Unit Four: Decision Making Under Uncertainty &

Risk Situations

This chapter focuses on making decision under:

o Uncertainty conditions
o Risk Conditions
4.1. Decision Making Under Condition of Uncertainty
 Under complete uncertainty, either no estimates of the
probabilities for the occurrence of the different states of nature
are available.
 Under this circumstance, the decision maker lacks confidence in
the state of nature to make decision.
 For this kind of decision, probabilities are not used at the choice
of the best alternative.
 Most of the rules for decision making under uncertainty express a
different degree of decision maker´s optimism.
4.2. Decision Making Criteria under Uncertainty Situation

For making decisions under uncertainty condition, different

techniques to be used. Some of these are as follows:

4.2.1.The Maximax Criterion

 The maximax criteria is appropriate for extreme optimists that
expect the most favorable situation.
 Decision makers choose the alternative that could result in the
maximum payoff.
 Under this criteria, the decision maker will find the largest payoff
in the decision matrix and select the alternative associated with it.
 The largest payoff is determined for each alternative and then the
largest payoff from these values (maximax) is selected.
o The procedure for maximax is shown in the following table:
Example 1:
Demand® Low Moderate High Row
Order Maximum

Small 50 50 50 50

Medium 42 52 52 52

Large 34 44 54 54 ¬
Maximum

 The best overall profit is $54 in the third row. Hence, the
maximax rule leads to the large order (the grocer hopes that the
demand will be high).
 Exercise:
 The investor wants to make decision for investment on best
alternative under the following given state of nature.

State of nature
Alternatives
Good Medium Poor economic
economic condition condition
condition
Apartment $50,000 $45,000 &30,000
building
Office building $100,000 $70,000 - $40,000
Warehouse $30,000 $20,000 $10,000
building

 Which alternative and what payoff should the investor choose

on the basis of the maximax criteria?
 4.2.2. The Wald Criteria (Maxmin Rule)
 The maximin rule (Wald criterion) represents a pessimistic
approach when the worst decision results are expected.
 The decision maker determines the smallest payoff for each
alternative and then chooses the alternative that has the best
(maximum) of the worst (minimum) payoffs .
Example 2:
Demand Low Moderate High Row
Minimum
Order
Small 50 50 50 50
Maximum
Medium 42 52 52 42
Large 34 44 54 34
 Since 50 is the largest, the small order should be chosen (if demand is low,
the $50 grocer‘s profit is guaranteed).
• Exercise
• The investor wants to make decision for investment
on best alternative under the following given state of
nature.
State of nature
Alternatives
Good economic Medium Poor economic
condition condition condition
Apartment $50,000 $45,000 $30,000
building
Office building $100,000 $70,000 - $40,000
Warehouse $30,000 $20,000 $10,000
building
 Which alternative and what payoff should the investor choose
on the basis of the Wald Criteria (Maxmin Rule)?
 4.2.3. The Hurwicz Criterion
 The Hurwicz - criterion represents a compromise between the
optimistic and the pessimistic approach to decision making
under uncertainty.
 The measure of optimism and pessimism is expressed by an
optimism - pessimism index ( ), 0 <= <=1.
 The more this index is near to 1, the more the decision maker is
optimistic.
 If  = 0, the decision maker is said to be completely pessimistic.
 By means of the index , if  is the coefficient of optimism, 1- 
is the coefficient of pessimism.
 The weighted average will be computed for each alternative and
the alternative with the largest weighted average should be
chosen.
 If we choose = 0.7 at determining the best size of the order in
examples 1 &2 above, the weighted average (WA) of the largest
and the smallest profit for each size of the order has the
following values:
 WA (small) = 0.7* 50 + 0.3 * 50 = 50
 WA (medium) = 0.7* 52 + 0.3 * 42 = 49
 WA (large) = 0.7* 54 + 0.3 *34 = 48

 Maximizing the weighted average of the largest and the smallest

profit, the small order should be selected.
 Exercise:

 Which alternative of investment to be selected using the

Hurwicz criterion for the following given data with 0.5
coefficient of optimism?
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition

Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse $30,000 $20,000 $10,000

building
 4.2.4. The savage criterion (Minimax Regret Rule)
 The maximax and maximin rules and the Hurwicz criterion
can be criticized because they focus only on extreme payoffs
and exclude the other payoffs.

 An approach that does take all payoffs into account is the

minimax regret rule (Savage criterion).
 This rule represents a pessimistic approach used for an
opportunity loss table.
 The opportunity loss reflects the difference between each
payoff and the best possible payoff in a column.
 The opportunity loss can be defined as the amount of profit
foregone by not choosing the best alternative for each state of
nature.
 The opportunity loss amounts are found by identifying the greatest
payoff in a column and, then, subtracting each of the other values
in the column from that payoff.

 The values in an opportunity loss table can be viewed as potential

”regrets” that might be suffered as the result of choosing various
alternatives.

 Minimizing the maximum possible regret requires identifying the

maximum opportunity loss in each row and, then, choosing the
alternative that would yield the minimum of those regrets (this
alternative has the “best worst”).
 To illustrate the Savage criterion procedure, we will recall the
decision problem given in example 1 &2 and first construct the
corresponding regret table.
 Payoff table:

Demand ® Low Moderate High

Order
Small 50 50 50
Medium 42 52 52
Large 34 44 54
 In the first column of the payoff matrix, the largest number is 50, so each of
the three numbers in that column must be subtracted from 50.
 In the second column, we must subtract each payoff from 52 and in the third
column from 54 as calculations are summarized in the following Table. A
column with the maximum loss in each row is presented to this table.

Demand® Low Moderate High Maximum

Loss
Order
Small 0 2 4 4 ¬
Minimum
Medium 8 0 2 8
Large 16 8 0 16

 To minimize the maximum loss, the small order should be chosen.

 Make a decision for the type of investment to be selected on the
basis of the following data using the Savage criterion (Minimax
Regret Rule).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition

Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse $30,000 $20,000 $10,000

building
 4. 2.5. The Lap place criterion (Equal Likelihood Criterion)

 The lap place criterion assumes that all states of nature are
equally likely.

 Under this assumption, the decision maker can compute the

average payoff for each row (the sum of the possible
consequences of each alternative is divided by the number of
states of nature).

 Finally, the alternative that has the highest row average will be
selected as best alternative. This procedure is illustrated by the
following calculations with the data in Table 2.2
 The procedure for the Lap Place Criterion (Equal Likelihood
Criterion) is illustrated by the following calculations with the
data given under example 1 and 2.

 Expected monetary value (EMV):

 EMV (small) = (50 + 50 + 50)/3 = 50
 EMV (medium) = (42 + 52 + 52)/3 = 48.7
 EMV (large) = (34 + 44 + 54)/3 = 44

 Since the profits at the small order have the highest average, that
order should be realized.
 Exercise:
 Make a decision for the investment to be made using the lap
place criterion (equal likelihood criterion) under the following
state of nature.

State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse building $30,000 $20,000 $10,000

4. 3. Decision Making Under Condition of Risk

 In this case, the decision maker doesn´t know which state of

nature will occur but can estimate the probability of occurrence
for each state.
 The probabilities may be subjective (they usually represent
estimates from experts in a particular field), or they may reflect
historical frequencies.

 A widely used approach to decision making under risk is

expected monetary value criterion.

 There are also other techniques that can be used to make

decision under this condition.
 4.3.1. Expected Monetary Value Criterion

 The Expected Monetary Value (EMV) of an alternative is

calculated by multiplying each payoff that the alternative can
yield by the probability for the relevant state of nature and
summing the products.

 The value is computed for each alternative, and the one with the
highest EMV is selected.
 Suppose that the grocer can assign probabilities of low,
moderate and high demand on the basis of his experience with
sale of pastry.
 The estimates of these probabilities are 0.3, 0.5, 0.2,
respectively.
 We will recall the payoff table for the considered problem.
 Payoff table:

Demand Low Moderate High

Order

Small 50 50 50

Medium 42 52 52

Large 34 44 54
 The EMV for various sizes of the order are as follows:

 EMV (small) = 0.3*50 + 0.5*50 + 0.2*50 = 50

 EMV (medium) = 0.3*42 + 0.5*52 + 0.2*52 = 49
 EMV (large) = 0.3*34 + 0.5*44 + 0.2*54 = 43
 Therefore, in accordance with the EMV criterion, the small
order should be chosen.
 Note that the EMV of $50 will not be the profit on any one day.
It represents an expected or average profit.
 If the decision were repeated for many days (with the same
probabilities), the grocer would make an average of $50 per day
by ordering the small amount of pastry.
 Even if the decision were not repeated, the action with the
highest EMV is the best alternative that the decision maker has
available.
 The EMV criterion remains as the most useful of all the
decision criteria for decision making under risk.

 For risky decisions, a sensible approach is first to calculate the

EMV, and then to make a subjective adjustment for the risk in
making the choice.
 Exercise:
 If you need to make a decision for investment using the
expected monetary value criterion (EMV), which alternative
do you select ? Recall the following data. (Assume that the
probabilities are 0.5, 0.3 and 0.2 for good economic, medium
economic and poor economic conditions respectively).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000

Office building $100,000 $70,000 - $40,000

Warehouse building $30,000 $20,000 $10,000

4.3.2. The Expected Opportunity Loss (ELO) Criterion
 The expected opportunity loss (EOL) is nearly identical to the
EMV approach, except that a table (or matrix) of opportunity
losses (or regrets) is used.

 The opportunity losses for each alternative are weighted by the

probabilities of their respective states of nature and these products
are summed.

 The alternative with the smallest expected loss is selected as the

best choice.
 We will use EOL procedure in the regret matrix shown above
on slide number 39.
Regret table:
Demand® Low Moderate High

Order

Small 0 2 4

Medium 8 0 2

Large 16 8 0
 Supposing that the probabilities of various sizes of the demand
are 0.3, 0.5, 0.2, we can determine the EOL for each size of the
order as follows:
 EOL (small) = 0.3*0 + 0.5*2 + 0.2*4 = 1.8
 EOL (medium) = 0.3*8 + 0.5*0 + 0.2*2 = 2.8
 EOL (large) = 0.3*16 + 0.5*8 + 0.2*0 = 8.8
 Since the small order is connected with the smallest EOL, it is
the best alternative.
 The EOL approach resulted in the same alternative as the EMV
approach.

 The two methods always result in the same choice, because

maximizing the payoffs is equivalent to minimizing the
opportunity losses.
 Exercise:
 Make a decision for selection of a type of investment to be made
using EOL criterion by recalling the following data (Assume
probabilities of 0.3, 0.5 and 0.2 for good, medium and poor
economic conditions respectively).
State of nature
Alternatives
Good economic Medium condition Poor economic
condition condition
Apartment building $50,000 $45,000 $30,000
Office building $100,000 $70,000 - $40,000
Warehouse building $30,000 $20,000 $10,000
 4.3.3. Maximum - likelihood Decision Criterion
 According to this criterion, we consider only the state of nature
with the highest probability and choose the best alternative for
that state of nature.
 If we suppose in the decision problem given under EOL that the
probabilities of various sizes of the demand are 0.3, 0.5, 0.2, the
moderate demand is most likely. Under this situation, the
medium order is the best.
 Since the maximum-likelihood criterion takes only one uncertain
state of nature into account, it may lead to bad decisions.

 The expected value approach (the calculation of the EMV or the

EOL) is particularly useful for decision making when a number
of similar decisions must be made; it is a “long-run” approach.
 4.3.4. Decision Tree Analysis
 Decision tree is a graphical diagram consisting of nodes and
branches.

 In a decision tree, the user computes the expected value of each

outcome and makes a decision based on these expected values.

 The primary benefit of a decision tree is that it provides an

illustration (picture) of the decision making process which makes
the decision making process easier.
 A decision tree is composed of nodes and branches (arcs).

 The terminology of nodes and arcs comes from network models

which have a similar pictorial representation.

 A decision tree has three types of nodes: decision nodes, chance

event nodes, and terminating nodes.
 Decision nodes: are denoted by squares.

 Each decision node has one or more arcs beginning at the node and
extending to the right.

 Each of those arcs represents a possible decision alternative at that

decision point.
 Chance event nodes: are denoted by circles.
 Each chance event node has one or more arcs beginning at the node
and extending to the right.

 Each of those arcs represents a possible event at that chance event

point. The decision maker has no control over these chance events.

 The events associated with branches from any chance event node
must be mutually exclusive and all events included.

 The probability of each event is conditional on all of the decision

alternatives and chance events that precede it on the decision tree.

 The probabilities for all of the arcs beginning at a chance event node
must sum to 1.
 A terminating node: represents the end of the sequence of
decisions and chance events.

 No arcs extend to the right from a terminating node.

 Terminating nodes are the starting points for the

computations needed to analyze the decision tree.
Format of a decision tree
 Analysis of Decision Trees
 After the tree has been drawn, it is analyzed from right to left.

 The aim of this analysis is to determine the best strategy of the

decision maker, that means an optimal sequence of the decisions.
 To analyze a decision tree, we must know a decision criterion,
probabilities that are assigned to each event, and revenues and
costs for the decision alternatives and the chance events that
occur.
 Analyzing a decision tree, we begin at the end of the tree and
work backwards.
 We carry out two kinds of calculations:
i. For chance event nodes, we calculate the events emanating
from these nodes.

Under the assumption that the decision maker has a neutral

attitude toward risk, certainty equivalent of uncertain
outcomes can be replaced by their expected value.

ii. At decision nodes, the alternative with the best expected

value of the decision criterion is selected.
 The analysis of a decision tree is illustrated by the following
example.

 A firm is deciding between two alternatives: to introduce a new

product or to keep the existing product. Introducing a new product
has uncertain outcomes in dependence on the demand. If the demand
is high, the resulting profit of the firm will be $140. The low demand
will be result in the profit of $ 80. The firm estimates the probabilities
of a high and low demand 0.7 and 0.3, respectively. If the firm keeps
the existing product, its profit will be 110.
 The decision tree for the above decision problem can be shown
as follows: (If the alternative not to be chosen, (// ) will be used.
 Example1:

 The estimated profit is written at the end of the chance branches.

 The probabilities of a high and a low demand for the new product are
written below the branches leaving the chance node.
 The nodes are numbered.
 For the chance node 2, we calculate the expected value of the
profit (0.7*140 + 0.3*80 = 122) and write this value over the node
2.

 At the decision node 1, we select the decision alternative with the

higher expected profit. Because max (122;110) = 122, introducing
the new product is profitable.

 We write the maximum expected profit over the node 1 and draw
double lines (//) through the branch representing the inferior
(worse) decision alternative.
Exercise :
 Formulate the tree that represents a decision tree for the order
planning problem given in the following table with the
probabilities of 0.3, 0.5 and 0.2 for low, moderate and high
demand respectively. Them make a decision.
 The decision tree for order planning:
 The use of a decision table in comparison with the use of a
decision tree may seem easier and simpler when the decision
problem becomes simple.

 As the decision problem becomes more complex, the decision

tree becomes more valuable in organizing the information
needed to make the decision.

 This is especially true if the decision maker must make a

sequence of decisions, rather than a single decision, as the next
example illustrates.
 Suppose the marketing manager of a firm is trying to decide whether or not to
market a new product and at what price to sell it.
 The profit to be made depends on whether or not a competitor will introduce a
similar product and on what price the competitor charges.
 Note that there are two decisions: (1) introduce the product or not, and (2) the
price to charge.
 Likewise, there are two events: (1) competition introduces a competitive
product (or not), and (2) the competitor’s price.
 The timing or sequence of these decisions and events is very important in this
decision.
 If the marketing manager must act before knowing whether or not the
competitor has a similar product, the price may be different than with such
knowledge.
 A decision tree is particularly useful in this type of situation, since it displays
the order in which decisions are made and events occur as can be seen next.
 Suppose that the firm must decide whether or not to market its new product
shortly. However, the price decision can be made later.
 If the competitor is going to act, it will introduce its product within a month.
In three months, the firm will establish and announce its price.
 Note that the given problem is a sequential decision problem.
 The firm must make a decision now about introduction and subsequently set
price, after learning about the competitor’s action.
 This structure of the problem is diagrammed in the decision tree in the
following picture.
 Estimated profits for every path through the tree are shown at the ends of the
tree.
 The probabilities for each event are shown under the event branches.
 Note that the probabilities for the competitor’s price behavior are different
when the firm’s price is high than when the firm’s price is medium or low.
 A decision tree for a sequential decision problem:

 After the analysis of the drawn decision tree the following strategy can be
recommended to the firm:
 Introduce the new product and charge a high price if there is no
competitive entry; but charge a medium price if there is competition.
 For this strategy, the expected profit is $156,000.
 Chapter Five: Game Theory
 Game theory deals with decision making under conflict or competition.
 Decision making of this type appears in parlor games (from this area some
terms in game theory were adopted).
 There are many examples of real-life game theory problems: international
military conflicts, choice of marketing strategies, labor-management
negotiations, potential mergers and so on.
 Game theory has its beginning in the 1920’s, but its greatest advance
occurred in 1944.
 The main characteristic of games is that two or more decision makers with
conflicting objectives are involved and the consequences of the decisions
(payoffs) to each depend on the courses of action taken by all.
 Each decision maker is usually trying to maximize his welfare at the expense
of the others.
 The following basic terms are used in game theory:
 Play: is a one-shot decision in a conflict situation.
 Game: is a series of repetitive decisions (plays).
 Player: is an active participant of the game (it may be a single person or
a group of persons with the same interests).
 Strategy: is a predetermined plan for selecting a course of action. A set of
strategies for a player forms a space of strategies for this player.
 Payoff: is a numerically expressed consequence of the decisions of the
players. The payoff depends on the choice of the strategies of all players
and therefore we speak about payoff function.
 Value of a game: is an average payoff per play. A game whose value is
zero is called a fair game.
 A solution to game problems provides us with
answers to these two questions:

 What strategy should each player follow to maximize

his/her welfare.

 What will the payoff to each player be if the recommended

strategy is followed.
 In game theory, two or more decision makers, called players,
compete against each other.

 Each player selects one of several strategies without knowing in

advance the strategy selected by the other player or players.

 The combination of the competing strategies provides the value

of the game to the players.

 Game theory applications have been developed for situations in

which the competing players are teams, companies, political
candidates, and contract bidders.
5.1. Two-person, zero-sum games
 Two-person means that two players participate in the game.

 Zero-sum means that the gain (or loss) for one player is equal
to the loss (or gain) for the other player.

 As a result, the gain and loss balance out (resulting in a zero-

sum) for the game.

 What one player wins, the other player looses.

 Let us demonstrate a two-person, zero-sum game and its

solution by considering two companies competing for market
share.
 Suppose that two companies are the only manufacturers of a particular
product; they compete against each other for market share. In planning a
marketing strategy for the coming year, each company will select one of three
strategies designed to take market share from the other company. The three
strategies, which are assumed to be the same for both companies, are as
follows:

 Strategy 1: Increase advertising

 Strategy 2: Provide quantity discounts
 Strategy 3: Extend warranty
 Payoff table showing the percentage gain in market share for
company A

Company B
Increase Quantity Extend
advertizing b1 discount b2 Warranty b3
Increase Advertizing a1 4 3 2

Company A Quantity discount a2 -1 4 1

Extend warranty 5 -2 0

• A payoff table showing the percentage gain in the market share for Company A for
each combination of strategies .
• Because it is a zero-sum game, any gain in market share for Company A is a loss in
market share for Company B.
• In interpreting the entries in the table, we see that if Company A increases
advertising (a1) and Company B increases advertising (b1), Company A will come
out ahead with an increase in market share of 4%, while Company B will have a
decrease in market share of 4%.
 If Company A provides quantity discounts (a2) and Company B
increases advertising (b1), Company A will lose 1% of market
share, while Company B will gain 1% of market share.

 Therefore, Company A wants to maximize the payoff that is its

increase in market share. Company B wants to minimize the
payoff because the increase in market share for Company A is
the decrease in market share for Company B.
 This market-share game meets the requirements of a two-person,
zero-sum game.
 The two companies are the two players, and the zero-sum occurs
because the gain (or loss) in market share for Company A is the
same as the loss (or gain) in market share for Company B.

 Each company will select one of its three alternative strategies.

 Because of the planning horizon, each company will have to

select its strategy before knowing the other company’s strategy.

 What is the optimal strategy for each company?

 The logic of game theory assumes that each player has the same information
and will select a strategy that provides the best possible payoff from its point of
view.
 Suppose Company A selects strategy a1. Market share increases of 4%, 3%, or
2% are possible depending upon Company B’s strategy. At this point, Company
A assumes that Company B will select the strategy that is best for it.

 Thus, if Company A selects strategy a1, Company A assumes Company B will

select its best strategy b3, which will limit Company A’s increase in market
share to 2%. Continuing with this logic, Company A analyzes the game by
protecting itself against the strategy that may be taken by Company B.

 Doing so, Company A identifies the minimum payoff for each of its strategies,
which is the minimum value in each row of the payoff table as indicated in the
following table.
 Considering the entries in the Row Minimum, we see that
Company A can be guaranteed an increase in market share of at
least 2% by selecting strategy a1.

 Strategy a2 could result in a decrease in market share of 1% and

strategy a3 could result in a decrease in market share of 2%.

 After comparing the row minimum values, Company A selects

the strategy that provides the maximum of the row minimum
values. This is called a maximin strategy.

 Thus, Company A selects strategy a1 as its optimal strategy; an

increase in market share of at least 2% is guaranteed.
 Let us now look at the payoff table from the point of
view of the other player, Company B.

 The entries in the payoff table represent gains in

market share for Company A, which corresponds to
losses in market share for Company B.
 Payoff table with row minimum
Company B

Increase Quantity Extend Row

advertizing b1 discount b2 Warranty b3 Minimum
Increase 4 3 2 2
Advertizing a1 (maximum)
Company A
Quantity -1 4 1 -1
discount a2
Extend 5 -2 0 -2
warranty a3
 Consider what happens if Company B selects strategy b1.
 Company B market share decreases of 4%, –1%, and 5% are possible.
 Under the assumption that Company A will select the strategy that is best for it
 Company B assumes that Company A will select strategy a3, resulting in a
gain in market share of 5% for Company A and a loss in market share of 5%
for Company B. At this point, Company B analyzes the game by protecting
itself against the strategy taken by Company A.
 Doing so, Company B identifies the maximum payoff to Company A for each
of its strategies b1, b2, and b3. This payoff value is the maximum value in
each column of the payoff table.

 Considering the entries in the Column Maximum, Company B can be

guaranteed a decrease in market share of no more than 2% by selecting the
strategy b3.

 Strategy b1 could result in a decrease in market share of 5% and strategy b2

could result in a decrease in market share of 4%.

 After comparing the column maximum values, Company B selects the

strategy that provides the minimum of the column maximum values. This is
called a minimax strategy.
Payoff table with column maximum values
Company B

Increase Quantity Extend Row

advertizing b1 discount b2 Warranty b3 Minimum
Increase 4 3 2 2
Advertizing a1 (maximum)
Company A
Quantity -1 4 1 -1
discount a2
Extend 5 -2 0 -2
warranty a3
Column 5 4 2
Maximum (Minimum)

 Thus, Company B selects b3 as its optimal strategy in which it has

guaranteed that Company A cannot gain more than 2% in market share as
shown in the above table.
 Therefore, Company A selects the strategy of increase advertizing, while
Company B selects the strategy of extend warranty (optimal strategies).
5.2. Pure strategies: Game with Saddle point
 If it is optimal for both players to select one strategy and stay with
that strategy regardless of what the other player does, the game has
a pure strategy solution.

 Whenever the maximum of the row minimums equals the

minimum of the column maximums, the players cannot improve
their payoff by changing to a different strategy.
 The game is said to have a saddle point, or an equilibrium point.

 Thus, a pure strategy is the optimal strategy for the players.

 A Game has a Pure Strategy Solution if:

 Maximum (Row minimums) = Minimum (Column maximums)

 For the equality in the case of our example, the solution to the
game is for Company A to increase advertising (strategy a1) and
for Company B to extend the warranty (strategy b3).

 Company A’s market share will increase by 2% and Company B’s

market share will decrease by 2%.

 With Company A selecting its pure strategy a1, let us see what
happens if Company B tries to change from its pure strategy b3.
 Company A’s market share will increase 4% if b1 is selected or will
increase 3% if b2 is selected.
 Company B must stay with its pure strategy b3 to limit Company A to a 2%
increase in market share.
 Similarly, with Company B selecting its pure strategy b3, let us see
what happens if Company A tries to change from its pure strategy
a1.

 Company A’s market share will increase only 1% if a2 is selected or will not
increase at all if a3 is selected.

 Company A must stay with its pure strategy a1 in order to keep its 2%
increase in market share.

 Thus, even if one of the companies discovers its opponent’s pure strategy in
advance, neither company can gain any advantage by switching from its
pure strategy.
 If a pure strategy solution exists, it is the optimal solution to the game.
 The following steps can be used to determine when a game has a pure strategy
solution and to identify the optimal pure strategy for each player:

Step 1: Compute the minimum payoff for each row (Player A).
Step 2: For Player A, select the strategy that provides the maximum of the
row minimums.
Step 3: Compute the maximum payoff for each column (Player B).
Step 4: For Player B, select the strategy that provides the minimum of the
column maximums.
Step 5: If the maximum of the row minimums is equal to the minimum of the
column maximums, this value is the value of the game and a pure strategy
solution exists.

 The optimal pure strategy for Player A is identified in Step 2, and the optimal
pure strategy for Player B is identified in Step 4.
 If the maximum of the row minimums does not equal the
minimum of the column maximums, a pure strategy solution
does not exist.
 In this case, a mixed strategy solution becomes optimal.

 In the following discussion, we define a mixed strategy

solution and show how linear programming can be used to
identify the optimal mixed strategy for each player.
 5.3 Mixed strategies: Game without saddle point
 A mixed strategy game occurs when each player selects an
optimal strategy and they do not result in an equilibrium .
 The following example will demonstrate a mixed strategy game. The Colorid
camera company (company I) is going to introduce a new instant camera in to
its product line and hopes to capture large market share as possible. In
contrast, Camco Camera company (Company II) hopes to minimize Coloroid’s
market share increase.
 The strategies for each company are based on their promotional
campaigns, packaging, and cosmetic differences between the
products. Each player will first determine an optimal probability
distribution for selecting whether to increase promotion,
packaging or cosmetic differences.
 Then, when the game is played, each player will use his
probability distribution to randomly select one of his three
strategies.
 Payoff Table for Camera Companies
Company II
Camera Company I Strategies
Strategies
Promotion Packaging Cosmetic (b3)
(b1) (b2)

Promotion (a1) 9 7 2
Packaging (a2) 11 8 4
Cosmetic (a3) 4 1 7

 The values in the table are the percentage increases or decreases in market
share for Company I and II.
 The first step is to check the payoff table for any dominant strategy. Doing
so, we find that strategy a2 dominates strategy a1, and strategy b2 dominates
strategy b1.
 Thus, strategies a1 and b1 can be eliminated from the pay off
table and the following new payoff table will be formed.

Company II
Company I strategies
Strategies Packaging (b2) Cosmetic (b3)

Packaging (a2) 8 4
Cosmetic (a3) 1 7
 We apply the maximin decision criterion to the strategies for Company A
(offensive player).
 The minimum value for strategy 2 is 4% and the minimum value for strategy 3
is 1%.
 The maximum of these two minimum values is 4%, thus, strategy 2 is the
optimal strategy for company I.
 Payoff table with Maxmin Criterion

Company I Company II strategies

Strategies
b2 b3

a2 8 4
Maximum of the minimum values

a3 1 7
 Now the minimax decision criterion is applied to the strategies
for company II ( defensive player).

 The maximum value for strategy b2 is 8%, and the maximum

value for strategy b3 is 7%. Of these two maximum values, 7% is
the minimum; which is the optimal strategy for Company II.

Company I Company II strategies

Strategies b2 b3

a2 8 4
a3 1 7
Minimum of maximum values
 Company I and II combined strategies
Company I Company II strategies
Strategies
b2 b3

a2 8 4 (Company I)

a3 1 7 (Company II)

 The strategies selected by the companies do not result in an

equilibrium point. Therefore, this is not a pure strategy game.
 In fact this condition will not result in any strategy for either
firm.
 The companies come back where they started and they complete a
closed loop which could continue indefinitely if the two
companies persisted.

Company I Company
Strategies II
strategies
b2 b3
a2 8 4
a3 1 7

 The most common methods for solving mixed strategy games are
the expected gain and loss method (analytical) and linear
programming.
 Expected Gain and Loss method

 It is based on the principle that in a mixed strategy game, a plan

of strategies can be developed by each player so that:

 the expected gain of the maximizing player or the expected loss of the
minimizing player will be the same, regardless of what the opponent
does.
 In this method the player is indifferent to the opponent’s action.

 This method is based on the concept of expected values.

 The mixed strategy for the two camera companies will be used
to demonstrate the expected gain and loss method.
 First we will compute the expected gain for company I.

 Company I arbitrarily assumes that Company II will select

strategy b2.

 Given this condition, there is a probability of p that Company I

will select strategy a2 and 1-p that company I will select
strategy a3. Thus, if Company II selects b2, the expected gain
for Company I will be:
8p+1(1-p) = 1+7p
 Next, Company I assumes that Company II will select strategy b3.

 Given strategy b3, there is a probability of p that Company I will

select strategy a2 and a probability of 1-p that company I will
select strategy a3.

 Thus, the expected gain for Company I given strategy b3 is:

4p+7(1-P) = 7-3p
 If company I is indifferent to whether Company II selects
strategy b2 or b3, we can simply equate the expected gain from
each of these strategies:
1+7p = 7-3p
10p= 6
P=6/10=0.60
 Recall that p is the probability of using strategy a2 or the
percentage of time strategy a2 would be employed.

 Thus, company I’s plan is to use strategy a2 for 60% of the time
and to use strategy a3 the remaining 40% of the time.
 The expected gain (market share increase for company I) can be
computed using the payoff of either strategy b2 or b3 since the
gain will be the same regardless.
EG (Company I)=0.60(8)+0.40(1)
= 5.2 % market share increase

 In order to check this result, we will compute the expected gain

if strategy b3 is used by Company II.
EG (Company I) = 0.60 (4) +0.40(7)
= 5.2% market share increase
 We must also repeat the above process for Company II to develop its mixed
strategy (Company II’s expected loss).
 First, we assume that company I will select strategy a2.
 Thus, company II will employ strategy b2 for p probability (percentage of the
time) and b3 for the remaining 1-p probability( percent of the time). Thus, the
expected loss for company II is:
8p+4(1-p) = 4+4p
 Next, we compute the expected loss for company II given that Company I
selects strategy a3.
1p + 7(1-p)= 7-6p
By equating the two expected losses for strategies a2 and a3, the
result of p and 1-p will be
4+4p= 7-6p
10p = 3
P= 3/10
P= 0.30 and 1-p = 0.70
 Since p is the probability of employing strategy b2, Company II
will employ strategy b2 for 30% of the time and thus strategy b3
will be employed 70% of the time.

 The actual expected loss given strategy a2 (which is the same as

that for strategy a3) is computed as:
EL(Company II) = 0.30 (8) +0.70 (4)
= 5.2% market share loss.
 The mixed strategies for each company are summarized as
follows:
Company I
Strategy a2: 60% of the time
Strategy 3: 40% of the time
Company II
Strategy b2: 30% of the time
Strategy b3: 70% of the time
 5.4. Dominant Strategy
 Dominance of strategy occurs when all the payoffs for one
strategy are better than the corresponding payoffs for another
strategy.
 Let’s see the following table:
Athlete /agent
Strategies General manager strategies
A B C
1 $50,000 $35000 $30,000
2 $60,000 $40,000 $20,000
 In the above table, values $30,000 and $20,000 are both lower than the
corresponding payoffs of $50,000 and $60,000 for strategy A and the
corresponding payoffs $35,000 and $40,000 for strategy B.
 Since strategy C dominates A and B, these two latter strategies can be
eliminated from consideration in case of payment to be made by general
manger to the athlete/agent.
 If this approach had been done, strategy C could have been
selected automatically without applying the minimax criterion.
 Thus, the most efficient approach is to first examine the payoff
table for dominance in order to possibly reduce its size.

Athlete/agent General Manager Strategies

Strategies

C
1 $30,000
2 $20,00
 The optimal strategy for each player in this game resulted in the
same payoff game value of $30,000 which is classified as a pure
strategy game.

 Since the outcome of a $30,00 results from a pure strategy, it is

referred to as an equilibrium point or saddle point. A point of
equilibrium is a value that is simultaneously the minimum of a
row and the maximum of a column as $30,000 indicated above.