Chapter Six

Game Theory
1
Game Theory
• In decision analysis, All the decision situations involved one
decision maker. There were no competitors whose decisions
might alter the decision maker's analysis of a decision situation.
• However, many situations do, in fact, involve several decision
makers who compete with one another to arrive at the best
outcome.
• These types of competitive decision-making situations are the
subject of game theory.
• Although the topic of game theory encompasses a different type
of decision situation than does decision analysis,
• Many of the fundamental principles and techniques of decision
making apply to game theory as well.

2
• Thus, game theory is, in effect, an extension of decision
analysis rather than an entirely new topic area.
• Game theory addresses decision situations with two or
more decision makers in competition.
• Anyone who has played card games or board
games is familiar with situations in which
competing participants develop plans of action to
win.
• Game theory encompasses similar situations in
which competing decision makers develop plans
of action to win.
• In addition, game theory consists of several
mathematical techniques to aid the decision
maker in selecting the plan of action that will
result in the best outcome. 3
Types of Game Situations
• Competitive game situations can be
subdivided into several categories.
• One classification is based on the number of
competitive decision makers called; players
involved in the game.
• A game situation consisting of two players is
referred to as a two-person game.
• When there are more than two players, the game
situation is known as an n-person game.
• A two-person game encompasses two players
4
• Games are also classified according to their
outcomes in terms of each player's gains and
losses.
• If the sum of the players' gains and losses equals
zero, the game is referred to as a zero-sum game.
• In a two-person game, one player's gains represent
another's losses. For example, if one player wins
$100, then the other player loses $100; the two
values sum to zero (i.e., +$100 and -$100).
• Alternatively, if the sum of the players' gains and
losses does not equal zero, the game is known as a
non-zero-sum game.
• In a zero-sum game, one player's gains represent
another's exact losses.

5
• The two-person, zero-sum game is the one most
frequently used to demonstrate the principles of
game theory because it is the simplest
mathematically.
• Thus, we will confine our discussion of game
theory to this form of game situation.
• The complexity of the n-person game situation
not only prohibits us from demonstrating it but
also restricts its application in real-world
situations.

6
 The Two-Person, Zero-Sum Game
• Examples of competitive situations that can be
organized into two-person, zero-sum games include.
1. A union negotiating a new contract with
management;
2. Two armies participating in a war game;
3. Two politicians in conflict over a proposed
legislative bill, one attempting to secure its passage
and the other attempting to defeat it;
4. A retail firm trying to increase its market share
with a new product and a competitor attempting to
minimize the firm's gains; and
5. A contractor negotiating with a government agent
for a contract on a project.
7
• The following example will demonstrate a two-
person, zero-sum game.
• A professional athlete, Biff Rhino, and his
agent, Jim Fence, are renegotiating Biff's
contract with the general manager of the Texas
Buffaloes, Harry Sligo.
• The various outcomes of this game situation can
be organized into a payoff table similar to the
payoff tables used for decision analysis.
• The payoff table for this example is shown in
the following table;
8
 Payoff Table for Two-Person, Zero-Sum Game

General Manager Strategy

A B C
• Athlete 1. $50,000 $35,000 $30,000
/Agent Strategy 2. 60,000 40,000 20,000

9
• The payoff table for a two-person game is organized
so that the player who is trying to maximize the
outcome of the game is on the left and the player
who is trying to minimize the outcome is on the
top.
• The athlete and agent want to maximize the
athlete's contract, and the general manager hopes to
minimize the athlete's contract.
• In a sense, the athlete is an offensive player in the
game, and the general manager is a defensive
player.
• In game theory, it is assumed that the payoff table is
known to both the offensive player and the
defensive player an assumption that is often
unrealistic in real-world situations and thus restricts
the actual application of this technique.
10
• In a game situation, it is assumed that the payoff
table is known to all players.
• A strategy is a plan of action that a player follows.
• Each player in a game has two or more strategies,
only one of which is selected for each playing of a
game.
• In the above Table the athlete and his agent have
two strategies, 1 and 2, and the general manager
has three strategies, A, B, and C.
• The values in the table are the payoffs or
outcomes associated with each player's strategies.
11
• The athlete's strategies involve different types of
contracts and the threat of a holdout and/or of
becoming a free agent.
• The general manager's strategies are alternative
contract proposals that vary with regard to such
items as length of contract, residual payments, no-
cut/no-trade clauses, and off-season promotional
work.
• The outcomes are in terms of dollar value.
• If the athlete selects strategy 2 and the general
manager selects strategy C, the outcome is a $20,000
gain for the athlete and a $20,000 loss for the general
manager.
• This outcome results in a zero sum for the game (i.e.,
+$20,000 -20,000 = 0).
• The amount $20,000 is known as the value of the
game. 12
• The value of the game is the offensive player's gain and
the defensive player's loss in a zero-sum game.
• The purpose of the game for each player is to select the
strategy that will result in the best possible payoff or
outcome, regardless of what the opponent does.
• The best strategy for each player is known as the optimal
strategy.
• Next, we will discuss methods for determining strategies.
• The best strategy for each player is his or her optimal
strategy.

13
 A Pure Strategy
• When each player in a game adopts a single
strategy as an optimal strategy, the game is a
pure strategy game.
• The value of a pure strategy game is the same for
both the offensive player and the defensive
player.
• In contrast, in a mixed strategy game, the players
adopt a mixture of strategies if the game is played
many times.
• In a pure strategy game, each player adopts a
single strategy as an optimal strategy.
14
• A pure strategy game can be solved according to
the mini-max decision criterion.
• According to this principle, each player plays the
game to minimize the maximum possible losses.
• The offensive player selects the strategy with the
largest of the minimum payoffs (called the maxi-
min strategy), and
• The defensive player selects the strategy with the
smallest of the maximum payoffs (called the
mini-max strategy).

15
• In our example involving the athlete's contract
negotiation process, the athlete will select the
maxi-min strategy from strategies 1 and 2, and
• The general manager will select the minimax
strategy from strategies A, B, and C.
• We will first discuss the athlete's decision,
although in game theory the decisions are
actually made simultaneously.

16
• With the mini-max decision criterion, each player seeks
to minimize maximum possible losses;
• The offensive player selects the strategy with the largest
of the minimum payoffs, and the defensive player selects
the strategy with the smallest of the maximum payoffs.
• To determine the maxi-min strategy, the athlete first
selects the minimum payoff for strategies 1 and 2, as
shown in Table E.2.
• The maximum of these minimum values indicates the
optimal strategy and the value of the game for the
athlete.

17
 Payoff Table with Maxi-min Strategy

General Manager Strategy

• Athlete
/Agent Strategy
• A B C
• 1 $50,000 $35,000 $30,000*
• 2 60,000 40,000 20,000
• *=max.of min.payoffs

18
• The value $30,000 is the maximum of the minimum
values for each of the athlete's strategies.
• Thus, the optimal strategy for the athlete is strategy
1. The logic behind this decision is as follows.
• If the athlete selected strategy 1, the general
manager could be expected to select strategy C,
which would minimize the possible loss (i.e., a
$30,000 contract is better for the manager than a
$50,000 or $35,000 contract).
• Alternatively, if the athlete selected strategy 2, the
general manager could be expected to select strategy
C for the same reason (i.e., a $20,000 contract is
better for the manager than a $60,000 or $40,000
contract).
19
• Now, because the athlete has anticipated how the
general manager will respond to each strategy, he
realizes that he can negotiate either a $30,000 or a
$20,000 contract.
• The athlete selects strategy 1 in order to get the larger
possible contract of $30,000, given the actions of the
general manager.
• Simultaneously, the general manager applies the
mini-max decision criterion to strategies A, B, and C.
• First, the general manager selects the maximum
payoff for each strategy.
• The minimum of these maximum values determines
the optimal strategy and the value of the game for the
general manager.

20
 Payoff Table with Mini-max Strategy

General Manager Strategy

• Athlete
/Agent Strategy
• A B C
• 1 $50,000 $35,000 $30,000*
• 2 60,000 40,000 20,000
• $=min.of the max.

21
• The value $30,000 is the minimum of the maximum
values for each of the strategies of the general manager.
• Thus, the optimal strategy for the general manager is C.
• The logic of this decision is similar to that of the athlete's
decision.
• If the general manager selected strategy A, the athlete
could be expected to select strategy 2 with a payoff of
$60,000 (i.e., the athlete will choose the better of the
$50,000 and $60,000 contracts).
• If the general manager selected strategy B, then the
athlete could be expected to select strategy 2 for a payoff
of $40,000.
• Finally, if the general manager selected strategy C, the
athlete could be expected to select strategy 1 for a payoff
of $30,000.
22
• Because the general manager has anticipated how
the athlete will respond to each strategy, he
realizes that either a $60,000, $40,000, or $30,000
contract could possibly be awarded.
• Thus, the general manager selects strategy C,
which will result in the minimum contract of
$30,000.
• In general, the manager considers the worst
outcome that could result if a particular strategy
were followed.
• Under the mini-max criterion, the general
manager will select the strategy that ensures that
the loses only the minimum of the maximum
amounts that could be lost. 23
 Dominant Strategies Cont’d…
• Dominance occurs when all the payoffs for one
strategy are better than the corresponding
payoffs for another strategy.
• The 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 of $35,000 and $40,000 for strategy B.
• Because strategy C dominates A and B, these
two latter strategies can be eliminated from
consideration altogether.
24
• A strategy is dominated, and can be eliminated, if all
its payoffs are worse than the corresponding payoffs
for another strategy.
• The fact that the optimal strategy for each player in
this game resulted in the same pay-off game value of
$30,000 is what classifies it as a pure strategy game.
• In other words, because strategy 1 is optimal for the
athlete and strategy C is optimal for the general
manager, a contract for $30,000 will be awarded to
the athlete.
• Because the outcome of $30,000 results from a pure
strategy, it is referred to as an equilibrium point (or
sometimes as a saddle point).
• A point of equilibrium is a value that is
simultaneously the minimum of a row and the
maximum of a column, as is the payoff of $30,000. 25
• In a pure strategy game, the optimal strategy
for each player results in the same payoff,
called an equilibrium, or saddle, point.
• The equilibrium point in a game is
simultaneously the minimum of a row and the
maximum of a column.
• The mini-max criterion will result in the
optimal strategies only if both players use it.

26
 A Mixed Strategy
• A mixed strategy game occurs when each player
selects an optimal strategy and the two
strategies do not result in an equilibrium point
(i.e., the same outcome) when the maxi-min and
mini-max decision criteria are applied.
• The Coloroid Camera Company (which we will
refer to as company I) is going to introduce a
new camera into its product line and hopes to
capture as large an increase in its market share as
possible.

27
• In contrast, the Camco Camera Company (which we
will refer to as company II) hopes to minimize
Coloroid's market share increase.
• Coloroid and Camco dominate the camera market,
and any gain in market share for Coloroid will result
in a subsequent identical loss in market share for
Camco.
• The strategies for each company are based on their
promotional campaigns, packaging, and cosmetic
differences between the products.
• The payoff table, which includes the strategies and
outcomes for each company (I = Coloroid and II =
Camco), is shown in the following Table. The values
in the next Table are the percentage increases or
decreases in market share for company I.
28
Payoff Table for Camera Companies
Company II
Strategy
Company I
Strategy
A B C
1 9 7 2
2 11 8 4
3 4 1 7

29
 Contd.
• The first step is to check the payoff table for
any dominant strategies.
• Doing so, we find that strategy 2 dominates
strategy 1, and strategy B dominates strategy
A.
• Thus, strategies 1 and A can be eliminated
from the payoff table.

30
Payoff Table with Strategies 1 and A Eliminated
Company II
Strategy
Company I
Strategy
B C

2 8 4
3 1 7

31
 Contd.
• We apply the maxi-min decision criterion to
the strategies for company I, as shown in the
following Table.
• 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 optimal for company I.

32
Payoff Table with Maximin Criterion

Company II
Strategy
Company I
Strategy
B C

2 8 4 *
3 1 7
Max. of the min. values
33
• Next, we apply the mini-max decision criterion
to the strategies for company II in the above
table.
• The maximum value for strategy B is 8%, and
the maximum value for strategy C is 7%. Of
these two maximum values, 7% is the
minimum;
• Thus, the optimal strategy for company II is C.

34
Payoff Table with Minimax Criterion
Company II
Strategy
Company I
Strategy
B C

2 8* 4
3 1 7**
**=min. of the max. values

35
 Mixed strategy
• Combines the results of the application of the maxi-
min and mini-max criteria by the companies:
Company II
Strategy
Company I
Strategy
B C
2 8 4

3 1 7

36
 Contd.

• We can see that 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.
• Company I maximizes its market share
percentage increase by selecting strategy 2.
• Company II selects strategy C to minimize
company I's market share.
• However, as soon as company I noticed that
company II was using strategy C, it would switch
to strategy 3 to increase its market share to 7%.
37
• This move would not go unnoticed by company
II, which would immediately switch to strategy B
to reduce company I's market share to 1%.
• This action by company II would cause company I
to immediately switch to strategy 2 to maximize its
market share increase to 8%.
• Given the action of company I, company II would
switch to strategy C to minimize company I's
market share increase to 4%.
• Now you will notice that the two companies are
right back where they started.
• They have completed a closed loop.
38
• In a mixed strategy game, a player switches
decisions in response to the decision of the other
player and they eventually return to the initial
decisions, resulting in a closed loop.

THE END!
39
10/24/2022 40
 1 2 3
1 20 10 22
2 30 40 38
3 15 18 25

1 2 3
1 25 20 35
2 50 45 55
3 58 40 42

10/24/2022 41
 1 2
1 3 1
2 2 7

3 1 11

1 2 1 2 3 4
1 9 7 7 1 5 4 1 0
2 5 11 5 2 4 3 2 -1
9 11 3 0 -1 4 3
4 1 -2 1 2

10/24/2022 42