Game theory analyzes strategic interactions in which the outcome of one's choices depends upon the choices of others. For a situation to be considered a game, there must be at least two rational players who take into account one another's actions when formulating their own strategies.

If one does not consider the actions of other players, then the problem becomes one of standard decision analysis, and one is likely to arrive at a strategy that is not optimal. For example, a company that reduces prices to increase sales and therefore increase profit may lose money if other players respond with price cuts. As another example, consider a risk averse company that makes its decisions by maximizing its minimum payoff (maxmin strategy) without considering the reactions of its opponents. In such a case, the minimum payoff might be one that would not have occurred anyway because the opponent might never find it optimal to implement a strategy that would make it come about. In many situations, it is crucial to consider the moves of one's opponent(s).

Game theory assumes that one has opponents who are adjusting their strategies according to what they believe everybody else is doing. The exact level of sophistication of the opponents should be part of one's strategy. If the opponent makes his/her decisions randomly, then one's strategy might be very different than it would be if the opponent is considering other's moves. To analyze such a game, one puts oneself in the other player's shoes, recognizing that the opponent, being clever, is doing the same. When this consideration of the other player's moves continues indefinitely, the result is an infinite regress. Game theory provides the tools to analyze such problems.

Game theory can be used to analyze a wide range of strategic interaction environments including oligopolies, sports, and politics. Many product failures can be attributed to the failure to consider adequately the responses of competitors. Game theory forces one to consider the range of a rival's responses.

• Players: The decision makers in the game.
  
• Actions: Choices available to a player.
  
• Information: Knowledge that a player has when making a decision.
  
• Strategies: Rules that tell a player which action to take at each point of the game.
  
• Outcomes: The results that unfold, such as a price war, world peace, etc.
  
• Payoffs: The utilities (or happiness) that each player realizes for a particular outcome.
  
• Equilibria: An equilibrium is a stable result. Equilibria are not necessarily good outcomes, a fact that is illustrated by the prisoner's dilemma.
  

1. Define the problem
2. Identify the critical factors. Examples of critical factors include differentiated products, first-mover advantage, entry and exit costs, variable costs, etc.
3. Build a model, such as a bimatrix game or an extensive form game.
4. Develop intuition by using the model
5. Formulate a strategy - cover all possible scenarios.

The general form of equilibrium in a bimatrix game is called a Nash Equilibrium. If both rivals have dominant strategies that coincide, then the equilibrium is called a dominant strategy equilibrium, a special case of a Nash equilibrium.

A dominant strategy, if it exists, is for one of the players the strategy that is always the best strategy regardless of what one's rival plays. A dominated strategy is one that is always the worst regardless of what one's rival plays. In games having more than two rows or problems, one may find it useful to identify one option that is always better or worse than another option, in other words, that dominates or is dominated by another option. In this case, the inferior strategy can be eliminated and the game simplified such that more options can be eliminated based on the smaller matrix.

 
Structure of an Extensive Form Game