Game Theory and

Competitive Strategy
13.1 Gaming and Strategic Decisions
● game Situation in which players (participants) make strategic
decisions that take into account each other’s actions and responses.

● payoff Value associated with a possible outcome.

● strategy Rule or plan of action for playing a game.

● optimal strategy Strategy that maximizes a player’s expected payoff.

If I believe that my competitors are rational and act to maximize their own
payoffs, how should I take their behavior into account when making my
decisions?

Determining optimal strategies can be difficult, even under conditions of

complete symmetry and perfect information.
Noncooperative versus Cooperative Games

● cooperative game Game in which participants can negotiate

binding contracts that allow them to plan joint strategies.
● noncooperative game Game in which negotiation and enforcement of
binding contracts are not possible.

It is essential to understand your opponent’s point of view and to deduce his

or her likely responses to your actions.
Note that the fundamental difference between cooperative and noncooperative
games lies in the contracting possibilities. In cooperative games, binding contracts are
possible; in noncooperative games, they are not.

HOW TO BUY A DOLLAR BILL

A dollar bill is auctioned, but in an unusual way. The highest bidder receives the
dollar in return for the amount bid. However, the second-highest bidder must
also hand over the amount that he or she bid—and get nothing in return.
If you were playing this game, how much would you bid for the dollar bill?
Classroom experience shows that students often end up bidding more than a
dollar for the dollar.
EXAMPLE 13.1 ACQUIRING A COMPANY

You represent Company A, which is considering acquiring Company T. You plan

to offer cash for all of Company T’s shares, but you are unsure what price to
offer. The value of Company T depends on the outcome of a major oil
exploration project.
If the project succeeds, Company T’s value under current management could be
as high as $100/share. Company T will be worth 50 percent more under the
management of Company A. If the project fails, Company T is worth $0/share
under either management. This offer must be made now—before the outcome
of the exploration project is known.
You (Company A) will not know the results of the exploration project when
submitting your price offer, but Company T will know the results when deciding
whether to accept your offer. Also, Company T will accept any offer by Company
A that is greater than the (per share) value of the company under current
management.
You are considering price offers in the range $0/share (i.e., making no offer at all)
to $150/share. What price per share should you offer for Company T’s stock?
The typical response—to offer between $50 and $75 per share—is wrong. The
answer is provided later in this chapter, but we urge you to try to find the answer
on your own.
13.2 Dominant Strategies
● dominant strategy Strategy that is optimal no matter what an
opponent does.

TABLE 13.1 PAYOFF MATRIX FOR ADVERTISING GAME

Firm B
Advertise Don’t advertise

Advertise 10, 5 15, 0

Firm A
Don’t advertise 6, 8 10, 2

Advertising is a dominant strategy for Firm A. The same is true for

Firm B: No matter what firm A does, Firm B does best by advertising. The outcome for
this game is that both firms will advertise.

● equilibrium in dominant strategies Outcome of a game in which each firm

is doing the best it can regardless of what its competitors are doing.
Unfortunately, not every game has a dominant strategy for each player.

TABLE 13.2 MODIFIED ADVERTISING GAME

Firm 2
Advertise Don’t advertise

Advertise 10, 5 10, 10

Firm 1
Don’t advertise 6, 8 20, 2

Now Firm A has no dominant strategy. Its optimal decision depends on what
Firm B does. If Firm B advertises, Firm A does best by advertising; but if Firm B
does not advertise, Firm A also does best by not advertising.
13.3 The Nash Equilibrium Revisited

Dominant Strategies: I’m doing the best I can no matter what you do.
You’re doing the best you can no matter what I do.
Nash Equilibrium: I’m doing the best I can given what you are doing.
You’re doing the best you can given what I am doing.

THE PRODUCT CHOICE PROBLEM

Two new variations of cereal can be successfully introduced—provided that
each variation is introduced by only one firm.
TABLE 13.3 PRODUCT CHOICE PROBLEM
Firm 2
Crispy Sweet
Crispy –5, –5 10, 10
Firm 1
Sweet 10, 10 –5, –5

In this game, each firm is indifferent about which product it produces—so long as it does not
introduce the same product as its competitor. The strategy set given by the bottom left-hand
corner of the payoff matrix is stable and constitutes a Nash equilibrium: Given the strategy of its
opponent, each firm is doing the best it can and has no incentive to deviate.
THE BEACH LOCATION GAME

FIGURE 13.1
BEACH LOCATION GAME
You (Y) and a competitor (C) plan to sell soft drinks on a beach.
If sunbathers are spread evenly across the beach and will walk to the closest vendor, the
two of you will locate next to each other at the center of the beach. This is the only Nash
equilibrium.
If your competitor located at point A, you would want to move until you were just to the
left, where you could capture three-fourths of all sales.
But your competitor would then want to move back to the center, and you would do the
same.
Maximin Strategies

TABLE 13.4 MAXIMIN STRATEGY

Firm 2
Don’t invest Invest

Don’t invest 0, 0 –10, 10

Firm 1
Invest –100, 0 20, 10

In this game, the outcome (invest, invest) is a Nash equilibrium. But if

you are concerned that the managers of Firm 2 might not be fully informed or
rational—you might choose to play “don’t invest.” In that case, the worst that
can happen is that you will lose $10 million; you no longer have a chance of losing
$100 million.

● maximin strategy Strategy that maximizes the minimum gain that can be
earned.
MAXIMIZING THE EXPECTED PAYOFF
If Firm 1 is unsure about what Firm 2 will do but can assign probabilities to
each feasible action for Firm 2, it could instead use a strategy that maximizes
its expected payoff.
THE PRISONERS’ DILEMMA

TABLE 13.5 PRISONERS’ DILEMMA

Prisoner B
Confess Don’t confess

Confess –5, –5 –1, –10

Prisoner A
Don’t confess –10, –1 –2, –2

the ideal outcome is one in which neither prisoner

confesses, so that both get two years in prison. Confessing, however, is a
dominant strategy for each prisoner—it yields a higher payoff regardless of the
strategy of the other prisoner.

Dominant strategies are also maximin strategies. The outcome in which both prisoners
confess is both a Nash equilibrium and a maximin solution. Thus, in a very strong
sense, it is rational for each prisoner to confess.
Mixed Strategies
● pure strategy Strategy in which a player makes a specific choice
or takes a specific action.

MATCHING PENNIES

TABLE 13.6 MATCHING PENNIES

Player B
Heads Tails
Heads 1, –1 –1, 1
Player A
Tails –1, 1 1, –1

In this game, each player chooses heads or tails and the two players reveal
their coins at the same time. If the coins match Player A wins and receives a
dollar from Player B. If the coins do not match, Player B wins and receives a
dollar from Player A.
Note that there is no Nash equilibrium in pure strategies for this game. No
combination of heads or tails leaves both players satisfied—one player or the
other will always want to change strategies.
● mixed strategy Strategy in which a player makes a random
choice among two or more possible actions, based on a set of chosen
probabilities..
Although there is no Nash equilibrium in pure strategies, there is a Nash
equilibrium in mixed strategies.
In the matching pennies game, for example, Player A might simply flip the coin,
thereby playing heads with probability 1/2 and playing tails with probability 1/2.
In fact, if Player A follows this strategy and Player B does the same, we will
have a Nash equilibrium: Both players will be doing the best they can given
what the opponent is doing. Note that although the outcome is random, the
expected payoff is 0 for each player.
It may seem strange to play a game by choosing actions randomly. But put
yourself in the position of Player A and think what would happen if you followed
a strategy other than just flipping the coin. Suppose you decided to play heads.
If Player B knows this, she would play tails and you would lose. Even if Player
B didn’t know your strategy, if the game were played repeatedly, she could
eventually discern your pattern of play and choose a strategy that countered it.
Once we allow for mixed strategies, every game has at least one Nash
equilibrium.
THE BATTLE OF THE SEXES

TABLE 13.7 THE BATTLE OF THE SEXES

Jim
Wrestling Opera

Wrestling 2, 1 0, 0
Prisoner A
Opera 0, 0 1, 2

There are two Nash equilibria in pure strategies for this game—the one in which Jim
and Joan both watch mud wrestling, and the one in which they both go to the opera.
This game also has an equilibrium in mixed strategies: Joan chooses wrestling with
probability 2/3 and opera with probability 1/3, and Jim chooses wrestling with
probability 1/3 and opera with probability 2/3.
Should we expect Jim and Joan to use these mixed strategies? Unless they’re very risk
loving or in some other way a strange couple, probably not. By agreeing to either form
of entertainment, each will have a payoff of at least 1, which exceeds the expected
payoff of 2/3 from randomizing.