CH-6 Game Theory

Slide 1.
1
2.1
Chapter 6
Game Theory
05/07/2022 Game
Saunders, Theory
Lewis and 1
Thornhill, Research Methods for Business Students, 5th Edition, © Mark Saunders, Philip Lewis and Adrian Thornhill 2009
Slide 1.2
2.2
Game Theory
 Game theory may be defined as a body of knowledge
that deals with making decisions when two or more
opponents are involved under conditions of conflict
and competition.
 A competitive situation exists when two or more
opposing parties are making decisions involving
conflicting interests and wherein the action of one
depends on the action which the opponent takes.
 Such situations arise in business, in military
operations, etc. games theory is used to handle such
conflicting situations. It seeks to provide a rational
course of action in a conflicting situation.
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Slide 1.3
2.3
 Instead of making inferences from the past behavior

of the opponent, the approach of game theory is to
seek to determine a rival’s most profitable counter-
strategy to one’s own best moves and to formulate
the appropriate defensive measures.
 For example, if two firms are locked up in a war to
maintain their market share, then a price cut by the
first firm will invite reaction from the second firm in
the nature of a price cut.
 This will, in turn, affect the sales and profits of the
first firm which will again have to develop a counter-
strategy to meet the challenge from the second firm.
The game will thus go on.
05/07/2022 Game
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Slide 1.4
2.4
 Game theory helps to determine the best course of

action for a firm in view of the expected
countermoves from the competitors. The competitors
in the game are known as players. Game theory deals
with competitive situations of decision-making under
uncertainty.
 There can be several types of games, e.g., two person
and n person games, zero-sum and non-zero sum
games. Constant sum game, cooperative and non-co-
operative games, pure strategy games and mixed
strategy games, etc.
 When there are two competitors playing a game, it is
called two person game.
 If the number of competitors are N (where N > 2), it
is known as an N
05/07/2022 person game.
Game Theory 4
Saunders, Lewis and Thornhill, Research Methods for Business Students, 5th Edition, © Mark Saunders, Philip Lewis and Adrian Thornhill 2009
Slide 1.5
2.5
 Where the sum of amounts won by all winners is equal

to the sum of the amounts lost by all losers, we call it
a zero sum game.
 In a non-zero sum game there exists a jointly
preferred outcome, i.e., in a zero sum game or a
constant sum game the sum of gains and losses of the
game is zero. As opposed to this if the sum of gains or
losses is not equal to zero, we call it a non-zero sum
game.
 When the best strategy for each player is to play one
particular strategy throughout the game, it is known
as a pure strategy game.
 In case the optimum plan for each player is to employ
different strategy at different times, it is called a
mixed strategy
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game.
Game Theory 5
Slide 1.6
2.6
 When there is communication between the

participants they may reach agreement and increase
their payoff through some forms of co-operative
game, otherwise it is a non-cooperative game.
05/07/2022 Game
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Lewis and 6
Slide 1.7
2.7
Underlying Assumption/Rules of Game: Game Theory is

Applicable to Situations that Satisfy the Following
Conditions.
 The number of competitors is finite
 The players act rationally and intelligently.
 Each player has available to him a finite set of
possible courses of action
 There is a conflict of interests between the
participants.
 The player makes individual decisions without direct
communication.
 The players simultaneously select their respective
courses of action.
 The payoff (outcome) is fixed and determined in
advance.
05/07/2022 Game Theory 7
Slide 1.8
2.8
Basic terminology
1. Strategy. A strategy for a player has been
defined as a set of rules or alternative courses
of action available to him in advance, by which
player decides the course of action that he
should adopt.
 Pure strategy. If the players select the same
strategy each time, then it is referred to as
pure-strategy. In this case each player know
exactly what the other is going to do i.e.,
there is a deterministic situation and the
objective of the players is to maximize gain
or to minimize losses.
05/07/2022 Game
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Slide 1.9
2.9
 Mixed strategy. When the players use a

combination of strategies and each player always
kept guessing as to which course of action is to be
selected by the other player at a particular
occasion then this is known as mixed- strategy.
Thus, there is a probabilistic situation and
objective of the player is to maximize expected
gains or to minimize losses. Thus, mixed strategy is
a selection among pure strategies with fixed
probabilities.
2. Optimum strategy. A course of action or play which
puts the player in the most preferred position,
irrespective of the strategy of his competitors is called
an optimum strategy. Any deviation from this strategy
results in a decreased
05/07/2022 Game Theory
pay-off for the player. 9
Slide 1.10
2.10
3. Value of the game. It is the expected pay-off of play

when all the players of the game follow their optimum
strategies. The game is called fair if the value of the
game is zero and unfair if it is non-zero.
4. Two-person zero-sum game. There are two types of
two person zero-sum games. In one, the most preferred
position is achieved by adopting a single strategy and
therefore the game is known as the pure strategy game.
The second type requires the adoption by both players a
combination of different strategies in order to achieve
the most preferred position and is, therefore, referred
to as the mixed strategy game.
05/07/2022 Game
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Lewis and 10
Slide 1.11
2.11
5. Pay-off matrix. A two-person zero-sum game is

conveniently represented by a matrix. The matrix,
which shows the outcome of the game as the players
select their particular strategies, is known as the
payoff matrix. It is important to assume that each
player knows not only his own list of possible courses of
action but also of his opponent.
05/07/2022 Game
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Lewis and 11
Slide 1.12
2.12
Let player A have m course of action (A1, A2, …,Am) and

player B has n course of action (B1,B2, …, Bn). The number n
and m need not be equal. The total number of possible out
came is, therefore (mxn). These outcomes are shown in
the following table.
A’s pay-off matrix B’s pay-off
Player B matrix
Player B
B1  B2    Bn 
B1  B2    Bn 
 
 a11 a12 a1n 
 
 A1
A2 
Player A A1   _ a11 a12  _ a1n 
_
Player A   a21 a22 a2n
 A2   
      _ a21 _ a22  _ a2n 
   

 Am

 am 1 am 2  amn

  
Am
 _ am1 _ am2  _ amn
05/07/2022 Game
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Lewis and 12
Slide 1.13
2.13
Pure Strategies (Games With Saddle Point)

 The minimum value in each row represents the least gain
(payoff) guaranteed to player A, if he plays his particular
strategy. These are indicated in the matrix by row minima.
Player A will then select the strategy that maximizes his
minimum gains. player A’s selection is called the maxi-min
strategy and his corresponding gain is called the maxi-min
value of the game.
 Player B, on the other hand, likes to minimize his losses.
The maximum value in each column represents the
maximum losses to player B, if he plays his particular
strategy. These are indicated in the matrix by column
maxima. Player B will then select the strategy that
minimizes his maximum losses. Player B’s selection is called
the mini-max strategy and his corresponding loss is called
the mini-max value of the game.
05/07/2022 Game
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Slide 1.14
2.14
 If the maxi-min value equals the mini-max value,

then the game is said to have a saddle point and the
corresponding strategies are called optimum
strategies.
 The amount of payoff at an equilibrium point is
known as the value of the game. It may be noted
that if player A adopts maxi-min criterion, then
player B has to adopt mini-max criterion as it is a
two-person zero-sum game.
05/07/2022 Game
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Slide 1.15
2.15
Determination of saddle point

1. Select the minimum (lowest) element in each row of the
payoff matrix and write them under row minima heading.
Then select a largest element among these elements and
enclose it in a rectangle.
2. Select the maximum (largest) element in each column of
the payoff matrix and write them under column maxima
heading. Then select a lowest element among these
elements and enclose it in a circle.
3. Find out the element which is same in the circle as well
as rectangle and mark the position of such element in the
matrix. This element represents the value of the game
and is called the saddle (or equilibrium) point.
05/07/2022 Game
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Slide 1.16
2.16
Rule (principle) of dominance

 The concept of dominance can be applied to any
two-person zero-sum game with any number of
strategies for each player. For a payoff matrix of
large size, the rule of dominance can be used to
reduce its size by carefully eliminating certain
rows and/or columns prior to final analysis to
determine the optimum strategy selection for
each player. In general the following rules for
properties of dominance are used to reduce the
size of pay-off matrix.
05/07/2022 Game
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Slide 1.17
2.17
Rule of Dominance
o Rule 1. If all the elements in a row (say ith row) of a
pay-off matrix are less than or equal to the
corresponding elements of the other row (say jth row)
then the player A will never choose the ith strategy or
in other words the ith strategy is dominated by the
jth strategy.
o Rule 2. If all the elements in a column (say rth
column) of a pay-off matrix are greater than or equal
to the corresponding elements of the other column
(say sth column) then the player B will never choose
the rth strategy or in the other words the rth
strategy is dominated by the sth strategy.
o Rule 3. A pure strategy may be dominated if it is
inferior to average of two more other pure strategy.
05/07/2022 Game
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Slide 1.18
2.18
Example 1. A company management and the labor union are

negotiating a new 3 years settlement. Each of these has 4
strategies. I: hard and aggressive bargaining. II: reasoning
and logical approach. III: legalistic strategy. IV: conciliatory
approach. The costs to the company are given for every pair of
strategy choice
Company strategies
I II III IV
I 20 15 12 35
Union strategiesII 25 14 8 10
III 40 2 10 5
IV 5 4 11 0
What strategy will the two sides adopt? Also determine the
value of the gameGame Theory
05/07/2022 18
Slide 1.19
2.19
Company strategies
I II III IV RMi
Union strategies I 20 15 12 35 12
II 25 14 8 10 9
III 40 2 10 5 2
IV 5 4 11 0 0
Cma 40 15 12 35
Maxi-min = Mini-max = value of game = 12.
The company incurs and hence its strategy is mini-max (i.e.,)
minimizing maximum losses for the union, negotiation results in
gain, hence union strategy will be maxi-min, i.e. maximizing
minimum gains. Since there exists a saddle point, strategies are
pure and the strategies adopted are: company will always adopt
strategy III- legalistic strategy and union will always adopt
strategy
05/07/2022
I- hard and aggressive bargaining.
Game Theory 19
Slide 1.20
2.20
Example 2. Two competitive manufacturers are producing

a new toy under license from a patent holder. In order to
meet the demand they have the option of running the
plant for 8, 16 or 24 hours a day. As the length of
production increases so does the cost. One of the
manufacturer, say A, has set up the matrix given bellow,
in which he estimates the % of the market that he could
capture and maintain the different product schedules:
Manufacturer B
Manufacturer C1: 8 hrs. C2: 16 C3: 24
A hrs. hrs.
S1: 8 hrs. 60% 56% 34%

S2: 16 hrs. 63% 60% 55%
At which level should each produce? What % of the market will A
05/07/2022
have? 83%
S3: 24 hrs. Game Theory 72% 60%
2009
Slide 1.21
2.21
Solution
Percentage of market captured by A
Manufacturer B
Manufacturer A C1 C2 C3 Rmi
S1 60 56 34 34
S2 63 60 55 55
S3 83 72 60 60
CMA 83 72 60
The saddle point occurs at the S3-C3 position. Thus a
maximin-minimax solution is obtained:
• Both A and B should produce at the level of 24 hours
per day.
• At the optimum level of 24 hours per day, A will have
60% of the market
05/07/2022 and B will have 40% of the market. 21
Game Theory
Slide 1.22
2.22
Example 3. What is the optimum strategy in the

following game
Player B
Player A I II III IV
I -5 3 1 20
II 5 5 4 6
III -4 -2 0 -5
05/07/2022 Game
Saunders, Thornhill, Research Methods for Business Students, 5th Edition, © Mark Saunders, Philip Lewis and Adrian Thornhill 22
Theory
Lewis and 2009
Slide 1.23
2.23
Solution. Suppose the given game is played by player A

and B. then it can be written as:
Player B
Player A I II III IV
I -5 3 1 20
II 5 5 4 6
FromIII
the above -4
pay-off -2
matrix, 30rd row is -5
dominated
by 2nd row and the reduced pay-off matrix is:
Player B
Player A
I II III IV
I -5 3 1 20
05/07/2022
II Game 5 5 4 6
Theory 2009
Slide 1.24
2.24
2nd column and 4th column are dominated by 1st column

and the reduced pay-off matrix is:
Player B
Player A I III Rmi
I -5 1 -5
4
FromII the above,5 it is apparent
4 that the value of maxi-
min Cma
coincides5 with the
4 value of mini-max,
therefore a
saddle point exists.
• The optimum strategy for player A is II
• The optimum strategy for player B is III
• The value of the game is 4.
05/07/2022 Game
Theory
Lewis and 2009
Slide 1.25
2.25
Solution Methods of Games Without Saddle Point

 In certain cases when there is no pure strategy
solution for games, i.e., no saddle point exists;
both the players must determine an optimum
mixture of strategies to find a saddle
(equilibrium) point.
 The optimum strategy mixture for each player
may be determined by assigning to each strategy
its probability of being chosen. Since strategies so
determined are probabilistic combination for
available choices of strategy, they are mixed
strategies.
05/07/2022 Game
Theory
Lewis and 2009
Slide 1.26
2.26
Arithmetical method.
 For a zero-sum two-person game in which each of the
players. Say A and B, has a strategies A1 & A2 and B1 &
B2 respectively, and the payoffs as given below, then
if p1 is the probability with which A choose strategy
A1 and if q1 is the probability that B plays strategy B1,
the payoff matrix for player A is given by:
05/07/2022 Game
Theory
Lewis and 2009
Slide 1.27
2.27
A’s pay-off matrix

Player B’s strategy
 
 B1  B 2 
 
 A1   a 11 a 12   p1 
    
 A 2   a 21 a 22
Player A     
  p 2 
q1 q2
Then following formula are used to find the value of the game and the
probability of using optimum strategy:
05/07/2022 Game
Theory
Lewis and 2009
Slide 1.28
2.28
Example 1; solve the following game and determine the

value of the game:
Player Y
Strategy 1 Strategy 2
Player X Strategy 1 4 1
Strategy 2 2 3
Solution. Clearly, the pay-off matrix does not possess any
saddle point. The two players, therefore, use mixed
strategies. Let
p 1= probability that player X uses strategy 1
q 1 = probability that player Y uses strategy 1
then 1-p1 = probability that player X uses strategy 2

1-q1 = probability that player Y uses strategy 2
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Lewis and 2009
Slide 1.29
2.29
.
The optimum mixed strategy for player X is determined by:
q=
Hence the optimum strategies for the two players are:
1 2  1 2 
Sx   andSy
   
1 / 2 1 / 2 
1/ 4 3/ 4   
and the value of the game = 10/4
05/07/2022 Game
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Slide 1.30
2.30
 If player Y selects strategy 1 and player X selects

the options with probabilities p1 and 1-p1, then
expected pay-off to player X will be:
 4(probability of player X selects strategy 1) + 2
(probability of player X selecting strategy 2) =
4p1+2(1-p1)=2p1+2
 If player Y selects strategy 2 then expected pay-off
to player X will be:
1p1+ 3(1-p1) = -2p1 + 3
 The probability p1 should be such that expected pay-
offs under both conditions are equal, i.e., 2p1+2 = -2p1
+ 3 or p1 = ¼
 i.e., player X selects strategy 1 with a probability of ¼
or 25% of the time and strategy 2, 75% of the time.
Similarly expected
05/07/2022 Game Theory pay-offs player Y can be computed30
Slide 1.31
2.31
 Expected pay-offs from player Y when player X

selects strategy 1 = expected pay-off from player Y
when player X selects strategy 2
Or 4q1 + 1 (1-q1) = 2q1 + (1-q1) or q1 = ½ and 1-q1 = ½
 This implies that player y selects each strategy with
equal probability, i.e., 50% of the time he choose
strategy 1 and 50% of the time strategy 2.
 Value of game = (expected profit t player X when
player Y uses strategy) x prob. (player Y using
strategy 1) + (expected profits to player X when
player Y uses strategy 2) x prob. (player Y using
strategy 2).
 Value of game = [4*p+2(1-p)]q +[1*p + 3 (1-p)](1-q)
= [4*1/4 +2(1-1/4)]1/2 + [1*1/4 + 3(1-
1/4)] (1-1/2)= 10/4
05/07/2022 Game Theory 31
Slide 1.32
2.32
Example 2 in an election campaign, the strategies adopted

by the ruling and opposition party along with pay-off
(ruling party’s % share in votes polled) are given bellow.
Assume a zero sum game, find optimum strategies for both
parties and expected pay off ruling party.
Opposition party strategies
Ruling party Campaign one day Campaign two Spend two days
strategies in each city days in large in large rural
towns sectors
Campaign one day 55 40 35
in each city
Campaign two 70 70 55
days in large
towns
Spend two days 75 55 85
in05/07/2022
large ruralSaunders,Game Theory
Lewis and Thornhill, Research Methods for Business Students, 5 th
Edition, © Mark Saunders, Philip Lewis and Adrian Thornhill 32
2009
Slide 1.33
2.33
b) Graphic method for for 2xn or mx2 games. Since the optimum
strategies for both the players assign non zero probabilities to the
same number of pure strategies, it is obvious that if ne player has only
two strategies the other will also use two strategies. Graphical method
is helpful in finding out which of the two strategies can be used. It is
also useful if the nature of the game is of the form 2 x n or m x 2. The
graphic method consists of two graphs:
i) the pay-off (gains) available to player A versus his strategies
options, and
ii) the pay-off (losses) faced
Player B’s by playerprobability
B versus his strategies options.
Consider the following 2 x n pay-off matrix of a game without
Probability
saddle
q q --- q
point:
1 2 n
B1 B2    Bn 
 
Player A A1
a a
11 12
   a1n     p1
   
  a a a 
A2  21 22 2n
05/07/2022 Game
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Lewis and 2009
Slide 1.34
2.34
Player A has two strategies A1 and A2 with probability of

their selection p1 and p2 respectively, such that p1 + p2 =1 and
p1, p2 ≥ 0. Now for each of the pure strategies available to
player B, expected pay-off for player A is given in the
following table:
B’s pure strategies A’s expected pay-off
B1 a11p1+ a12p2=(a11-a12)p1+a12
B2 a12p1+ a22p2=(a12-a22)p1+a22
Bn a1np1+ a2np2=(a1n-a2n)p1+a2n
Thus A’s expected pay-off varies linearly with p1.
To plot the expected pay-off lines, we draw two parallel lines one unit
apart and mark a scale on each of them. These two lines represent the
two strategies available to player A. then we draw lines to represent
each of B’s strategies. To represent B’s 1st strategy (B1), we join a11 on
scale 1 to a21 on scale 2. This line will represent the expected pay-off
of the line E1 = (a11-a21) p1+p2 with p1 as x-axis and E1 as y-axis.
Similarly, other pay-off lines can be drawn.
05/07/2022 Game
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Lewis and 2009
Slide 1.35
2.35
The lower boundary of these lines will give the minimum

expected pay-off and the highest point on this lower
boundary will then give the maximum expected pay-off of
player A and hence the optimum value of p1. The two
optimum strategies for B are, then given by the two lines
which pass through this maximum point. Thus the 2 x n
game is reduced to 2x 2 game which can be easily solved
by any of the methods described earlier.
The m x 2 games are also treated in the same manner
except that minimax point is the lowest point on the
upper boundary of the straight lines (instead of highest
point on the lower boundary).
05/07/2022 Game
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Lewis and 2009
Slide 1.36
2.36
Algebraic/linear programming method

It is sometimes very difficult to solve a game problem
with an m x n payoff matrix having neither a saddle nor
any dominance relation in rows or columns. Game
problems in such cases can be formulated as a linear
programming problem as explained below:
Consider a game where pay-off matrix is (aij) m x n. let
(p1, p2, … pm) and (q1, q2, …qm) are the probabilities with
which players A and B adopt their mixed strategies (A1,
A2, …Am) and (B1, B2, …Bn ) respectively. If V is the value
of game, then expected gain to player A for this game
when player B select strategies B1, B2, …Bn one by one is
given by left hand side of simultaneous equations
respectively. Sine, player A is the gainer player and
expects at least
05/07/2022
V, we must have
Game Theory 36
Slide 1.37
2.37
a11p1+a12p2+…+a1mpm≥v
a21p1+a22P2+…+a2mpm≥v
an1+an2p2+…+anmpm≥v
Where p1+p2+….+pm=1and pi≥0 for all i
Similarly, the expected loss to player B when
player A adopts strategies A1, A2, …, Am can be
determined. Since player B is the loser player, he
must have
a11q1+a12q2+…+a1nqn≤v
a21q1+a22q2+…+a2nqn≤v
an1+an2p2+…+anmqn≤v
Where
05/07/2022
p1+p2+….+p m=1and pi≥0 for all i
Game Theory 37
Slide 1.38
2.38
Since the objective of player A is to maximize the

value of the game, V, which is equivalent to minimizing
1/v the resulting linear programming problem can be
stated as:
Minimize Zp = 1/v= x1+x2+…+xm
Subject to the constraints
a11x1+a12x2+…+am1xm≥1
a21x1+a22x2+…+am2xm≥1
an1x1+a2nx2+…+amnxm≥1
Where x1=R/V≥0; x1,x2….xm≥0
05/07/2022 Game
Theory
Lewis and 2009
Slide 1.39
2.39
Similarly, player B has a similar problem with the inequalities

of the constraints revised, i.e., minimizes the expected
losses. Since minimizing of V is equivalent to maximizing 1/V,
therefore, the resulting linear programing problem can be
stated as:
Maximize Zp = 1/v= y1+y2+…+yn
Subject to the constraints
a11y1+a12y2+…+a1nyn≤1
a21y1+a22y2+…+a2nyn≤1
am1y1+am2y2+…+amnyn≤1
Where y1=qi/V≥0; y1,y2….yn≥0
Remark. It may be noted that the linear programming
problem for player B is the dual of LP problem for player A.
Thus the solution of the dual problem can be obtained from
the primal simplex tableau. Since the value if the objective
function for the both the players is the same, i.e., zp=zq, the
expected player Game
05/07/2022 in the
Theorygame will be exactly equal to expected
39

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Slide 1.

 Instead of making inferences from the past behavior

 Game theory helps to determine the best course of

 Where the sum of amounts won by all winners is equal

 When there is communication between the

Underlying Assumption/Rules of Game: Game Theory is

 Mixed strategy. When the players use a

3. Value of the game. It is the expected pay-off of play

5. Pay-off matrix. A two-person zero-sum game is

Let player A have m course of action (A1, A2, …,Am) and

Pure Strategies (Games With Saddle Point)

 If the maxi-min value equals the mini-max value,

Determination of saddle point

Rule (principle) of dominance

Example 1. A company management and the labor union are

Example 2. Two competitive manufacturers are producing

S1: 8 hrs. 60% 56% 34%

Example 3. What is the optimum strategy in the

Solution. Suppose the given game is played by player A

2nd column and 4th column are dominated by 1st column

Solution Methods of Games Without Saddle Point

A’s pay-off matrix

Example 1; solve the following game and determine the

then 1-p1 = probability that player X uses strategy 2

Hence the optimum strategies for the two players are:

 If player Y selects strategy 1 and player X selects

 Expected pay-offs from player Y when player X

Example 2 in an election campaign, the strategies adopted

Player A has two strategies A1 and A2 with probability of

The lower boundary of these lines will give the minimum

Algebraic/linear programming method

Since the objective of player A is to maximize the

Similarly, player B has a similar problem with the inequalities

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