Asrar Chowdhury

Game Theory: Class Handout 1- Introduction

INTRODUCTION
The first formal presentation of games was in economics by John von Neumann
(1903-1957) and Oskar Morgenstern (1902-1977) in their magnum treatise The
Theory of Games and Economic Behavior in 1944 at Princeton University, USA where
both were at the time. Von Neumann was one of the most influential
mathematicians of the 20th Century. In 1928, von Neumann invented Game
Theory- the name which he, himself, gave. It started in 1921from the solution of
the famous mini-max theorem in response to the French mathematician, Emile
Borel (1871-1956). The year 1928 was also coincidentally the birth year of John
Nash, another great mathematician of the 20th Century also from Princeton
University and a game theorist whose PhD Thesis earned him a Nobel Prize in
Economic Theory in 1994. Nashs solution to non-cooperative games is now
universally known as the Nash Equilibrium. John von Neumann, Oskar
Morgenstern and John Nash are just one of the many game theorists well
encounter in our journey into the wonderful world of Game Theory.
Game Theory is a branch of applied mathematics that discusses decision-making
under strategic situations. Strategic situations arise when decisions are interdependent. Inter-dependent means: the outcome of one the decision of one
decision-maker depends on what decision another decision-maker makes. Lets
assume there are two decision-makers, whom well call Players: You and I. The
intuition behind interdependent decision-making then becomes:
SA1: The decision I decide to take depends on what decision you decide to
take.
SA2: The decision you decide to takes depends on what decision I decide to
take.
Each of the above two statements are true on their own. When they are both true,
they qualify as inter-dependent decision-making. Its now slowly becoming clear
that: I know as a clever (rational) person, you wont respond with a silly
(irrational) move to whatever decision I take if a more clever response is
available at your disposal. You also think in the same line.
The notion behind equilibrium in interdependent decision-making is amazingly
simple. Look at the following two statements:
SB1: Im doing the best I can to your response assuming youre doing the best
you can to my response.
SB2: Youre doing the best you can to my response assuming Im doing the
best I can to your response.

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Asrar Chowdhury

Game Theory: Class Handout 1- Introduction

Lets define equilibrium as a state where once reached no decision-maker has a

tendency to move given what the others have decided to do. If at least one
player wants to deviate, the interdependent decision-making outcome cant be
equilibrium. Let Statement 4 be true, but Statement 3 be false. If youre doing the
best you can to my response, you wont have a tendency to move given what Im
doing. However, if Im not doing the best I can given, what youre doing this
means I havent responded with my best available action given what youve
done, IE I will want to move from the situation weve found ourselves locked
in. The outcome of our interdependent decision-making can thus not be
equilibrium. Surprisingly, this is the notion behind what has become to be
known as The Nash Equilibrium.
As rational human beings, we seek to maximize things we like (EG: utility for
consumers and profits for producers) and minimize things we dont like
(expenditures for consumers and costs for producers). This is consistent with the
optimization models of the neoclassical school of economics. Where Game
Theory takes one step ahead is when our decisions depend on each other IE
when our decisions are inter-dependent. Although the French mathematicians,
Augustine Cournot and Joseph Betrandt and later the German mathematician
Heinrich Stackelberg tackled the issue of interdependent decision making in their
models of oligopoly, it was not until 1944 at Princeton when John von Neumann
of Hungary and Oskar Morgenstern of Austria published Theory of Games and
Economic Behavior that the word Game Theory was coined and this wonderful
branch of applied mathematics was born. Lets save that story for later. Now,
lets introduce some technical terminology:
BASIC ASSUMPTIONS OF GAMES
Players:
The decision makers in the game. There has to be at least two players, IE two
decision-makers for a Game. These decision-makers can be individuals
(consumers); firms (producers); nations. These decision-makers can even be a
nation and an individual EG: when you apply for a visa to say Thailand, the
Royal Thai Embassy is one player who sets the terms and conditions which you
cant argue about; and youre the other player who either accepts the terms and
conditions set by the Embassy or doesnt. This type of a game is known as the
Dictator Game. Well come across this game later.
Depending on the number of players, games are known as Two-Person (two
players IE two decision-makers, Three-Person and n-Person. Well be discussing
2-Person Games mostly. 3-Person Games may come up as anecdotes or games
where we play the Public Goods Game.

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Game Theory: Class Handout 1- Introduction

Strategies:
Choices players in a game make when decisions are interdependent. A formal
definition of strategies will be given later. Heres the intuition behind what
strategies means: You and I are playing Heads and Tails in a game called
Matching Pennies. If both sides are the same [{Heads, Heads} or {Tails, Tails}] you
pay me Tk 100. This means I receive Tk 100 at the end of the game and you
receive minus Tk 100 since youre paying. If the sides are different [{Heads,
Tails}; or {Tails, Heads}] I pay you Tk 100 and get minus Tk 100, while you get Tk
100 at the end of the game. What can I do?1 If you decide to play Heads, then as a
response I can play either Heads and match or play Tails and make different.
These are my set of actions with which I can respond with against your decision
to play Heads. What do I do? If you play Heads, and if Im a rational player, Ill
match with Heads to get Tk 100 my prize. As a rational player I wont play Tails
against your Heads and get Tk Zero (or gain Tk 100). Thats not what a clever
person would do as a response, right?
There are many types of strategies, but three are the most popular. These are the
strategies well focus on. Detailed discussions will be made, but for the time
being:
Pure Strategies: These are pure because you know exactly what Ill do as a
response to a certain action youll play. Differently put, you know Ill never
respond with any other action as a response to what you decide to play. Thus
Pure Strategies are the set of actions that are played with certainty by one player
in response to what the other player(s) in the game decide to play. There is no
probability attached to Pure Strategies. These strategies will become obvious
once we explore examples.
Mixed Strategies: Lets get back to the Matching Pennies Game. Your objective is
to make the two sides different to get the Tk 100 prize, while mine is to match
them to get the Tk 100 prize. If against your Tails, I always respond with Heads
as a Pure Strategy (with certainty), what will you do? Youll always play Tails
and win Tk 100. Simple! Now, if Im rational, would I play a Pure Strategy of
Heads all the time, or would I mix Heads and Tails as a response to what you
do? The natural consequence would be to mix my actions against your actions as
a best response. This means, sometimes I play Heads (say 3/5 times IE 60% of the
times) and Tails (say 2/5 times IE 40% of the times). In essence, by mixing my
actions, Im assigning some probability distribution to my choice of actions.
What can I do? Includes the set of all possible responses I can make to what youve decided to
do. What do I do? Includes the set of rational responses I shall make to what youve decided to do.
Strategies include the set of What do I do? The set of What can I do? Includes the set of actions.
Some books use Strategies and Sets synonymously on the assumption players are rational and
will this respond with their Best Responses to what other players decide to do.

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Game Theory: Class Handout 1- Introduction

What would you do, knowing I would do this? You would also respond by
mixing your choices of Heads and Tails against what I decide to do.
Contingent Strategies: These are strategies players choose after observing how
the previous move in a game ended by the decision of another player. These are
features of sequential games where players make moves in a sequence. We shall
elaborate this strategy when the time comes. For the time being heres an
example. There are two players in a game- A and B. Player B knocks on the door
of a classroom while the teacher is delivering a lecture. Lets assume Player A is
the teacher taking the class. A has two options. He will open the door IF B is a
student of the class; or not open the door if B is not a student of the class. If B is a
student of the class who was late for some reason, As Best Response to Bs knock
would be to open the door. Would or could any teacher deny access to their
student to enter the class even if they were late? That would be irrational,
wouldnt it?
Payoffs: These are the returns players receive at the end of the game. They can be
utility for consumers; profits for firms and the like. A crucial assumption is that
payoffs are quantifiable. This is one of the original assumptions (restriction)
imposed by von Neumann and Morgenstern in the 1944 Treatise.
Information: All players in the game are aware of what responses other players
shall make to their chosen decisions. This assumption is crucial if we are to have
a meaningful model. As an example, I know if I play Heads in the Matching
Pennies Game youll play Tails. We also know under what institutional
framework the game will be played. As an example, If a student cheats in an
exam game, a neutral player, the invigilator will penalize. This is also known as
common knowledge.
TYPES OF GAMES
Depending of the nature of decision-making, games can be divided into a few
categories.
Timing of Decision Making: Under this category games can be either
Simultaneous or Sequential. Simultaneous decisions have two definitions. First:
when players make a decision at the same time. These decisions are made in
games like Matching Pennies or Rock, Paper Scissors. In any of the above two
games, neither A nor B will want to reveal to the other what they are choosing.
Thus decisions have to be made at the same time. Second: A and B can make
decisions at different points of time, but A wont know what B chooses and B
wont know what A chooses. This is just as good as making decisions
simultaneously. As an example: two prisoners A and B are locked in different
cells. A judge or police officer asks them the same question and the consequence

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Asrar Chowdhury

Game Theory: Class Handout 1- Introduction

of their actions are interdependent where both A and B know what the
consequences are. A and B cant cooperate between themselves. So neither of
them knows what response the other will make. Thus even if the judge or the
police officer asks A and B the same question at separate times, the game can be
considered simultaneous. Simultaneous games are also known as Static Games.
When players make decisions in a sequence, such games are known as Sequential
Games. As an example: the student of a class knocking on the door. The two
games moves in a sequence of two decisions. First: the student knocks. Second:
the decision of the teacher to open the door or not. Sequential Games are also
known as Dynamic Games.
Nature of Payoff Optimization: If a binding contract between players in a game
cant be established then players seek to optimize their individual payoffs. In the
Matching Pennies Game A and B have mutually conflicting interests. A wants to
match both sides; while, B wants to make them different. The nature of the game
doesnt allow a binding contract to be established. Thus A and B both opt to
optimize their individual payoffs. These games are known as Non Cooperative
Games or Games of Conflict.
If a binding contract between players in a game can be established, then players
seek to optimize their joint payoffs. In the Battle of the Sexes Game, it is in the
mutual interest of the players to cooperate to get utility. Let A and B be two
friends who both want to spend time together. If A and B go to the same place
they both get positive utility (payoff) for being together. If they go to different
places they get less utility, individually. Thus it is in the mutual interest for both
players to jointly optimize their payoffs. Well explore this game later. For the
time being, such games are known as Cooperative Games.
Nature of Times Games Played: If the same game is played once, its known as a
Single Shot Game or Single Stage Game. If the same game is played more than once,
it is known as Repeated Game or Multi-Stage Game. Through a special game
called the Prisoners Dilemma, well see when the game is played once,
cooperation cant evolve, but when the game is played more than once, the scope
of cooperation can evolve with whats known as Trigger Strategies.
Nature of Information: When information is symmetric between players IE
players have the same set of information, such games are known as Games of
Complete Information. When information is asymmetric between players IE
players have different sets of information, such games are known as Game of
Incomplete Information. Classical Probability assumes the set of probabilities
remain unchanged from one event to another. When this assumption is violated,

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Game Theory: Class Handout 1- Introduction

probability becomes Bayesian Probability. Games based on Bayesian Probability

are known as Bayesian Games.
Multiple Characteristics within the Same Game: Let there be two football
teams: A (Argentina) and B (Brazil). At the surface, A and B have mutually
conflicting interests. Each wants to defeat the other. The games teams play are
thus non-cooperative or games of conflict. A and B will be optimizing their
individual payoffs. However, within each team (A and B), coordination is
required between the 11 players if they are to win a match with a positive payoff.
Thus within each team, players play games of coordination or cooperative
games.
RATIONAL BEHAVIOUR
Von Neumann and Morgenstern based their exposition of Game Theory on
individual rationality. All players in the game are rational (clever) and all players
know others in the game are too. This assumption is consistent with mainstream
neoclassical economics where agents optimize their objective functions.
Optimization means maximizing benefits and minimizing costs. If payoffs
involve both benefits and costs, players optimize their net functions. Rationality
in Game Theory can be simplified as follows, where all the following four
statements are true on their own and also true together at the same time:
SC1: All players in a game are rational.
SC2: Each player in a game responds with only rational responses to the chosen
actions of other players in a game.
SC3: No player in a game will respond irrationally in response to the chosen
actions of other players in a game if a rational response is available.
SC4: Each rational player in a game is aware that all the other players in the
game are rational at the same time and think and respond in the same line
of reasoning.

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