Game Theory

Till now, we have studied economic decision-making in situations where an agent’s payoff is
based on their actions alone. In other words, the payoff to an agent’s actions is known, and the
trick is to figure out how to get the highest payoff. But there are many situations in which the
payoffs to an agent’s actions are determined in part by the actions of other agents.

As for example, one knows that, there are a number of parties going to be held in the winter
season. How much one will enjoy attending any one party is in large part determined by how
many of his friends will be there. In other words, one’s payoff is a function of not only his
decision about which party to attend but also the decisions of his friends. These types of
interactions are called strategic interactions, where agents must anticipate the actions of others
when making their own decisions.

Here, there is game theory to model the situation, so that one can think about the outcomes of
these interactions just like one thinks about outcomes in markets without strategic interaction,
like the price and quantity outcome in a product market. Game theory is thus, the study of
strategic interactions among economic agents. It is extremely useful because it allows one to
anticipate the behavior of economic agents within a game and the outcomes of strategic games.

Game theory gets its name from actual games. Chess is a strategic game where two players
interact, and the outcome of the game is determined by the actions of both players. In economics,
game theory is particularly useful in understanding imperfectly competitive markets like
oligopoly, because the price and output decisions of one firm affect the demand and therefore
profit function of the other firms.

All games have three basic elements: players, strategies, and payoffs. The players of the game
are the agents actively participating in the game and who will experience outcomes based on the
play of all players. The strategies are all the possible strategic choices available to each player;
they can be the same for all players or different for each player. The payoffs are the outcomes
associated with every possible strategic combination for each player. Any complete description
of a game must include these three elements. In the games that we will study in this chapter, we
will assume that each player’s goal is to maximize their individual payoff, which is consistent
with the rational utility maximizing agent that is the foundation of modern economic theory.

Assumption of rationality
Game theory is the science of rational behavior in interactive situations. When one thinks
carefully before he acts, he is said to be behaving rationally; as, he is aware of his objective,
preferences, limitations or constraints of his actions. Game theory provides some general
principles for thinking about strategic interactions. When a person decides to interact with other
people, there must be some cross effect of their actions. What one does must affect the outcome
for the other. For an interaction to become a strategic game, we need the participants’ mutual
awareness of this cross effect. Hence, the most fundamental assumption in game theory is
rationality. It implies that every player is motivated by increasing his own payoff, i.e. every
player is looking to maximize his own utility. Moreover, it is assumed that players are perfect
calculators and flawless followers of their best strategies. It does not mean that players are
selfish. Here, rationality implies pursuing one’s own value system consistently.

Classification of games
On the basis of number of players
Games can be classified into different categories according to certain significant features. A
game can be classified according to the number of players in the game; it can be designated as a
one-player game, two-player game or n-players game. In addition, a player need not be an
individual person; it may be a nation, a corporation, or a team comprising many people with
shared interests.

Game may be played once or repeatedly, with the same or different opponents
Here, there can be one shot games where actions tend to be ruthless. In case of ongoing games,
there is involved opposite considerations. Other concerned issues may be building up of
reputations or learning more about the opponent. The players can also attempt to exploit
mutually beneficial prospects. They may focus on the issue of how to divide a win.
Non-cooperative and cooperative (coalition) games
A game is called non-cooperative when each agent (player) in the game, who acts in her self-
interest, is the unit of the analysis. While the cooperative (coalition) game treats groups or
subgroups of players as the unit of analysis and assumes that they can achieve certain payoffs
among themselves through necessary cooperative agreements.

In non-cooperative games, the actions of each individual player are considered and each player is
assumed to be selfish, looking to improve its own payoff and not taking into account others
involved in the game. So, non-cooperative game theory studies the strategic choices resulting
from the interactions among competing players, where each player chooses its strategy
independently for increasing its own gains or reducing its losses. Conversely, cooperative game
theory assesses the allocation of costs or benefits in a situation where the individual/group
contribution depends on others’ actions.

Games with perfect/imperfect, complete/incomplete, equal/unequal information

A game is said to be a perfect information game if each player, when it is her turn to choose an
action, knows exactly all the previous decisions of other players in the game. Then again, if a
player has no information about other players’ actions when it is her turn to decide, this game is
called imperfect information game.

In games with complete information, all factors of the game are common knowledge to all
players. That is, each individual player is fully aware of other players in the game, their
strategies and decisions and the payoff of each player. As a result, a complete information game
can be represented as an efficient perfectly competitive game.

On the other hand, in the incomplete information games, the players do not have all the
information about other players in the game, which make them not able to predict the effect of
their actions on others. Players can release information selectively. Signals mean actions by the
more informed player and signaling means information given out. Screening implies that the
player can create a situation where their opponent will have to take some action that credibly
reveals his information. These methods are known as screening devices.
Players’ interests may be in total conflict or have some commonality
As in zero sum games, one player’s winnings are the others’ losses. Here, player’ interests are in
complete conflict. Conversely, in some games, players may be dividing up any fixed amount of
possible gain among themselves.

Zero-sum (constant-sum) games and non-zero-sum (variable-sum) game

Another way to categorize games is according to their payoff structure. Generally speaking, a
game is called zero-sum game (sometimes called if one gains, another losses game, or strictly
competitive games) if the player’s gain or loss is exactly balanced to those of other players in the
game. Here, any benefit gained by one player is lost to another. Payoffs to all players will sum to
a constant (like 0) in each cell. In case of non-zero-sum (variable-sum) game, Games in which
players have some common interests, so one does not gain strictly as a rival loses and there is no
simple relationship between payoffs for different players. The game table must show separately,
a payoff for every player in each of its cells.

Nash Equilibrium
In game theory, the Nash Equilibrium method is used to solve non-cooperative games involving
two or more players; in which each player is assumed to know the equilibrium strategies of the
other players, and no player has anything to gain by changing only their own strategy. If each
player has chosen a strategy and no player can benefit by changing strategies while the other
players keep theirs unchanged, then the current set of strategy choices and the corresponding
payoffs constitute Nash equilibrium. At Nash equilibrium, each player must be satisfied with the
strategy choice made, given what other players have chosen. No player should want to change
their strategy once they have seen what their rivals have done.

Game theorists use the Nash equilibrium concept to analyze the outcome of the strategic
interaction of several decision makers. In other words, it provides a way of predicting what will
happen if several people or several institutions are making decisions at the same time, and if the
outcome depends on the decisions of the others. The simple insight underlying the idea is that
one cannot predict the result of the choices of multiple decision makers if one analyzes those
decisions in isolation. Instead, one must ask what each player would do, taking into account the
decision-making of the others.

Informally, a set of strategies is in Nash equilibrium if no player can do better by unilaterally

changing his or her strategy. To see what this means, imagine that each player is told the
strategies of the others. Suppose then that each player asks himself or herself: ‘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? If any player would answer ‘Yes’, then that set of strategies
does not constitute Nash equilibrium. But if every player prefers not to switch (or is indifferent
between switching and not) then the set of strategies is a Nash equilibrium. Thus, each strategy
in Nash equilibrium is the best response to all other strategies in that equilibrium.

Coordination game
The coordination game is a classic (symmetric) two player, two strategy-game, with an example
payoff matrix shown to the right. The players should thus coordinate, both adopting strategy A,
to receive the highest payoff; i.e., 4. If both players chose strategy B though, there is still Nash
equilibrium. Although each player is awarded less than optimal payoff, neither player has
incentive to change strategy due to a reduction in the immediate payoff (from 2 to 1).

Player 2 adopts strategy A Player 2 adopts strategy B

Player 1 adopts strategy A 4/4 1/3
Player 1 adopts strategy B 3/1 2/2

A famous example of this type of game was called the stag hunt; in the game two players may
choose to hunt a stag or a rabbit, the former providing more meat (4 utility units) than the latter
(1 utility unit). The requirement is that the stag must be cooperatively hunted, so if one player
attempts to hunt the stag, while the other hunts the rabbit, he will fail in hunting (0 utility units),
whereas if they both hunt it they will split the payload (2, 2). The game hence exhibits two
equilibria at (stag, stag) and (rabbit, rabbit) and hence the players' optimal strategy depends on
their expectation on what the other player may do. If one hunter trusts that the other will hunt the
stag, he should hunt the stag; however if he suspects that the other will hunt the rabbit, he should
hunt the rabbit.

This game was used as an analogy for social cooperation, since much of the benefit that people
gain in society depends upon people cooperating and implicitly trusting one another to act in a
manner corresponding with cooperation. Another example of a coordination game is the setting
where two technologies are available to two firms with compatible products, and they have to
elect a strategy to become the market standard. If both firms agree on the chosen technology,
high sales are expected for both firms. If the firms do not agree on the standard technology, few
sales result. Both strategies are Nash equilibria of the game.

Finding the Nash equilibrium in normal form games is made relatively easy by following a
simple technique that identifies the best response functions on the payoff matrix itself. Consider
a game, where there are two sellers/players who are competing for many of the same customers
for their product. The first player, A, opens first and sets its price; the second player, B, opens
second and sets its price after observing the price set by A. To keep it simple, three prices, high,
medium and low has been considered.

Payoff Matrix
Player B
Strategy High Medium Low
Player A

High A: 65; B: 44 A: 29; B: 38 A: 44; B: 29

Medium A: 53; B: 41 A: 35; B: 31 A: 19; B: 56
Low A: 30; B: 57 A: 41; B: 63 A: 72; B: 27

If B plays high, for player A, the maximum payoff is 65, which comes from playing high. Hence,
if, B plays high, A should also play high. Moving along the columns, it is found that, A should
play low if B plays medium, and A should play low again if B plays low. Switching perspective,
if A plays high, B gets a maximum payoff from playing high. Continuing on, if A plays medium,
B should play low, and if A plays low, B should play medium. Now, that each player’s best
response has been identified, all that remains is to look for outcomes where the best responses
correspond. In this game, the two Nash equilibriums are (high, high) and (low, medium).

Let now, payoffs in the game are changed as is shown below. If B plays high, for player A, the
maximum payoff is 65, which comes from playing low. Hence, if, B plays high, A should play
low. Moving along the columns, it is found that, A should play low if B plays medium, and A
should play low again if B plays low. Switching perspective, if A plays high, B gets a maximum
payoff from playing medium. Continuing on, if A plays medium, B should also play medium,
and if A plays low, B should play medium. So now that we have identified each player’s best
response functions, all that remains is to look for outcomes where the best responses correspond.

Payoff Matrix
Player B
Strategy High Medium Low
Player A

High A: 30; B: 41 A: 29; B: 44 A: 44; B: 24

Medium A: 53; B: 33 A: 35; B: 56 A: 19; B: 39
Low A: 65; B: 57 A: 41; B: 63 A: 72; B: 27

It is noticed that each player has a dominant strategy, as seen by the three red figures all in the
row ‘low’ for player A and all three green figures are in the column ‘medium’ for player B. That
is ‘low’ is always the best strategy choice for player A no matter what player B chooses, and
‘medium’ is always the right strategic choice for player B no matter what player A chooses.
A dominant strategy is a strategy for which the payoffs are always greater than any other strategy
no matter what the opponent does. Moreover, the dominant strategy equilibrium (low, medium)
also fulfills the requirements of Nash equilibrium.

This will always be true of dominant strategy equilibriums: all dominant strategy equilibriums
are Nash equilibriums. From the example above, however, we know the reverse is not true: not
all Nash equilibriums are dominant strategy equilibriums. So dominant strategy equilibriums are
a subset of Nash equilibriums, or to put it in another way, the Nash equilibrium is a more general
concept than the dominant strategy equilibrium.
Simultaneous/strategic and sequential/extensive games
In case of simultaneous game, the players make their own decisions simultaneously at the
beginning of the game; and, the players have no information about the actions of the other
players in the game. That is, the players choose their actions at exactly the same time. The
prisoner’s dilemma is a strategic game. A game is simultaneous when players choose their
actions in isolation, with no information about what other players have done or will do. In this
case, the players must figure out what his opponent is going to do right at that point. The
opponent also tries to figure out this player’s current move, while recognizing he is doing the
same with him. It is also known as games of imperfect information or imperfect knowledge.
Strategies for simultaneous-move games cannot be made contingent on another’s action, as is
possible with sequential-move games.

Alternatively, if players have some information about the choices of other players, the game is
usually presented in sequentially or in extensive form (sometimes called as a game tree).
Sequential move games are games where players take turns making their strategic choices: one
player observes their opponent’s choice prior to making their own strategic choice. Chess is a
good example of sequential games.

Here, one player moves, the other player observes the move and then responds with their own
move, and so on. In other words, in case of sequential game, the player attempts to assume, if he
moves in some way, how his opponent will react. In this case, current move of any player is
governed by his calculation of its future consequences. Here, games have strict order of play;
players take turns making their moves. Moreover, they know what players who have gone before
them have done. They utilize interactive thinking and decide their current moves based on
calculations of future consequences.

Game Tree
Sequential games are also called extensive form games. These games are illustrated by drawing
a game tree; which describes all the principal elements of the game: the players, the strategies,
and the payoffs. In other words, the diagram describes the players, their turns, all of their choices
at every turn, all possible actions and the payoffs for every possible set of strategy choices. The
players are described at each decision node of the game, each place where a player might
potentially have to choose a strategy. From each node, branches extend, representing the strategy
choices of a player. At the end of the final set of branches are the payoffs for every possible
outcome of the game. That is, game tree contains the complete description of the game.

Game Tree

High: 400, 380

Player B Medium: 340*, 410*
Low: 230, 330
High High: 400, 340
Player A Medium Player B Medium: 360, 350
Low: 210, 360*
Low High: 370, 300
Medium: 350, 260
Player B Low: 320, 310*

In this game, player ‘A’ is at the first decision node, so he moves first. Player ‘B’ is at the second
set of decision nodes, so he moves second. How will the game resolve itself? To determine the
outcome, it is necessary to use backward induction: to start at the last play of the game and
determine what the player with the last turn of the game will do in each situation and then, given
deduction, determine what the payer with the second-to-last turn will do at that turn and continue
this way until the first turn is reached. Using backward induction leads to the subgame perfect
Nash equilibrium of the game. The subgame perfect Nash equilibrium is the solution in which
every player, at every turn of the game, is playing an individually optimal strategy.

In above case, it is found by first determining what player B will do for each possible play by A.
Player B is only concerned with his payoffs shown right hand side, and will play medium if A
plays high and thus will get 410. He will play low if A plays medium and will get 360. He will
play low if A plays low and will get 310. Because of common knowledge, A knows this as well
and so has only three possible outcomes. A knows that if he plays high, B will play medium, and
A will get 340; if he plays medium, B will play low, and A will get 210; and if he plays low, B
will play low, and A will get 320. Since 340 is the best of the possible outcomes, A will pick
high. Since A picks high, B will pick medium, and the game ends.

Since the best response changes for both players depending on the strategy choice of the other
player, we know immediately that neither one has a dominant strategy. What then? How do we
think about the outcome of the game? The solution concept most commonly used in game theory
is the Nash equilibrium concept. Nash equilibrium is an outcome where, given the strategy
choices of the other players, no individual player can obtain a higher pay off by altering their
strategy choice.

An equivalent way to think about Nash equilibrium is that it is an outcome of a game where all
players are simultaneously playing a best response to the others’ strategy choices. The
equilibrium is intuitive if, when placed in a certain outcome, no player wishes to unilaterally
deviate from it, which means equilibrium is achieved, there are no forces within the game that
would cause the outcome to change.