GAME THEORY

Abhishek Shukla
MBA(IT)
IIITA
 Survivor Immunity Challenge

 There are 21 flags

 Players alternate removing 1, 2, or 3 flags
 The player to take the last flag wins
 What is Game Theory?
 Game theory is the branch of decision
theory concerned with interdependent
decisions.

Strategic interaction: When actions of a

player influence payoffs to other players
 Where can we use GT?
 Any situation that requires us to anticipate our
rival’s response to our action is a potential context
for GT.
– Games: Checkers, poker, chess, tennis, soccer etc.
– Economics: Industrial Organization, Micro/Macro/
International/Labor/Natural resource Economics, and
Public Finance
– Political science: war/peace
– Law: Designing laws that work
– Biology: animal behavior, evolution
– Information systems: System competition/evolution
 Where can we use GT? (cont.)
 Business:
– Games against rival firms:
• Pricing, advertising, marketing, auctions, R&D,
joint ventures, investment, location, quality, take
over etc.
– Games against other players
• Employee/employer, managers/stockholders
• Supplier/buyer, producer/distributor,
firm/government
 Why Do Economists Study
Games?
 Games are a convenient way in which to model
strategic interactions among economic agents.
 Many economic issues involve strategic
interaction.
 Behaviour in imperfectly competitive markets,
e.g. Coca-Cola versus Pepsi.
 Behaviour in auctions, e.g. when to bid in
dynamic internet auctions.
 Behaviour in economic negotiations, e.g. trade.
 How to use GT
 Explanation: What is the game to be
played?
 Prediction: What outcome will prevail?
 Advice or prescription: Which strategies
are likely to yield good results in which
situations?
 Rules, Strategies, Payoffs, and
Equilibrium
 Economic situations are treated as games.
The rules of the game state who can do
what, and when they can do it.
A player's strategy is a plan for actions in
each possible situation in the game.
 Rules, Strategies, Payoffs, and
Equilibrium

A player's payoff is the amount that the player

wins or loses in a particular situation in a game.
A players has a dominant strategy if that player's
best strategy does not depend on what other
players do.
 Prisoners’ Dilemma
 Two suspects are caught and put in different
rooms (no communication). They are offered the
following deal:
– If both of you confess, you will both get 5 years in
prison (-5 payoff)
– If one of you confesses whereas the other does not
confess, you will get 0 (0 payoff) and 10 (-10 payoff)
years in prison respectively.
– If neither of you confess, you both will get 2 years in
prison (-2 payoff)
 Easy to Read Format of
Prisoner’s Dilemma
Prisoner 2

Confess Don’t
Confess
Prisoner 1

Confess -5, -5 0, -10

Don’t
Confess
-10, 0 -2, -2
Solution of Prisoners’ Dilemma
Dominant Strategy Equilibrium
Prisoner 2
Confess Don’t
Confess
Prisoner 1

Confess
-5, -5 0, -10
Don’t
Confess -10, 0 -2, -2
 Nash Equilibrium

– In equilibrium neither player has an incentive

to deviate from his/her strategy, given the
equilibrium strategies of rival players.
– Neither player can unilaterally change his/her
strategy and increase his/her payoff, given the
strategies of other players.
 NE of Prisoners’ Dilemma
 The strategy profile {confess, confess} is
the unique pure strategy NE of the game.
 In equilibrium both players get a payoff of
–5.
 Inefficient equilibrium; (don’t confess,
don’t confess) yields higher payoffs for
both.
 An Example: Advertising
 The prisoner's dilemma applies to
advertising.
All firms advertising tends to equalize the
effects.
Everyone would gain if no one advertised.
 Simultaneous v. Sequential
Move Games
 Games where players choose actions simultaneously are
simultaneous move games.
Examples: Prisoners' Dilemma, Sealed-Bid Auctions.
 Must anticipate what your opponent will do right now,
recognizing that your opponent is doing the same.
 Games where players choose actions in a particular
sequence are sequential move games.
Examples: Chess, Bargaining/Negotiations.
 Must look ahead in order to know what action to choose
now.
 Many sequential move games have deadlines/ time limits
on moves.
 A Sequential Game
New Firm Chooses

New Firm Enters New Firm Does Not Enter

Monopoly Monopoly
Chooses Chooses
High Price Low Price High Price Low Price

Monopoly gets Monopoly gets Monopoly gets Monopoly gets

$3, New firm $0, New firm $5, New firm $2, New firm
gets $2 gets –$1($ millions) gets $0 gets $0
 Payoffs in a Sequential Game of
Entry

New Firm
Enter Do Not Enter

Monopoly High Monopoly gets $3 Monopoly gets $5

Price New firm gets $2 New firm gets $0
Low Monopoly gets $0 Monopoly gets $2
Price New firm gets –$1 New firm gets $0
 Decision Tree for the Coca Cola
Company

If Pepsi Charges the If Pepsi Charges the

Low Price Monopoly Price
Coke Coke

Low Price Low Price

Monopoly Price Monopoly Price
$3 million $8 million

Best $2 million $6 million

Best
Strategy
Strategy
 Decision Tree for the United
States
If Japan If Japan Does Not
Imposes a Tariff Impose a Tariff

Unit ed United
States States

Tariff Tariff
Free Trade Free Trade
$5 mil ion $9 mil ion

$4 mil ion $8 mil ion