GAME THEORY

Mr. Casiano DC. Jaurigue

Outline

 Chapter 1 Introduction
 Brief History
 Game Theory Defined
 Importance and Applications of Game
Theory
 Methodology
 Classification of Game Models
 Elements of a Game

2
Outline
 Chapter 2 Two-Person, Zero-Sum Game
 Conservative Strategies
 Minimax Criterion
 Nash Equilibrium
 Dominance
 Pure Strategy Game
 Mixed Strategy Game
 Analytical Method
 Graphical Method
 Linear Programming Solution
3
Outline

 Chapter 3 Two-Person, Non-

constant-
Sum Game

 Chapter 4 N-Person Game

 Chapter 5 Applications

4
INTRODUCTION
Brief History of Game Theory

 1913 - E. Zermelo provided the first theorem of

game theory; asserts that chess is strictly
determined
 1928 - John von Neumann proved the minimax
theorem
 1944 - John von Neumann & Oskar Morgenstern
wrote "Theory of Games and Economic
Behavior”
 1950-1953 - John Nash describes Nash
equilibrium
 1972 - John Maynard Smith wrote “Game Theory
and The Evolution of Fighting”
Source: Xiao, Thomas & Westwell, 6
Evolutionary Game Theory
Brief History of Game Theory

 In 1994, John Harsanui, John Nash, and

Reinhard Selten jointly received the Nobel Prize
in Economics from the Royal Swedish Academy
of Sciences for developing the notion of
noncooperative game theory.

 John Nash developed the concepts of the Nash

equilibrium and the Nash bargaining problem
which are the cornerstones of modern game
theory.

7
What is Game Theory?

Game theory deals with decision making

under conflict or competition where 2 or
more decision makers are involved (with
conflicting objectives) and the
consequences (payoff) to each depends
on the course of action taken by all, and
each party is usually trying to maximize
its overall welfare at the expense of the
others.

8
Why Study Game Theory?

 It stimulates us to think about conflicts in

a novel way.
 Helps us to analyze situations more
rationally and formulate an acceptable
alternative with respect to circumstance.
 It is applicable to almost any type of
conflict (military, economic, political,
social, etc.)

9
Why Study Game Theory?
Because the press tells us to …

“ Managers have much to learn from game theory —

provided they use it to clarify their thinking, not as a
substitute for business experience.”
The Economist, 15 June 1996

“ Game Theory, long an intellectual pastime, came into

its own as a business tool.”
Forbes, 3 July 1995

“ Game theory is hot.”

The Wall Street Journal, 13 February 1995

Source: Mike Shor. Game Theory & Business Strategy 10 10

Why Study Game Theory?
Because recruiters tell us to …

 “Game theory forces you to see a business situation

over many periods from two perspectives: yours and
your competitor’s.”
 Judy Lewent – CFO, Merck

 “Game theory can explain why oligopolies tend to be

unprofitable, the cycle of over capacity and
overbuilding, and the tendency to execute real
options earlier than optimal.”
 Tom Copeland – Director of Corporate Finance, McKinsey

Source: Mike Shor. Game Theory & Business Strategy 11 11

Applications

 Marketing strategies
 Labor-management negotiations
 Potential mergers
 International military conflicts
 Competitive bidding
 Advertising
 Etc.

12
Methodology

 Present the managerial situation,

problem, or conflict in game format.
 View the decision makers as players.
 Determine the optimal playing
strategies for the participants.

13
Strategy
a comprehensive plan of action

a decision rule or set of instructions

about which actions a player should take
following all possible histories of play

14
Classification of Game Models

 by the number of players

 by the sum of all payoffs
 by the number of strategies employed

15
Elements of a Game

 Players
 Set of possible actions
 Information available
 Payoff consequences (in matrix form)
 Players’ preference over payoffs

16
Payoff Matrix
Brilliant Lights
Use radio Use newspaper

Use radio 3 5
Bright Lights
Use
newspaper 1 -2

 Payoffs are shown only for the row player (Bright Lights).
Brilliant Light’ payoffs are just the negative of each number.

 A player’s payoff is the amount that the player wins or loses in

a particular situation in a game.

17
Illustration 1
Consider two lighting fixture stores, namely,
Bright Lights and Brilliant Lights. The
respective market shares have been stable up
until now, but the situation may change. The
owner of Bright Lights has developed two
distinct advertising strategies – using radio
spots and newspaper ads. Upon hearing this,
the owner of Brilliant Lights also proceeds to
prepare radio and newspaper ads. The next
slide shows what will happen to current market
shares if both stores begin advertising.

18
Bright Lights’ Payoff Table
Brilliant Lights
Use radio Use newspaper

Use radio 3 5
Bright Lights
Use
newspaper 1 -2

 Positive entries in the matrix represent wins for the

row player (Bright Lights) but losses for the column
player (Brilliant Lights).
 Negative entries represent losses for the row player
(Bright Lights) but wins for the column player (Brilliant
Lights).
19
Bright Lights’ Payoff Matrix
Brilliant Lights
Use radio Use newspaper

Use radio 3 5
Bright Lights
Use
newspaper 1 -2

Assumption:
 Row player tries to maximize winnings
while column player tries to minimize
losses.

20
Two-Person, Zero-Sum Game
 There are only two players.
 One player wins a certain amount and
the other player loses the same amount
(i.e., the sum of the gains and losses for
both players is zero).
 Assumption:
 Each player moves to maximize his own
payoff without knowing in advance how the
opponent will move.

21
MINIMAX CRITERION
Conservative Strategies
 Playing safe by adopting the conservative strategy
of assuming the worst:
 The row player chooses the move where
smallest payoff is as large as possible (to guard
himself when his opponent manage to select
the column that will result in the smallest
payoff).
 The column player (wanting to maximize his
payoff) minimizes his opponent’s payoff by
choosing the column where maximum entry is
as small as possible.
23
Minimax Criterion
 an approach to selecting strategies that
will minimize losses for each player
Bad news: Knowing game theory does not
guarantee winning

Good news: There is a framework for thinking

about strategic interaction
 minimization
of one’s maximum losses
(or maximization of one’s minimum
gains)
24
Row Player’s Maximin Strategy

 Choose the row whose minimum entry is

the largest of the minimum row entries

Column Player’s Minimax Strategy

 Choose the column whose maximum
entry is the smallest of the maximum
column entries
25
Illustration 2
Consider B Row min
 −1 − 3 5  - 3
A − 2.5 1 3  -2.5
 
 4 0 − 2 -2 maximin

Column max 4 1 5
minimax

 Player A’s conservative (maximin) strategy is to choose

strategy 3.
 Player B’s conservative (minimax) strategy is to choose
strategy 2.

26
Illustration 2
Consider B Row min
 −1 − 3 5  - 3
A − 2.5 1 3  -2.5
 
 4 0 − 2 -2 maximin

Column max 4 1 5
minimax

 If player A knows that player B is playing conservatively,

will he change his strategy? Why or why not?
 If player B knows that player A is playing conservatively,
will he change his strategy? Why or why not?

27
Illustration 3

Consider B Row min

8 4 4 maximin
A − 4 0 -4

 5 3 3
Column max 8 4 minimax

 If player A knows that player B is playing conservatively,

will he change his strategy? Why or why not?
 If player B knows that player A is playing conservatively,
will he change his strategy? Why or why not?

28
Remark

 There are games where the knowledge

that one’s opponent is playing
conservatively cannot be used to
advantage.

29
PURE STRATEGY GAMES
Pure Strategy
(or Strictly Determined) Games
 neither player can benefit from the
knowledge that the opponent is using
the conservative strategy
 the strategy of each player does not
change regardless of the other player’s
strategy.
 if and only if its payoff matrix has a
saddle point (or minimax point)

31
Saddle Point

a situation where both players are facing

pure strategies or using conservative
strategies
 an entry in the payoff matrix that is both
the smallest entry in its row and the
largest entry in its column
 also considered as the value of the
game
32
Value of the Game

 the numerical value of the saddle point

 average
or expected game outcome if
the game is played an infinite number of
times

33
Remark

 Strategiesfor saddle point games can

be determined without performing any
calculations.

 The game has a saddle point if

maximin = minimax.

34
Illustration 4

Express Airlines and Air Speed are two airlines

that are competing on two particular routes.
They each have two strategies for improving
their relative market position: pricing (cheaper
tickets) and service (more flight attendants,
better food, more comfortable seats). Market
research indicates when these strategies are
employed, the results will be as indicated on
the next slide.

35
 Air Speed
pricing service

pricing 25 18
Express Airlines

service -15 15

Entries are number of passengers (in

hundreds).

 Check if the game has a saddle point.

 Determine the optimal strategy for each airline.
 Who wins the game?
36
Solution

 Game’s saddle point: 18

 Optimum strategy for
 Express Air: cut fares
 Air Speed: offer improved service

 Ifboth airlines follow this policy, Express

Air will gain 18 units (1,800 passengers)
from Air Speed.

37
Exercise
Find the saddle point/s, the conservative
strategies, and the value of each of the
following strictly determined games:

a) b) 3 54 3
 8 0 − 2
− 6 4 1  2 4 
0 − 2
  
 4 3 2  1 − 6 5 0 
 
0 2 6 − 1 

38
Illustration 4
Two video rental chains, VCity and Vvid, are thinking
about opening a new store in one of three cities. If
chain VCity locates its new store in city 1, its estimate
earning per year will be PhP 225,000 more than chain
Vvid if Vvid also locates in city 1 and PhP 90,000 more
if Vvid locates in city 3, but it will earn PhP 450,000
less than Vvid if Vvid locates in city 2. If chain Vcity
locates in city 2, it will earn PhP 900,000, PhP
675,000, and PhP 540,000 more than Vvid if Vvid
locates in cities 1, 2, and 3, respectively. Finally, if
chain VCity locates in city 3, it will earn PhP 675,000
and PhP 450,000 more than Vvid if Vvid locates in
cities 1 and 3, respectively, and it will earn PhP
225,000 less than Vvid if Vvid locates in city 2. Where
should each chain locate its new store?

39
Solution

VCity
city 1 city 2 city 3
city 1
Vvid city 2
city 3

40
Dominance

a procedure used to reduce the size of

games to simpler form that is equivalent
to the original by eliminating strategies
that would never be played
 When is strategy eliminated?
 ifall its game’s outcomes are the same or
worse than the corresponding game
outcomes of another strategy

41
Procedure for Finding the Reduced
Form of a Matrix Game
 Compare the rows in the matrix. Delete any
row that is dominated by another row (i.e.,
each entry is less than the corresponding
entry of the other row).
 Compare the columns in the matrix. Delete
any column that dominates another column
(i.e., each entry is greater than the
corresponding entry of the other column).
 Repeat Steps 1 and 2 to eliminate all
redundant rows and columns.

42
Illustration
Consider the following matrix game:
C
3 1 0 − 3
R
7 − 1 1 6 
 
2 4 5 1 

Does player R have a superior move?

Will player C prefer column 4 to column 1?

43
Reduced form of the game:

R
 − 1 6
 4 1
 

44
Exercise

Find the reduced form of the ff. matrix games:

 2 −1 4   3 −2 6 2
− 1 5   4 −1 − 2 0 
 1   
− 1 3 − 4 − 1 0 6 − 2
 
2 1 5 0

45
Nash Equilibrium
 Occurs when each player's strategy is optimal,
given the strategies of the other players.

 A player's best response (or best strategy) is

the strategy that maximizes that player's
payoff, given the strategies of other players.

 A Nash equilibrium is a situation in which

each player makes his or her best response.

Source: Harcourt Brace & Company 46