Chapter Five: Game Theory

5.1 Introduction

 Game theory deals with decision making under conflict or competition.

 Game theory is a body of knowledge that deals with making decisions when two or
more intelligent and rational opponents are involved under conditions of conflict or
competition

 The main characteristic of games is that two or more decision makers with conflicting
objectives are involved and the consequences of the decisions (payoffs) depend on the
courses of action taken by all.

 Each decision maker is usually trying to maximize his welfare at the expense of the
others.
 A solution to game problems provides us with answers
to these two questions:

 What strategy should each player follow to maximize his/her

welfare.

 What will the payoff to each player be if the recommended

strategy is followed.

 In game theory, two or more decision makers, called players,

compete against each other.

 Each player selects one of several strategies without knowing in

advance the strategy selected by the other player or players.
 5.2. Two-person, zero-sum games

 Two-person means that two players participate in the game.

 Zero-sum means that the gain (or loss) for one player is equal to the
loss (or gain) for the other player.

 As a result, the gain and loss balance out (resulting in a zero-sum) for
the game.

 What one player wins, the other player looses.

 Let us demonstrate a two-person, zero-sum game and its solution by

considering two companies competing for market share.
 Suppose that two companies are the only manufacturers of a
particular product; they compete against each other for market
share. In planning a marketing strategy for the coming year, each
company will select one of three strategies designed to take
market share from the other company. The three strategies, which
are assumed to be the same for both companies, are as follows:

 Strategy 1: Increase advertising

 Strategy 2: Provide quantity discounts
 Strategy 3: Extend warranty
 Payoff table showing the percentage gain in market share for
company A
Company B
Increase Quantity Extend
advertizing b1 discount b2 Warranty b3
Increase Advertizing a1 4 3 2
Quantity discount a2 -1 4 1
Company A
Extend warranty 5 -2 0

• A payoff table showing the percentage gain in the market share for Company A
for each combination of strategies .
• Because it is a zero-sum game, any gain in market share for Company A is a
loss in market share for Company B.
• In interpreting the entries in the table, we see that if Company A increases
advertising (a1) and Company B increases advertising (b1), Company A will
come out ahead with an increase in market share of 4%, while Company B
will have a decrease in market share of 4%.
 If Company A provides quantity discounts (a2) and Company B increases
advertising (b1), Company A will lose 1% of market share, while Company B will
gain 1% of market share.

 Therefore, Company A wants to maximize the payoff that increase in market share.

 Company B wants to minimize the payoff because the increase in market share for
Company A is the decrease in market share for Company B.

 Each company will select one of its three alternative strategies.

 The logic of game theory assumes that each player has the same information and will
select a strategy that provides the best possible payoff from its point of view

 What is the optimal strategy for each company

 Considering the entries in the Row Minimum, we see that
Company A can be guaranteed an increase in market share of at
least 2% by selecting strategy a1.

 Strategy a2 could result in a decrease in market share of 1% and

strategy a3 could result in a decrease in market share of 2%.

 After comparing the row minimum values, Company A selects

the strategy that provides the maximum of the row minimum
values. This is called a maximin strategy.

 Thus, Company A selects strategy a1 as its optimal strategy; an

increase in market share of at least 2% is guaranteed.
 Let us now look at the payoff table from the point of
view of the other player, Company B.

 The entries in the payoff table represent gains in

market share for Company A, which corresponds to
losses in market share for Company B.
 Payoff table with row minimum
Company B
Increase Quantity Extend Row
advertizing b1 discount b2 Warranty b3 Minimum
Increase 4 3 2 2
Advertizing a1 (maximum)
Company A
Quantity -1 4 1 -1
discount a2
Extend 5 -2 0 -2
warranty a3
 Consider what happens if Company B selects strategy b1.
 Company B market share decreases of 4%, –1%, and 5% are possible.
 Under the assumption that Company A will select the strategy that is best for it
 Company B assumes that Company A will select strategy a3, resulting in a
gain in market share of 5% for Company A and a loss in market share of 5%
for Company B. At this point, Company B analyzes the game by protecting
itself against the strategy taken by Company A.
 Doing so, Company B identifies the maximum payoff to Company A for each
of its strategies b1, b2, and b3. This payoff value is the maximum value in
each column of the payoff table.

 Considering the entries in the Column Maximum, Company B can be

guaranteed a decrease in market share of no more than 2% by selecting the
strategy b3.

 Strategy b1 could result in a decrease in market share of 5% and strategy b2

could result in a decrease in market share of 4%.

 After comparing the column maximum values, Company B selects the

strategy that provides the minimum of the column maximum values. This is
called a minimax strategy.
Payoff table with column maximum values
Company B
Increase Quantity Extend Row
advertizing b1 discount b2 Warranty b3 Minimum
Increase 4 3 2 2
Advertizing a1 (maximum)
Company A
Quantity -1 4 1 -1
discount a2
Extend 5 -2 0 -2
warranty a3
Column 5 4 2
Maximum (Minimum)

 Thus, Company B selects b3 as its optimal strategy in which it has

guaranteed that Company A cannot gain more than 2% in market share as
shown in the above table.
 Therefore, Company A selects the strategy of increase advertizing, while
Company B selects the strategy of extend warranty (optimal strategies).
 5.3. Pure strategies: Game with Saddle point
 If it is optimal for both players to select one strategy and stay with
that strategy regardless of what the other player does, the game has
a pure strategy solution.

 Whenever the maximum of the row minimums equals the

minimum of the column maximums, the players cannot improve
their payoff by changing to a different strategy.
 The game is said to have a saddle point, or an equilibrium point.

 Thus, a pure strategy is the optimal strategy for the players.

 A Game has a Pure Strategy Solution if:

 Maximum (Row minimums) = Minimum (Column maximums)

 If a pure strategy solution exists, it is the optimal solution to the game.
 The following steps can be used to determine when a game has a pure
strategy solution and to identify the optimal pure strategy for each player:

Step 1: Compute the minimum payoff for each row (Player A).
Step 2: For Player A, select the strategy that provides the maximum of the
row minimums.
Step 3: Compute the maximum payoff for each column (Player B).
Step 4: For Player B, select the strategy that provides the minimum of the
column maximums.
Step 5: If the maximum of the row minimums is equal to the minimum of the
column maximums, this value is the value of the game and a pure
strategy solution exists.

 The optimal pure strategy for Player A is identified in Step 2, and the optimal
pure strategy for Player B is identified in Step 4.
 If the maximum of the row minimums does not equal the
minimum of the column maximums, a pure strategy solution
does not exist.

 In this case, a mixed strategy solution becomes optimal.