Game Theory and Strategic Behaviour

CA. Abha Dammani

Introduction

Game theory is a branch of mathematics that studies strategic interactions

between individuals, where the outcome of each individual's decision depends on
the decisions of others. It models these interactions using games and analyses the
optimal strategies for each player in different game scenarios, taking into account
their preferences.
Game theory explained using normal-form
game
The best way to explain game theory is to use a normal-form game example. The normal
form of a simple game is a four-square matrix that presents the personal payoffs for two
players who are choosing between two decisions. Adjacent table shows the concept of a
payoff matrix, or normal form, for a simple game between two players. Notice that each
player's outcome depends on their choice and the other player's choice.
 Normal-form game

• If both players choose A. Knowing

that player 2 is choosing A, player 1
has two options. Either stick with A,
in which case they both win, or choose
to switch to B, in which case player 1
wins even more!
• While player 1 realizes that switching
to B can make them win even more,
player 2 also thinks the same thing. So
the rational outcome in this example is
for both players to choose B. The
result is that both players have a worse
outcome than if both had remained at
A.
• A key factor in this particular game is that the players are not allowed to discuss their
choices with each other in advance. That's why both players are in the dark about their
opponent's choice. With this lack of information, it is not rational to choose A.
• However, if the players could talk with each other, then any rational person would say
"why don't they just agree to both choose A?"
The Payoff Matrix
• A strategy is a course of action taken by one of the participants in a game, and the payoff is
the result or outcome of the strategy.
• Consider a market with two competing firms whose objective is to increase their profits by
price changes. Assume that each firm has two possible strategies – it can either maintain its
price at the present level or it can increase its price.
• In this game there are four possible combinations of strategies- both of the firms increase
their prices, neither firms increases its prices, firm 1 increases its price but firm 2 does not,
and firm 2 increases price but the other firm does not.
• The results are shown in the table on the next slide. The first number in each cell is the
profit of firm 1, and the second value is the corresponding profit for firm 2. This table is
referred to as a payoff matrix because it shows the outcomes or payoffs that result from
each combination of strategies adopted by the two participants in the game.
The Payoff Matrix (in crores)
 Table 2

Notice that the payoffs are numbers. A higher

number is a better payoff. If we think of each
player as a firm, then these numbers might
represent each firm's profit or loss. Each box
with a set of numbers displays the outcome for
Player 1 first, and then the outcome for Player
2.
 Game Theory concept and analysis
• Strategy: A strategy is a player's complete plan of action in a game. An optimal strategy is one that
maximizes personal gain.
• Dominant strategy: A player has a dominant strategy in a game if there is one choice that always
gives a higher personal payoff, regardless of the other player's choice.
• Table for payoff for firms, the optimal strategy for each firm depends on the strategy selected by
the other firms. But in some situations, one firm’s best strategy may not depend on the choice made
by other participants in the game. In this case, firm has a dominant strategy.
Nash Equilibrium
• A limitation of the concept of Nash equilibrium is that there can be more than one
equilibrium.
• The same can be seen in the table, if both the firms are not increasing prices and if both
increase the prices.
• The actual outcome of the game depends on which action occurs first. Because no price
change is the initial condition, the expected outcome of this game would be that prices
would not change.
• For some games, there may be no Nash equilibrium. In these cases, participants may
continuously switch from one strategy to another.
 Dominant Strategy( in crores)
FIRM 2
FIRM 1 No price change Price change
No price change 10,10 100,-30
Price change -20,30 140,25

If firm does not change prices, firm 2’s best strategy is to also make no price adjustment.
But based on the profits if firm 1 increases its price, firm 2 is still better off with no price change
because profit will be 30 crores compared to 25 crores if it increases price.

Hence firm 2’s dominant strategy is to hold prices at the existing level, regardless of what firm 1 does.

When one player has a dominant strategy, the game will always have a nash equilibrium because that
player will use the strategy and the other will respond with its best alternative. Firm 1’s best response
to no price change by firm 2 is also not to change price.
DOMINATED STRATEGY
• A dominated strategy is an alternative that yields a lower payoff than some other strategy,
no matter what the other players in the game do.
• In the analysis of the game theory, dominated strategies are identified so that they can be eliminated from
the game. Let us understand the dominated strategy with the help of an example.
• Suppose in a football match, the aim of offense team is to maximize its goals, while that of defense team is
to minimize the offense’s goal. Now, assume that there are only two plays left and the ball is with the
offense team.
• In this case, the offense team would adopt two strategies; one is to run and another is to pass. On the other
hand, the defense team would have three strategies; one is to defend against running, defend against pass
through line-backers and defend against pass through quarterback blitz.
• In Table, the numerical value represents the goals made by the offense team. In this case, neither offense nor
defense team have a dominant strategy. However, the defense team does have one dominated strategy that is
quarterback blitz.
• Either in case of defending run or pass, quarterback blitz strategy would yield more goals to the offense
team. Therefore, the defense team should avoid quarterback blitz strategy. Dominated strategy helps in
making the analysis of game easier by reducing the number of options.
DOMINATED STRATEGY

Defensive Strategy

Defense against Linebackers back Blitz

runs

2 6 14
Run
Offensive Strategy
8 7 10
Pass
 MAXIMIN STRATEGY
• As we know, the main aim of every organization is to earn maximum profit. However, in the
highly competitive market, such as oligopoly, organizations strive to reduce the risk factor. This is
done by adopting the strategy that increases the probability of minimum outcome. Such a strategy
is termed as maximin strategy.
• Maximin strategy is not used only for profit maximization problems, but it is also used for
restricting the unrealistic and highly unfavorable outcomes.
• In the present case, for both the organizations, A and B, it would be better if they do not launch
any new product to yield maximum profit.
MAXIMIN STRATEGY

ORGANISATION B
ORGANISATION A No New New Product Organization A
Product minimum

No New 7, 7 6, 9 6
Product

New Product 9, 6 4, 4 4

Organization B 6 4
minimum
Mixed Strategies
• In all of the games discussed, it has been assumed that each participant selects
one course of action. This approach is called pure strategy.
• In other words, a pure strategy is the one that provides maximum profit or the
best outcome to players. Therefore, it is regarded as the best strategy for every
player of the game.
• On the other hand, in a mixed strategy, players adopt different strategies to get
the possible outcome. For example, in cricket a bowler cannot throw the same
type of ball every time because it makes the batsman aware about the type of
ball. In such a case, the batsman may make more runs. However, if the bowler
throws the ball differently every time, then it may make the batsman puzzled
about the type of ball, he would be getting the next time.
• Therefore, strategies adopted by the bowler and the batsman would be
mixed strategies, which are shown ion Table
Mixed Strategies
Bowler
Throws spin ball Throws fast ball

Anticipates Spin ball 30% 10%

Batsman
Anticipates fast ball 10% 30%
Mixed Strategies

• In table, when the batsman’s expectation and the bowler’s ball type are same, then the
percentage of making runs by batsman would be 30%. However, when the expectation of
the batsman is different from the type of ball he gets, the percentage of making runs
would reduce to 10%. In case, the bowler or the batsman uses a pure strategy, then any
one of them may suffer a loss.
• Therefore, it is preferred that bowler or batsman should adopt a mixed strategy in this
case. For example, the bowler throws a spin ball and fastball with a 50-50 combination
and the batsman predicts the 50-50 combination of the spin and fast ball. In such a case,
the average hit of runs by batsman would be equal to 20%.
• This is because all the four payoffs become 25% and the average of four
combinations can be derived as follows:
• 0.25(30%) + 0.25(10%) + 0.25(30%) + 0.25(10%) = 20%
 Mixed Strategies
• However, it may be possible that when the bowler is throwing a 50-50 combination of spin ball and
fastball, the batsman may not be able to predict the right type of ball every time. This would decrease
his average run rate below 20%. Similarly, if the bowler throws the ball with a 60-40 combination of
fast and spin ball respectively, and the batsman would expect either a fastball or a spin ball randomly.
In such a case, the average of the batsman hits remains 20%.
• The probabilities of four outcomes now become:
• Anticipated fastball and fastball thrown: 0.50*0.60 = 0.30
• Anticipated fastball and spin ball thrown: 0.50*0.40 = 0.20
• Anticipated spin ball and spin ball thrown: 0.50*0.60 = 0.30
• Anticipated spin ball and fastball thrown: 0.50*0.40 = 0.20
• When we multiply the probabilities with the payoffs given in Table, we get
0.30(30%) + 0.20(10%) + 0.20(30%) + 0.30(10%) = 20%
Mixed Strategies
• This shows that the outcome does not depends on the combination of fastball
and spin ball, but it depends on the prediction of the batsman that he can get
any type of ball from the bowler.
Game theory and Oligopoly:
Noncooperative Games: The Prisoner’s Dilemma
• Non-cooperative games refer to the games in which the players decide on their own strategy
to maximize their profit. It is not possible to negotiate with other participants and enter into
some form of binding agreement.
• The best example of a non-cooperative game is prisoner’s dilemma. Non-cooperative games
provide accurate results. This is because in non-cooperative games, a very deep analysis of a
problem takes place.
Cooperative Games: Enforcing a Cartel

• Cooperative games are the one in which players are convinced to adopt a
particular strategy through negotiations and agreements between players.
• Let us take the example cited in prisoner’s dilemma to understand the concept
of cooperative games. In case, John and Mac had been able to contact each
other, then they must have decided to remain silent. Therefore, their
negotiation would have helped in solving out the problem.
Repeated Games: Dealing with Cheaters
• Consider the advertising example:
• If the game is played once, neither firm will adopt low level because the other could
select high level, capture most of the profit and the game would be over.
• Even if each firm agrees to hold down advertising and eventually renege, the high
advertising equilibrium will occur.
• But if this decision is made repeatedly, the outcome may change.

•TIT FOR TAT (optimal strategy)-

Whether cooperate or renege.
Sequential Games: The advantage of being first
• Sequential games are the one in which players are aware about the moves of
players who have already adopted a strategy.
• However, in sequential games, the players do not have a deep knowledge about the
strategies of other players. For example, a player has knowledge that the other
player would not use a single strategy, but he/she is not sure about the number of
strategies the other player may use.
• In a sequential game, one of the players acts first and then the other responds.
Entry into a new market is an example of a sequential game. The new firm decides
whether or not to enter, and the existing firm then decides whether to ignore the
new firm or try to prevent entry.
• There may be an advantage to the player who acts first. For example two firms
introduce nearly identical new products. The first firm getting the product to the
market is more likely to get successful because it can develop brand loyalties and
willingness of the consumers.
 Sequential Games: The advantage of being
first
The advantage of moving first is shown in the table.

Assume that the firms use maximin criteria. If the firms

must announce their decisions independently and
simultaneously the maximin criteria specifies that neither
should introduce a new product and that each firm earn Rs.2
crores.

Now assume that firm 1 has R & D advantages that give it

the option of introducing its product first. With firm 1
already in the market, firm 2’s optimal strategy to stay out
because it will lose only Rs. 5 crores, compared to Rs. 7
crores if it enters.

Consequently, firm 1 will earn Rs 10 crores as the only

supplier. Clearly, firm 1 has benefitted by being the first
Strategic Behaviour
Present versus Future Profits: Limit Pricing
• Joe Staten Bain locates the reason for the difference between the limit price and the average cost of
the oligopolist in barriers to entry. These barriers confer a cost advantage on the entrenched firm
over the fresh entrant. The cost advantage may be absolute or relative.
• Limit Pricing is a pricing strategy a monopolist may use to discourage entry. If a monopolist set its
profit maximising price (where MR=MC) the level of supernormal profit would be so high it
attracts new firms into the market. Limit pricing involves reducing the price sufficiently to deter
entry. It leads to less profit than possible in short-term, but it can enable the firm to retain its
monopoly position and long-term profitability.
Strategic Behaviour
Present versus Future Profits: Limit Pricing
• Using entry limiting pricing, manager alters the firm’s profit stream, as shown
in the table
• Economic profit resulting from setting the profit maximizing price in each
period is depicted by the profit stream labelled I. Note that economic profit is
substantial in the initial period but declines as the new firms enter the market.
In contrast, entry limiting pricing generates a relatively constant profit stream
over the planning horizon
• In fact, profit may actually increase over time if the market is growing as
shown by profit stream labelled II.
 Strategic Behaviour
• Stigler’s open oligopoly model considers Present value of the profits in both the scenarios.
• The optimal long run pricing strategy is the one that maximizes the PV of profit.

• Clearly, the appropriate long run strategy depends on how managers perceive future profits.
• Managers with a short planning horizon and those who view short term profits as paramount would be more
likely to behave in a manner consistent with the open oligopoly model. Conversely, those who have longer
time horizon and use a lower discount rate would be more likely to pursue entry limiting pricing.
 The value of a bad reputation: Price Retaliation
• Purpose of limit pricing is to prevent entry by keeping prices at low level over a long period of
time.
• Example :
General Foods ( Maxwell House Brand)- 43% market share in the eastern US (non
instant ground coffee market.
Proctor & Gambles ( Folger’s brand)- leading seller in the west, but was not distributed in the more
areas of the east.
1971: P & G started to advertise and distribute in the east. Initiated in GF’s Youngstown, Ohio,
sales district, which included the cities of Cleveland and Pittsburgh.
Strategy by GF: To increase advertising and cut prices for this region. At times the price was lower
than the cost of producing the coffee. As a result profit dropped from +30% in 1971 to -30% in
1974. And when P&G reduced its promotional activities, GF increased its prices back and
eventually the profits returned to its normal.
The value of a bad reputation: Price
Retaliation
• Reducing prices every time entry occurs or appears likely to occur would be a costly
proposition for the existing firms in the market.
• But a strong implication of this strategy can have a significant outcome.
• If a firm establishes a consistent pattern of reacting to entry by drastically reducing prices, then
potential rivals may become convinced that they will face the same response and decide not to
compete. Thus, by firmly establishing a reputation for dealing harshly with all new entrants, the
firm may create an effective barrier to entry.
Establishing Commitment: Capacity Expansion
• The threat of price retaliation will not be credible if the existing firm are unable to produce
enough output to meet extra demand resulting from lower prices due to production capacity.
• Investment in excess capacity reduces the profits earned by an existing firm.
• This investment will be undertaken only if the mgmt. believes that the certain and immediate
loss of profit from making the investment is less than the expected future profit loss resulting
from the new entry.
• Eg: Suppose monopolist to decide between small or large plant whereas second firm to decide
between whether to enter or not.
Establishing Commitment: Capacity Expansion

• If monopolist build small plant, the competitor will enter as its profit would be
4 crores as opposed to zero if not entered.
• However if the large plant is build, it is better for the new firm to stay out.
• For the monopolist, the better strategy is to build small plant, restrict output
and continue as the only supplier. But this option is not viable because it will
induce entry and then monopoly will earn only 4 crores of profit.
• But if mgmt. is confident that the large firm will deter entry, its construction is
the best strategy as it will fetch a profit of 8 crores.
Pre-emptive action: Market Saturation
• As the total amount of production can affect the rate entry so as the geographical
location of that capacity can also cause barriers to entry.
• When the cost of transportation of goods are high relative to its value, consumers not
close to the production facility will pay substantially higher prices to have the good
delivered to their location. Thus firms closer to the consumers will have a cost
advantage and should be able to attract those customers. E.g.: Ford and General Motors