Game Theory

In business and economics literature, the term ‘games’ refers to the general
situation of conflict and competition in which two or more competitors are
engaged in decision making activities in anticipation of certain outcomes over
time. The competitors are called players.
Many a decisions are taken in competitive situations in which the outcome
depends not on decision of one party alone but rather on the interaction
between that party’s decision and the decision of a competitor.
The parties could be individuals, groups, organizations etc.
Examples:
 Two or more candidates (but finite) contesting an election with the
objective of winning over the other/s with more votes.
 Two or more (but finite) firms having competitive advertising strategies
to increase one’s own market share.
 Two or more (but finite) contractors bidding for a contract.
Theoretically, game theory provides mathematical models that can be quite
useful in explaining interactive decision making concepts.
Researchers in the present times use the game theory models in behavioural
economics.
Initial popular work on game theory was published around the period of the
Second World War.
A competitive situation is called a game if fulfils the following conditions:
1) There is finite number of participants (interested and disinterested/willing
and unwilling).
2) Each participant has a finite number of possible courses of action.
3) The participant who willingly enters a game must know all the courses of
action available to the competitors but must not know which of these will be
chosen.
4) after all players have chosen a course of action their respective gains are
finite.
5) The gain of the participant depends upon the actions of the others as well as
her/his own.
6) All possible outcomes are calculable.

Models in game theory can be classified based on the following:

1) Number of players: If there are only two players (competitors) in a game, it
is called a two-person game. If there are more than two players, it is called a n-
person game.
2) Sum of gains and losses: If in a game, the gains to one player are exactly
equal to the losses to another player so that the sum of gains and losses equals
zero, then the game is said to be a zero-sum game.
Otherwise, it is called a non-zero game.
3) Strategy: The strategy for a player is the list of all possible actions (or moves
or courses of action) that she/he will take for every payoff (outcome) that
might arise.
It is assumed that the rules governing the choices are known in advance to the
players. The outcome resulting from a particular choice is also known to the
players in advance and is expressed in numerical values (e.g. money,
percentage of market share, utility and so on). Here, it is not necessary that
players have a definite information about each others’ strategies.

The particular strategy (or complete plan) by which a player optimizes her/his
gains or losses without knowing the strategy of competitor/s is called optimal
strategy. The expected outcome per play when players follow their optimal
strategy is called value of the game. Generally two types of strategies are
employed by players in a game.
a) Pure strategy: It is a decision rule which is always used by the player to
select a particular course of action. Thus, each player knows in advance of all
the strategies available to her/him out of which she/he always selects only one
particular strategy irrespective of the strategy the opponent/s may choose;
and the objective of the player is to get maximum possible gains or minimise
losses.
b) Mixed strategies: When both/all players keep guessing as to which course of
action to select at a particular point in the game and there is a probabilistic
expectation about the outcome, then the game is a game of mixed strategies.
The player makes a solution to maximise gains or minimise losses by choosing
among pure strategies with fixed probabilities.
That is, out of n strategies, there is a probability p1 that strategy n1 will be
selected.
c) Dominant strategy: In game theory, a dominant strategy is the course of
action that results in the highest payoff for a player regardless of what the
other player does. Not all players in all games have dominant strategies; but
when they do, they can blindly follow them.
Dominant strategies are considered as better than other strategies, no matter
what other players might do. In game theory, there are two kinds of strategic
dominance:
-a strictly dominant strategy is that strategy that always provides
greater utility to a the player, no matter what the other player’s strategy is;
-a weakly dominant strategy is that strategy that provides at least the same
utility for all the other player’s strategies, and strictly greater for some
strategy.
Dominant strategy equilibrium is reached when each player chooses their own
dominant strategy. In the prisoner’s dilemma, the dominant strategy for both
players is to confess, which means that confess-confess is the dominant
strategy equilibrium.

Games can be:

1. Cooperative and Non-Cooperative Games:
Cooperative games are the one in which players are convinced to adopt a
particular strategy through negotiations and agreements between players. Let
us take the example cited in prisoner’s dilemma to understand the concept of
cooperative games.
However, non-cooperative games refer to the games in which the players
decide on their own strategy to maximize their profit.

2. Normal Form and Extensive Form Games:

Normal form games refer to the description of game in the form of matrix. In
other words, when the payoff and strategies of a game are represented in a
tabular form, it is termed as normal form games. Normal form games help in
identifying the dominated strategies and Nash equilibrium. In normal form
games, the matrix demonstrates the strategies adopted by the different
players of the game and their possible outcomes.
On the other hand, extensive form games are the one in which the description
of game is done in the form of a decision tree. Extensive form games help in
the representation of events that can occur by chance. These games consist of
a tree-like structure in which the names of players are represented on different
nodes.
In addition, in this structure, the feasible actions and pay offs of each players
are also given. Let us understand the concept of extensive form games with
the help of an example. Suppose organization A wants to enter a new market,
while organization B is the existing organization in that market.
Organization A has two strategies; one is to enter the market and challenge to
survive or do not enter the market and remain deprived of the profit that it can
earn. Similarly, organization B also has two strategies either to fight for its
existence or to cooperate with organization A.

Extensive Form Game

In the figure above, organization A takes the first step that would be followed
by organization B later on. In case, organization A does not enter the market,
then its payoffs would be zero. However, if it enters the market, the market
situation would be totally dependent on organization B.
If they both get into the price war, then both of them would suffer the loss of
3. On the other hand, if organization B cooperates, then both of them would
earn equal profits. In this case, the best option would be that organization A
enters the market and organization B cooperates.

3. Simultaneous Move Games and Sequential Move Games:

Simultaneous games are the one in which the move of two players (the
strategy adopted by two players) is simultaneous. In simultaneous move,
players do not have knowledge about the move of other players. On the
contrary, sequential games are the one in which players are aware about the
moves of players who have already adopted a strategy.
However, in sequential games, the players do not have a deep knowledge
about the strategies of other players. For example, a player has knowledge
that the other player would not use a single strategy, but he/she is not sure
about the number of strategies the other player may use. Simultaneous games
are represented in normal form while sequential games are represented in
extensive form.
Suppose organizations X and Y want to minimize their cost by outsourcing their
marketing activities. However, they have a fear that outsourcing of marketing
activities would result in increase of sale of the other competitor. The
strategies that they can adopt are either to outsource or not to outsource the
marketing activities.

Payoff matrix for simultaneous move game:

In the table above, it can be seen that both the organizations X and Y are
unaware about the strategy of each other. Both of them work on the
perception that the other one would adopt the best strategy for itself.
Therefore, both the organizations would adopt the strategy, which is best for
them.

The same example can also be used for the explanation of sequential move
games. Suppose organization X is the first one to decide whether it should
outsource the marketing activities or not.
The game tree that represents the decision of organization X and Y is shown
in the figure below:

Sequential move game:

In the figure above, the first move is taken by organization X while organization
Y would take decision on the basis of the decision taken by X. However, the
final outcome depends on the decision of organization Y. In the present case,
the second player is aware of the decision of the first player.

4. Constant Sum, Zero Sum, and Non-Zero Sum Games:

Constant sum game is the one in which the sum of outcome of all the players
remains constant even if the outcomes are different. Zero sum game is a type
of constant sum game in which the sum of outcomes of all players is zero. In
zero sum game, the strategies of different players cannot affect the available
resources.
Moreover, in zero sum game, the gain of one player is always equal to the loss
of the other player. On the other hand, non-zero sum game are the games in
which sum of the outcomes of all the players is not zero.
A non-zero sum game can be transformed to zero sum game by adding one
dummy player. The losses of dummy player are overridden by the net earnings
of players. Examples of zero sum games are chess and gambling. In these
games, the gain of one player results in the loss of the other player. However,
cooperative games are the example of non-zero games. This is because in
cooperative games, either every player wins or loses.
5. Symmetric and Asymmetric Games:
In symmetric games, strategies adopted by all players are same. Symmetry can
exist in short-term games only because in long-term games the number of
options with a player increases. The decisions in a symmetric game depend on
the strategies used, not on the players of the game. Even in case of
interchanging players, the decisions remain the same in symmetric games.
Example of symmetric games is prisoner’s dilemma.
On the other hand, asymmetric games are the one in which strategies adopted
by players are different. In asymmetric games, the strategy that provides
benefit to one player may not be equally beneficial for the other player.
However, decision making in asymmetric games depends on the different
types of strategies and decision of players. Example of asymmetric game is
entry of new organization in a market because different organizations adopt
different strategies to enter in the same market.

Nash Equilibrium
Nash equilibrium is one of the fundamental concepts in game theory. It conceptualizes the
behaviour and interactions between game participants to determine the best outcomes. It also
allows predicting the decisions of the players if they are making decisions at the same time
and the decision of one player takes into account the decisions of other players.
Nash equilibrium was discovered by American mathematician, John Nash. He was awarded
the Nobel Prize in Economics in 1994 for his contributions to the development of game
theory.

Example
Imagine two competing companies: Company A and Company B. Both companies want to
determine whether they should launch a new advertising campaign for their products. If both
companies start advertising, each company will attract 100 new customers. If only one
company decides to advertise, it will attract 200 new customers, while the other company will
not attract any new customers. If both companies decide not to advertise, neither company
will engage new customers. The payoff table is below:
Company A should advertise its products because the strategy provides a better payoff than
the option of not advertising. The same situation exists for Company B. Thus, the scenario
when both companies advertise their products is a Nash equilibrium.

Example of Multiple Nash Equilibria

Under some circumstances, a game may feature multiple Nash equilibria.
John and Sam are registering for the new semester. They both have the option to choose
either a finance course or a psychology course. They only have 30 seconds before the
registration deadline, so they do not have time to communicate with each other. If John and
Sam register for the same class, they will benefit from the opportunity to study for the exams
together. However, if they choose different classes, neither of them will get any benefit.
In the example, there are multiple Nash equilibria. If John and Sam both register for the same
course, they will benefit from studying together for the exams. Thus, the outcomes
finance/finance and psychology/psychology are Nash equilibria in this scenario.