Game Theory 101

Shama-e Zaheer
Institute of Business Administration
University of Dhaka
Multi-party Decisions are Pervasive
• Strategic competition (& cooperation) in the
marketplace
• Joint ventures, contracts & incentive systems
• Negotiation, bargaining & fair division
• Auctions, bidding & other price discovery
mechanisms
• Voting, group decision systems & coalition building

2
“Game” is an Inclusive Concept
• Situations where multiple players’ decisions
interact to determine each player’s payouts
• Types of games
– Rule-based (e.g. artificial and recreational games)
– Free-form (e.g. the marketplace, society, the real world)
• Emergence of Game Theory ideas
– 1944 - von Neumann & Morgenstern
– John Nash’s “Nash Equilibrium”

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Some Dimensions for Classifying Games
• Sequential vs. Simultaneous
– what is known of others’ moves at time of own move?
• Zero-sum vs. Variable-sum
– can pie be created or destroyed by moves?
• Repeated vs. One-shot
– how many times will players interact?
• Rules fixed vs. Rules manipulable
– rule-based (e.g. artificial and recreational games)
– free-form (e.g. the marketplace, society, the real world)

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Analysis Driven by Basic Modes of “Play”
• Sequential Games
– Parties take turns and get to see the others’
moves before deciding theirs
• Simultaneous Games
– All parties must decide their own move before
knowing the others’ moves

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Sequential Example: Entry into a New Market
• Player A is currently alone in the market (= the incumbent)
• Player B can choose to either
– Stay out;
• B earns Tk.0 incremental contribution
– Incumbent A earns Tk.220k (present value of all future earnings).
– or, Enter the market.
• B’s payoff depends on what incumbent A then decides to do.
– Player A might choose to fight a price war.
» B loses Tk.200k, A earns Tk.150k.
– Player A might choose to accommodate our entry.
» B earns Tk.100k, A earns Tk.120k.
• Player B believes that Player A
– believes these same things, and
– wants to maximize its own contribution, just as B does

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A Decision Tree
B’s Profit (Tk.k)
Prob p
- Tk.200
They fight a price war
A
We enter They accommodate
+ Tk.100
Prob 1-p
B

We stay out
+ Tk.0

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Game Theory Approach: A Game Tree
B’s Profit A’s Profit

- Tk.200 + Tk.150
They fight a price war
A
We enter They accommodate
+ Tk.100 + Tk.120

We stay out
+ Tk.0 + Tk.220

What B believes A’s scoring system to be

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Backwards Induction - step 1
B’s Profit A’s Profit

- Tk.200 + Tk.150
They fight a price war
A
We enter They accommodate
+ Tk.100 + Tk.120

B
All I care about is my own
profit, not the other guy’s,
We stay out so I’ll fight a price war,
which gives me a gain +ofTk.0 + Tk.220
Tk.150 vs. a gain of
Tk.120.

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 He would fight a price
war if we entered,
Backwards Induction - step 2
which would give us a
loss of Tk.200, vs. Tk.0 B’s Profit A’s Profit
if we stay out.
- Tk.200 + Tk.150
They fight a price war
A
We enter They accommodate
+ Tk.100 + Tk.120

We stay out
+ Tk.0 + Tk.220

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How to Play Sequential Games
• Incorporate the other players’ perspectives.
– We don’t “know” them – just as we don’t “know” costs,
revenues, probabilities, etc.
– We elicit (and develop) our best available beliefs.
• Use backwards induction (i.e. once again, “Look
forward, reason back”):
– Set up the problem in sequence, left-to-right, but analyze
the problem back from the end, right-to-left;
– Put yourself into the other players’ shoes to anticipate
their moves, i.e. estimate their best-response (or
“reaction”) function.
• If the game is finite, there is a best strategy.
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Simultaneous Example: Cover Stories
• We (Daily Star) and our competitor (Independent) are
putting the latest issue to bed.
– Each player wants to maximize its own short-term profit.
– Each must choose its headlines - either Iraq or the Election -
without knowing which one the other will choose.
• Having different headlines would result in a greater
number of total readers
• Having identical headlines would split the readership
interested in that topic.
• More readers are interested in Iraq than in the Election.

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Simultaneous Game Table
ILLUSTRATIVE
Independent
Payouts = Contribution Tk.000 Iraq Election

350 300
Iraq
350 700
Daily Star

700 150
Election
300 150

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Dominant & Dominated Strategies
• A dominant strategy is one that results in
the highest payoff to a player, i. e. it is
better than all other strategies, no matter
what the other players do.
• A dominated strategy is one that results in a
lower payoff than some other strategy
(which is said to “dominate” it), no matter
what the other players do.

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How to Play Simultaneous Games
• Look for a dominant strategy
– If you have one, use it.
– If another player has one, assume s/he’ll use it.
• Eliminate any dominated strategies (yours
and those of other players), if they exist
• REPEAT
• If there are no dominant strategies … ?

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Variation on Cover Story Problem
Independent
ILLUSTRATIVE
Payouts = Contribution Tk.000 Iraq Election

280 300
Iraq
420 700
Daily Star

700 120
Election
300 180

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How Much Variety Should We Offer?
Them
Payouts = Profit Tk.000 Low Medium High

200 250 225

High
300 100 150

75 150 195
Us Medium
200 125 70
225

100 200 300

Low
100 150 70
200
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How to Play Simultaneous Games
• Look for a dominant strategy
– If you have one, use it.
– If another player has one, assume s/he’ll use it.
• Eliminate any dominated strategies (yours and
those of other players), if they exist
• REPEAT
• If there are no dominant strategies (even after
iteratively removing dominated strategies), look
for an equilibrium point.

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Our Best Responses
Them
Low Medium High

200 250 225

High
300 100 150

75 150 195
Us Medium
200 125 70
225

100 200 300

Low
100 150 200
70
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Their Best Responses
Them
Low Medium High

200 250 225

High
300 100 150

75 150 195
Us Medium
200 125 70
225

100 200 300

Low
100 150 200
70
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Nash Equilibrium Point
• At the Nash (or competitive) equilibrium
point, each player is playing its best response
to what the others are playing.
• The equilibrium is stable:
– no player has an incentive to change plays;
– it doesn’t even matter if you tell each other what
you’re planning to do.
• The equilibrium is not necessarily the best
point for the players, individually or in total
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Finding an Equilibrium
• Look for the intersection of best-response
functions
• Successive rounds of best responses
– multi-period play
– thought experiments (I think that he thinks that
I think that…)

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Equilibrium: Mutually Best Responses
Them
Low Medium High

200 250 225

High
300 100 150

75 150 195
Us Medium
200 125 70
225

100 200 300

Low
100 150 200
70
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Equilibrium: No Incentive to Change
Them
Low Medium High

200 250 225

High
300 100 150

75 150 195
Us Medium
200 125 70
225

100 200 300

Low
100 150 200
70
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 Purely Win-Lose Situations are
Special Cases: e.g. Zero-Sum Games
Payouts = Profit Tk.000
Player B
West East
The sum of
payouts in each -1 -4
outcome literally is North
zero!
1 4
Player A

-5 -3
South
5 3

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Unpredictability
• All games have Nash equilibrium – but not
necessarily in “pure strategies”
• “Mixed strategies” are probabilistic mixes
of pure ones
• Some mixes are better than others!

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Pure Coordination Game
Payouts = Utility
Driver B
Right Lane Left Lane

-100 0
Right Lane
-100 0
Driver A
0 -100
Left Lane
0 -100

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Comp or Coop? The Prisoner’s Dilemma
Payouts = Years in Prison
Suspect B
(considered bad) Cooperate Defect

Cooperate 3 1
(= remain silent)
3 25
Suspect A
25 10
Defect
(= confess)
1 10

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The Dilemma in a Prisoner’s Dilemma
• All players have a dominant strategy.
• If everyone plays their dominant strategy,
the outcome is unattractive, and collectively
the worst.
• The best collective outcome can be
achieved by cooperation, BUT…
• …At that cooperative arrangement,
everyone has incentive to cheat.

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Enforcing Cooperation
• 2 essential ingredients of a healthy cartel
– the ability to detect cheating
• whether it’s happening
• who’s doing it
– the ability to punish cheating
• outside the game structure (e.g., reputation), or
through future replays of the game
• LT losses must overcome ST cheating gains

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The Essence of Strategic Moves
• Strategic moves are pre-emptive commitments to a course of
action.
• Generally they involve intentionally -- and credibly --
restricting one’s own possible actions.
– Moving first: unconditional declarations
– Moving second: move first by making conditional
declarations of response rules, i.e. programmed responses
• threats & promises
• (not the same as warnings & assurances)
• Observability and irreversibility are key.
• Brinkmanship

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 These Frameworks Can be Combined into
Complex Games & Sub-Games
Them
Example: a sequential … followed by a
decision about product competitive
introductions... pricing sub-game.
Them Us

Us Us

Them
Us

Us

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How to Analyze a Two-Stage Game
2. … then use Them 1. First determine
backward outcome of each
induction to solve possible subgame (e.g.
the sequential
game. Them Us Nash equilibrium, if
appropriate) …

Us Us

Them
Us

Us

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