Strategic Behavior

and Game Theory

Learning Objectives
• Game Theory
• Nash Equilibrium
• Prisoner’s Dilema
• Application in business strategy
• Strategic interactions (cooperation, competition)
Game Theory
• An analytical guide or tool for making decisions in situations involving
interdependence
• This theory was develop to provide a systematic approach to strategic
decision making
• It is a mathematical framework used for analyzing situations where the
outcomes depend on the actions of multiple decision-makers, known as
players.
• It provides tools for understanding strategic interactions in competitive
environments, making it highly applicable in economics, political science,
psychology, and biology
• Game theory provides valuable insights into strategic decision-making and the
behavior of individuals and organizations in competitive settings.
• Its concepts and models are widely used to analyze real-world situations,
helping predict outcomes based on the interactions between rational agents
How Game Theory Works
• The goal of game theory is to explain the strategic actions of two or more
players in a given situation with set rules and outcomes. Any time a situation
with two or more players involves known payouts or quantifiable
consequences, we can use game theory to help determine the most likely
outcomes.
• The focus of game theory is the game, which is an interactive situation that
involves rational players. The key to game theory is that one player's
payoff is contingent on the strategy implemented by the other player.
• The game identifies the players' identities, preferences, available
strategies, and how these strategies affect the outcome. Depending on
the model, various other requirements or assumptions may be necessary.
• Game theory has a wide range of applications, including psychology,
evolutionary biology, war, politics, economics, and business. Despite its
many advances, game theory is still a young and developing science.
Useful Terms
• Game: Any set of circumstances that has a result dependent on the
actions of two or more decision-makers (players).
• Players: A strategic decision-maker within the context of the game.
• Strategy: A complete plan of action a player will take given the set of
circumstances that might arise within the game.
• Payoff: The payout a player receives from arriving at a particular
outcome. The payout can be in any quantifiable form, from dollars to
utility.
• Information set: The information available at a given point in the
game. The term "information set" is most usually applied when the game
has a sequential component.
• Equilibrium: The point in a game where both players have made their
decisions and an outcome is reached
Impact of Game Theory
• Economics
Game theory brought about a revolution in economics by
addressing crucial problems in prior mathematical economic
models. For instance, neoclassical economics struggled to
explain entrepreneurial anticipation and could not handle the
imperfect competition.
Game theory turned attention away from steady-state
equilibrium toward the market process.
Economists often use game theory to explain oligopoly firm
behavior. It helps to predict likely outcomes when firms engage
in certain behaviors, such as price-fixing and collusion.
• Business
In business, game theory is beneficial for modeling competing
behaviors between economic agents. Businesses often have
several strategic choices that affect their ability to realize
economic gain. For example, businesses may face dilemmas
such as whether to retire existing products and develop new
ones or employ new marketing strategies.
Businesses can often choose their opponent as well. Some focus
on external forces and compete against other market
participants. Others set internal goals and strive to be better
than their previous versions.
Whether external or internal, companies are always
competing for resources, attempting to hire the best
candidates away from rivals, and dissuade customers
from choosing competing goods.
• Project Management

Project management involves social aspects of game

theory, as different participants may have different influences.
For example, a project manager may be motivated to successfully
complete a building development project. Meanwhile, the
construction worker may be motivated to work slower for safety
or to delay the project to add more billable hours.
When dealing with an internal team, game theory may be
less prevalent as all participants working for the same employer
often have a greater shared interest for success. However, third-
party consultants or external parties assisting with a
project may be motivated by other factors separate from
the project's success.
• Consumer Product Pricing
The strategy of Black Friday shopping is at the heart of game
theory. The concept holds that should companies reduce prices,
more consumers will buy more goods. The relationship between
a consumer, a good, and the financial exchange that transfers
ownership plays a major part in game theory, as each consumer
has a different set of expectations.
Other than sweeping sales in advance of the holiday season,
companies must utilize game theory when pricing products for
launch or in anticipation of competition from rival goods. A
balance must be found. Price a good too low and it won't
reap profit. Price a good too high and it might push
customers toward a substitute
Example of Game Theory
The Prisoner's Dilemma
• 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 the
other. Officials present four deals, often displayed as a 2 x 2 box.
1.If both confess, they will each receive a three-year prison sentence.
2.If Prisoner 1 confesses, but Prisoner 2 does not, Prisoner 1 will get one year
and Prisoner 2 will get five years.
3.If Prisoner 2 confesses, but Prisoner 1 does not, Prisoner 1 will get five years,
and Prisoner 2 will get one year.
4.If neither confesses, each will serve two years in prison.
• 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
three-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
• The Prisoner’s Dilemma effectively illustrates the tension
between individual interests and collective welfare,
highlighting the challenges of achieving cooperation in
competitive situations. It serves as a foundational example
in game theory, helping to explore strategic decision-making
across various contexts
Types of Strategies in Game
Theory
• Maximax Strategy

A maximax strategy involves no hedging. The participant is

either all in or all out; they'll either win big or face the worst
consequence.
Consider a new start-up company introducing new products to the
market.
Its new products may result in the company's market cap
increasing fifty-fold. On the other hand, a failed product launch will
leave the company bankrupt. The participant is willing to take
a chance on achieving the best outcome even if the worst
outcome is possible.
• Maximin Strategy

A maximin strategy in game theory results in the

participant choosing the best of the worst payoff.
The participant has decided to hedge risk and sacrifice
full benefit in exchange for avoiding the worst outcome.

Often, companies face and accept this strategy when

considering lawsuits. By settling out of court and
avoiding a public trial, companies agree to an adverse
outcome. However, that outcome could have been
worse if the case had gone to trial.
• Dominant Strategy

In a dominant strategy, a participant performs

actions that are the best outcome for the play,
irrespective of what other participants decide to
do.

In business, this may be a situation where a company

decides to scale and expand to a new market,
regardless of whether a competing company has
decided to move into the market as well. In Prisoner's
Dilemma, the dominant strategy would be to confess.
• Pure Strategy

Pure strategy entails the least amount of strategic

decision-making, as pure strategy is simply a
defined choice that is made regardless of
external forces or actions of others.

Consider a game of rock-paper-scissors in which one

participant decides to throw the same shape with
each trial. As the outcome for this participant is well-
defined in advance (outcomes are either a specific
shape or not that specific shape), the strategy is
defined as pure.
Limitation of Game Theory
• The biggest issue with game theory is that, like most other economic models,
it relies on the assumption that people are rational actors who are
self-interested and utility-maximizing. Of course, we are social beings
who do cooperate often at our own expense.
• Game theory cannot account for the fact that in some situations we may fall
into a Nash equilibrium, and other times not, depending on the social context
and who the players are.
• In addition, game theory often struggles to factor in human elements
such as loyalty, honesty, or empathy. Though statistical and mathematical
computations can dictate what a best course of action should be, humans may
not take this course due to incalculable and complex scenarios of self-sacrifice
or manipulation.
• Game theory may analyze a set of behaviors but it cannot truly forecast
the human element.
Nash Equilibrium
• The Nash equilibrium is an important concept referring to a stable state in a
game where no player can gain an advantage by unilaterally changing
a strategy, assuming the other participants also do not change their
strategies.
• The Nash equilibrium provides the solution concept in a non-cooperative
(adversarial) game. It is named after John Nash, who received the Nobel Prize
in 1994 for his work.
• Nash equilibrium is a key concept in game theory that describes a situation in
which each player in a strategic interaction chooses their optimal strategy
given the strategies of the other players. In this equilibrium, no player has
anything to gain by changing their strategy unilaterally.
• Nash equilibrium is a fundamental concept in understanding strategic
interactions in competitive environments. It provides insights into how rational
players might behave in games where their choices are interdependent
Key Features of Nash
Equilibrium
1. Mutual Best Responses: In a Nash equilibrium, each
player’s strategy is the best response to the strategies
chosen by the other players. This means that each player is
doing the best they can, given the choices of others.

2. Stability: Since no player can benefit from changing their

strategy while others keep theirs unchanged, the equilibrium
is stable. Players have no incentive to deviate from their
current strategy.

3. Existence: Nash equilibria can exist in various forms,

including pure strategies (where players choose a specific
action) and mixed strategies (where players randomize over
Strategic Interaction
• Strategic interaction refers to situations where the
outcome of one participant's decision depends on the
choices of other participants.
• This concept is central to game theory and can be applied
across various fields, including economics, politics,
sociology, and biology
• Strategic interaction is a fundamental concept that shapes
decision-making in competitive environments.
• Understanding the dynamics of these interactions can lead
to better strategies for negotiation, competition, and
cooperation
Key Concepts of Strategic
Interaction
1. Players: The decision-makers involved in the interaction. They can
be individuals, firms, or groups.

2. Strategies: The choices available to each player. A strategy can

be simple (one specific choice) or complex (a plan of action that
may involve multiple decisions).

3. Payoffs: The outcomes associated with each combination of

strategies chosen by the players. Payoffs can represent profits,
utility, or any measure of benefit.

4. Information: The level of knowledge that players have about each

other’s choices and preferences can significantly impact strategic
interactions.
Types of Strategic Interactions
1. Cooperative vs. Non-Cooperative:
o Cooperative: Players can form binding agreements or coalitions to
enhance their outcomes (e.g., cartels in business).
o Non-Cooperative: Players make decisions independently, and binding
agreements are not possible (e.g., the Prisoner’s Dilemma).

2. Simultaneous vs. Sequential:

o Simultaneous: Players make decisions at the same time without
knowledge of the others' choices (e.g., choosing prices in an oligopoly).
o Sequential: Players make decisions one after another, where later
players can observe earlier choices (e.g., a negotiation process).
3. Zero-Sum vs. Non-Zero-Sum:
o Zero-Sum: One player’s gain is exactly equal to another’s loss (e.g.,
competitive
o games).
o Non-Zero-Sum: Outcomes can benefit multiple players, allowing for
cooperation to improve overall results (e.g., trade negotiations).
Examples of Strategic
Interaction
1. Market Competition:
o Firms competing in pricing strategies must consider how their prices affect
competitors and consumer behavior. Decisions on pricing, advertising, and product
development are interdependent.

2. International Relations:
o Countries often engage in strategic interactions concerning trade, defense, and
diplomacy. For example, in arms races, each country must consider the actions of
others when deciding whether to increase military spending.

3. Negotiations:
o In bargaining situations, each party must strategize based on the other's likely
responses. Successful negotiations often depend on understanding the
counterpart’s interests and incentives.