Theory of games

•
HISTORY:
Game theory came in to existence in 20 Century.
th

• In 1944 John Von Neumann and Oscar Morgenstern published a book Theory of game and
Economic Behaviour,in which they discussed how businesses of all types may use this
technique to determine the best strategies given a competitive business environment.

DEFINITION :
In business and economics literature, the term ‘game’ refers to a situation of conflict and
competition in which two or more competitor(or participant) are involved in the decision
making process in anticipation of certain outcome over a period of time.

BASIC TERMS USED IN GAME THOERY

1. Player
2. Two-person game/n-person game 3.Zero-
sum game/non-zero sum game
4.Strategy
a. Pure Strategy
b.Mixed Strategy
5.Saddle point
PLAYER :
The competitor are referred to as player. A player may be individual, a group of
individual, or an organization.
TWO-PERSON GAME/ N-PERSON GAME :
• If a game involves only two player(competitors),then it is called a two-person
game.
• If number of player are more than two, then game is referred to as n-person
game.
ZERO SUM GAME/NON-ZERO SUM GAME :

In a game ,if sum of the gain to one player is exactly equal to the sum of losses to
another player, so that the sum of the gains and losses equals to zero, then the
game is said to be a zero-sum game. Otherwise it is said to be non zero-sum
game.

STRATEGY :
• The decision rule by which a player determines his course of action is called a
strategy.
• The strategy for a player is the list of all possible action that he will take
for every payoff(outcome) that might arise.
PURE STRATEGY :
• This is a decision rule that is always used by the player to select the particular
strategy(course of action).thus each player know in advance all strategies, out
of which he always selects only one particular startegy,regardess of the other
player’s strategy.
• The objective of the player is to maximize their gains or minimize their losses.

MIXED STRATEGY
• If a player decide in advance, to use all or some of his available courses of
action in some fixed proportion, he is said to use mixed strategy.
• Thus mixed strategy is a selection among pure strategies with
some fixed probabilities(proportions).

OPTIMUM STRATEGY :

• The particular strategy by which a player optimizes his gains or losses,

without knowing the competitors strategies, is called optimal strategy.
 PAYOFF MATRIX

The payoff (a quantitative measure of satisfaction that a player gets at the end of
the play) in terms of gains and losses, when player select their particular
strategies, can be represented in the form of a matrix, called the payoff matrix.

PLAYER Y
Y1 Y2
Y3

24 36 8
PLAYER X

X1

X2
32 20 16
In this pay-off matrix, positive pay-off is the gain to maximizing player (X) and loss
to minimizing player (Y).E.g., if X chooses strategy X1 and Y chooses strategy Y1,
then X’s gain is 32 and Y’s loss is 32.
ASSUMPTIONS OF THE GAME
 There are finite number of competitors.

 There is conflict of interests between them.

 Each player has available with him finite number of possible

strategies(courses of action).

 One player attempts to maximize gains and the other attempts to minimize
losses.

 Players know all possible available choices but does not know which one is
going to be chosen.

 Players simultaneously select their respective courses of action.

 The payoff is fixed and determined in advance.

 Players have to make individual decisions without direct communication.

FLOW CHART OF Write the payoff matrix
GAME THEORY Apply maximin and minimax principle
Identify the value of game
and write the optimal Ye Is there is
strategy of the player s saddle point

No

Solve by using analytical(or Ye

s Is it a 2*2 matrix
algebraic) or matrix method
for mixed strategy game
No
Use dominance rules to reduce the size of matrix

Ye Is payoff matrix
s reduced to
2*2 size ?
No
Use graphical method to Ye
Is payoff matrix
solve the problem s
reduced to a 2*n
or m*2 size ??
No
Formulate and solve as an L.P Problem
Method to find value of game under decision making environment
of certainty are as follows
Decision Making Environment

Certainty Uncertainty Risk

Non-Competitive Competitive
Situation Situation

Pure Strategy Mixed Strategy

Minimax and Maximin 2*2 order 2*n or m*2 order m*n order
Principle(saddle point) payoff matrix payoff matrix payoff matrix

• Algebraic Method
• Analytical Method Graphical LP Method
• Matrix Method Method
• Short-cut Method
RULES FOR GAME THEORY

RULE 1: Look for pure Strategy (Saddle point)

RULE 2: Reduce game by Dominance

If no pure strategies exist, the next step is to eliminate certain

strategies(row/column) by law of Dominance.

RULE 3: Solve for mixed Strategy

A mixed strategy game can be solved by different solution method, such

as 1.Arithmetic Method
2.Algebraic Method
3.Graphical method
4.Matrix Method
5.Short Cut Method
PURE STRATEGIES (MINIMAX AND MAXIMIN PRINCIPLE) :
Maximin Principle
• Maximize the player’s minimum gains. That means select the strategy that gives
the maximum gains among the row minimum value.

Minimax Principle

• Minimize the player’s maximum gains. That means ,select the strategy that gives
the minimum loss among the column maximum values.

Saddle Point
• If the maximin value equals the minimax value, the the game is said to have a
saddle
(equilibrium) point and the corresponding strategies are called “Optimal
Strategies”

Value of game
This is the expected payoff at the end of the game, when each player uses his optimal
strategy
• A game is said to be a fair game if the lower (maximin) and upper (minimax) value
of the
 RULES TO FINDOUT SADDLE POINT
Example:
B1
4 6 Maximin
B2 4
A1
3Minimum5of row
3
A2
Saddle point =4
4 6
Maximum
of column Minimax

 Select the minimum (lowest) element in each row of the payoff matrix and write them under
‘Minimum of row’ heading. Then, select the largest element among these element and
enclose it in a rectangle.
 Select the maximum (largest) element in each column of the pay off matrix and write them
under ‘column maxima’ heading. Then select the lowest element among these elements and
enclose it in a circle.
 Find out the element(s) that is same in the circle as the well as rectangle and mark the
position of such element(s) in the matrix . This element represents the value of the game
and is called the saddle (or equilibrium) point.
RULES OF DOMINANCE
 The rule of dominance are used to reduce the size of payoff matrix. These rule helps in
deleting certain rows and columns of the payoff matrix that are inferior(less attractive) to
at least one of the remaining rows and columns.
 Rows and columns once deleted can never be used for determining the optimum
strategy for both players.
 The rule of dominance are especially used for the evaluation of ‘two-person zero-sum’
games without a saddle point(equilibrium) point.

Example :
Player B
B1 B2 B3
A1 -5 10 20
Player A

5 -10 -10
A2
5 -20 -20
A3
 Player B
Minimum of row
B1 B2 B3
A1 -5 10 20 -5 Maximin
Player A

A2
5 -10 -10 -10  Given game have no saddle point
5 -20 -20 because Maximin is not equal to
A3 -20 Minimax. Therefore, further we
Must try to reduce the size of the
Maximum 5 20 given payoff matrix as further as
of 10 possible .
column Minimax
Note that : every element of column B3 is more than or equal to every corresponding element
of Row B2 Evidently , the choice of strategy B3, will always result in more losses as compared to
that of selecting the strategy B2.Thus , strategy B3 is inferior to B2. Hence, delete The B3
strategy from the payoff matrix. Reduced payoff matrix is …
Player B
B1 B2
A1 -5 10
Player A

5 -10
5 -20
• Now, it may be noted that strategy A2 of player A is dominated by his A3 strategy (every
element of column A2 is more than or equal to every corresponding element of Row A3 ),
since the profit due to strategy A2 is greater than or equal to the profit due to strategy A3.
Hence, strategy A3(row 3) can be deleted from further consideration.
Thus the reduced payoff matrix becomes:

Player B
Minimum of row

B1 B2
Player A

A1 -5 10 -5 Maximin

A2 5 -10 -10

Maximum 5 10
of column
Minimax

Note : the maximin value is not equal to minimax value, hence there is no saddle point.
For this type of game situation, it is possible to obtain a solution by applying the concept
of mixed strategies.
MIXED STRATEGY: GAME WITHOUT
SADDLE POINT
In certain case, there is no pure strategy solution for a game ,i.e. no saddle point exists.

Algebraic Method
This method is used to determine the probability of using different
strategies by players A and B. This method becomes quite lengthy
when a number of Strategies for both the players are more than
two.

 Players selects each of the available strategies for certain

proportion of time i.e., each player selects a strategy with some
probability.

It could be stated specifically with the help of following

example :
 Player B
Player A B1 B2
A1 5 2 p1

A2 3 4 p2

q1 q2

As it can be seen that saddle point does not exist, we follow following method :
Let,
p1= probability of selecting the strategy A1,
p2= probability of selecting the strategy A2,
q1= probability of selecting the strategy B1
q2= probability of selecting the strategy B2

And V be the value of game,

5p1+3p2=v----------------------(1)

2p1+4p2=v----------------------(2)

p1+p2=1--------------------------(3)
 After solving above three equation,

P1=1/4 P2=3/2 V=7/2

Therefore optimum strategy for player A is (1/4,3/4).player A should play strategy A1 25%
time and A2 75% time in order to maximize is expected game by 7/2 units

In the same way for player B

5q1+2q2=V----------(1)
3q1+4q2=V----------(2)
q1+q2=1--------------(3)
After solving above equation,

q1=1/2 V=7/2
q2=1/2
Therfore optimum strategies for player B is(1/2,1/2) player b should play strategy B1
50% time and B2 50% time in order to minimize is expected game by 7/2 unit.
 Arithmetic Method
The arithmetic method (also known as short cut method) provide an easy
method for finding optimal strategies for each player in a payoff matrix of size
2*2,without saddle point.The step of this method are as follows-

Step 1: Find the differences between the two values in the first row and put it
against the second row of the matrix, neglecting the negative sign (if any).

Step 2 : Find the differences between the two values in the second row and put it
against the first row of the matrix, neglecting the negative sign (if any).

Step 3 : Repeat step 1 and step 2 for two column also.

The value obtained by ‘swapping the difference’ represent the optimal relative
frequency of play for both players strategies. These may be converted to
probabilities by dividing each of them by their sum.
Example: no saddle point in below payoff matrix

Neglect negative
Player B sign.

B1 B2
Player A

-1-0=-1 , 1/1+3=1/4
A1 2 -1
A2
-1 0 2-(-1)=3 , 3/1+3=3/4

-1-0=-1 2-(-1)=3

1/1+3=1/4 3/1+3=3/4
Using A’s oddments

Player B plays B1
2*1/4+(-1)*3/4=-1/4
Player B plays B2
(-1)*1/4+0*3/4=-1/4
Using B’s oddments

Player A plays A1
2*1/4+(-1)*3/4=-1/4
Player A plays A2
(-1)*1/4+0*3/4=-1/4

Therefore the optimum strategy for player A is (1/4,3/4) and player b is

(1/4,3/4) and value of game is -1/4
 GRAPHICAL METHOD
The graphical method is useful for the game where the payoff matrix is of the size 2*n or m*2
.i.e. the game with mixed strategies that has only two undominated pure strategies for one of
the player in two-person zero-sum game.
Player B
B1 B2 B3 B4
2 2 3 -2
Player A
A1 p1
Example: • A2
4 3 2 6

p2

•Step 1 : As this 2*3 matrix does not have saddle point. Therefore graphic method is to be used
to reduce it to 2*2 game.
•Step 2 : let B’s
p1 and
Purep2 be the probabilities with which
Strategies player
E(v) A’s A usespay-off
expected his pure strategies,
•The expected pay-off of player A corresponding to player B’s pure strategies is :
B1 2p1+4p2
B2 2p1+3p2
B3 3p1+2p2
B4 -2p1+6p2
 These three expected pay-off lines are plotted on the graph to solve the game

Step 3 : Graph for player A. draw two parallel lines apart from each other and mark a scale on
each. These two represent the two strategies of player A. The graph is :
8 8
7 7
6 6
5 5
4 4
3 Maximin 3
2 2
1 1
0 0
-1 -1
-2 -2
-3 -3
-4 -4
-5 -5
From above graph given payoff matrix is reduced to 2*2 matrix and it can be solved by using
arithmetic matrix. Player B
B3 B4
Player A

A1 3 -2 4 4/9

A2 2 6 5 5/9

8 1

8/9 1/9

Value of game=3*4/9+2*5/9=22/9

Optimum strategy of A is (4/9,5/9) and B

is(0,0,8/9,1/9) and value of game is
22/9.
 Helps in decision making : Game theory develops a framework for analyzing decision-
makings under the situations of inter-dependence of firms with existing uncertainties about
the competitor’s reactions to any course of action adopted by a firm.

 Provide scientific quantitative technique: This theory outlines a scientific quantitative

technique which can be fruitfully used by players to arrive at an optimal strategy, given
firm’s objectives.
 Gives insight into situation of conflicting interests: game theory gives insight into several
less-known aspects which arise in situations of conflicting interests. For example, it
describes and explains the phenomena of bargaining and coalition-formation.
1.The assumption that the players have the knowledge about their own pay-offs and pay-offs of
others is rather unrealistic. He can only make a guess of his own and his rivals’ strategies.

2.As the number of maximum and minimax show that the gaming strategies becomes
increasingly complex and difficult. In practice, there are many firms in an oligopoly situation
and game theory cannot be very helpful in such situation

3.The assumptions of maximum and minimax show that the players are risk-averse and
have complete knowledge the strategies. These do not seen practical.

4.Rather than each player in an oligopoly situation working under uncertain conditions,
the players will allow each other to share the secrets of business in order to work out a
collusion. Thus, the mixed strategy are also not very useful.