Lecture 17 - Game Theory

Game Theory
The bird flu epidemic is expected to hit your
town and it is estimated that 600 people will die. Which of following two drugs, A or B will you recommend to combat the epidemic given the following information?
If Drug A is used: 200 will be saved If Drug B is used: 1/3 chance that all 600 will be
saved and 2/3 chance that nobody will be saved.
The bird flu epidemic is expected to hit your
town and it is estimated that 600 people will die. Which of following two drugs, C or D will you recommend to combat the epidemic given the following information?
If Drug C is used: 400 will die If Drug D is used: 1/3 chance that nobody will
die, and 2/3 chance that 600 will die.
Three Elements of a Game

1)The players how many players are there? does nature/chance play a role? 2) A complete description of the strategies of each player 3) A description of the consequences (payoffs) for each player for every possible profile of strategy choices of all players.
Why Game theory?

Managers make decisions on pricing & output
Based on their anticipation or reaction to the decisions made by their competitors.
The kinked demand model:
Explains : Why prices in such markets tend to be very similar But does not explain : how & why this price is established in the first place
Game theory helps in understanding these decisions
Game theory
How individuals make decisions - when they are aware that their actions effect each other & when each individual takes this into account
The perquisites:
Interdependence Your decisions effect others & their decisions effect you Uncertainty You dont know what decisions will they take nor do they know what decisions will you take
STRATEGY
In Oilgopolistic market situation
The problem is to choose a rational course of action Strategy.
A Strategy is a course of action or policy which player or participant in a game will adopt during the play of the game.
The various alternative strategies are: 1) Changing the price 2) Changing the level of output 3) Increasing advertisement expenditure 4) Varying the product
A firm behaves strategically, that is while taking its decision regarding price, output, advertising it takes into account how its rivals firms will react assuming them to be rational i.e they will do there best to promote their interest while making decisions. Kinds of Games: Cooperative Games: A binding contract that permits them to adopt a strategy to maximise joint profits. Non- Cooperative Games: Competing firm take each other actions into account but they take decisions independently and adopt strategies.
Dominant Strategy
A Strategy which will be successful or optimal for a firm regardless of what others do, i.e no matter what the strategy the rival firm adopts.
For example: Two companies A & B Firms need to promote its sales and profits Strategy for them is to Advertise or Not Advertise
DOMINANT STRATEGY Pay- Off Matrix for Advertising Games

Dominant Strategy
In Rs Crores
Firm B Advertise Not Advertise Dominant Strategy
F I r m A
Advertise
5 10
15 8
2 10
Not Advertise
DOMINANT STRATEGY Pay- Off Matrix for Advertising Games

Firm A: Choice of advertising is optimal for it irrespective whatever
decision firm B makes
Firm B: Choice of advertising is optimal for it irrespective whatever

decision firm A makes Since it is assumed that both firms behave rationally each of them will choose the strategy of Advertising and the outcome will be profits of Rs 10 cr for firm A and Rs 5 cr for firm B
Absence of Dominant Strategy

Pay- Off Matrix for Advertising Games
In Rs Crores
Firm B Advertise Not Advertise
F I r m A
Advertise
5 10
15 8
2 20
Not Advertise
Absence of Dominant Strategy

Optimal strategy for Firm A depends on which strategy the firm B
adopts. Advertising strategy is optimal for firm A, given that firm B adopts the same. Non- Advertising by firm A is better given that firm B adopts the same.
Thus there is no Dominant strategy existing But how does firm make an optimal decision regarding choice of
strategy if both the firm choose their strategies simultaneously.
Choice of an Optimal strategy in the absence of a Dominant Strategy.

Both the firm must put itself in other firms place
and then decide.

If firm A choosers strategy of Advertising the firm
B will make profit of 5 cr
Nashs Equilibrium
Nash equilibrium (named after John Forbes Nash) is a
solution concept of a game involving two or more players.
Each player is assumed to know the equilibrium strategies
of the other players, and no player has anything to gain by changing only his or her own strategy (i.e., by changing unilaterally).
If each player has chosen a strategy and no player can
benefit by changing the strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium.
Nashs Equilibrium
In a Nash equilibrium, each player must respond negatively to the question: "Knowing the strategies of the other players, and treating the strategies of the other players as set in stone, can I benefit by changing my strategy?
However, Nash equilibrium does not necessarily mean the
best cumulative payoff for all the players involved; in many cases all the players might improve their payoffs if they could somehow agree on strategies different from the Nash equilibrium (e.g. competing businessmen forming a cartel in order to increase their profits).
In Dominant strategy equilibrium describes an
optimal or best choice regardless of what strategy the other player adopts
Whereas
In Nash each player adopts a strategy that is
best or optimal for him given the strategy of the other player
Prisoners Dilemma
Dominant Strategy SUSPECT 1 Confess Not Confess Dominant Strategy S U S P E C T 2 Confess 4 4 7
1 1
2 2
Not confess
Prisoners Dilemma
In this model the decision of each prisoner in favour of
confession is quite rational because each person works in self- interest and tries to make the best of the worst outcome in an uncertain situation.
Prisoners
Dilemma can never be resolved if you approach the problem from outside, that is from the others viewpoint first. The problem offers a resolution only if you approach the problem from inside, that is , from your own self.
Prisoners Dilemma
The only way to resolve the dilemma is to ask,
Whats the right course of action that could be best for BOTH. If you look inward, no matter how selfish you are, you will find the correct resolution to the dilemma.
Show Dilbert Video
Game Theory Rules

Choose your strategy by asking what makes most sense for you
In the context of companies

In Rs Lakhs
COMPANY 1 Cheat Cooperate

C Cheat O M PA N Y Cooperate 2
5 5
25 2 15 25
15
Equilibrium State
In the context of companies

If both the firm cooperate and abide by cartel they share
huge amount of profits.

Each firm has strong incentive to cheat
Its the pursuit of self- interest rather than common
interest that prompts the firms to cheat each other.

Thus if both the firm cheat they will break down the
cartel.
Steal v/s Split

Player 1
Split P L A Y E R 2 Split 50075 Steal
In $
100150
0
50075 0
Steal
100150
If its a one time game then a the chances of steal are high but a repeated game would make the players split.
Game Theory Rules

You should choose your strategy on the assumption that your opponent will act in his best interest
Repeated Games & Tit- for Tat Strategy

The Games so far are played just once, so they can
cheat.
However in case of repeated games the oligopolist may
adopt a cooperative behaviour which enables them to earn large profits

In repeated game one firm has the the opportunity to
penalise the other for his previous bad behaviour Tit for TAT Strategy
Nashs Equilibrium
PEPSI High Price Low Price High Price 200
150 20
C O K E
200 20
150
Low Price
50
50
Firms will form a cartel and go for high price than cheating on one another

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Game Theory

The bird flu epidemic is expected to hit your

saved and 2/3 chance that nobody will be saved.

The bird flu epidemic is expected to hit your

die, and 2/3 chance that 600 will die.

Three Elements of a Game

Why Game theory?

Based on their anticipation or reaction to the decisions made by their competitors.

The kinked demand model:

Game theory helps in understanding these decisions

The problem is to choose a rational course of action Strategy.

DOMINANT STRATEGY Pay- Off Matrix for Advertising Games

Firm B Advertise Not Advertise Dominant Strategy

DOMINANT STRATEGY Pay- Off Matrix for Advertising Games

Firm B: Choice of advertising is optimal for it irrespective whatever

Absence of Dominant Strategy

Firm B Advertise Not Advertise

Absence of Dominant Strategy

strategy if both the firm choose their strategies simultaneously.

Choice of an Optimal strategy in the absence of a Dominant Strategy.

and then decide.

B will make profit of 5 cr

solution concept of a game involving two or more players.

Each player is assumed to know the equilibrium strategies

In Dominant strategy equilibrium describes an

In Nash each player adopts a strategy that is

Show Dilbert Video

Game Theory Rules

In the context of companies

COMPANY 1 Cheat Cooperate

In the context of companies

huge amount of profits.

interest that prompts the firms to cheat each other.

Steal v/s Split

Game Theory Rules

Repeated Games & Tit- for Tat Strategy

adopt a cooperative behaviour which enables them to earn large profits

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