Topic 1: Introduction

1.1 What is Game Theory?

Game theory is the study of multi-person decision problems. Such problems arise
frequently in economics and business. Game theory studies the strategic interactions
between multiple decision-makers such as firms, governments, central banks and
trade unions, known as players, in situations where the outcome of each player's
choice depends on the choices made by others. It provides a framework for analyzing
and understanding the strategic interaction of rational agents in competitive or
cooperative situations.

1.1.1 Decisions versus Games

Decisions focus on individual choices made by a single decision-maker. The decision-

maker considers various options and selects the one that they believe will yield the
best outcome for themselves. The outcome is typically independent of the choices
made by others. The decision-maker's choice affects only their own outcome. In
decision-making, the objective is usually to maximize the decision-maker's own utility.

A motivating example: Let's say you have received multiple job offers from different
companies, and you need to decide which offer to accept. You assess various factors
such as salary, benefits, location, work-life balance, career growth opportunities, and
company culture. Based on your personal preferences and priorities, you evaluate
each job offer and weigh the pros and cons. After careful consideration, you make a
decision to accept one of the job offers that you believe aligns best with your goals
and preferences. This decision is made independently and does not involve
interactions or considerations of other decision-makers.

In contrast to decisions, there is interdependency among different individuals in a

game. Games involve multiple decision-makers, known as players, who interact
strategically with each other. In games, players also aim to maximize their own utility
or payoff, but the outcome depends not only on their individual objectives but also
on the strategies chosen by other players. The interaction between players introduces
competition or cooperation dynamics that shape the outcomes.

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A business example: Consider the scenario of two rival companies, Company A and
Company B, competing in the smartphone market. Both companies are about to
release their latest flagship smartphones, and they have to make decisions regarding
their pricing strategies.

1. If Company A sets a high price for its smartphone while Company B sets a low
price, Company A may earn higher profits, but it risks losing market share to
Company B.
2. If both companies set high prices, they may both earn substantial profits, but
there is a chance that potential customers will be deterred by the high prices,
leading to lower overall sales.
3. If both companies set low prices, they may attract more customers and increase
market share, but profit margins may be reduced.

Both companies are aware of the potential outcomes and the strategies available to
their rival. They must anticipate the other company's pricing decision and consider
their own objectives, market conditions, and consumer behavior. This game represents
a classic example of strategic competition in the business world. The companies'
decisions are interdependent, as the outcome for each company depends not only
on its own pricing strategy but also on the strategy chosen by its competitor.

1.2 Individual Decision Making: A Lottery Choice Experiment

Imagine you have a 10-sided dice. Now, it's time for you to make a decision. You must
choose whether you want to participate in lottery A or B by referring to the table
below.

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 Lottery A Lottery B Your choice
A or B
D1 $2.00 if throw of dice is 1 $3.85 if throw of dice is 1
$1.60 if throw of dice is 2-10 $0.10 if throw of dice is 2-10
D2 $2.00 if throw of dice is 1-2 $3.85 if throw of dice is 1-2
$1.60 if throw of dice is 3-10 $0.10 if throw of dice is 3-10
D3 $2.00 if throw of dice is 1-3 $3.85 if throw of dice is 1-3
$1.60 if throw of dice is 4-10 $0.10 if throw of dice is 4-10
D4 $2.00 if throw of dice is 1-4 $3.85 if throw of dice is 1-4
$1.60 if throw of dice is 5-10 $0.10 if throw of dice is 5-10
D5 $2.00 if throw of dice is 1-5 $3.85 if throw of dice is 1-5
$1.60 if throw of dice is 6-10 $0.10 if throw of dice is 6-10
D6 $2.00 if throw of dice is 1-6 $3.85 if throw of dice is 1-6
$1.60 if throw of dice is 7-10 $0.10 if throw of dice is 7-10
D7 $2.00 if throw of dice is 1-7 $3.85 if throw of dice is 1-7
$1.60 if throw of dice is 8-10 $0.10 if throw of dice is 8-10
D8 $2.00 if throw of dice is 1-8 $3.85 if throw of dice is 1-8
$1.60 if throw of dice is 9-10 $0.10 if throw of dice is 9-10
D9 $2.00 if throw of dice is 1-9 $3.85 if throw of dice is 1-9
$1.60 if throw of dice is 10 $0.10 if throw of dice is 10
D10 $2.00 if throw of dice is 1-10 $3.85 if throw of dice is 1-10

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As an expected payoff maximizer, or a risk-neutral individual, your decision between
lottery A and B relies solely on comparing the expected payoffs. You would choose
option A over B if and only if the expected payoff from A surpasses that of B.

For example, in D1, the expected payoff from lottery A:

𝑝(2) + (1 − 𝑝)(1.6) = 0.1(2) + (1 − 0.1)(1.6) = 1.64
Similarly, the expected payoff from lottery B:
𝑝(3.85) + (1 − 𝑝)(0.1) = 0.1(3.85) + (1 − 0.1)(0.1) = 0.48

The following table shows the expected payoffs for different values of 𝑝. ‘✓’ denotes
the preferred lottery for a risk-neutral individual:

Expected payoff
Lottery A B
D1 1.64 ✓ 0.48
D2 1.68 ✓ 0.85
D3 1.72 ✓ 1.23
D4 1.76 ✓ 1.60
D5 1.80 1.98 ✓
D6 1.84 2.35 ✓
D7 1.88 2.73 ✓
D8 1.92 3.10 ✓
D9 1.96 3.48 ✓
D10 2.00 3.85 ✓

In D10 with no uncertainty an individual should choose lottery B. This is because

lottery B guarantees a higher payoff of 3.85, compared to lottery A which only offers a
payoff of 2.

Different individuals have different tolerance levels of risk and will have different
preferences for decisions 1-9. If you are “very” risk-averse, you might choose lottery
A over B for all decisions 1-9. Similarly, if you are an extreme risk-seeker, you might
choose lottery B over A for all decisions 1-9. Typically, it has been seen that most of
us are risk-averse with the degree of aversion differing across individuals.

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1.3 Elements of a Game

The essential elements of a game are rationality, players, actions (or moves),
strategies, information, payoffs, equilibria and outcomes.

1. Rational agents strive to make optimal decisions within the limits of their
constraints and the information they have at hand. In the realm of economic theory,
this principle is expressed as utility maximization. When faced with uncertain
situations, this concept evolves into expected utility maximization. Moreover, the
notion of "rationality" assumes that all participants possess common knowledge
about each other's rationality, meaning that every player is aware that all others
are rational, and this knowledge extends recursively, with each player knowing that
others know the same, and so on (I know that you know that I know that you
know that……).

2. The players are individuals or other economic agents who make decisions. They
choose actions to maximize their utility.

3. Information available to each player is central to game theory. The information set
is the knowledge available to each player at each point in time. This may include
observations of key variables affecting their utility such as price and the history of
moves of other players up to that point.

4. Each player has a set of possible actions or strategies. Let 𝑆𝑖 be the set of
strategies available to player 𝑖 . Strategies can be mixed strategies where each
player randomizes over pure strategies. We will discuss mixed strategies in Topic 2.

5. Assuming that there are two players in a game, 𝑖 = 1,2. The corresponding to
each combination of actions by all players is a payoff function 𝒖𝒊 (. ). The payoff
function translates actions into payoffs.
For example, the payoff function for player 1 is 𝒖𝟏 (. ). If player 1 chooses high
price and player 2 chooses low price, we can plug in the strategies into the payoff
function: 𝒖𝟏 (𝒉𝒊𝒈𝒉 𝒑𝒓𝒊𝒄𝒆, 𝒍𝒐𝒘 𝒑𝒓𝒊𝒄𝒆). Then, the payoff function will translate
actions into payoffs: 𝒖𝟏 (𝒉𝒊𝒈𝒉 𝒑𝒓𝒊𝒄𝒆, 𝒍𝒐𝒘 𝒑𝒓𝒊𝒄𝒆) = 𝟐 . This means if player 1
chooses high price and player 2 chooses low price, the payoff of player 1 is 2.

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6. An equilibrium is a strategy combination consisting of the best strategy for all
players.

7. There could be many possible outcomes in a game. Corresponding to each

equilibrium is an equilibrium outcome.

Consider a two-player one-shot simultaneous-move game. It is typically summarized

using a payoff matrix as follows:
Player 2
Left (L) Right (R)
Player 1 Up (U) 𝑢1 (𝑈, 𝐿), 𝑢2 (𝑈, 𝐿) 𝑢1 (𝑈, 𝑅), 𝑢2 (𝑈, 𝑅)
Down (D) 𝑢1 (𝐷, 𝐿), 𝑢2 (𝐷, 𝐿) 𝑢1 (𝐷, 𝑅), 𝑢2 (𝐷, 𝑅)

Player 2
Left (L) Right (R)
Player 1 Up (U) (4, 5) (6, 1)
Down (D) (2, 2) (4, 4)

 There are two players: player 1 is the row player and player 2 is the column
player.
 The set of strategies available to player 1 (𝑆1) is U and D. The set of strategies
available to player 2 (𝑆2 ) is L and R.
 Player 1’s payoff function is 𝑢1 (. ) and player 2's payoff function is 𝑢2 (. ). For
example, given player 1’s strategy is U and player 2’s strategy is L, the payoff of
player 1 is 𝑢1 (𝑈, 𝐿) = 4 and the payoff of player 2 is 𝑢2 (𝑈, 𝐿) = 5.
 Possible outcomes of this games are: (𝑈, 𝐿), (𝑈, 𝑅), (𝐷, 𝐿), (𝐷, 𝑅).
 Suppose the best strategy for player 1 is U and the best strategy for player 2 is L,
then the equilibrium is (𝑈, 𝐿) and the equilibrium outcome is player 1 play U
and player 2 plays L.
 In equilibrium, the payoff for player 1 is 𝑢1 (𝑈, 𝐿) = 4 and the payoff for player
2 is 𝑢2 (𝑈, 𝐿) = 5.

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1.3.1 ICE

Let's consider the following game.

Player 2
Up (U) Middle (M) Down (D)
Up (U) (1, 1) (-1, 2) (5, 0)
Player 1 Middle (M) (2, 3) (1, 2) (3, 0)
Down (D) (1, 1) (0, 5) (1, 7)

a. Write down the set of strategies of each player.

b. Write down all the possible outcomes.
c. What are the payoffs in 𝑢1 (𝑈, 𝐷), 𝑢1 (𝑀, 𝑀), 𝑢2 (𝐷, 𝑀), and 𝑢2 (𝑈, 𝐷)?

Answers
a. The set of strategies available to player 1 (𝑆1) is U, M and D. The set of strategies
available to player 2 (𝑆2 ) is U, M and D.
b. Possible outcomes of this games are:
(𝑈, 𝑈), (𝑈, 𝑀), (𝑈, 𝐷), (𝑀, 𝑈), (𝑀, 𝑀), (𝑀, 𝐷), (𝐷, 𝑈), (𝐷, 𝑀), (𝐷, 𝐷)
c. 𝑢1 (𝑈, 𝐷) = 5, 𝑢1 (𝑀, 𝑀) = 1, 𝑢2 (𝐷, 𝑀) = 5, and 𝑢2 (𝑈, 𝐷) = 0.

1.4 Types of Games

1.4.1 The Time Aspect

 Static or Simultaneous Games: Players make one-shot simultaneous move.

 Dynamic Games: Players make sequential moves and possibly interact many
times. If dynamic games continue forever, we call them infinite games.

1.4.2 The Information Aspect

 Complete Information: In games of complete information each player’s payoff

function is common knowledge among all the players.
 Perfect Information: In games of perfect information the player with the move
knows the full history of the game up to that point.

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1.4.3 Equilibrium Concepts

Different types of games have their own equilibrium concept. Different combinations
of aspects result in different equilibrium concepts as summarized in the below table.

Information Structure Time Aspect Equilibrium Concepts

Complete Static Nash
Complete Dynamic Subgame-Perfect
Incomplete Static Bayesian
Incomplete Dynamic Perfect Bayesian

1.4.4 Cooperative and Non-Cooperative Games

We can also distinguish between cooperative and non-cooperative games. The key
distinction lies in the ability of players to make binding agreements to foster
cooperation in cooperative games, while in non-cooperative games, players act
independently and pursue their own self-interest without formal collaboration.

1.4.5 Zero-Sum Games

For such a game the sum of the payoffs is zero whatever the strategy combination of
the players. Then there are clearly no gains from cooperation.

In poker, players compete to win the pot, which contains the bets and chips placed by
both players. If Player 1 wins the pot, they receive a positive payoff equal to the
amount of chips in the pot, while Player 2 receives a negative payoff of the same
amount. The total payoff across the two players always sums to zero.