Ch.

14: Game Theory/Strategic Behavior

1. Motivation: Honda and Toyota
2. The Prisoner's Dilemma
3. Dominant Strategy Equilibrium
4. Nash Equilibrium
5. Sequential Moves Games

1
 Honda and Toyota:
A Capacity Expansion Decision
The two giants face a simultaneous capacity decision problem:

(a) If both do nothing, their current yearly profits will stay at $18b.

(b) By investing in a new plant, each manufacturer expects to raise its

profits to $20b (at the expense of its competitor, whose profits will
be reduced to $15b).

(c) If both expand, profits will go down to $16b.

What should they do?

2
 Capacity Expansion Game

Toyota
Toyota
Build a new Do not Build
plant

Build a new 16,16 20,15

Honda
Honda plant

Do not Build 15,20 18,18

3
What is the likely outcome of this game?
 Game Theory

Game Elements

Players: agents participating in the game (Toyota, Honda)

Strategies: Actions that each player may take under any possible
circumstance (Build, Don't build)

Outcomes: The various possible results of the game (four, each

represented by one cell of matrix)

Payoffs: The benefit that each player gets from each possible
outcome of the game (the profits entered in each cell of the matrix) 4
Game Theory

Information: A full specification of who

knows what when (full information)

Timing: Who can take what decision,

when, and how often the game is
repeated (simultaneous, one-shot)

Solution concept of the game: "What is

the likely outcome"? (Dominant Strategy
Equilibrium, Nash Equilibrium)
5
Simultaneous Move Games

Games
Games in
in which
which both
both players
players act
act at
at the
the
same
sametime.
time.

Equivalently,
Equivalently, one
one player
player may
may take
take anan
action
action before
before the
the other
other but
but the
the second
second
cannot
cannotobserve
observethetheaction
actiontaken
takenby bythe
the
first
first(and
(andthe
thefirst
firstknows
knowsit).
it).

6
 Prisoner's Dilemma
Definition:
Definition: AA game
game situation
situation inin which
which there
there isis aa tension
tension
between
betweenthethecollective
collectiveinterest
interestofofall
allof
ofthe
theplayers
playersand andthe
the
self-interest
self-interest of
of individual
individual players
players isis called
called aa Prisoner's
Prisoner's
Dilemma.
Dilemma.

Confess Don't Confess

Confess -5,-5 0,-10

Don't Confess -10,0 -1,-1

7
 Prisoner's Dilemma

The Plausible outcome: both confess

Their payoffs, however, are worse than what they would

receive if neither confesses

Definition: A dominant strategy is a strategy that is better

than any other strategy that a player might choose, no matter
what strategy the other player follows.

8
 Dominant Strategy Equilibrium
Definition: A Dominant Strategy Equilibrium occurs when
each player uses a dominant strategy.

Toyota
Toyota
Build a new Do not Build
plant

Build a new 16,16 20,15

Honda
Honda plant

Do not Build 15,20 18,18

9
Dominant Strategy Equilibrium?
Most games do not possess a dominant strategy
equilibrium (see below).
Toyota
Toyota

Build a Don’t
New Plant Build
Build a 12,4 20,3
Honda
Honda New Plant
Don’t 15,6 18,5
Build

10

Hence, we try something else

 Dominated Strategy
Definition: A player has a dominated strategy when the player has another
strategy that gives it a higher payoff no matter what the other player does.

Toyota
Toyota
Build a Don’t
New Plant Build
Build a 12,4 20,3
Honda New Plant
Honda
Don’t 15,6 18,5
Build

11
Dominant or Dominated Strategy

Why
Whylook
lookfor
fordominant
dominantor
ordominated
dominatedstrategies?
strategies?

AA dominant
dominant strategy
strategy equilibrium
equilibrium isis particularly
particularly
compelling
compellingas
asaa"likely"
"likely"outcome
outcome

Similarly,
Similarly, because
because dominated
dominated strategies
strategiesare
are unlikely
unlikely
to
to be
be played,
played, these
these strategies
strategies can
can be
be eliminated
eliminated
from
from consideration
consideration in in more
more complex
complex games.
games. This
This
can
canmake
makesolving
solvingthe
thegame
gameeasier.
easier.
12
 Elimination of Dominated Strategies
Toyota
Toyota
Build Build Do Not
Large Small Build
Build Large 0,0 12,8 18,9

Honda Build Small 8,12 16,16 20,15

Honda
Do Not 9,18 15,20 18,18
Build

"Build Large" is dominated by "Build Small" for each player 13

By eliminating the dominated strategies, we can reduce the
game to the first one, and then solve it.
Elimination of Dominated Strategies?
As before, many games do not possess a unique outcome
that survives elimination of dominated strategies (below).
Depositor
Depositor22
Withdraw Don't
Withdraw

Withdraw 25,25 50,0

Don't 0,50 110,110

Withdraw

Depositor
Depositor11

14

Again, we will try something else

Nash Equilibrium

Definition:
Definition: AA Nash
Nash Equilibrium
Equilibrium occurs
occurs
when
when each
each player
player chooses
chooses aa strategy
strategy
that
that gives
gives him/her
him/her the
the highest
highest payoff,
payoff,
given
given the
the strategy
strategy chosen
chosen byby the
the other
other
player(s)
player(s) in
in the
the game.
game. ("rational
("rational self-
self-
interest")
interest")

15
 Capacity Expansion Game again

Toyota
Toyota
Build a new Do not Build
plant

Build a new 16,16 20,15

Honda
Honda plant

Do not Build 15,20 18,18

16
Nash Equilibrium Limitations
Nash equilibrium may
not be unique Depositor
Depositor22
Withdraw Don't
Withdraw

Withdraw 25,25 50,0

Don't 0,50 110,110

Depositor
Depositor11 Withdraw

18
Nash Equilibrium Limitations
Again, two Nash equilibria
Sirius
Sirius
Stay Exit

Stay -200, -200 300,0

XM
XM
Exit 0,300 0,0

19
Nash Equilibrium Limitations
Nash Equilibrium need not exist

Matching Pennies

Player
Player22

Heads Tails

Heads 1,-1 -1,1

Player
Player11

Tails -1,1 1,-1

20
Adding Mixed Strategies
Pure Strategy – A specific choice of a strategy
from the player’s possible strategies in a game.

Mixed Strategy – A choice among two or more

pure strategies according to pre-specified
probabilities.

21
Nash Equilibrium Limitations
Nash Equilibrium does not always make sense

The Travellers’ dilemma

• Two travelers come to the airline manager after losing
their luggage
• They are asked to state their claim, simultaneously and
independently, as an integer sum between $1 and
$100
• Then, they will receive the lower of the two sums, and
$2 will be transferred from the person who gave the
“greedier” offer to the more “modest” person
Nash Equilibrium Limitations
What do we expect to happen?
Consider $100, $100 --> $100, $100

Is this an equilibrium? NO
Nash Equilibrium Limitations
What do we expect to happen?
Consider $100, $100 --> $100, $100

Is this an equilibrium? NO
$100, $99 --> $97, $101

Is this an equilibrium? NO
Nash Equilibrium Limitations
What do we expect to happen?
Consider $100, $100 --> $100, $100

Is this an equilibrium? NO
$100, $99 --> $97, $101

Is this an equilibrium? NO
$98, $99 --> $100, $96
Nash Equilibrium Limitations
What do we expect to happen?
Consider $100, $100 --> $100, $100

Is this an equilibrium? NO
$100, $99 --> $97, $101

Is this an equilibrium? NO
$98, $99 --> $100, $96
And so on
$98, $97 --> $95, $99
Nash Equilibrium Limitations

Therefore, the unique Nash equilibrium is

$1, $1

But this seems like a terribly bad outcome

Shouldn’t something near $100, $100

be attainable?
Sequential Move Games

Games
Games in in which
which oneone player
player (the
(the first
first
mover)
mover) takes
takes anan action
action before
before another
another
player
player (the
(the second
second mover).
mover). The
The second
second
mover
moverobserves
observesthetheaction
actiontaken
takenby bythe
the
first
firstmover
moverbefore
beforedeciding
decidingwhat
whataction
action
ititshould
shouldtake.
take.

28
 Sequential Move Games - Terms

AA game
game tree
tree shows
shows the
the different
different strategies
strategies that
that each
each player
player can
can
follow
follow in
in the
the game
game and
and the
the order
order in
in which
which those
those strategies
strategies get
get
chosen.
chosen.

Backward
Backward induction
induction isis aa procedure
procedure for
for solving
solving aa sequential-move
sequential-move
game
game by
by starting
starting at
at the
the end
end of
of the
the game
game tree
tree and
and finding
finding the
the
optimal
optimaldecision
decisionfor
forthe
theplayer
playerat
ateach
eachdecision
decisionpoint.
point.

29
Sequential Move Games – Game Tree
Game Tree 1: Toyota and Honda, Revisited

0 0
12 8
18 9

8 12
16 16
20 15

9
18 15
20 18 30

18
The game in a matrix form
Toyota
Toyota
Build Build Do Not
Large Small Build
Build Large 0,0 12,8 18,9

Build Small 8,12 16,16 20,15

Do Not 9,18 15,20 18,18

Honda
Honda Build

31
Sequential Move Games – Game Tree

The solution to the sequential game differs from that of the

simultaneous game. Why?

The first mover can force second mover's hand: it illustrates

the value of commitment (i.e. limiting one's own actions)
rather than flexibility

32
Sequential Games – Backwards Induction?

The
The Centipede
Centipede Game
Game

33
 Do people understand the game?
Acquiring a Company
You are Company A
You want to acquire Company T
– Company T is undertaking a project
– Project outcome range: $0 to $100
– The value of T equals the outcome of the project
– All outcomes equally likely
– Company T worth 50% more if acquired
Offer must be made early
Company T will decide after outcome is known
 Acquiring a Company

As a representative of company A, you are

deliberating on offers in the range from $0
per share to $150 per share.

What price offer would you make?

What Do People Actually Do?
 Acquiring a Company - analysis

If Company A offers $50:

– Offer not accepted if T > $50
– In accepted offers, average T value: $25
– Value to Company A: $37.50
– Company A loss: $12.50
A loses on any offer > $0
Company A shouldn’t offer anything