L13

• Game Theory


  The science of strategic decision making
• Players


  The people or firms or agents involved in a game
• Assumptions of players

  • Humans are rational beings
  • Humans always seek the best alternative
• Games


  Any set of circumstances that has a result dependent on the actions of all players
• Rules


  States what the players can do and when they can do it
• Strategies


  All possible actions for the players
• Payoffs


  The incentives for the players
• Outcome


  A consequence of the choices made by both players
• Nash Equilibrium (NE)


  The optimal outcome of a simultaneous game where no player has an incentive to deviate from their chosen strategy
• Simultaneous decision-making game


  A game in which each player makes a choice without the other knowing
• Sequential decision-making game


  A game in which one player makes a choice before the other
• Forms of games

  • Matrix
  • Extensive
• Solving a basic game in Matrix Form

  1. Identify Pepsi's pricing strategy

  2. Determine Coke's best response

  3. Identify dominant strategy

  4. Determine Nash Equilibrium
• Dominant Strategy


  A strategy whose payoff is strictly higher relative to all other feasible strategies
• Nash Equilibrium


  A situation where every player is choosing their best response given what the other player is doing
• All purely rational, self-interested prisoners would betray the other
• Sequential Games


  • Players make moves in turns
  • Players who move later have additional information
  • Used in business situations for forecasting and planning
• Rollback


  A method used in sequential games to determine optimal strategies
• Players make moves in turns in sequential games
• Sequential games


  Players who move later have additional information about the actions of other players
• Extensive form representation uses decision trees to represent sequential games
• Rollback (backward induction)


  Iterative process for solving finite extensive form or sequential games
• Rollback process

  1. First player determines optimal strategy of last mover

  2. First player’s optimal action is based on last player's action
• Backward induction is reasoning backwards to determine strategies
• Strategies in Game Theory

  • Mixing Moves
  • Strategic Moves
  • Bargaining
  • Concealing and revealing information
• Definitions of strategies


  • Use threats and promises
  • When one player knows something that others do not
  • Keeping the rival guessing
  • Deciding how to split the pie
• Application of Game Theory

  1. Advertising

  2. Trade between countries

  3. Collusion among firms
• Game Theory involves behaviour that takes into account the expected behaviour of others
• Key concepts in Game Theory

  • Simultaneous Decision Making
  • Sequential Decision Making
  • Strategies
  • Dominant Strategy
  • Backward Induction
  • Nash Equilibrium
  • Rollback Equilibrium