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Game Theory

Game theory examines strategic decision-making between players. It analyzes situations like the Prisoner's Dilemma, where two prisoners must decide whether to confess or remain silent. According to game theory, players will act rationally to maximize their own outcomes even if it results in a collectively worse result. A Nash equilibrium exists when no player can benefit by changing their strategy given others' choices. However, critics argue that game theory makes unrealistic assumptions about rationality and information.

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Shaheryar Rashid
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167 views

Game Theory

Game theory examines strategic decision-making between players. It analyzes situations like the Prisoner's Dilemma, where two prisoners must decide whether to confess or remain silent. According to game theory, players will act rationally to maximize their own outcomes even if it results in a collectively worse result. A Nash equilibrium exists when no player can benefit by changing their strategy given others' choices. However, critics argue that game theory makes unrealistic assumptions about rationality and information.

Uploaded by

Shaheryar Rashid
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Game Theory

Game theory examines the decisions that individual players make in order to win a game against one
or more competitors. The players are abstract, intelligent, individual agents who act in pursuit of their
own limited goals in an environment in which situation exists. Originally inspired by parlor games
like chess and poker, it delves into games of strategy where players' choices impact their outcomes.
Game theory has found significant application in fields such as economics, management, accounting,
biology, finance, law, marketing, and political science.
The Prisoner's Dilemma is the most well-known example of game theory. Consider the example of
two criminals arrested for a crime. Prosecutors have no hard evidence to convict them. However, to
gain a confession, officials remove the prisoners from their solitary cells and question each one in
separate chambers. Neither prisoner has the means to communicate with each other. Officials present
four deals, often displayed as a 2 x 2 box.
1. If both confess, they will each receive a five-year prison sentence.
2. If Prisoner 1 confesses, but Prisoner 2 does not, Prisoner 1 will get three years and Prisoner 2
will get nine years.
3. If Prisoner 2 confesses, but Prisoner 1 does not, Prisoner 1 will get 10 years, and Prisoner 2
will get two years.
4. If neither confesses, each will serve two years in prison.
Basic Game Theory Concepts:
Player: An intelligent, self-interested decision-maker. Strategy: A rule guiding a player's actions at
each game stage. Outcome: The result of all possible player decisions. Payoff: Satisfaction derived
from a particular game outcome. Equilibrium: The optimal sequence of decisions in the game.
In game theory, a Nash equilibrium is a situation in which each player in a game makes the best
decision they can, taking into account the decisions of other players. At this point, no player has an
incentive to change their strategy because any change would result in a worse outcome for them. It
represents a stable state where each player's choices are optimal given the choices of the others, even
though they may not be collectively optimal for all players.
➢ Prisoner’s Dilemma example continued:
The most favorable strategy is to not confess. However, neither is aware of the other's strategy and
without certainty that one will not confess, both will likely confess and receive a five-year prison
sentence. The Nash equilibrium suggests that in a prisoner's dilemma, both players will make the move
that is best for them individually but worse for them collectively.
Key Assumptions in Game Theory:
Complete information: Players know all game rules and each other's preferences.
Rationality: Players act to maximize their payoffs and act rationally.
Subjective estimates: When faced with uncertainty, players make probabilistic judgments.
Empathy: Players consider opponents' perspectives.
Competitiveness: Players seek self-maximization, often at the expense of cooperation.
Dynamic: Games evolve over time.
Interdependence: Player performance depends on others; no unilateral decisions.

Types of Games:
One-Person Games: These are essentially decision-making problems where a single individual is
trying to solve a particular issue or puzzle
Two-Person Games: These involve two individuals or entities who make strategic decisions while
interacting with each other. Classic examples include chess and poker
Three-Person Games: In these games, three players are making decisions, and the interactions
between them can become more complex.
Few-Person Games: These might include scenarios like committee decisions, club activities, or
interactions within a small group.
Many-Person Games: These games involve a larger number of players, often ranging from around
twenty to a few hundred participants. Examples could include situations in villages, small firms, or
tribes, where various players make choices impacting the group.
Large but Finite Games: These games involve a substantial number of participants but still have a
finite, defined set of players. While the number of players is significant, it is not infinite.
Games with an Infinite Number of People: In these games, the number of participants is
theoretically infinite. These are more theoretical and less common in practical applications.

➢ Some games start with players having limited information about opponents. The players then
update their knowledge about their opponents based on player actions during the game.

Criticisms and Critiques of Game Theory:


Assumption of Perfect Rationality: One of the primary criticisms of game theory is its assumption
that all players are perfectly rational and always act in their best interest. In real-world scenarios,
individuals and organizations often make decisions based on emotions, biases, and bounded
rationality.
Complete Information Assumption: Game theory assumes that all players have complete and
accurate information about the game, including knowledge of other players' preferences and
strategies. In reality, information is often incomplete or uncertain.
Lack of Cooperation: Game theory typically assumes that players are solely focused on
maximizing their own payoffs, leading to competitive behavior. In many real-world situations,
cooperation and collaboration are critical, especially in business and social interactions. Game theory
can fall short in addressing scenarios where mutual benefit and trust play a significant role.
Complexity and Realism: Critics argue that the mathematical models and calculations used in game
theory can be overly complex and divorced from real-life decision-making. The so-called "chopstick
problem" points out that the intricate mathematical formulations in game theory may not be easily
applicable to practical situations.
Difficulty of Testing: Testing game theory predictions in real-life scenarios can be challenging. The
models are often highly abstract and may not provide clear and testable hypotheses. This can limit
the empirical validation of game theory.
Neglect of Behavioral Insights: Game theory often does not account for behavioral insights and
psychological factors that influence decision-making. It tends to focus on strategic calculations
rather than exploring why individuals or entities make certain choices.
Imperfect Predictive Power: Game theory may not always accurately predict real-world behavior
because it cannot fully account for the complexities of human interactions, especially in situations
with unknown or uncertain consequences.
Implications of theory on Managers
Game theory offers managers valuable insights. It highlights that employees tend to prioritize self-
interest, which suggests a need for careful compensation strategies. Managers should adapt strategies
based on outcomes and consider introducing additional players, such as trusted third parties.
Negotiating close to failure can enhance bargaining power. Reciprocity and credible commitments can
foster cooperation.
Adaptability is another key lesson from game theory. Managers should be willing to shift their
strategies based on outcomes. If a non-cooperative strategy consistently outperforms cooperative
approaches, it makes sense to stick with it. Conversely, if a cooperative strategy proves unsuccessful,
it's crucial to be ready to change course to maximize benefits.
Demonstrating that one's commitment to cooperation is credible is essential for building and
maintaining trust. By creating situations in which neither party can independently escape without
incurring a loss, managers can help establish stable cooperative arrangements. Motivation among
employees is often influenced by a sense of fairness. Game theory suggests that managers should strive
to distribute resources, responsibilities, and opportunities in ways that minimize envy.
Lastly, the dynamics of group size play a significant role in cooperation. Smaller groups tend to
cooperate more effectively than larger ones, which can lead to increased individual engagement.
However, managing numerous groups can pose its own set of challenges.

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