Game Theory

Game theory was developed to analyse situations

in which strategic decisions have to be made.

A game is a situation in which a number of

individuals make decisions, and each cares
both about her own choices and about others’
choices.

The payoff to each player in general depends on

the set of strategies chosen by all the players.
 Games
The basic elements of a game are
· n players,
their strategies,
and their payoffs.
•who are the players? They may be people, firms, organizations,
governments, ethnic groups, and so on.
• what actions are available to them? All actions that the players might
take that could affect any player's payoffs should be listed.
• Ascertaining payoffs involves estimating the costs and benefits of each
potential set of choices by all players. In many situations it may be easier
to estimate payoffs for some players (such as yourself) than others, and it
may be unclear whether other players are also thinking strategically.
 Games
• Are actions taken simultaneously or sequentially?
• In sequential move games, the order of play is also
important. Moving after another player may give player i
an advantage of knowing what the other player has done;
it may also put player i at a disadvantage in terms of lost
time or the ability to take some action.

Games can therefore be represented

either in the normal form (one-stage)
or in extensive form (multiple-stage).
In a normal form game, players choose
their strategies sim ultaneously and the
game is played only once.
The game is represented in the form of a
payoff matrix.

In an extensive form game, players make

sequential moves.

Players are “rational”:

their choices of strategies are dictated
only by the payoffs consequent upon such
choices.
 The Prisoners' Dilemma Game: Dominant
Strategy Equilibrium

Amar
Confess Not confess
-------------------------------------------
Confess (4,4) (0,8)
Akbar -------------------------------------------
Not Confess (8,0) (1,1)
-------------------------------------------

 Confessing is a dom inant strategy for both

prisoners.

 In the dom inant strategy equilibrium , each

ends up spending 4 years in jail.
 Note:
Both firms are fully aware of the payoffs
involved and of the virtues of cooperation.

But they do not have any way of entering

into an agreement that will be respected by
both parties.
Two tobacco firms competing in a market - Each
can choose either to advertise or not to advertise.
Firm 2
Not Advertise Advertise
(cooperate) (cheat)
--------------------------------------------------
Not Advertise (30,30) (0,55)
Firm 1 --------------------------------------------------
Advertise (55,0) (5,5)
--------------------------------------------------
 US and China
• Each year the United States considers renewal of Most Favored
Nation (MFN) trading status with China.
• Historically, legislators have made threats of not renewing MFN
status because of human rights abuses in China. The non-
renewal of MFN trading status is likely to involve some
retaliatory measures by China.
• The Game below reflects the potential economic gains
associated with a two-outcome game in which China may
impose trade sanctions against U.S. firms and the United States
may not renew MFN status with China. The following table
contains the dollar value of all trade flow benefits to the United
States and China under two trade-relationship scenarios.
 China

Impose trade sanctions Do not impose trade

against U.S. firms sanctions against U.S.
firms
Don't renew MFN U.S. trade value = $65 b U.S. trade value = $140 b
United status with China China trade value = $75 b China trade value = $5 b
States Renew MFN U.S. trade value = $35 b U.S. trade value = $130 b
status with China China trade value = $285 b China trade value = $275 b
A way out of the Prisoners' Dilemma :
The Criminal's Revenge

Take actions to change the payoffs: Amar and

Akbar enters into a binding agreement with a hit
man (say Anthony):

Amar
Confess Not confess
-------------------------------------------
Confess (4,4) (3,8)
Akbar -------------------------------------------
Not Confess (8,3) (1,1)
-------------------------------------------
The best strategy for each prisoner now
depends on w hat the other player does.

I n practice, how do the players transform the

P risoners' Dilem m a gam e into a Crim inal's
Revenge gam e?
W ays out of the P risoners' Dilem m a:

(2)Repeated Gam es

When players interact repeatedly, there arises the

possibility of punishing a cheater.

Punishment:
Not necessarily physical punishment

Possibility of punishment arises from the fact of

repeated interactions between players and non-
cooperation.
The OPEC price fixation game

Iraq's Output (millions of barrels per day)

2 4
-------------------------------
2 (46,42) (26,44)
Iran's Output -------------------------------
4 (52,22) (32,24)
------------------------------

Note that this is a Prisoners’ Dilemma Game.

The dominant strategy for both countries is to cheat and

produce 4 million barrels per day
 Suppose Iran cheats for a day successfully,
while Iraq stays honest.
Iran gains $6 million.

 When Iraq finds out Iran has cheated, the

mutual trust breaks down. The two settle down to
a regime of high outputs.

 Relative to cooperation, Iran now loses $14

million a day.

 If it takes Iraq a month to detect the cheating,

Iran's gain is $180m.
Once cheating is detected, it takes only 13 days
(13x14 = 182) to wipe out Iran's gain from
cheating.

A player will cheat if

B > pLT/R,
where:
B: (short run) benefit from cheating
L: loss each period if cheating is detected
T: Number of periods of non-cooperation
P: probability of detection
R: a discount factor
FINITE NUMBER OF REPETITIONS
Now suppose the game is repeated a finite number of times—say,
N months. (N can be large as long as it is finite.) If my competitor
(Firm 2) is rational and believes that I am rational.

In this case, both firms will not consider undercutting until the last
month, before the game is over, so Firm 1 cannot retaliate.

However, Firm 2 knows that I will charge a low price in the last
month. But then what about the next-to-last month? Because there
will be no cooperation in the last month, anyway, Firm 2 figures
that it should undercut and charge a low price in the next-to-last
month. But, of course, I have figured this out too. In the end, the
only rational outcome is for both of us to charge a low price every
month.
 Nash Equilibria

Nash equilibrium as the weakest concept of

equilibrium appropriate to games like that of
Criminal's Revenge.

Definition:

A set of strategies, one for each player,

constitutes a Nash equilibrium if the strategy for
each player is the best, given that all other
players are playing the corresponding strategies
in the set .
Thus, in a Nash equilibrium,

strategies are optimal only against each other,

unlike a dominant strategy equilibrium where

each player's strategy is optimal regardless of the
strategy of the other players.

Therefore a set of strategies forms an equilibrium

if no player can do better by deviating from the
prescribed strategy.
Battle of the Sex es Gam e: The P roblem of
Coordination
Husband
Go Shopping Watch TV
Go Shopping (2,1) (0,0)
Wife ______________________
Watch TV (0,0) (1,2)
_____________________
Two Nash equilibria in this game :
(go shopping, go shopping) and (watch TV, watch
TV)
A problem of coordination: The players are better
off if they do the same thing rather than if they
do different things.
Two problems:
1. Problem of non-existence

2
Head __________Tail
Head (1,-1) (-1, 1)
1 ------------------------------
Tail (-1,1) (1,-1)
-----------------------------

This problem can be solved if mixed strategies are

allowed.

2. Problem of non-uniqueness
The Gam e of Chicken : The P roblem of
Differentiation
B
Stay Swerve
-----------------------------------------
Stay (-10,-10) (5, -1)
A ------------------------------------------
Swerve (-1, 5) (0, 0)
----------------------------------------

•There are two Nash equilibria, in each of which

one player swerves and the other stays.

Commitment: Can be dangerous/risky in such

situations.
The product choice problem
Consider the market for chocolates. Two chocolate
companies can produce either “bitter” chocolates or
“sweet” chocolates. In each type, two companies
will saturate the market.

Firm 2
Bitter _______ Sweet
Bitter (-5,-5) (10, 10)
Firm 1 ------------------------------
Sweet (10, 10) (-5,-5)
-----------------------------
 How to identify NE
Priya

L C R
Ankit
U 1, 0 1*, 2* 3*, 1

M 2*, 3* 0, 2 1, 1

D 1, 1* 1*, 0 1, 1*

1. Find Ankit’s best response to Priya’s strategies. Mark the

associated payoffs with an asterisk.
2. Find Priya’s best response to Ankit’s strategies. Mark
associated payoffs similarly.
3. Identify cells where both players’ payoffs have asterisks.
4. In the example above, both (U, C) and (M, L) are NE.
 NE and the treatment of risk
B
Left Right
A Up (9,10) (8,9.9)
Down (10,10) (-1000,9.9)

Let p be the probability with which B plays right.

- Suppose A chooses Up. Then the expected value of her payoff
is 9(1-p) + 8p = 9 – p
- If A chooses Down, then the expected value is 10(1-p) +
(-1000)p.

A should then choose Up if 9 – p > 10(1-p) – 1000p,

i.e. p > 1/1009

So even if there is a very small probability that B’s dominant

strategy is Right, then A should play Up rather than Down.
 Games with Multiple Stages
• In most strategic settings events unfold over
time
– Actions can provoke responses
– These are games with multiple stages
• In a game with perfect inform ation ,
players make their choices one at a time and
nothing is hidden from any player
• Multi-stage games of perfect information are
described using tree diagrams
12-26
Game Tree:

Nodes – decisions are taken or payoffs made.

Branches – represent decisions.

Let us again consider the “battle of the sexes”.

Assume that one of the players, (say) the wife,

makes her choice before the husband does.

Once the wife has made her choice, the husband

makes his.

The sequence of moves can be represented by

means of a gam e tree :
 Watch TV
________ (1,2)
Watch TV |
_________ Husband ----|
| |________(0,0)
| Go Shopping
|
Wife | Watch TV
| |------------ (0,0)
| _________ Husband --|
Go Shopping |________ (2,1)
Go Shopping
 Strategy in an extensive form
game
• A strategy is one player’s plan for
playing a game, for every situation that
might come up during the course of
play
 Strategy in an extensive form
game
• Wife’s strategies are her possible
actions: “watch TV” and “go shopping”
• Husband’s strategies must say what he
will do when he learns that either wife
has chosen “watch TV” or “go
shopping”
• He will have 4 strategies to choose from
 Husband’s strategies
1. If wife chooses “watch TV”, then watch TV. If
wife chooses to go shopping, go shopping.
2. If wife chooses “watch TV”, then watch TV. If
wife chooses to go shopping, then watch TV.
3. If wife chooses “watch TV”, then go shopping.
If wife chooses to go shopping, then watch TV.
4. If wife chooses “watch TV”, then go shopping.
If wife chooses to go shopping, then go
shopping.
 Backward Induction
• To solve a game with perfect information
– Player should reason in reverse, start at the
end of the tree diagram and work back to
the beginning
– An early mover can figure out how a late
mover will react, then identify her own best
choice
• Backw ard induction is the process of
solving a strategic problem by reasoning
in reverse
12-33
 Nash equilibrium
• Can always find a Nash equilibrium in a
multi-stage game of perfect information
by using backward induction
A Nash equilibrium consists of a pair of
strategies:
Wife’s strategy: Go shopping
Husband’s strategy: If wife chooses “watch TV”,
then watch TV. If wife chooses to go shopping,
go shopping.
 In the original normal form game, one Nash
equilibrium consisted of both players watching
TV.

Is this also a reasonable equilibrium?

Suppose that the husband threatens to “always
watch TV”.

I f the w ife takes this threat seriously , she should

choose to watch TV and get a payoff of 1.
If she chooses to go shopping and he watches
TV, her payoff will be 0.

But should she take this seriously, i.e., is this a

credible threat? No.

Perfect rationality here undermines credibility of

threat.
In the simple game considered here, it is easy to
work out the equilibrium by backw ard induction .
Sequential Games and Business Strategy

The Decision Tree for an

Entry Game
Sequential Games and Business Strategy
• Deterring Entry – Hurdle rate of 15%
The Decision Tree for an
Entry Game
 The Cuban Missile Crisis
• In October 1962, the Soviet Union, under
Nikita Kruschchev, began to install nuclear
missiles on Cuba, 90 miles from the
American mainland.
• On October 22, John F. Kennedy
announced a naval quarantine of Cuba
• After a few anxious days, Krushchev shied
away from confrontation and ordered the
Soviet missiles in Cuba dismantled and
shipped back