Game 3

Cards, Probability
And Game Theory

By, Shivarama Shetty M Sunil N Shantanu Bhat
Saturday 26 November 11
INTRODUCTION
Honour and profit lie not in one sack.
Your life consists of games, situations in which you compete for a high score. Game theory studies how smart, ruthless people should act and interact in strategic settings. This book will teach you to solve games. In some games you will negotiate for a raise; in others you will strive to ensure that an employee works as hard as possible. Sometimes you will know everything, while in other games you will have to guess at what others know that you dont. Occasionally competitors will have to work together to survive, while in other situations cooperation will be impossible since the winner will take all. Many of the games will seemingly have nothing to do with business, but will be presented to give you insights into strategy. Since the games that business people play are both complicated and diverse, this book will provide you with the intellectual tools necessary to recognize what kind of game youre playing, and, more important, to maximize your payoff in any game youre in.You will find game theory ideally suited for solitary study because its interesting. Sure, accounting is at least as important to business as game theory, but do you really want to spend your free time memorizing the rules of what constitutes a debit? Perhaps the most interesting thing that human beings do is compete. Game theory, the study of conflict,illuminates how rational, self-interested people struggle against each other for supremacy. illuminates how rational, self-interested people struggle against each other for supremacy.
In game theory players often base their moves on what they think other people might do. But if your move is based on what your opponents might do, and their moves are based on what they think you are going to do, then your move will in fact be somewhat based on what you think your opponents think that you will do! Game theory can get complicated, but then so can business. Honour and profit lie not in one sack. Economists have devoted much thought to how you should play games of strategy, and these ideas, which constitute game theory, influence the thinking of businesspeople, military strategists, and even biologists. They also infiltrate everyday life, whether you recognize it or not. Almost all MBA students and undergraduate economics majors will formally encounter game theory in the classroom. Not understanding game theory puts you at a tactical disadvantage when playing against those who do.
Some rules in Game Theory are:

1. Never hire someone too eager to work for you. 2. Have less trust in smokers. 3. Many people in business exhibit honesty not because they are moral but because they are greedy. 4. Eliminating choices can increase your payoff. 5. Burning money can increase your wealth. 6. Stock prices respond quickly to new information. 7. Day-traders still need to worry about their stocks long-term prospects. 8. Exposing yourself to potential humiliation can increase your negotiating strength when seeking a raise. 9. Inmates in mental institutions have a few negotiating advantages over their somewhat more sane corporate counterparts. 10. Learning about Odysseus recruitment into the Trojan War provides insight into why stores issue coupons.
What Exactly Is Game Theory?

There are three parts to any game: 1. A set of players 2. Moves the players can make 3. Payoffs the players might receive The players choose their moves to maximize their payoff. Each player always assumes that other players are also trying to maximize their score. Game theory gets interesting, however, only when there is tactical interaction, that is, when everyone tries to figure out their rivals strategy before they move. Football (American or European) could be analyzed using game theory because the players try to determine their opponents strategy before making their move. Bowling and golf are not interesting to game theorists because although players compete in these sports, they mostly ignore their competitors when formulating their moves because they have no control over how their competitor might play. Mathematics dominates much of formal game theory. In an attempt to maximize this authors book royalties, however, Game Theory at Work keeps the math to a minimum. Fortunately, you can learn most of the practical applications of game theory without using any math more complicated than addition and subtraction. This book does, however, contain many figures and diagrams, and if you skip them you will learn little.
How to utilize Game Theory:
GAMBLING, PROBABILITY, AND RISK

(Basic Probability and Counting Methods)
5
A GAMBLING EXPERIMENT
Everyone in the room takes 2 cards from the deck (keep face down)
Everyone in the room takes 2 cards from the deck (keep face down) Rules, most to least valuable:

Pair of the same color (both red or both black) Mixed-color pair (1 red, 1 black) Any two cards of the same suit Any two cards of the same color


In the event of a tie, highest card wins (ace is top)

WHAT DO YOU WANT TO BET?
Look at your two cards.
Look at your two cards. Will you fold or bet?
Look at your two cards. Will you fold or bet? What is the most rational strategy given your hand?
RATIONAL STRATEGY
RATIONAL STRATEGY
There are N people in the room
RATIONAL STRATEGY
There are N people in the room What are the chances that someone in the room has a better hand than you?
RATIONAL STRATEGY
There are N people in the room What are the chances that someone in the room has a better hand than you? Need to know the probabilities of different scenarios
PROBABILITY
PROBABILITY
Probability the chance that an uncertain event will occur (always between 0 and 1)
PROBABILITY
PROBABILITY
Symbols:
PROBABILITY
Symbols: P(event A) = the probability that event A will occur
PROBABILITY
Symbols: P(event A) = the probability that event A will occur P(red card) = the probability of a red card
PROBABILITY
Symbols: P(event A) = the probability that event A will occur P(red card) = the probability of a red card P(~event A) = the probability of NOT getting event A [complement]
PROBABILITY
Symbols: P(event A) = the probability that event A will occur P(red card) = the probability of a red card P(~event A) = the probability of NOT getting event A [complement] P(~red card) = the probability of NOT getting a red card
PROBABILITY
Symbols: P(event A) = the probability that event A will occur P(red card) = the probability of a red card P(~event A) = the probability of NOT getting event A [complement] P(~red card) = the probability of NOT getting a red card P(A & B) = the probability that both A and B happen [joint probability]
PROBABILITY
Symbols: P(event A) = the probability that event A will occur P(red card) = the probability of a red card P(~event A) = the probability of NOT getting event A [complement] P(~red card) = the probability of NOT getting a red card P(A & B) = the probability that both A and B happen [joint probability] P(red card & ace) = the probability of getting a red ace
ASSESSING PROBABILITY


1. Theoretical/Classical probabilitybased on theory (a prior understanding of a phenomena)
e.g.: theoretical probability of rolling a 2 on a standard die is 1/6

theoretical probability of choosing an ace from a standard deck is 4/52 theoretical probability of getting heads on a regular coin is 1/2

1. Theoretical/Classical probabilitybased on theory (a prior understanding of a phenomena)
e.g.: theoretical probability of rolling a 2 on a standard die is 1/6

theoretical probability of choosing an ace from a standard deck is 4/52 theoretical probability of getting heads on a regular coin is 1/2
2. Empirical probabilitybased on empirical data e.g.: you toss an irregular die (probabilities unknown) 100 times and nd that you get a 2 twentyve times; empirical probability of rolling a 2 is 1/4

empirical probability of an Earthquake in Bay Area by 2032 is .62 (based on historical data) empirical probability of a lifetime smoker developing lung cancer is 15 percent (based on empirical data)
COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

Great for gambling! Fun to compute!


If outcomes are equally likely to occur






Note: these are called counting methods because we have to count the number of ways A can occur and the number of total possible outcomes.
COUNTING METHODS: EXAMPLE 1

Example 1: You draw one card from a deck of cards. Whats the probability that you draw an ace?

Example 1: You draw one card from a deck of cards. Whats the probability that you draw an ace?

Example 2. Whats the probability that you draw 2 aces when you draw two cards from the deck?





Two counting method ways to calculate this: 1. Consider order:



Numerator: AA, AA, AA, AA, AA, AA, AA, AA, AA, A AA, or AA = 12

Numerator: AA, AA, AA, AA, AA, AA, AA, AA, AA, A AA, or AA = 12 Denominator = 52x51 = 2652 -- why?

52 cards 51 cards
Denominator = 52x51 = 2652 -- why?
. . .
. . .

52 cards 51 cards
Denominator = 52x51 = 2652 -- why?
. . .
. . .
Counting methods: Example 2

2. Ignore order:

2. Ignore order:

2. Ignore order:
Numerator: AA, AA, AA, AA, AA, AA = 6

2. Ignore order:
Denominator =

2. Ignore order:
Denominator =

2. Ignore order:
Denominator = Divide out order!

2. Ignore order:
Denominator = Divide out order!
SUMMARY OF COUNTING METHODS

Counting methods for computing probabilities

Permutations order matters!
Combinations Order doesnt matter

With replacement
Without replacement

With replacement Without replacement Without replacement

With replacement
Without replacement
PERMUTATIONSORDER MATTERS!
A permutation is an ordered arrangement of objects.
With replacement=once an event occurs, it can occur again (after you roll a 6, you can roll a 6 again on the same die). Without replacement=an event cannot repeat (after you draw an ace of spades out of a deck, there is 0 probability of getting it again).

With replacement
PERMUTATIONSWITH REPLACEMENT
With Replacement Think coin tosses, dice, and DNA. memoryless After you get heads, you have an equally likely chance of getting a heads on the next toss (unlike in cards example, where you cant draw the same card twice from a single deck). Whats the probability of getting two heads in a row (HH) when tossing a coin?
Toss 1: 2 outcomes H Toss 2: 2 outcomes H T T H T 22 total possible outcomes: {HH, HT, TH, TT}
Toss 1: 2 outcomes H Toss 2: 2 outcomes H T T H T 22 total possible outcomes: {HH, HT, TH, TT}
Whats the probability of 3 heads in a row?
Toss 3: 2 outcomes Toss 2: 2 outcomes Toss 1: 2 outcomes
H T H T
HHH HHT HTH HTT THH
H T
T
H T
H T H T
THT TTH TTT
H T H T
HHH HHT HTH HTT THH
H T
T
H T
H T H T
THT TTH TTT
H T H T
HHH HHT HTH HTT THH
H T
T
H T
H T H T
THT TTH TTT
When you roll a pair of dice (or 1 die twice), whats the probability of rolling 2 sixes?
Whats the probability of rolling a 5 and a 6?
Whats the probability of rolling a 5 and a 6?
SUMMARY: ORDER MATTERS, WITH REPLACEMENT
Formally, order matters and with replacement use powers

Without replacement
PERMUTATIONSWITHOUT REPLACEMENT
Without replacementThink cards (w/o reshufing) and seating arrangements.
Example: You are moderating a debate of gubernatorial candidates. How many different ways can you seat the panelists in a row? Call them Arianna, Buster, Camejo, Donald, and Eve.
PERMUTATIONWITHOUT REPLACEMENT
Trial and error method:
Trial and error method: Systematically write out all combinations:
Trial and error method: Systematically write out all combinations: ABCDE
Trial and error method: Systematically write out all combinations: ABCDE ABCED
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE ABDEC
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE ABDEC ABECD
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE ABDEC ABECD ABEDC
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE ABDEC ABECD ABEDC .
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE ABDEC ABECD ABEDC . .
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE ABDEC ABECD ABEDC . . .
Trial and error method: Systematically write out all combinations: ABCDE ABCED ABDCE ABDEC ABECD ABEDC . . .
Quickly becomes a pain! Easier to gure out patterns using a the probability tree!
PERMUTATIONWITHOUT REPLACEMEN
Seat One: 5 possible Seat Two: only 4 possible Etc.
A B C D E A
A B D E .
B C D
A B C D E A
A B D E .
B C D
# of permutations = 5 x 4 x 3 x 2 x 1 = 5!
A B C D E A
A B D E .
B C D
# of permutations = 5 x 4 x 3 x 2 x 1 = 5!
There are 5! ways to order 5 people in 5 chairs (since a person cannot repeat)
What if you had to arrange 5 people in only 3 chairs (meaning 2 are out)?
Seat One: 5 possible Seat Two: Only 4 possible B A C D E A B C D B D E D E Seat Three: only 3 possible
A B
A B
A B
A B
Note this also works for 5 people and 5 chairs:
Note this also works for 5 people and 5 chairs:
How many two-card hands can I draw from a deck when order matters (e.g., ace of spades followed by ten of clubs is different than ten of clubs followed by ace of spades)
52 cards 51 cards
. . .
. . .
52 cards 51 cards
. . .
. . .
SUMMARY: ORDER MATTERS, WITHOUT REPLACEMENT
Formally, order matters and without replacement use factorials
SUMMARY: ORDER MATTERS, WITHOUT REPLACEMENT
Formally, order matters and without replacement use factorials
Simultaneous Games
Interest will not lie. 17th-century proverb
Softening sales cause both ford and gm to reconsider their pricing. If both move at the same time, then they are playing a simultaneous-move game. Figure 11 presents an example of a simultaneous-move game. Its important that you understand how to interpret games like this one, so please read this paragraph very carefully. In this game Player One chooses A or B, while at the same time Player Two chooses X or Y. Each player moves without knowing what the other person is going to do. The players combined moves determine their payoffs. For example, if Player One chooses A, and Player Two chooses X, then we are in the top left corner. Player One scores the first number, 10, as his payoff, and Player Two scores the second number, 5,as her payoff. If Player One chooses A, and Player Two chooses Y, then we would be in the top right box, and Player One scores 3 while Player Two scores 0. In all simultaneous-move games Player One will always be on the left, and Player Two will always be on top. The first number in the box will usually be Player Ones payoff and the second will be Player Twos payoff. The players always know what score they will receive if they end up in any given box. The players, therefore, see Figure 11 before they move. Each player knows everything except what his opponent is going to do.
As with sequential games, in simultaneous games a players only goal is to maximize his payoff. The players are not trying to win by getting a higher score than their opponents. Consequently, Player Two would rather be in the top left box (where Player One gets 10, and Player Two gets 5) than the bottom right box (where Player
One gets 1, and Player Two gets 4).

What should the players do in a simultaneous game? The best way to solve a simultaneous-move game is to look for a dominant strategy. A dominant strategy is one that you should play, regardless of what the other player does. In Figure 11, strategy A is dominant for Player One. If Player Two chooses X, then Player Onegets 10 if he picks A, and 8 if he picks B. Thus, Player One would be better off playing A if he knows that Player Two will play X. Also, if Player Two plays Y, then Player One gets 3 if he plays A and 1 if he plays B. Consequently, Player One is also better off playing A if Player Two plays Y. Thus, regardless of what Player Two does, Player One gets a higher payoff playing A than B. Strategy A is therefore a dominant strategy and should be played by Player One no matter what.
A dominant strategy is a strategy that gives you a higher payoff than all of your other strategies, regardless ofwhat your opponent does. Player Two does not have a dominant strategy in this game. If Player Two believes that Player One will play A,then Player Two should play X. If, for some strange reason, Player Two believes that her opponent will play B, then she should play Y. Thus, while Player One should always play A no matter what, Player Twos optimal strategy is determined by what she thinks Player One will do. A dominant strategy is a powerful solution concept because you should play it even if you think your opponentis insane, is trying to help you, or is trying to destroy you. Playing a dominant strategy, by definition, maximizesyour payoff. To test your understanding of dominant strategies, consider this: Is stopping at a red light and going on agreen light a dominant strategy when driving? Actually, no, it isnt. You only want to go on green lights and stop on red lights if other drivers do the same. If you happened to drive through a town where everyone elsewent on red and stopped on green, you would be best off following their custom. In contrast, if everyone in thisstrange place were intent on electrocuting herself, you would be best served by not following the crowd.Avoiding electrocution is a dominant strategy; you should do it regardless of what other people do. In contrast, driving on the right side of the road is not a dominant strategy; you should do it only if other people also do it. Lets return to Ford and GMs pricing game. Figures 12 and 13 present possible models for the auto pricinggame. In these games Ford is Player One while GM is Player Two. In response to weakening sales, both firms can either offer a discount or not offer a discount. Please look at these two figures and determine how thefirms optimal strategies differ in these two games.
Figure 12
Figure 13
In Figure 12, offering a discount is a dominant strategy for both firms since offering a discount always yields a greater profit. Perhaps in this game, consumers will purchase cars only if given discounts. Figure 13 lacks dominant strategies. If your opponent offers a discount, you are better off giving one too. If, however, your opponent doesnt lower his prices, then neither should you. Perhaps in this game consumers are willing toforgo discounts only as long as no one offers them. Of course, if you can maintain the same sales, you are always better off not lowering prices. This doesnt mean that neither firm in Figure 13 should offer a discount.
Not offering a discount is not a dominant strategy. Rather, each firm must try to guess its opponents strategybefore formulating its own move.
A strictly stupid strategy is a strategy that gives you a lower payoff than at least one of your other strategies, regardless of what your opponent does. Knowing that your opponent will never play a strictly stupid strategy can help you formulate your optimal move.Consider the game in Figure 14 in which two competitors each pick what price they should charge. Player Twocan choose to charge either a high, medium, or low price, while for some reason Player One can charge only ahigh or low price. As you should be able to see from Figure 14, if Player One knows that Player Two willchoose high or medium prices, than Player One will be better off with high prices. If, however, Player Two goes with low prices, then Player One would also want low prices. The following chart shows Player Onesoptimal move for all three strategies that Player Two could employ:
Figure 14
Table 1
Player Twos Strategy High Medium Low Player Ones Best Strategy* High High Low
*If he knows what Player Two is going to do. When Player One moves, he doesnt know how Player Two will move. Player One, however, could try to figureout what Player Two will do. Indeed, to solve most simultaneous games, a player must make some guess as to what strategies the other players will employ. In this game, at least, its easy to figure out what Player Two wont do because Player Two always gets a payoff of zero if she plays low. (Remember, the second number in each box is Player Twos payoff.) Playing high or medium always gives Player Two a positive payoff.Consequently, for Player Two, low is a strictly stupid strategy and should never be played. Once Player One
knows that Player Two will never play low, Player One should play high. When Player Two realizes that PlayerOne will play high, she will also play high since Player Two gets a payoff of 7 if both play high and gets a payoff of only 5 if she plays medium while Player One plays high. Player Two will play high because Player One also will play high. Player One, however, only plays highbecause Player One believes that Player Two will not play low. Player Twos strategy is thus determined bywhat she thinks Player One thinks that Player Two will do. Before you can move in game theory land, youmust often predict what other people guess you will do.
Nash Equilibria
In a Nash equilibrium, all of the players expectations are fulfilled and their chosen strategies are optimal. From a 1994 press release announcing the Nobel Prize winners in economics. John Nash has been one of the most important men in developing game theory. Both the book and the Oscar winning movie A Beautiful Mind are about his life. Nash developed a method of solving games that is appropriately called a Nash equilibrium, a no-regrets outcome in which all the players are satisfied with their strategy given what every other player has done. In a Nash equilibrium you are not necessarily happy with the other players strategies; rather your strategy is an optimal response to your opponents moves. Players in a Nash equilibrium never cooperate and always assume that they cant alter their opponents actions. Nash equilibrium: No player regrets his strategy, given everyone elses move.
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,free
yes
free,death
life,life
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,free
yes
free,death
life,life
If player 1 confesses,what should player 2 do? If player 1 doesnt confess, what should player 2 do? If player 2 confesses, what should player 1 do? If player 2 doesnt confess what should player 1 do?
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,free
yes
free,death
life,life
If player 1 confesses,what should player 2 do? confess If player 1 doesnt confess, what should player 2 do? If player 2 confesses, what should player 1 do? If player 2 doesnt confess what should player 1 do?
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,free
yes
free,death
life,life
If player 1 confesses,what should player 2 do? confess If player 1 doesnt confess, what should player 2 do? confess If player 2 confesses, what should player 1 do? If player 2 doesnt confess what should player 1 do?
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,free
yes
free,death
life,life
If player 1 confesses,what should player 2 do? confess If player 1 doesnt confess, what should player 2 do? confess If player 2 confesses, what should player 1 do? confess If player 2 doesnt confess what should player 1 do?
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,free
yes
free,death
life,life
If player 1 confesses,what should player 2 do? confess If player 1 doesnt confess, what should player 2 do? confess If player 2 confesses, what should player 1 do? confess If player 2 doesnt confess what should player 1 do? confess
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,free
yes
free,death
life,life
Nash Equilibrium
If player 1 confesses,what should player 2 do? confess If player 1 doesnt confess, what should player 2 do? confess If player 2 confesses, what should player 1 do? confess If player 2 doesnt confess what should player 1 do? confess
Prisoners Dilemma
Player 2: no yes
Player 1: no
1year,1year
death,murder
yes
murder,death
murder,murder
under the influence of Mafia!
Penalty kick game

l L
4
r
9
U(L,l)=4, i.e. 40% chance
payoffs for shooter
THANK YOU

Game 3

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Cards, Probability

And Game Theory

Some rules in Game Theory are:

What Exactly Is Game Theory?

How to utilize Game Theory:

GAMBLING, PROBABILITY, AND RISK

In the event of a tie, highest card wins (ace is top)

WHAT DO YOU WANT TO BET?

WHAT DO YOU WANT TO BET?

Look at your two cards.

WHAT DO YOU WANT TO BET?

Look at your two cards. Will you fold or bet?

WHAT DO YOU WANT TO BET?

There are N people in the room

Symbols: P(event A) = the probability that event A will occur

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

If outcomes are equally likely to occur

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

If outcomes are equally likely to occur

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

If outcomes are equally likely to occur

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

If outcomes are equally likely to occur

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

If outcomes are equally likely to occur

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

If outcomes are equally likely to occur

COMPUTING THEORETICAL PROBABILITIES:COUNTING METHODS

If outcomes are equally likely to occur

COUNTING METHODS: EXAMPLE 1

COUNTING METHODS: EXAMPLE 1

COUNTING METHODS: EXAMPLE 1

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

COUNTING METHODS: EXAMPLE 2

Denominator = 52x51 = 2652 -- why?

COUNTING METHODS: EXAMPLE 2

Denominator = 52x51 = 2652 -- why?

Counting methods: Example 2

Counting methods: Example 2

Counting methods: Example 2

Numerator: AA, AA, AA, AA, AA, AA = 6

Counting methods: Example 2

Numerator: AA, AA, AA, AA, AA, AA = 6

Counting methods: Example 2

Numerator: AA, AA, AA, AA, AA, AA = 6

Counting methods: Example 2

Numerator: AA, AA, AA, AA, AA, AA = 6

Denominator = Divide out order!

Counting methods: Example 2