree can therefore be analyzed in terms of
the strategic form.
• It is not hard to see that backward induction always
defines a Nash equilibrium. It is the strategy
combination (High; H: buy, L: don’t).
• A game that evolves over time is better represented
by a game tree than using the strategic form.
• The tree reflects the temporal aspect, and backward
induction is succinct and natural.

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 Extensive games
Repeated
First Games
Mover Advantage
The first-mover
advantage
is also known as:
Stackelberg
leadership,

Economist
Heinrich von
Stackelberg
in 1934.

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 Extensive games
Repeated
First Games
Mover Advantage
• The game can be solved by dominance considerations.
• Clearly, no production is dominated by low or medium production,
• so that row N and column n can be eliminated.
• Then, high production is dominated by medium production,
• so that row H and column h can be omitted.
• now only medium and low productions remain.

• Regardless of whether the opponent produces

medium /low, it is always better for each firm to produce medium.
• Therefore, the Nash equilibrium of the game is (M;m),
• Both firms making $16 million each. 52
 Extensive games
Repeated
First Games
Mover Advantage
• commitment version of the game

• Suppose that firm I is able to publicly announce and

commit to a level of production, given by a row in the
Figure.
• Then firm II, informed of the choice of firm I, will respond
• to H by l (with maximum payoff 9 to firm II),
• to M by m,
• to L also by m, and
• to N by h.
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 Homework
Repeated Games
• What is your Strategy to pass this course?
• Is there an Equilibrium state?
• What payoff do you expect?

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