Lecture Notes

Decision Making Theory

Game Theory

Compiled from various sources by:

Teaching Team of Decision Making Theory
Department of Management FEUI
What will we discuss?
 Basic Definition of Game Theory
 Payoff Matrix
 Types of Games
 Zero sum-games
 Non-zero sum games ;
 Dominant Strategy Equilibrium
 Nash Equilibrium
What is Game Theory?
Game theory is a study of how to
mathematically determine the best strategy
for given conditions in order to optimize the
outcome
Game theory -- set of ideas and principles to
guide strategic thinking
 simultaneous actions: strategic form

 sequential actions: extensive form

Game Theory
 Finding acceptable, if not optimal,
strategies in conflict situations.
 Abstraction of real complex situation
 Game theory is highly mathematical
 Game theory assumes all human
interactions can be understood and
navigated by presumptions.
Why is game theory
important?
 All intelligent beings make decisions all the
time.
 AI needs to perform these tasks as a result.
 Helps us to analyze situations more
rationally and formulate an acceptable
alternative with respect to circumstance.
Components of a Game
 Games have the following characteristics:
 Players
 Rules
 Payoffs
 Strategies
 Payoff
 Each game outcome has a payoff, which we can
represent as a number
 By convention, we prefer positive numbers
 In some games, the outcome is either a simple win
(+1) or a simple loss (-1)
 In some games, you might also tie, or draw (0)
 In other games, outcomes may be other numbers
(say, the amount of money you win at Poker)
 The Payoff Matrix
Player #2

Strategy #1 Strategy #2

P
l Strategy #1

a
Payoff (1,1) Payoff (1,2)
y
e
r
Strategy #2
# Payoff (2,1) Payoff (2,2)

1
Types of Games
• Zero vs. non-zero sum
• Sequential vs. Simultaneous moves
• Single Play vs. Iterated
• Perfect vs. Imperfect information
• Cooperative vs. non-cooperative
Types of Games
 We classify games into several types.
 By the number of players:
 By the Rules:
 By the Payoff Structure:
 By the Amount of Information Available to
the players
Games as Defined by the
Number of Players:

 1-person (or game against nature,

game of chance)
 2-person
 n-person( 3-person & up)
Games as Defined by the
Rules:
 These determine the number of
options/alternatives in the play of the
game.
 The payoff matrix has a structure
(independent of value) that is a function
of the rules of the game.
 Thus many games have a 2x2 structure
due to 2 alternatives for each player.
Games as Defined by the
Payoff Structure:
 Zero-sum
 Non-zero sum
 (and occasionally Constant sum)
 Examples:
 Zero-sum
 Classic games: Chess, checkers, tennis, poker.
 Political Games: Elections, War
 Non-zero sum
 Classic games: Football (?), D&D, Video games
 Political Games: Policy Process
Games defined by information
 In games of perfect information, each player
moves sequentially, and knows all previous
moves by the opponent.
 Chess & checkers are perfect information games
 Poker is not
 In a game of complete information, the rules are
known from the beginning, along with all possible
payoffs, but not necessarily chance moves
Zero-sum and Nonzero-sum
Games
 Objectives of the players
 Zero-sum games: strictly competitive
 Example: Matrix games; what one player gains is what

the other player pays.

 Nonzero-sum games: not necessarily strictly competitive
 Example: Bimatrix game: each player has own reward.

(1,-1) (0,0) (1,-1) (0,0)

(-2,2) (3,-3) (2,2) (3,3)

Matrix game Bimatrix game
Zero-Sum Games
 The sum of the payoffs remains constant
during the course of the game.
 Two sides in conflict
 Being well informed always helps a player
 Zero-sum describes a situation in which a
participant's gain (or loss) is exactly
balanced by the losses (or gains) of the
other participant(s).
Zero Sum Games
 The total gains of the participants minus the
total losses always equals 0.
 Poker is a zero sum game
 The money won = the money lost

 Trade is not a zero sum game

 If a country with an excess of bananas

trades with another for their excess of

apples, both benefit from the transaction.
 Zero Sum Games
 The following matrix defines a zero-sum game. Notice the sum of
the payoffs to each player, at every outcome, adds to zero.
Player 2 (Column)

A B

X (2,-2) (2,-2)
Player 1
( row )
Y (1,-1) (3,-3)

If both players know the possible strategies for both players and the
resulting payoffs and play their best possible strategy in terms of their
own best interest, in this case, what will happen?
 Battle of the Bismarck Sea
• The previous game was actually played out in February 1943
as the Battle of the Bismark Sea between U.S. and Japanese
forces. We may consider the U.S. commander, General Kenny
as player 1, while his opponent, player 2, is Admiral Imamura.
 Battle of the Bismarck Sea
• In the middle of World War II, the Japanese Admiral was
ordered to deliver reinforcements to Japanese soldiers fighting in
Papua New Guinea. The Japanese had to choose between two
available routes…
Battle of the Bismarck Sea
The Japanese reinforcements could
be sent either by a northern route,
through the Bismarck Sea, or through
a southern route, through the
Solomon sea.

General Kenney expected the

reinforcements to be sent and knew
the supply routes available to the
Japanese. Both commanders also
knew of the significance of certain
weather conditions. If the U.S.
commander anticipated his
opponent’s move, and sent his
planes toward that route, he would
have more days of bombing
available.
Battle of the Bismarck Sea
If the U.S. commander guessed his
opponent’s decision incorrectly, he
would have to redirect his planes
and would lose a day of bombing.

Let’s say the “payoffs” in this game

are the number of days of
bombing: positive for the U.S.
forces and negative for the
Japanese. The number of days is
the same for each, just positive for
one and negative for the other.
Hence, this is a zero-sum game.

A deciding factor was the bad

weather in the north, limiting the
number of days the Americans
could bomb the Japanese to only
two days in the northern route.
 The Battle of the Bismarck Sea
• We can put this game into matrix form as follows. The numbers at
each outcome represent number of days of bombing, positive for the
Americans and negative for the Japanese. Admiral Imamura

Travel Travel
North South
Search (2,-2) (2,-2)
General Kenney North
Search (1,-1) (3,-3)
South
As the name of the battle suggests, both commanders choose the
northern route, through the Bismarck Sea.
In spite of this being an “optimal strategy” for the Japanese, they
suffered heavy losses. However, the loss certainly would have been
greater for the Japanese with another day of bombing.
 Zero Sum Games
• Normally, if a matrix game is a zero-sum game, we don’t need to
write the payoffs for both players. Instead we write only one number
in each matrix cell.
Admiral Imamura Admiral Imamura
Travel Travel Travel Travel
North South North South
General General
Search (2,-2) (2,-2) Search 2 2
Kenney Kenney
North North
Search (1,-1) (3,-3) Search 1 3
South South

• If only one number is written in each cell of the matrix, then the
game is understood to be a zero-sum game.
 Zero Sum Games
• For example, in the matrix below, because only one number is
written in each cell, it is understood that the payoffs are the given
numbers for the row player (General Kenney) and the negative of
each of these values for the column player (Admiral Imamura).

Admiral Imamura

Travel Travel
North South
General Kenney Search 2 2
North
Search 1 3
South
 Zero Sum Games
• For zero-sum games, we can look for saddle points by recognizing
the following two facts:
• The row player will want to the maximum value in the matrix.
• The column player will want the minimum value in the matrix.

Column Player

Travel Travel
North South
Search 2 2
Row Player
North
Search 1 3
South
 Zero Sum Games
Column Player
Travel Travel
North South
Search 2 2
Row Player 2
North
Search 1 3
1
South
• To look for a saddle point in a matrix game, begin by finding the
minimum values of each row. ( These are called the row minima. )
• Then, choose the maximum value of these minima. (This is called the
maximin strategy for the row player. )
• We do this because a rationalization for the row player is to find the
best move possible assuming that the column player chooses his best
strategy. It’s like thinking “what’s the best I can do when he plays his
best.”
 Zero Sum Games
Column Player

Travel Travel
North South
Search 2 2
Row Player North 2
Search 1 3
1
South

2 3
• Now, look for the maximum values for each column. (These are
column maxima.)
• Then, choose the smallest of the column maxima. This is called the
minimax strategy for the column player.
• Here, the column player is thinking: “What is the best I can do when
the row player is playing his best strategy.”
 Zero Sum Games
Column Player

Travel Travel
North South
Search 2 2
2
Row Player North
Search 1 3
1
South
2 3
• Because, in this example, the row maximin and the column minimax
strategies coincide with the same outcome, these strategies are called a
saddle point (or an equilibrium point).
• In some cases, given a 2x2 matrix game, we can find equilibria by
determining if the row maximin and column minimax coincide with one
outcome.
 Zero Sum Games
equilibrium
Column Player
point
Travel Travel
North South
Search 2 2
Row Player North
Search 1 3
South
• The “equilibrium point” or “saddle point” for this game is the
combination of the strategies of traveling and searching north. It is the
best each player can do assuming the other player does their best.
• The outcome associated with the equilibrium point is called the value of
the game. In this case, the value is 2.
• We say a game is fair if it’s value is 0. Thus, this particular game is not
fair.
 Saddle Points
• In zero-sum games, the terms saddle point and equilibrium point are
interchangeable.

• These terms refer to the combination of strategies that are in each

player’s best interest assuming all other player’s use the strategy in their
best interest.

• The term saddle point comes from the fact that, in a game with two
players, each with two strategies, it represents at one point a highest
point for the lowest payoff values and also a lowest point for the highest
payoff values. player 2 (column player)

player 1 (row player)

 Consider the following scenario…
 Shooter has a penalty shot. Can choose to
shoot left or shoot right.
 Goalie can choose to dive left or dive right.
 If goalie guesses correctly, he saves the day.
If not, it’s a goooooaaaaall!
 Vice-versa for shooter.
 2-Player Zero-Sum games
 Game defined by matrix with a row for each of
S’s options and a column for each of G’s
options. Matrix tells who wins how much.
 an entry (x,y) means: x = payoff to row player, y =
payoff to column player. “Zero sum” means that y = -x.
 E.g., penalty shot: Left Right goalie

Left (0,0) (1,-1) GOAALLL!!!

shooter

Right (1,-1) (0,0) No goal

 Minimax-optimal strategies
 Minimax optimal strategy is a (randomized)
strategy that has the best guarantee on its
expected gain, over choices of the opponent.
[maximizes the minimum]
 I.e., the thing to play if your opponent knows
you well. Left Right goalie

Left (0,0) (1,-1)

shooter GOAALLL!!!

Right (1,-1) (0,0) No goal

 Minimax-optimal strategies
 Minimax optimal strategy is a (randomized)
strategy that has the best guarantee on its
expected gain, over choices of the opponent.
[maximizes the minimum]
 I.e., the thing to play if your opponent knows
you well.
 Minimax-optimal strategies

penalty shot: Left Right

Left (0,0) (1,-1)

Right (1,-1) (0,0)

Minimax optimal strategy for both players is

50/50. Gives expected gain of ½ for shooter
(-½ for goalie). Any other is worse.
 Minimax-optimal strategies

penalty shot with goalie who’s weaker on

the left. Left Right

Left (½,-½) (1,-1)

Right (1,-1) (0,0)

Minimax optimal for shooter is (2/3,1/3).

Guarantees expected gain at least 2/3.
Minimax optimal for goalie is also (2/3,1/3).
Guarantees expected loss at most 2/3.
Non-Zero Sum Games
 Non-zero sum games are more complex to
analyze
 We find more non-zero sum games as the
world becomes more complex, specialized,
and interdependent
Dominant Strategy Equilibrium
 If every player in the game has a dominant
strategy, and each player plays the
dominant strategy, then that combination of
strategies and the corresponding payoffs are
said to constitute the dominant strategy
equilibrium for that game.
Dominant Strategies
 Dominant Strategy
 One that is optimal no matter what an
opponent does.
 An Example
 A & B sell competing products
 They are deciding whether to undertake
advertising campaigns
 Payoff Matrix for Advertising Game
Firm B Don’t
Advertise Advertise

Advertise 10, 5 15, 0

Firm A

Don’t
Advertise 6, 8 10, 2
Payoff Matrix for Advertising Game
 Observations Firm B Don’t
 A: regardless of Advertise Advertise

B, advertising is
the best Advertise 10, 5 15, 0
 B: regardless of Firm A
A, advertising is Don’t
best Advertise 6, 8 10, 2
Payoff Matrix for Advertising Game
 Observations Firm B Don’t
 Dominant Advertise Advertise

strategy for A &

B is to advertise Advertise 10, 5 15, 0
 Do not worry Firm A
about the other Don’t
player Advertise 6, 8 10, 2
 Equilibrium in
dominant
strategy
Dominant Strategies
 Game Without Dominant Strategy
 The optimal decision of a player without a
dominant strategy will depend on what the
other player does.
 Modified Advertising Game
Firm B Don’t
Advertise Advertise

Advertise 10, 5 15, 0

Firm A

Don’t
Advertise 6, 8 20, 2
 Modified Advertising Game
 Observations Firm B Don’t
 A: No dominant Advertise Advertise
strategy;
depends on B’s
Advertise 10, 5 15, 0
actions
 B: Advertise Firm A
 Question Don’t
Advertise 6, 8 20, 2
 What should A
do? (Hint:
consider B’s
decision
Dominant strategies equilibrium
 Dominant Strategies
 “I’m doing the best I can no matter what
you do.”
 “You’re doing the best you can no matter
what I do.”
Nash Equilibrium
 If there is a set of strategies with the
property that no player can benefit by
changing her strategy while the other
players keep their strategies unchanged,
then that set of strategies and the
corresponding payoffs constitute the Nash
Equilibrium
 Nash Equilibrium and Game
 Game theory:
 Studies interaction between people
 Rationality: every one wants to maximize his profit.
(Non-cooperative games) High Low
B price price
 Example: TV Sales A
 Players (companies): A, B High 100 0
 Actions: high price, low price price
100 10
 Payoff matrix
A Low 10 5
 Outcome: profile of actions B price
0 5
 Example of Nash Equilibrium
 Companies A and B sell TVs
 <A-high price, B-high price> is a NE
A: High Low, gets 100  10;
B: High Low, gets 100  10;
 <A-low price, B-low price> is also a NE
A: Low  High, gets 5  0; B High Low
B: Low  High, gets 5  0; A price price
High 100 0
 Most NE is not efficient price 100 10
(best outcome) A Low 10 5
B price 0 5
NE
The Nash Equilibrium
Revisited
 Nash Equilibrium
 “I’m doing the best I can given what you
are doing”
 “You’re doing the best you can given
what I am doing.”
The Nash Equilibrium Revisited
 Maximin Strategies
 Scenario
 Two firms compete selling file-encryption
software
 They both use the same encryption standard
(files encrypted by one software can be read by
the other - advantage to consumers)
The Nash Equilibrium Revisited
 Maximin Strategies
 Scenario
 Firm 1 has a much larger market share than
Firm 2
 Both are considering investing in a new
encryption standard
Maximin Strategy
Firm 2
Don’t invest Invest

Don’t invest
0, 0 -10, 10
Firm 1

Invest -100, 0 20, 10

 Maximin Strategy
 Observations
 Dominant
strategy Firm 2: Firm 2
Invest Don’t invest Invest

 Nash equilibrium
 Firm 1: invest Don’t invest 0, 0 -10, 10
 Firm 2: Invest
Firm 1

Invest -100, 0 20, 10

 Maximin Strategy
 Observations Firm 2
Don’t invest Invest
 If Firm 2 does
not invest, Firm Don’t invest 0, 0 -10, 10
1 incurs
significant losses Firm 1
 Firm 1 might
play don’t invest Invest -100, 0 20, 10
 Minimize losses
to 10 --maximin
strategy
 The Nash Equilibrium Revisited
Maximin
Maximin Strategy
Strategy
 If both are rational and informed
 Both firms invest
 Nash equilibrium
The Nash Equilibrium Revisited
Maximin
Maximin Strategy
Strategy

 Consider
 If Player 2 is not rational or completely
informed
 Firm 1’s maximin strategy is to not invest
 Firm 2’s maximin strategy is to invest.
 If 1 knows 2 is using a maximin strategy, 1
would invest