Operations Research - Game Theory

OPERATIONS RESEARCH

A Report Submitted for External Assessment on

Project Topic: Game Theory Coke V/S Pepsi.

NEW DELHI

STUDENT NAME: ISHMEET SINGH KOHLI

BATCH: UGP FW 2007-2010/ PGP FW 2008-2010

Ph.: 9999971855

EMAIL: [email protected]

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INDEX

S.No. Contents Page No.

1. Abstract 3

2. Introduction 4

3. Concepts in Game Theory 7

4. Representation of Games 9

5. Types of Games 13

6. Application & Challenges 24

7. Coke V/S Pepsi 28

8. Bibliography 29

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Abstract
Game theory is a branch of applied mathematics that is used in the social sciences, most notably

in economics, as well as in biology, engineering, political science, international relations,

computer science, and philosophy. Game theory attempts to mathematically capture behavior

in strategic situations, in which an individual's success in making choices depends on the choices

of others. While initially developed to analyze competitions in which one individual does better

at another's expense (zero sum games), it has been expanded to treat a wide class of interactions,

which are classified according to several criteria. Today, "game theory is a sort of umbrella or

'unified field' theory for the rational side of social science, where 'social' is interpreted broadly, to

include human as well as non-human players.

Game theory is the mathematical analysis of a conflict of interest to find optimal choices that

will lead to desired outcome under given conditions. To put it simply, it's a study of ways to win

in a situation given the conditions of the situation. While seemingly trivial in name, it is actually

becoming a field of major interest in fields like economics, sociology, and political and military

sciences, where game theory can be used to predict more important trends.

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Introduction

Game theory is concerned with the decision-making process in situations where outcomes

depend upon choices made by one or more players. The word "game" is not used in the

conventional sense but describes any situation involving positive or negative outcomes

determined by the players' choices and, in some cases, chance. In order for game theory to apply,

certain assumptions must be made. The first is that each player is rational, acting in his self-

interest. In addition, the players' choices determine the outcome of the game, but each player has

only partial control of the outcome.

Though the title of originator is given to mathematician John von Neumann, the first to explore

this matter was a French mathematician named Borel. In the 1930s, Neumann published a set of

papers that outlined the tenets of game theory and thus made way for the first simulations which

considered mathematical probabilities. This was used by strategists during the Second World

War, and since then has earned game theory a place in the context of Social Science.

It may at first seem arcane to involve mathematics in something that seems purely based on skill

And chance, but game theory is in actuality a complex part of many branches of mathematics

including set theory, probability and statistics, and plain algebra. This results from the fact that

games are dictated by a given set of rules that can be used to outline a set of possible moves

which can be ranked by desirability and effectiveness, and with information available, such a set

can also be constructed for the opponent, thus allowing predictions about the possible outcomes

within a certain number of moves with a probabilistic accuracy.

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Von Neumann and the development of Game Theory

Emile Borel: The Forgotten Father of Game Theory

In 1921, Emile Borel, a French mathematician, published

several papers on the theory of games. He used poker as

an example and addressed the problem of bluffing and

second-guessing the opponent in a game of imperfect

information. Borel envisioned game theory as being used in economic and military applications.

Borel's ultimate goal was to determine whether a "best" strategy for a given game exists and to

find that strategy. While Borel could be arguably called as the first mathematician to envision an

organized system for playing games, he did not develop his ideas very far. For that reason, most

historians give the credit for developing and popularizing game theory to John Von Neumann,

who published his first paper on game theory in 1928, seven years after Borel. Traditional

applications of game theory attempt to find equilibrium in these games. In equilibrium, each

player of the game has adopted a strategy that they are unlikely to change. Many equilibrium

concepts have been developed (most famously the Nash equilibrium) in an attempt to capture

this idea. These equilibrium concepts are motivated differently depending on the field of

application, although they often overlap or coincide. This methodology is not without criticism,

and debates continue over the appropriateness of particular equilibrium concepts.

Appropriateness of equilibria altogether and the usefulness of mathematical models more

generally. Although some developments occurred before it, the field of game theory came into

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being with the 1944 book Theory of Games and Economic Behavior by John von

Neumann and Oskar Morgenstern. This theory was developed extensively in the 1950s by many

scholars. Game theory was later explicitly applied to biology in the 1970s, although similar

developments go back at least as far as the 1930s. Game theory has been widely recognized as an

important tool in many fields. Eight game theorists have won the Nobel Memorial Prize in

Economic Sciences, and John Maynard Smith was awarded the Crawford Prize for his

application of game theory to biology.

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Concepts in Game Theory

Game

A conflict in interest among n individuals or groups (players). There exists a set of rules that

define the terms of exchange of information and pieces, the conditions under which the game

begins, and the possible legal exchanges in particular conditions. The entirety of the game is

defined by all the moves to that point, leading to an outcome.

Move

The way in which the game progresses between states through exchange of information and

pieces. Moves are defined by the rules of the game and can be made in either alternating fashion,

Occur simultaneously for all players, or continuously for a single player until he reaches a certain

state or declines to move further. Moves may be choice or by chance. For example, choosing a

card from a deck or rolling a die is a chance move with known probabilities. On the other hand,

asking for cards in blackjack is a choice move.

Information

A state of perfect information is when all moves are known to all players in a game. Games

without chance elements like chess are games of perfect information, while games with chance

involved like blackjack are games of imperfect information.

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Strategy

A strategy is the set of best choices for a player for an entire game. It is an overlying plan that

cannot be upset by occurrences in the game itself.

Payoff

The payoff or outcome is the state of the game at its conclusion. In games such as chess, payoff

is defined as win or a loss. In other situations the payoff may be material (i.e. money) or a

ranking as in a game with many players.

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Representation of Games
The games studied in game theory are well-defined mathematical objects. A game consists of a

set of players, a set of moves (or strategies) available to those players, and a specification of

payoffs for each combination of strategies. Most cooperative games are presented in the

characteristic function form, while the extensive and the normal forms are used to define no

cooperative games. Games can be characterized as extensive or normal. A in extensive form

game is characterized by a rules that dictate all possible moves in a state. It may indicate which

player can move at which times, the payoffs of each chance determination, and the conditions of

the final payoffs of the game to each player. Each player can be said to have a set of preferred

moves based on eventual goals and the attempt to gain the maximum payoff, and the extensive

form of a game lists all such preference patterns for all players. Games involving some level of

determination are examples of extensive form games.

The normal form of a game is a game where computations can be carried out completely. This

stems from the fact that even the simplest extensive form game has an enormous number of

strategies, making preference lists are difficult to compute. More complicated games such as

chess have more possible strategies that there are molecules in the universe. A normal form game

already has a complete list of all possible combinations of strategies and payoffs, thus removing

the element of player choices. In short, in a normal form game, the best move is always known.

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Extensive Form

The extensive form can be used to formalize games with some important order. Games here are

often presented as trees (as pictured to the left). Here each vertex (or node) represents a point of

choice for a player. The player is specified by a number listed by the vertex. The lines out of the

vertex represent a possible action for that player. The payoffs are specified at the bottom of the

tree.

The extensive form can also capture simultaneous-move games and games with imperfect

information. To represent it, either a dotted line connects different vertices to represent them as

being part of the same information set (i.e., the players do not know at which point they are), or a

closed line is drawn around them.

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Normal Form

The normal (or strategic form) game is usually represented by a matrix which shows the players,

strategies, and payoffs (see the example to the right). More generally it can be represented by any

function that associates a payoff for each player with every possible combination of actions. In

the accompanying example there are two players; one chooses the row and the other chooses the

column. Each player has two strategies, which are specified by the number of rows and the

number of columns. The payoffs are provided in the interior. The first number is the payoff

received by the row player (Player 1 in our example); the second is the payoff for the column

player (Player 2 in our example). Suppose that Player 1 plays up and that Player 2 plays Left.

Then Player 1 gets a payoff of 4, and Player 2 gets 3.

When a game is presented in normal form, it is presumed that each player acts simultaneously or,

at least, without knowing the actions of the other. If players have some information about the

choices of other players, the game is usually presented in extensive form.

Characteristic Function Form

In cooperative games with transferable utility no individual payoffs are given. Instead, the

characteristic function determines the payoff of each coalition. The standard assumption is that

the empty coalition obtains a payoff of 0.

The origin of this form is to be found in the seminal book of von

Neumann and Morgenstern who, when studying coalitional normal form games, assumed that

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when a coalition C forms, it plays against the complementary coalition ( ) as if they were

playing a 2-player game. The equilibrium payoff of C is characteristic. Now there are different

models to derive coalitional values from normal form games, but not all games in characteristic

function form can be derived from normal form games.

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Types of Games

One-Person Games

A one-person game has no real conflict of interest. Only the interest of the player in achieving a

particular state of the game exists. Single-person games are not interesting from a game-theory

perspective because there is no adversary making conscious choices that the player must deal

with. However, they can be interesting from a probabilistic point of view in terms of their

internal complexity.

Zero-Sum Games

In a zero-sum game the sum of the total possible payoffs at the end is zero since the amounts

won or lost are equal. Von Neumann and Oskar Morgenstern demonstrated mathematically that

n-person non-zero-sum game can be reduced to an n + 1 zero-sum game, and that such n + 1

Person games can be generalized from the special case of the two-person zero-sum game.

Another important theorem by Von Neumann, the minimax theorem, states certain aspects of the

maximal and minimal strategies of are part of all two-person zero-sum games. Thanks to these

discoveries, such games are a major part of game theory.

Two-Person Games

Two-person games are the largest category of familiar games. A more complicated game derived

from 2-person games is the n-person game. These games are extensively analyzed by game

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theorists. However, in extending these theories to n-person games a difficulty arises in predicting

the interaction possible among players since opportunities arise for cooperation and collusion.

Cooperative & Non Cooperative

A game is cooperative if the players are able to form binding commitments. For instance the

legal system requires them to adhere to their promises. In no cooperative games this is not

possible.

Often it is assumed that commuHeadsation among players is allowed in cooperative games, but

not in any cooperative ones. This classification on two binary criteria has been rejected

Of the two types of games, no cooperative games are able to model situations to the finest

details, producing accurate results. Cooperative games focus on the game at large. Considerable

efforts have been made to link the two approaches. The so-called Nash-program has already

established many of the cooperative solutions as no cooperative equilibrium.

Hybrid games contain cooperative and non-cooperative elements. For instance, coalitions of

players are formed in a cooperative game, but these play in a non-cooperative fashion.

Symmetric & Asymmetric

A symmetric game is a game where the payoffs for playing a particular strategy depend only on

the other strategies employed, not on who is playing them. If the identities of the players can be

changed without changing the payoff to the strategies, then a game is symmetric. Many of the

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commonly studied 2×2 games are symmetric. The standard representations of chicken,

the prisoner's dilemma, and the stag hunt are all symmetric games. Some scholars would

consider certain asymmetric games as examples of these games as well. However, the most

common payoffs for each of these games are symmetric.

Most commonly studied asymmetric games are games where there are not identical strategy sets

for both players. For instance, the ultimatum game and similarly the dictator game have different

strategies for each player. It is possible, however, for a game to have identical strategies for both

players, yet be asymmetric. For example, the game pictured to the right is asymmetric despite

having identical strategy sets for both players.

Simultaneous& Sequential

Simultaneous games are games where both players move simultaneously, or if they do not move

simultaneously, the later players are unaware of the earlier players' actions (making

them effectively simultaneous). Sequential game (or dynamic games) is games where later

players have some knowledge about earlier actions. This need not be perfect information about

every action of earlier players; it might be very little knowledge. For instance, a player may

know that an earlier player did not perform one particular action, while he does not know which

of the other available actions the first player actually performed.

The difference between simultaneous and sequential games is captured in the different

representations discussed above. Often, normal form is used to represent simultaneous games,

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and extensive form is used to represent sequential ones; although this isn't a strict rule in a

techHeadsal sense.

Perfect Information & Imperfect Information

An important subset of sequential games consists of games of perfect information. A game is one

of perfect information if all players know the moves previously made by all other players. Thus,

only sequential games can be games of perfect information, since in simultaneous games not

every player knows the actions of the others. Most games studied in game theory are imperfect-

information games, although there are some interesting examples of perfect-information games,

including the ultimatum game and centipede game. Perfect-information games include

also chess, go, mancala, and arimaa.

Perfect information is often confused with complete information, which is a similar concept.

Complete information requires that every player know the strategies and payoffs of the other

players but not necessarily the actions.

Infinitely Long Games

Games, as studied by economists and real-world game players, are generally finished in finitely

many moves. Pure mathematicians are not so constrained, and set theorists in particular study

games that last for infinitely many moves, with the winner (or other payoff) not known

until after all those moves are completed.

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The focus of attention is usually not so much on what is the best way to play such a game, but

simply on whether one or the other player has a winning strategy. (It can be proven, using

the axiom of choice, that there are games—even with perfect information, and where the only

outcomes are "win" or "lose"—for which neither player has a winning strategy.) The existence of

such strategies, for cleverly designed games, has important consequences in descriptive set

theory.

Discrete & Continuous Games

Much of game theory is concerned with finite, discrete games that have a finite number of

players, moves, events, outcomes, etc. Many concepts can be extended, however. Continuous

games allow players to choose a strategy from a continuous strategy set. For instance, Cournot

competition is typically modeled with players' strategies being any non-negative quantities,

including fractional quantities.

Differential games such as the continuous pursuit and evasion game are continuous games.

Zero-Sum Games

A zero-sum game is one in which no wealth is created or destroyed. So, in a two-player zero-sum

game, whatever one player wins, the other loses. Therefore, the players share no common

interests. There are two general types of zero-sum games: those with perfect information and

those without.

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In a game with perfect information, every player knows the results of all previous moves. Such

games include chess, tic-tac-toe, and Nim. In games of perfect information, there is at least one

"best" way to play for each player. This best strategy does not necessarily allow him to win but

will minimize his losses. For instance, in tic-tac-toe, there is a strategy that will allow you to

never lose, but there is no strategy that will allow you to always win. Even though there is an

optimal strategy, it is not always possible for players to find it. For instance, chess is a zero-sum

game with perfect information, but the number of possible strategies is so large that it is not

possible for our computers to determine the best strategy.

In games with imperfect information, the players do not know all of the previous moves. Often,

this occurs because the players play simultaneously. Here are some examples of such games:

Game 1

Suppose two people are playing a simple game with Heads and Tails. At the same time, they

each put out either a Heads or a Tails. If at least one player plays a Heads, player 1 gets both

coins. Otherwise, player 2 gets both. Naturally, both players wish to gain as much money as

possible. How should they play in order to do this?

Game 2

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Suppose two people are playing a similar game with Heads and Tails. Now, if player 1 plays a

Heads, player 2 gives him 5 cents. If player 2 plays a Heads and player 1 plays a Tails, player 1

gets 25 cents. If both players play Tails, player 2 gets 25 cents.

Game 3

We still have two people playing a game with Heads and Tails. Now, if both players play the

same coin, player 2 gives player 1 the average value of the coins; otherwise, player 1 gives

player 2 the average value of the coins.

Although the three games seem similar, the methods used to find the best strategies in each are

very different. Game 1 is solved by eliminating dominant strategies, game 2's solution is known

as a saddle point, and game 3 requires a mixed strategy.

Game 1 – Dominant Strategies

Suppose two people are playing a simple game with Heads and Tails. At the same time, they

each put out either a Heads or a Tails. If at least one player plays a Heads, player 1 gets both

coins. Otherwise, player 2 gets both. Naturally, both players wish to gain as much money as

possible. How should they play in order to do this?

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We can assign payoff matrices to such games that define the payoffs that players will get based

on the strategies they use. In this example, each player has only two strategies--put out a Heads

or put out a Tails. Here is a payoff matrix for player 1:

Player 2

Heads Tails

Heads 5 25
Player 1
Tails 5 -25

The rows represent player 1's possible strategies, and the columns represent player 2's possible

strategies. If player 1 and player 2 both play Heads (the top left entry), player 1 wins player 2's

Heads so gains 5 cents. On the other hand, if both play Tails (the bottom right entry), player 2

wins player 1's Tails, and so player 1 loses 25 cents.

Notice that every entry in the first row is greater than all of the entries in that column. In other

words, playing a Heads is always at least as good as playing a Tails for player 1. So, playing a

Heads is called a dominant strategy, and it dominates the strategy of playing a Tails. It is never

advantageous to play a dominated strategy, so we can reduce our payoff matrix to reflect this:

Player 2

Heads Tails

Heads 5 25
Player 1

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Now, the Heads strategy for player 2 also dominates. So, playing Heads is the best strategy for

both players. Notice that, if either plays Tails, he will not gain more money than if he had just

played Heads.

Game 2 – Saddle Points

This game differs from game 1 in that it has no dominant strategies. The rules are as follows: If

player 1 plays a Heads, player 2 gives him 5 cents. If player 2 plays a Heads and player 1 plays a

Tails, player 1 gets 25 cents. If both players play Tails, player 2 gets 25 cents. We get a payoff

matrix for this game:

Player 2

Heads Tails

Heads 5 25
Player 1
Tails 25 -25

Notice that there are no longer any dominant strategies. To solve this game, we need a more

sophisticated approach. First, we can define lower and upper values of a game. These specify the

least and most (on average) that a player can expect to win in the game if both players play

rationally. To find the lower value of the game, first look at the minimum of the entries in each

row. In our example, the first row has minimum value 5 and the second has minimum -25. The

lower value of the game is the maximum of these numbers, or 5. In other words, player 1 expects

to win at least an average of 5 cents per game. To find the upper value of the game, do the

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opposite. Look at the maximum of every column. In this case, these values are 25 and 5. The

upper value of the game is the minimum of these numbers, or 5. So, on average, player 1 should

win at most 5 cents per game.

Heads Tails Min

Heads 5 5 5

Tails 25 -25 -25

Max 25 5

Notice that, in our example, the upper and lower values of the game are the same. This is not

always true; however, when it is, we just call this number the pure value of the game. The row

with value 5 and the column with value 5 intersect in the top right entry of the payoff matrix.

This entry is called the saddle point or minimax of the game and is both the smallest in its row

and the largest in its column. The row and column that the saddle point belongs to are the best

strategies for the players. So, in this example, player 1 should always play a Heads while player

2 should always play a Tails.

Game 3 – Mixed Strategies

The rules of game 3 were as follows: two players have Heads and Tails. At the same time, they

each play one coin. If both players play the same coin, player 2 gives player 1 the average value

of the coins; otherwise, player 1 gives player 2 the average value of the coins. Here is the payoff

matrix for this game:

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Player 2

Heads Tails

Heads 5 -15
Player 1
Tails -15 25

The lower value of this game is -15 while the upper value is 5. Can we find a pure value for the

game? According to the Minimax Theorem, one of the most important results in game theory, we

can. The Minimax Theorem states that every finite, two-person, zero-sum game has a value V

that is the average amount that one player can expect to win if both players act sensibly.

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Application & Challenges

initially developed in economics to understand a large collection of economic behaviors,

including behaviors of firms, markets, and consumers. The use of game theory in the social

sciences has expanded, and game theory has been applied to political, sociological, and

psychological behaviors as well.

In addition to being used to predict and explain behavior, game theory has also been used to

attempt to develop theories of ethical or normative behavior. In economics and philosophy,

scholars have applied game theory to help in the understanding of good or proper behavior

Descriptive Use

The first known use is to describe how human populations behave. Some scholars believe that by

finding the equilibria of games they can predict how actual human populations will behave when

confronted with situations analogous to the game being studied. This particular view of game

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theory has come under recent criticism. First, it is criticized because the assumptions made by

game theorists are often violated. Game theorists may assume players always act in a way to

directly maximize their wins (theHomo economicus model), but in practice, human behavior

often deviates from this model. Explanations of this phenomenon are many; irrationality, new

models of deliberation, or even different motives (like that of altruism). Game theorists respond

by comparing their assumptions to those used in physics. Thus while their assumptions do not

always hold, they can treat game theory as a reasonable scientific ideal akin to the models used

by physicists. However, additional criticism of this use of game theory has been levied because

some experiments have demonstrated that individuals do not play equilibrium strategies. For

instance, in the centipede game, guess 2/3 of the average game, and the dictator game, people

regularly do not play Nash equilibria. There is an ongoing debate regarding the importance of

these experiments.

Alternatively, some authors claim that Nash equilibria do not provide predictions for human

populations, but rather provide an explanation for why populations that play Nash equilibria

remain in that state. However, the question of how populations reach those points remains open.

Some game theorists have turned to evolutionary game theory in order to resolve these worries.

These models presume either no rationality or bounded rationality on the part of players. Despite

the name, evolutionary game theory does not necessarily presume natural selection in the

biological sense. Evolutionary game theory includes both biological as well as cultural evolution

and also models of individual learning (for example, fictitious play dynamics).

Prescriptive & Nominative Analysis

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On the other hand, some scholars see game theory not as a predictive tool for the behavior of

human beings, but as a suggestion for how people ought to behave. Since Nash equilibrium of a

game constitutes one's best response to the actions of the other players, playing a strategy that is

part of Nash equilibrium seems appropriate. However, this use for game theory has also come

under criticism. First, in some cases it is appropriate to play a non-equilibrium strategy if one

expects others to play non-equilibrium strategies as well. For an example, see Guess 2/3 of the

average.

Second, the Prisoner's dilemma presents another potential counterexample. In the Prisoner's

Dilemma, each player pursuing his own self-interest leads both players to be worse off than had

they not pursued their own self-interests.

Computer science & Logic

Game theory has come to play an increasingly important role in logic and in computer science.

Several logical theories have a basis in game semantics. In addition, computer scientists have

used games to model interactive computations. Also, game theory provides a theoretical basis to

the field of multi-agent systems.

Separately, game theory has played a role in online algorithms. In particular, the k-server

problem, which has in the past been referred to as games with moving costs and request-answer

games (Ben David, Borodin & Karp et al. 1994). Yao's principle is a game-theoretic technique

for proving lower bounds on the computational complexity of randomized algorithms, and

especially of online algorithms.

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The field of algorithmic game theory combines computer science concepts of complexity

and algorithm design with game theory and economic theory. The emergence of the internet has

motivated the development of algorithms for finding equilibria in games, markets, computational

auctions, peer-to-peer systems, and security and information markets.

Economics
Many of the interactions in the business world may be modeled using game theory methodology.

A famous example is that of the similarity of the price-setting of oligopolies to the Prisoner's

Dilemma. If an oligopoly situation exists, the companies are able to set prices if they choose to

cooperate with each other. If they cooperate, both are able to set higher prices, leading to higher

profits. However, if one company decides to defect by lowering its price, it will get higher sales,

and, consequently, bigger profits than its competitor(s), who will receive lower profits. If both

companies decide to defect, i.e. lower prices, a price war will ensue, in which case neither

company will profit, since it will retain its market share and experience lower revenues at the

same time.

Similar arguments can be extended too many cases like:

 advertising for a company’s products

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 international trade between nations and Trade Barriers

 expenditure on National Defense for two neighboring nations

Coke v/s Pepsi

Suppose PepsiCo & Coca-Cola enter a new market and decide to form a cartel and fix prices.

Assuming that if they honor the cartel agreement, they both would land up with revenues of $6

million each. But in case one of them cheats and the other does not, the difference in revenues

could be huge ($6 million in this case; between the companies). The temptation to cheat is very

high in this case and if both the companies cheat on the agreement, then it’s a loss to both as can

be very well seen from the following table.

PepsiCo

Cheat on Cartel Don’t Cheat

(Charge Low Price) (Charge Monopoly Price)

Coca- Cheat on $3 million each Coke earns $8 million

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Cola Cartel Pepsi earns $2 million

Coke earns $2 million

Prisoner's dilemma is not the only game theory model which can be used to model economic

situations. Other models can be applied to different situations and, in many cases, can suggest the

best outcome for all parties concerned.

Bibliography
http://www.books.google.co.in

http://www.yahoo.groups.com

http://www.google.co.in – advanced pdf search

http://www.ask.com

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Indian Institute of Planning & Management UGP-FW- 2007-2010