CHAPTER 3. EXTENSIVE FORM GAMES 42 for Mason. Game Theory

Game Theory

1Robin MasonMarch 2, 2006

1

These notes are based on to a large extent on the notes of Dirk Bergemannand Juuso Valimaki for similar courses at Yale University and the Helsinki Schoolof Economics. I am grateful to them both for the permission to use and edit thosenotes.

Contents

1 Game Theory: An Introduction 4

1.1 Game Theory and Parlour Games—a Brief History . . . . . . 51.2 Basic Elements of Noncooperative Games . . . . . . . . . . . . 6

2 Normal Form Games 7

2.1 Pure Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . 72.2 Dominance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82.3 Nash equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . 122.3.1 Finite Normal Form Game . . . . . . . . . . . . . . . . 132.3.2 Cournot Oligopoly . . . . . . . . . . . . . . . . . . . . 142.3.3 Auctions with perfect information . . . . . . . . . . . . 152.4 Mixed Strategies . . . . . . . . . . . . . . . . . . . . . . . . . 152.4.1 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . 162.4.2 Construction of a mixed strategy Nash equilibrium . . 202.4.3 Interpretation of mixed strategy equilibria . . . . . . . 232.5 Mixed Strategies with a Continuum of Pure Strategies . . . . 232.5.1 All pay auction . . . . . . . . . . . . . . . . . . . . . . 232.5.2 War of attrition . . . . . . . . . . . . . . . . . . . . . . 292.5.3 Appendix: Basic probability theory . . . . . . . . . . . 302.6 Appendix: Dominance Solvability and Rationalizability . . . . 332.6.1 Rationalizable Strategies . . . . . . . . . . . . . . . . . 352.7 Appendix: Existence of Mixed Strategy Equilibria . . . . . . . 36

3 Extensive Form Games 38

3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 383.2 Deﬁnitions for Extensive Form Games . . . . . . . . . . . . . 403.2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . 403.2.2 Graph and Tree . . . . . . . . . . . . . . . . . . . . . . 401

CONTENTS

23.2.3 Game Tree . . . . . . . . . . . . . . . . . . . . . . . . . 403.2.4 Notion of Strategy . . . . . . . . . . . . . . . . . . . . 433.3 Subgame Perfect Equilibrium . . . . . . . . . . . . . . . . . . 463.3.1 Finite Extensive Form Game: Bank-Run . . . . . . . . 473.4 The Limits of Backward Induction: Additional Material . . . . 483.5 Reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

4 Repeated Games 51

4.1 Finitely Repeated Games . . . . . . . . . . . . . . . . . . . . . 514.2 Inﬁnitely Repeated Games . . . . . . . . . . . . . . . . . . . . 544.2.1 The prisoner’s dilemma . . . . . . . . . . . . . . . . . . 544.3 Collusion among duopolists . . . . . . . . . . . . . . . . . . . 554.3.1 Static Game . . . . . . . . . . . . . . . . . . . . . . . . 554.3.2 Best Response . . . . . . . . . . . . . . . . . . . . . . . 564.3.3 Collusion with trigger strategies . . . . . . . . . . . . . 574.3.4 Collusion with two phase strategies . . . . . . . . . . . 58

5 Sequential Bargaining 60

5.1 Bargaining with Complete Information . . . . . . . . . . . . . 615.1.1 Extending the Basic Model . . . . . . . . . . . . . . . . 655.2 Dynamic Programming . . . . . . . . . . . . . . . . . . . . . . 655.2.1 Additional Material: Capital Accumulation . . . . . . . 68

6 Games of Incomplete Information 70

6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 706.1.1 Example . . . . . . . . . . . . . . . . . . . . . . . . . . 706.2 Basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 716.2.1 Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . 716.2.2 Belief . . . . . . . . . . . . . . . . . . . . . . . . . . . . 726.2.3 Payoﬀs . . . . . . . . . . . . . . . . . . . . . . . . . . . 726.3 Bayesian Game . . . . . . . . . . . . . . . . . . . . . . . . . . 726.3.1 Bayesian Nash Equilibrium . . . . . . . . . . . . . . . 736.4 A Game of Incomplete Information: First Price Auction . . . 746.5 Conditional Probability and Conditional Expectation . . . . . 756.5.1 Discrete probabilities - ﬁnite events . . . . . . . . . . . 766.5.2 Densities - continuum of events . . . . . . . . . . . . . 786.6 Double Auction . . . . . . . . . . . . . . . . . . . . . . . . . . 806.6.1 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 80