Game Theory

Chapter-04
Contents
Concept of game theory

Game theory and economics

What is a game?

Key elements in game theory

Boeing-Airbus game

Prisoners Dilemma

Dominated and Dominant Strategy

Economic applications of game theory
 What is Game theory?

• Game theory is an approach to modeling

behaviour in situations where the
outcome of your decisions depends on
the decisions of others.
• Game theory is the study of strategic,
interactive decision making among
rational individuals or organizations.
• Strategic decisions are those in which
each person, in deciding what actions to
take, must consider how others might
respond to that action
 Game theory and Economics

• If the market is composed by a small number of firms, each firm must

act strategically.
• Each firm affects the market price changing the quantity produced.
• Suppose 2 firms are producing 100 units.
- If one of the firms decides to increase the production by 10 units.
- The market supply will increase from 200 to 210 and the price
has to drop to reach an equilibrium.
• Therefore, it also affects the profits of other firms.
• Each firm knows that its profit depends not only on how much it
produced but also on how much the other firms produce.
 Mathematical concept in game theory

The following the prerequisite required for

game theory-
• Sum of gains and loss
If in a game sum of the gains to one player
is exactly equal to the sum of losses to
another player, so that sum of the gains
and losses equal zero, the corresponding
game is said to be zero sum game.
 What is a game?
• A game is a situation where the participants'
payoffs depend not only on their decisions, but
also on their rivals' decisions.

• This is called Strategic Interactions:

My optimal decisions will depend on what
others do in the game.
 Types of games
• One-person games
• Two-persons zero sum game
• Positive-sum game
• Perfect games
• Imperfect games
• Finite games
• Cooperative games
• Non-cooperative games
Key elements in game theory

Four elements to describe a game:

• Players: who is interacting?

• Rules: when each player moves, what are the
possible moves, what is known to each player
before moving;
• Outcomes of the moves;
• Payoffs of each possible outcome: how much
money each player receive for any specific
outcome.
Pay off
The outcome of the game resulting from a particular decision (or strategy) is called pay off. It is
assumed that pay off is also known to the player in advance.

Pay off matrix

The pay offs in terms of gains or losses, when players select their particular strategies, can be
represented in the form of matrix is called pay off matrix.
Let A1, A2,.............., Am are possible strategies for player A.
Let B1, B2,..............., Bn are possible strategies for player B.
The total number of possible outcomes are m x n and it is assumed that each player knows not
only his own list of possible course of action but also his opponent.
For our convenience, we assume that player A always a gainer whereas player B a looser.
Let aij=pay off which player A gain from player B, if player A choose strategy i and
player B chooses strategy j.
Pay off matrix
Strategy
The strategy for a player is the list of al possible actions
(moves or course of action) that he will take for every
pay-off (outcome) that might arise.

Types of Strategy
Mainly two types-
• Pure strategy
• Mixed strategy
Other type-
• Optimal strategy
Value of the game
The expected outcome when players follow their optimal strategy is called the value of the
game, It is denoted by V.

Basic assumptions of game

(i) Each player has available to him a finite number of possible strategies. The list may not be
same for each player.
(ii) Player A attempts to maximize gains and player B minimize losses.
(iii)The decisions of both players are made individually prior to the play with no communication
between them.
(iv) The decisions are made simultaneously and also announced simultaneously so that neither
player has an advantage resulting from direct knowledge of the other player's decision.
(v) Both the players know not only possible pay offs to themselves but also other.
 Minmax-Maxmin principle

The selection of an optimal strategy by each player without the

knowledge of the competitor's strategy is the basic problem of
playing games. The objective of the study is to know how these
players select their respective strategy so that they may
optimize their pay off. Such a decision making criterion is
referred to as the minmax -maxmin principle.
 Saddle point
If the minmax value = maxmin value, then the game is said to have a saddle (equilibrium)
point.
Procedure to determine saddle point
Step:-01
Select the minimum (lowest ) element in each row of the pay off matrix and write them under 'row
minima' heading. Then select the largest element among these elements and enclose it in a rectangle.
Step:-02
Select the maximum (largest) element in each column of the pay of matrix and write them under 'column
maxima' heading. Then select the lowest element among these elements and enclose it in a circle.
Step:-03
Find out the elements which is same in the circle as well as rectangle and mark the position of such
elements in the matrix. This element represents the value of the game and is called the saddle point.
Mathematical examples
Mathematical examples
Mathematical examples
 Boeing-Airbus game
• Boeing and Airbus have to decide whether
to invest in the development of a Super
Jumbo for long distance travel;
• If they both develop successfully the new
plane, their profits will drop by 50 millions a
year;
• If only one develop the Super Jumbo, it will
make 80 millions a year in additional profits,
whereas the profits of the other firm will
drop by 30 millions a year;
• If no firm develops the plane, nothing Matrix representation of Boeing-
changes. Airbus game
 Prisoners Dilemma

• Tom and Mary have been arrested for

possession of guns.
• The police suspects that they have
committed 10 bank robberies.
• If nobody confesses the police, they will be
jailed for 2 years.
• . If only one confesses, she'll go free and her
partner will be jailed for 40 years.
• If they both confess, they get 16 years.

Matrix representation of Prisoners

Dilemma
We want to predict the outcome of the game
Suppose the Tom decides to confess. What is Suppose that Tom decides to remain silent.
the best decision for Mary? What is the best decision for Mary?
Dominated and Dominant Strategy
Dominant Strategy:
• a strategy that gives higher payoffs no
matter what the opponent does;
Dominated Strategy:
• a strategy is dominated if there exists
another strategy that is dominant.
• So far we have only assumed that
each player is rational to determine
the outcome of the game.
 We want to predict the outcome of the game

Suppose the Mary decides to confess. What is Suppose that Mary decides to remain silent.
the best decision for Tom? What is the best decision for Tom?
Outcome of the Game
Nash Equilibrium
A Nash equilibrium occurs when the payoff
to player one is the best given the other’s
choice. Nash equilibrium where each player
has nothing to gain by changing strategy,
given the choices of the other player. A
Nash equilibrium is not necessarily Pareto
efficient. Both players could gain from co-
operation.
Nash Equilibrium

ØIn this case IfP1 chooses down, P2 will choose right

Ø If P1 choose UP, P2 will choose right. But, if P2 choose right, P1 will want to choose down.
Ø The Nash equilibrium will be downright, (5,5) despite UP left being the optimal Pareto
outcome.
 Economic applications of game theory

• The study of oligopolies (industries containing only a few

firms)
• The study of cartels, e.g., OPEC
• The study of externalities, e.g., using a common resource
such as a fishery
• The study of military strategies
• The study of international negotiations
• Bargaining, etc.
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