Professional Documents
Culture Documents
A. Daripa
EC2066
2016
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This is an extract from a subject guide for an undergraduate course offered as part of the
University of London International Programmes in Economics, Management, Finance and
the Social Sciences. Materials for these programmes are developed by academics at the
London School of Economics and Political Science (LSE).
For more information, see: www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr Arup Daripa, Lecturer in Financial Economics, Department of Economics, Mathematics and
Statistics, Birkbeck, University of London.
This is one of a series of subject guides published by the University. We regret that due to
pressure of work the author is unable to enter into any correspondence relating to, or arising
from, the guide. If you have any comments on this subject guide, favourable or unfavourable,
please use the form at the back of this guide.
Contents
1 Introduction 1
1.1 Routemap to the subject guide . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 Introduction to the subject area and prior knowledge . . . . . . . . . . . 2
1.3 Syllabus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4 Aims of the course . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.5 Learning outcomes for the course . . . . . . . . . . . . . . . . . . . . . . 3
1.6 Overview of learning resources . . . . . . . . . . . . . . . . . . . . . . . . 4
1.6.1 The subject guide . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.6.2 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
1.6.3 Further reading . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.6.4 Online study resources . . . . . . . . . . . . . . . . . . . . . . . . 6
1.6.5 The VLE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.6.6 Making use of the Online Library . . . . . . . . . . . . . . . . . . 7
1.7 Examination advice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.7.1 Format of the examination . . . . . . . . . . . . . . . . . . . . . . 7
1.7.2 Types of questions . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.7.3 Specific advice on approaching the questions . . . . . . . . . . . . 8
2 Consumer theory 11
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1.1 Aims of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1.2 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.1.3 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.2 Overview of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.3 Preferences, utility and choice . . . . . . . . . . . . . . . . . . . . . . . . 12
2.3.1 Preferences and utility . . . . . . . . . . . . . . . . . . . . . . . . 12
2.3.2 Indifference curves . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.3.3 Budget constraint . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.3.4 Utility maximisation . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.4 Demand curves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
i
Contents
4 Game theory 49
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.1.1 Aims of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.1.2 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 49
4.1.3 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
ii
Contents
iii
Contents
iv
Contents
8 Monopoly 129
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
8.1.1 Aims of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . 129
8.1.2 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 129
8.1.3 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
8.2 Overview of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
8.3 Properties of marginal revenue . . . . . . . . . . . . . . . . . . . . . . . . 130
8.4 Profit maximisation and deadweight loss . . . . . . . . . . . . . . . . . . 130
8.5 Price discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 132
8.6 Natural monopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134
8.7 A reminder of your learning outcomes . . . . . . . . . . . . . . . . . . . . 135
8.8 Test your knowledge and understanding . . . . . . . . . . . . . . . . . . . 135
8.8.1 Sample examination questions . . . . . . . . . . . . . . . . . . . . 135
v
Contents
9 Oligopoly 137
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137
9.1.1 Aims of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . 137
9.1.2 Learning outcomes . . . . . . . . . . . . . . . . . . . . . . . . . . 137
9.1.3 Essential reading . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
9.2 Overview of the chapter . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
9.3 Cournot competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
9.3.1 Collusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
9.3.2 Cournot with n > 2 firms . . . . . . . . . . . . . . . . . . . . . . 141
9.3.3 Stackelberg leadership . . . . . . . . . . . . . . . . . . . . . . . . 142
9.4 Bertrand competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
9.4.1 Collusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143
9.5 Bertrand competition with product differentiation . . . . . . . . . . . . . 143
9.5.1 Sequential pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
9.6 A reminder of your learning outcomes . . . . . . . . . . . . . . . . . . . . 146
9.7 Test your knowledge and understanding . . . . . . . . . . . . . . . . . . . 146
9.7.1 Sample examination questions . . . . . . . . . . . . . . . . . . . . 146
vi
Contents
vii
Contents
viii
Chapter 1
Introduction
1
1. Introduction
Nevertheless, a thorough reading of, and careful note-taking from, the recommended
textbook and the subject guide is a prerequisite for successful problem solving. The
subject guide aims to indicate as clearly as possible the key elements in microeconomic
analysis that you need to learn. The subject guide also presents detailed algebraic
derivations for a variety of topics. For each topic, you should consult both the subject
guide and the suggested parts of the textbook to understand fully the economic
principles involved.
The appropriate analysis will depend on the specific facts of a problem. However, you
are not expected to know the detailed facts about specific economic issues and policies
mentioned in textbook examples. Rather, you should use these examples (and the
end-of-chapter Sample examination questions) to aid your understanding of how
economic principles can be applied creatively to the analysis of economic problems.
If you are taking this course as part of a BSc degree you will also have passed ST104a
Statistics 1 and MT105a Mathematics 1 or MT1174 Calculus before beginning
this course. Every part of the syllabus can be mastered with the aid of diagrams and
relatively simple algebra. The subject guide indicates the minimum level of
mathematical knowledge that is required. Knowledge (and use in the examination) of
sophisticated mathematical techniques is not required. However, if you are
mathematically competent you are encouraged to use mathematical techniques when
these are appropriate, as long as you recognise that some verbal explanation is always
necessary.
1.3 Syllabus
The course examines how economic decisions are made by households and firms, and
how they interact to determine the quantities and prices of goods and factors of
production and the allocation of resources. Further, it examines the nature of strategic
2
1.4. Aims of the course
Producer theory: production and cost functions, firm and industry supply.
Game theory: normal-form and extensive form games, Nash equilibrium and
subgame perfect equilibrium, repeated games and cooperative equilibria.
Market failures arising from monopoly, externalities and public goods. The role of
policy.
3
1. Introduction
Each chapter includes a list of the learning outcomes that are specific to it. However,
you also need to go beyond the learning outcomes of each single chapter by developing
the ability of linking the concepts introduced in different chapters, in order to approach
the examination well.
The Essential reading lists the relevant textbook chapters and sections of chapters,
even though a more detailed indication of the required reading is listed throughout
the chapter.
The sections that follow specify in detail what you are expected to know about
each topic. The relevant sections of the recommended textbooks are referred to.
Wherever necessary, the sections integrate the textbook with additional material
and explanations. Finally, they draw attention to any problems that occur in
textbook expositions and explain how these can be overcome.
The boxes that appear in some of the sections give you exercises based on the
material discussed.
The learning outcomes show you what you should be able to do by the end of the
chapter.
A final section gives you questions to test your knowledge and understanding.
4
1.6. Overview of learning resources
This is available as an e-book at a discounted price via the VLE. Please visit
the course page for details.
Students may use the previous edition instead:
Note that the title of the twelfth edition differs slightly from that of the eleventh. If
using this edition, students should refer to the reading supplement on the VLE for
customised references.
N&S is more adequate for some parts of the syllabus while less so for others; as a
consequence we integrate some topics more with the extra material provided in the
subject guide. The textbook employs verbal reasoning as the main method of
presentation, supplemented by diagrammatic analyses. The textbook’s use of algebra is
not uniformly satisfactory. The subject guide supplements the textbook in many cases
in this regard. There are also some references to the following textbook:
Perloff, J.M. Microeconomics with Calculus. (Pearson Education, 2014) 3rd edition
[ISBN 9780273789987].
Detailed reading references in this subject guide refer to the editions of the textbooks
listed above. New editions of these textbooks may have been published by the time you
study this course. You can use a more recent edition of any of the textbooks; use the
detailed chapter and section headings and the index to identify relevant readings. Also,
check the virtual learning environment (VLE) regularly for updated guidance on
readings.
Unless otherwise stated, all websites in this subject guide were accessed in February
2016. We cannot guarantee, however, that they will stay current and you may need to
perform an internet search to find the relevant pages.
Besanko, D. and R. Braeutigam Microeconomics. (John Wiley & Sons, 2014) 5th
edition, international student version [ISBN 9781118716380].
Varian, H.R. Intermediate Microeconomics, a Modern Approach. (W.W. Norton,
2014) 9th edition [ISBN 9780393920772].
Pindyck, R.S. and D.L. Rubinfeld Microeconomics. (Pearson, 2014) 8th edition
[ISBN 9781292081977].
5
1. Introduction
Electronic study materials: All of the printed materials which you receive from
the University of London are available to download, to give you flexibility in how
and where you study.
Discussion forums: An open space for you to discuss interests and seek support
from your peers, working collaboratively to solve problems and discuss subject
material. Some forums are moderated by an LSE academic.
Videos: Recorded academic introductions to many subjects; interviews and
debates with academics who have designed the courses and teach similar ones at
LSE.
Recorded lectures: For a few subjects, where appropriate, various teaching
sessions of the course have been recorded and made available online via the VLE.
Audio-visual tutorials and solutions: For some of the first year and larger later
courses such as Introduction to Economics, Statistics, Mathematics and Principles
of Banking and Accounting, audio-visual tutorials are available to help you work
through key concepts and to show the standard expected in examinations.
Self-testing activities: Allowing you to test your own understanding of subject
material.
Study skills: Expert advice on getting started with your studies, preparing for
examinations and developing your digital literacy skills.
6
1.7. Examination advice
Note: Students registered for Laws courses also receive access to the dedicated Laws
VLE.
Some of these resources are available for certain courses only, but we are expanding our
provision all the time and you should check the VLE regularly for updates.
This subject guide is reproduced in colour on the VLE and you may find it easier to
understand if you access the online PDF.
7
1. Introduction
Numerical questions will sometimes require the use of a calculator. A calculator may be
used when answering questions on the examination paper for this course and it must
comply in all respects with the specification given in the Regulations.
Questions will not require knowledge of empirical studies or institutional material.
However, you will be awarded some marks for supplementary empirical or institutional
material which is directly relevant to the question.
Occasionally, you may be unsure exactly what a question is asking. If there is some
element of doubt about the interpretation of a question, state at the beginning of
your answer how you interpret the question. If you are very uncertain of what is
required, and the question is in Section B, do another question.
Explain briefly what you are doing: an answer that is simply a list of equations or
numbers will not be credited with full marks even if it gets to the correct solution.
Moreover, by explaining what you are doing, you will be awarded some marks for
correct reasoning even if there are mistakes in some part of the procedure.
It is essential to attempt eight questions in Section A. Even if you think you do not
know the answer, at least define any terms or concepts which you think may be
relevant (including those in the question!) and, if possible, present the question in
diagrammatic or algebraic form. The same applies to a specific part of a multi-part
question in Section B. The examiners can give no marks for an unattempted
question, but they can award marks for relevant points. A single mark may make
the difference between passing and failing the examination.
Although you should attempt all the questions and parts of questions that are
required, to avoid wasting time you should make sure that you do no more than is
required. For example, if only two parts of a three-part question need to be
answered, only answer two parts.
Note the importance of key words. In some of the ‘True or false?’ type questions,
the words ‘must’, ‘always’, ‘never’ or ‘necessarily’ usually invite you to explain why
the statement is ‘false’. Notice that this is simply a way in which you can start
approaching the problem, but there is no way to know in advance the correct
answer without analysing every specific question.
It is worth noting that in this type of question, simply writing ‘true’ or ‘false’ will
not earn you any marks, even if it happens to be the right answer. The examiners
are looking for reasoning, not blind guesses.
8
1.7. Examination advice
For many questions, good answers will require diagrammatic and/or algebraic
analysis to complement verbal reasoning. Good diagrams can often save much
explanation but free-standing diagrams, however well-drawn and labelled, do not
portray sufficient information to the examiners. Diagrams need to be explained in
the text of the answer. Similarly, symbols in algebraic expressions should be defined
and the final line of an algebraic presentation should be explained in words.
The examiners are primarily looking for analytical explanations, not descriptions.
On reading a question, your first thought should be: ‘what is the appropriate
hypothesis, theory, concept or model to use?’
where available, past examination papers and Examiners’ commentaries for the
course which give advice on how each question might best be answered.
9
1. Introduction
10
Chapter 2
Consumer theory
2.1 Introduction
How do people choose what bundle of goods to consume? We cannot observe this
process directly, but can we come up with a model to capture the decision-making
process so that the predictions from the model match the way people behave? If we can
build a sensible model, we should be able to use the model to understand how choice
varies when the economic environment changes. This should also help us design
appropriate policy. This is the task in this chapter – and as we go through the various
steps, you should keep this overarching goal in your mind and try to see how each piece
of analysis fits in the overall scheme.
Once we build such a model, we use it to analyse how optimal consumption choice
responds to price and income variations. We also extend the analysis to cover
labour-leisure choice as well as intertemporal consumption choice.
draw indifference curve diagrams starting from the utility function of a consumer
solve the consumer’s utility maximisation problem and derive the demand for a
consumer with a given utility function and budget constraint
11
2. Consumer theory
derive the present discounted value of payment streams and explain bond pricing.
12
2.3. Preferences, utility and choice
model of choice that has some predictive power, we do need to put some restrictions on
preferences to rule out irrational behaviour. Just a few relatively sensible restrictions
allow us to build a model of choice that has great analytical power. Indeed, this idea of
creating an analytical structure that can be manipulated to understand how changes in
the economic environment affect economic outcomes underlies the success of economics
as a tool for investigating the world around us.
Section 2.2 of N&S sets out three restrictions on preferences: completeness, transitivity
and non-satiation (‘more is better’). These restrictions allow us to do something very
useful. Once we add some further technical requirements (a full specification must await
Masters level courses but the main extra condition we need is that preferences have
certain continuity properties), these restrictions allow us to represent preferences by a
continuous function. This is known as a utility function.
Note that a utility function is an artificial concept – no-one actually has a utility
function (you knew that of course, since you surely do not have one). But because we
can represent preferences using such a function, it is as if agents have a utility function.
All subsequent analysis using utility functions and indifference curves has this ‘as if’
property.
Preferences generally give us rankings among bundles rather than some absolute
measure of satisfaction derived from bundles. You might prefer apple juice to orange
juice but would have difficulty saying exactly how much more satisfaction you derive
from the former compared to the latter. Preferences, therefore, typically give us an
‘ordinal’ ranking among bundles of goods. Since utility is simply a representation of
preferences, it is also an ordinal measure. This means that if your preferences can be
represented by a utility function, then a positive transformation of this function which
preserves the ordering among bundles is another function that is also a valid utility
function. In other words, there are many possible utility functions that can represent a
given set of preferences equally well.
However, there are some instances where we use cardinal utility and make absolute
comparisons among bundles. Money, for example, is a cardinal measure – you know that
20 pounds is twice as good as 10 pounds. In general, though, you should understand
utility as an ordinal concept.
Once we can represent preferences using a continuous utility function, we can draw
indifference curves. An indifference curve is the locus of different bundles of goods that
yield the same level of utility. In other words, an indifference curve for utility function
u(x, y) is given by u(x, y) = k, where k is some constant. As we vary k, we can trace out
the indifference map. Note that an indifference curve is simply a level curve of a utility
function. Just as you draw contours on a map to represent, say, a mountain, so
indifference curves drawn for two goods are contour plots of a utility function over these
two goods. You can see Figure 3.3 in Perloff for a pictorial representation. You should
read carefully the discussion in N&S (Sections 2.3 to 2.5) on indifference curves. You
13
2. Consumer theory
should know how different types of preferences generate different types of indifference
curves.
Activity 2.1 For each of the following utility functions, write down the equation for
an indifference curve and then draw some indifference curves.
(b) u(x, y) = x + y.
5. Every bundle of goods lies on some indifference curve (follows from completeness).
Typically, preferences have the following property. Consider a point where a lot of y and
very little x is being consumed. Starting from any such point, a consumer is willing to
give up a lot of y in exchange for another unit of x while retaining the same level of
utility as before. As we keep adding units of x and reducing y while keeping utility
constant (i.e. we are moving down an indifference curve), consumers are willing to give
up less and less of y in return for a further unit of x. One way to interpret this is that
14
2.3. Preferences, utility and choice
people typically have a taste for variety and want to avoid extremes (i.e. avoid
situations where a lot of one good and very little of the other good is being consumed).
This implies that MRS falls along an indifference curve. This property is referred to as
indifference curves being ‘convex to the origin’ in some textbooks. This works as a
visual description, but you should be aware that in terms of mathematics, this is not a
meaningful description – there is no mathematical concept where something is convex
relative to something else. The correct idea of convex indifference curves is as follows.
Consider a subset S of Rn . S is a convex set if the following property holds: if points s1
and s2 are in S, then a convex combination λs1 + (1 − λ)s2 is also in the set S for any
0 < λ < 1.
Now consider any indifference curve yielding utility level ū. Consider the set of all
points that yield utility ū or more. This is the set of all points on an indifference curve
plus all points above. Call this set B. Diminishing MRS implies that B is a convex set.
Figure 2.1 below shows a convex indifference curve. Note that the set B (part of which
is shaded) is a convex set. Try taking any two points in B and then making a convex
combination. You will find that the combinations are always inside B.
Next, Figure 2.2 shows an example of non-convex indifference curves. Note that the set
B of points on or above the indifference curve is not convex. If you combine points such
as a1 and a2 in the diagram, for some values of λ, the convex combinations fall outside
the set B.
Note that when two goods are perfect substitutes, you get a straight line indifference
curve. At the other extreme, the two goods are perfect complements (no
substitutability) and the indifference curve is L-shaped. Indifference curves with
diminishing MRS lie in between these two extremes.
15
2. Consumer theory
Here is an activity to get you computing the MRS for different utility functions.
Activity 2.2 Compute the MRS for the following utility functions.
√
(a) u(x, y) = xy.
(b) u(x, y) = ln x + ln y.
Once we have specified our model of preferences, we need to know the set of goods that
a consumer can afford to buy. This is captured by the budget constraint. Since
consumers are generally taken to be price-takers (i.e. what an individual consumer
purchases does not affect the market price for any good), the budget line is a straight
line. See Section 2.7 of N&S for the construction of budget sets. You should be aware
that budget lines would no longer be a straight line if a consumer buys different units at
different prices. This could happen if a consumer is a large buyer in a market or if the
consumer gets quantity discounts. See Application 2.6 in N&S for an example.
The consumer chooses the most preferred point in the budget set. If preferences are
such that indifference curves have the usual convex shape, the best point is where an
indifference curve is tangent to the budget line. This is shown as point A in Figure 2.3.
At A the slope of the indifference curve coincides with the slope of the budget
16
2.3. Preferences, utility and choice
constraint. So we have:
MUx Px
− =− .
MUy Py
Multiplying both sides by −1 we can write this as the familiar condition:
Px
MRSxy = .
Py
Let us derive this condition formally using a Lagrange multiplier approach. This is the
approach you are expected to use when faced with optimisation problems of this sort.
Note that the ‘more is better’ assumption ensures that a consumer spends all income (if
not, then the consumer could increase utility by buying more of either good). Therefore,
the budget constraint is satisfied with equality. It follows that the consumer maximises
u(x, y) subject to the budget constraint Px x + Py y = M . Set up the Lagrangian:
Px ∂u/∂x
= = MRSxy .
Py ∂u/∂y
17
2. Consumer theory
Second-order condition
Figure 2.4: Violation of the second-order condition under non-convex preferences. Note
that MRS is not always diminishing. Point A satisfies the first-order condition MRS equal
to price ratio, but is not optimal. (Source: Schmalensee, R. and R.N. Stavins (2013) ‘The
SO2 allowance trading system: the ironic history of a grand policy experiment,’ Journal
of Economic Perspectives, Vol. 27, pp.103–21. Reproduced by kind permission of the
American Economic Association.)
Read Sections 2.7 to 2.9 of N&S carefully and work through all the examples therein.
Note that if two goods are perfect substitutes or complements, the tangency condition
does not apply. For perfect substitutes, there is either a corner solution or the budget
line coincides with the indifference curve. In the latter case, any point on the budget
line is optimal. For the case of perfect complements, the optimum occurs where the kink
in the indifference curve just touches the budget line. Note that this is not a tangency
point – the slope of the indifference curve is undefined at the kink. N&S clarifies these
cases with appropriate diagrams.
18
2.3. Preferences, utility and choice
Demand functions
The maximisation exercise above gives us the demand for goods x and y at given prices
and income. As we vary the price of good x, we can trace out the demand curve for
good x. See Section 3.6 of N&S for a discussion. The activities below compute demand
functions in specific examples.
u(x, y) = xα y β
max xα y β subject to x + py = M.
x, y
This implies:
αxα−1 y β 1
= .
βxα y β−1 p
Simplifying:
αy 1
= .
βx p
Using this in the budget constraint and solving, we get the demand functions:
αM
x(p, M ) =
α+β
βM
y(p, M ) = .
p(α + β)
19
2. Consumer theory
Since we are at the kink, it must be that αx = βy. Using this in the budget
constraint, we get the demand functions:
βM
x(p, M ) =
β + αp
αM
y(p, M ) = .
β + αp
Figure 2.5: The optimum occurs at point E. Note that this is not a tangency point. The
slope of the indifference curve at the kink is undefined.
Income changes
Section 3.2 of N&S explains the classification of goods according to the response of
demand to income changes.
20
2.4. Demand curves
Note that it is not possible for all goods to be inferior. This would violate the ‘more is
better’ assumption. The full argument is left as an exercise.
Activity 2.3 ‘It is not possible for all goods to be inferior.’ Provide a careful
explanation of this statement.
The income-consumption curve of a consumer traces out the path of optimal bundles as
income varies (keeping all prices constant). Using this exercise, we also plot the
relationship between quantity demanded and income directly. The curve that shows this
relationship is called the Engel curve. See Perloff Section 4.2 for an exposition of the
income-consumption curve and the Engel curve.
The slope of the income-consumption curve indicates the sign of the income elasticity of
demand (explained below).
Price changes
See Sections 3.3 to 3.8 of N&S. It is very important to understand fully the
decomposition of the total price effect into income and substitution effects. This
decomposition is, of course, a purely artificial thought experiment. But this thought
experiment is extremely useful in understanding how the demand for different goods
responds to a change in price at different levels of income and given different
opportunities to substitute out of a good. You should understand how these effects
(and, therefore, the total price effect) differ across normal and inferior goods, and
understand how the effect known as Giffen’s paradox can arise.
The idea of income and substitution effects can help us understand the design of an
optimal tax scheme. See Section 3.4 of N&S for a discussion of this issue.
Finally, you should also study the impact on the demand for a good by changes in the
price of some other good, and how this effect differs depending on whether the other
good is a substitute or a complement.
Example 2.3 Suppose u(x, y) = x1/2 y 1/2 . Income is M = 72. The price of y is 1
and the price of x changes from 9 to 4. Calculate the income effect (IE) and the
substitution effect (SE).
Let (px , py ) denote the original prices and let p0x denote the lower price of x.
Under the original prices, the Marshallian demand functions (you should be able to
calculate these) are:
M
x∗ =
2px
and:
M
y∗ = .
2py
21
2. Consumer theory
where the subscript of u is a reminder that this is the original utility level (before
the price change).
The total price effect (PE) from a price fall is:
M M
PE = 0
− .
2px 2px
which implies:
M − ∆M M
p = √ .
2 p0x py 2 px py
Using the values supplied, ∆M = 24 so that M − ∆M = 48.
Under a reduced income of 48, and given the new price p0x = 4, the demand for x is
6. The original demand for x was 4. Under the compensated price change, the
demand is 6. Therefore, the SE is 2. It follows that the rest of the change must be
the IE. Since the total price effect is 5, the IE is 3.
In terms of algebra:
M − ∆M M
SE = 0
− .
2px 2px
The IE is the remainder of the price effect, so that:
M M M − ∆M M
IE = − − − .
2p0x 2px 2p0x 2px
Simplifying:
∆M
IE = .
2p0x
Looking ahead, the ∆M we calculated here is known as the ‘compensating
variation’. We will study this concept later in this chapter.
22
2.4. Demand curves
Figure 2.6: As the price of x falls, the change from A to C shows the total price effect.
The movement from A to B (under a compensated price change) shows the substitution
effect, while the movement from B to C shows the income effect.
From individual demand curves, we can construct the market demand curve by
aggregating across individuals. See N&S Section 3.10 for a discussion.
dQ/Q P dQ
ε= = .
dP/P Q dP
23
2. Consumer theory
Price elasticity of demand is the most common measure of elasticity and often referred
to as just elasticity of demand.
Other than price elasticity, we can define income elasticity and cross-price elasticity.
Income elasticity
Cross-price elasticity
Let us consider the elasticity of demand for good i with respect to the price of good j.
The cross-price elasticity of demand for good i is given by:
Pj dQi
εij = .
Qi dPj
This is negative for complements and positive for substitutes.
You should take a long look at the elasticity estimates presented in Section 3.16 of
N&S. Practical knowledge of elasticities forms an important part of designing and
understanding a variety of tax and subsidy policies in different markets.
24
2.4. Demand curves
For a normal good, the compensated demand curve is less elastic compared to the
uncompensated demand curve.
For an inferior good, the compensated demand curve is more elastic compared to
the uncompensated demand curve.
You should understand that all three properties result from the fact that only the
substitution effect matters for the change in compensated demand when the price
changes.
The next example asks you to calculate the compensated demand curve for a
Cobb–Douglas utility function.
Example 2.4 Suppose u(x, y) = x1/2 y 1/2 . Income is M . Calculate the compensated
demand curves for x and y.
To do this, we must first calculate the Marshallian demand curves. These are given
by (you should do the detailed calculations to show this):
M M
x= and y= .
2px 2py
This is the value of income which is compensated to keep utility constant at the level
given by the original choice of x and y. It follows that the compensated demand
functions are:
M∗
r
py
xc = =V
2px px
and:
M∗ px
r
yc = =V .
2py py
Note that the Marshallian demand for x does not depend on py , but the Hicksian, or
compensated, demand does. This is because changes in py require income
adjustments, which generate an income effect on the demand for x.
25
2. Consumer theory
When drawing demand curves, we typically draw the inverse demand curve (price on
the vertical axis, quantity on the horizontal axis). In such a diagram, the consumer
surplus (CS) is the area under the (inverse) demand curve and above the market price
up to the quantity purchased at the market price. This is the most widely-used measure
of welfare. We can measure the welfare effect of a price rise by calculating the change in
CS (denoted by ∆CS).
Much of our discussion of policy will be based on this measure. Any part of ∆CS that
does not get translated into revenue or profits is a deadweight loss. The extent of
deadweight loss generated by any policy is a measure of inefficiency associated with that
policy.
However, ∆CS is not an exact measure because of the presence of an income effect.
Ideally, we would use the compensated demand curve to calculate the welfare change.
CV and EV give us two such measures. You should use these measures to understand
the design of ideal policies, but when measuring welfare change in practice, use ∆CS.
CV is the amount of money that must be given to a consumer to offset the harm
from a price increase, i.e. to keep the consumer on the original indifference curve
before the price increase.
EV is the amount of money that must be taken away from a consumer to cause as
much harm as the price increase. In this case, we keep the price at its original level
(before the rise) but take away income to keep the consumer on the indifference curve
reached after the price rise.
Consider welfare changes from a price rise. For a normal good, we have
CV > ∆CS > EV, and for an inferior good we have CV < ∆CS < EV. The measures
would coincide for preferences that exhibit no income effect.
The example that follows shows an application of these concepts.
Example 2.5 The government decides to give a pensioner a heating fuel subsidy of
s per unit. This results in an increase in utility from u0 before the subsidy to u1
after the subsidy. Could the government follow an alternative policy that would
result in the same increase in utility for the pensioner, but cost the government less?
Let us show that an equivalent income boost would be less costly. Essentially, the
EV of a price fall is lower than the expenditure on heating after the price fall. The
intuition is that a per-unit subsidy distorts choice in favour of consuming more
heating, raising the total cost of the subsidy. To put the same idea differently, an
equivalent income boost would raise the demand for fuel through the income effect.
26
2.4. Demand curves
But a price fall (the fuel subsidy results in a lower effective price) causes an
additional substitution effect boosting the demand for heating.
To see this, consider Figure 2.7. The initial choice is point A and after the subsidy
the pensioner moves to point B. How much money is the government spending on
the subsidy? Note that after the subsidy, H1 units of heating fuel are being
consumed. At pre-subsidy prices, buying H1 would mean the pensioner would have
E 0 of other goods. Since the price of the composite good is 1, M is the same as total
income. It follows that the amount of income that would be spent on heating to buy
H1 units of heating at pre-subsidy prices is given by M E 0 . Similarly, at the
subsidised price, the amount of income being spent on heating fuel is M B 0 . The
difference B 0 E 0 is then the amount of the subsidy. This is the same length as
segment BE.
Once we understand how to show the amount of spending on the subsidy in the
diagram, we are ready to compare this spending with an equivalent variation of
income. This is added in Figure 2.8 below.
The pensioner’s consumption is initially at A, and moves to B after the subsidy.
Since the composite good has a price of 1, the vertical distance between the budget
lines (segment BE) shows the extent of the expenditure on the subsidy (as explained
above). An equivalent variation in income, on the other hand, would move
consumption to C. It follows that DE is the equivalent variation in income, which is
smaller than the expenditure on the subsidy. Therefore, a direct income transfer
policy would be less costly for the government.
27
2. Consumer theory
28
2.5. Labour supply
max u(N, M )
N, M
subject to:
Z = 24 − N
M = wZ + M̄ .
max u(N, M )
N, M
M + wN = 24w + M̄ .
At the optimum we have the slope of the indifference curve (−MRS) equal to the slope
of the budget line (−w). Therefore:
MUN
= w.
MUM
How does the optimal choice of labour respond to a change in w? We can analyse this
using income and substitution effects. In this case, a change in w also changes income
directly (as you can see from the budget constraint), so the exercise is a little different
compared to that under standard goods.
Suppose w rises.
Income effect
The rise in w raises income at current levels of labour and leisure. Assuming leisure
is a normal good (this should be your default assumption), this raises the demand
for leisure.
29
2. Consumer theory
Substitution effect
The rise in w makes leisure relatively more expensive, causing the agent to substitute
away from leisure. This reduces demand for leisure.
The two effects go in opposite directions, therefore the direction of the total effect is
unclear. In most cases, the substitution effect dominates, giving us an upward-sloping
labour supply function. However, it is possible, especially at high levels of income (i.e.
when wage levels are high), that the income effect might dominate. In that case we
would get a backward-bending labour supply curve which initially slopes upward but
then turns back and has a negative slope.
If leisure is, on the other hand, an inferior good, the two effects would go in the same
direction and labour supply would necessarily slope upwards.
Figure 2.9 (a) below shows a backward-bending labour supply curve while Figure 2.9
(b) shows an increasing labour supply curve.
30
2.6. Saving and borrowing: intertemporal choice
max u(C0 , C1 )
C0 , C 1
C1 Y1
C0 + = Y0 + .
1+r 1+r
This is similar to a standard optimisation problem with two goods, C0 and C1 , where
the price of the former is 1 and the price of the latter is 1/(1 + r). Unsurprisingly, the
optimum satisfies the property that:
MUC0
= 1 + r.
MUC1
Income effect
For a borrower, Y0 < C0 , so that a rise in the interest rate lowers income tomorrow.
Given consumption is normal in both periods, the agent should consume less in
period 0 (borrow less).
Substitution effect
A rise in the interest rate makes immediate consumption more costly. Therefore,
the substitution effect suggests that the individual should choose to lower C0 and,
therefore, borrow less.
Since the two effects go in the same direction, the direction of change is unambiguous: a
rise in the rate of interest lowers borrowing.
31
2. Consumer theory
Income effect
For a saver, Y0 > C0 , so that a rise in the interest rate raises income tomorrow. Given
consumption is normal in both periods, the agent should consume more in period 0
(save less).
Substitution effect
A rise in the interest rate makes immediate consumption more costly. Therefore,
the substitution effect suggests that the individual should choose to lower C0 (save
more).
Since the two effects go in opposite directions, the total effect on saving is uncertain.
Usually, the substitution effect dominates so that agents save less when the interest rate
rises, but it could go the other way.
Figure 2.10 shows the intertemporal budget constraint. The endowment point is
(Y0 , Y1 ). As the rate of interest increases, the budget constraint pivots around the
endowment point as shown.
Note that consumers reaching an optimum in the part of the budget constraint above
the endowment point are savers, and those reaching an optimum somewhere in the
lower part are borrowers.
32
2.7. Present value calculation with many periods
Activity 2.5 Using Figure 2.10 above, explain that a saver cannot become a
borrower if the rate of interest rises.
PV = y0 + δy1 + δ 2 y2 + · · · + δ n yn .
PV = y(1 + δ + δ 2 + · · · + δ n ).
S = 1 + δ + δ2 + · · · + δn.
Then:
δS = δ + δ 2 + · · · + δ n+1 .
We have:
S − δS = 1 − δ n+1 .
Therefore:
1 − δ n+1
S= .
1−δ
So:
1 − δ n+1
PV = y .
1−δ
If the payoff stream is infinite, the present value is very simple:
2 1
PV = y(1 + δ + δ + · · · ) = y .
1−δ
33
2. Consumer theory
2.7.1 Bonds
A bond typically pays a fixed coupon amount x each period (next period onwards) until
a maturity date T , at which point the face value F is paid. The price of the bond, P , is
simply the present value given by:
P = δx + δ 2 x + · · · + δ T F.
Note that the price declines if δ falls, which happens if r rises. Therefore, the price of a
bond has an inverse relationship with the rate of interest.
A special type of bond is a consol or a perpetuity that never matures. The price of a
consol has a particularly simple expression:
δ
P = δx + δ 2 x + · · · = x .
1−δ
Now δ = 1/(1 + r). Therefore:
δ 1/(1 + r) 1
= = .
1−δ r/(1 + r) r
It follows that:
x
P = .
r
This makes the inverse relationship between P and r clear.
draw indifference curve diagrams starting from the utility function of a consumer
solve the consumer’s utility maximisation problem and derive the demand for a
consumer with a given utility function and budget constraint
34
2.9. Test your knowledge and understanding
derive the present discounted value of payment streams and explain bond pricing.
2. The Hicksian demand curve for a good must be more elastic than the Marshallian
demand curve for a good. Is this true or false? Explain.
3. Savers gain more when the rate of interest rises. Is this true or false? Explain.
35
2. Consumer theory
36
Chapter 3
Choice under uncertainty
3.1 Introduction
In the previous chapter, we studied consumer choice in environments that had no
element of uncertainty. However, many important economic decisions are made in
situations involving some degree of risk. In this chapter, we cover a model of
decision-making under uncertainty called the expected utility model. The model
introduces the von Neumann–Morgenstern (vN–M) utility function. This is unlike the
ordinal utility functions we saw in the previous chapter and has special properties. In
particular, the curvature of the vN–M utility function can indicate a consumer’s
attitude towards risk. Once we introduce the model, we use it to derive the demand for
insurance and also introduce a measure of the degree of risk aversion.
explain the nature of the vN–M utility function and calculate the expected utility
from a gamble
explain the different risk attitudes and what they imply for the vN–M utility
function
analyse the demand for insurance and show the relationship between insurance and
premium
calculate the Arrow–Pratt measure of risk aversion for different specifications of the
vN–M utility function.
37
3. Choice under uncertainty
3.3 Preliminaries
You should already be familiar with concepts such as probability and expected value.
Do familiarise yourself with these concepts if this is not the case. Section 4.1 of N&S
discusses these.
Random variable
A variable that represents the outcomes from a random event. A random variable
has many possible values, and each value occurs with a specified probability.
38
3.5. Risk aversion
choice under uncertainty that might be deemed reasonable. They showed that under
their axioms, there exists a function u such that the gamble can be evaluated using the
following ‘expected utility’ formulation:
E(U (G)) = p1 u(x1 ) + p2 u(x2 ) + · · · + pn u(xn ).
The function u is known as the von Neumann–Morgenstern (vN–M) utility function.
The vN–M utility function is somewhat special. It is not entirely an ordinal function
like the utility functions you saw in the last chapter. Starting from a vN–M u function,
we can make transformations of the kind a + bu, with b > 0 (these are called positive
affine transformations), without changing the expected utility property but not any
other kinds of transformations (for example, u2 is not allowed). The reason is that, as
we discuss below, the curvature of the vN–M utility function captures attitude towards
risk. Transformations other than positive affine ones change the curvature of this
function, and therefore the transformed u function would not represent the same
risk-preferences as the original. Thus vN–M utility functions are partly cardinal.
Note that the expected utility representation is very convenient. Once we know the
vN–M utility function u, we can evaluate any gamble easily by simply taking the
expectation over the vN–M utility values.
39
3. Choice under uncertainty
Figure 3.1: The vN–M utility function for a risk-averse individual. Note that the function
is concave and u(E(G)) > E(U (G)) so that the agent does not accept a fair gamble.
Kim’s utility depends on wealth W . Kim’s vN–M utility function is given by:
√
u(W ) = W.
Kim’s wealth is uncertain. With probability 0.5 wealth is 100, and with probability 0.5
a loss occurs so that wealth becomes 64. In what follows, we will assume that Kim can
only buy full insurance. In other words, the insurance company offers to pay Kim 36
whenever the loss occurs and in exchange Kim pays them a premium of R in every state
(i.e. whether the loss occurs or not). In what follows, we will calculate the maximum
and minimum value of R.
40
3.6. Risk aversion and demand for insurance
How do we know Kim would be prepared to pay to buy full insurance? You can draw a
diagram as above to show that Kim would be prepared to pay a positive premium if
wealth is fully insured. Alternatively, you could point out that the expected utility of
the uncertain wealth (which is 9) is lower than the utility of expected wealth since:
√ √
u(E(W )) = 0.5 × 100 + 0.5 × 64 = 82 = 9.055.
This implies that the premium that Kim is willing to pay is positive.
√
You could also point out that W is a concave function (check that the second
derivative is negative), implying that Kim is risk-averse. Then draw the CE point as
above and point out that since expected wealth exceeds the certainty equivalent, the
premium is positive.
Let us now calculate the maximum premium that Kim would be willing to pay to
buy full insurance.
First, calculate the certainty equivalent of the gamble Kim is facing. This is given by:
u(CE) = E(U ).
Therefore: √
CE = 9
implying that CE = 81. Therefore, the maximum premium Kim is willing to pay is
100 − 81 = 19.
There is another way of finding this, which considers the maximum premium in terms of
expected wealth (i.e. how much expected wealth would Kim give up in order to fully
insure?). You need to understand this, since some textbooks use this way of identifying
the premium. For example, this is the approach adopted by Perloff. Unfortunately,
textbooks (including Perloff) never make clear exactly what they are doing, which can
be very confusing for students. Reading the exposition here should clarify the matter
once and for all.
The maximum premium in terms of expected wealth is calculated as follows. Note that
under full insurance the gross expected wealth Kim would receive is E(W ) = 82. We
also know that CE = 81. Therefore, the maximum amount of expected wealth Kim
would give up is 82 − 81 = 1. (Note that this should explain why in the diagram on risk
aversion in Perloff Section 16.2, and subsequent solved problems, the risk premium is
identified as the difference between expected wealth and the CE.)
To connect this approach to the one above, consider the actual premium and coverage.
Kim loses 36 with probability 0.5. So full insurance means a coverage of 36, which is
paid when the loss occurs. In return, Kim pays an actual premium of 19 in each state.
Therefore, the change in expected wealth for Kim is:
41
3. Choice under uncertainty
Once again, the purpose of writing this out in detail is to make you aware that
textbooks vary in their treatment of this. Some talk about premium in terms of
expected wealth, while others calculate the actual premium, but they do not make it
clear what it is that they are doing. In answering questions of this sort in an
examination, it is easiest (and clearest) to calculate the actual premium. You can follow
the other route and define the premium in terms of expected wealth, but in that case
you should make that clear in your answer.
Next, we calculate the minimum premium.
Assuming the insurance company is risk-neutral, it must break even. So the minimum
premium (or fair premium) is Rmin such that it equals the expected payout, which is
0.5 × (100 − 64) = 18. (Note that this is simply 100 − E(W ), where E(W ) is expected
wealth, which is 82 in this case.)
As above, the other way of answering the question is to say that in terms of the expected
wealth that Kim needs to give up, the minimum is zero. Think of this as follows. Kim
simply hands over her actual wealth to the insurance company, and in return receives
the expected wealth in all states. The insurance company is risk-neutral, and in
expected wealth terms it is giving and receiving the same amount, and breaks even.
42
3.7. Risk-neutral and risk-loving preferences
Note that the second-order condition for a maximum is satisfied since the agent is
risk-averse implying that u00 < 0 (u is concave). Therefore, we have:
u0 (WL ) (1 − p)r
0
= .
u (WN ) (1 − r)p
If insurance is fair, that implies the insurance company breaks even, i.e. the expected
payout pX equals the expected receipt rX. Since pX = rX, we have:
p = r.
It follows that:
u0 (WL ) = u0 (WN ).
Since u0 is a decreasing function (because u00 < 0), it is not possible to have this equality
if WL 6= WN . (Note that if u0 was a non-monotonic function and was going up and
down, it would be possible to have WL different from WN but have the same value of u0
at these two different points.)
It follows that WL = WN , i.e. we have:
W − L + X − rX = W − rX
implying that X = L. Therefore, the agent would optimally fully insure (cover the
entire loss) at the fair premium.
Note also what would happen if r > p. Then (1 − p)r > (1 − r)p. Therefore:
u0 (WL ) (1 − p)r
= > 1.
u0 (WN ) (1 − r)p
This implies that:
u0 (WL ) > u0 (WN ).
Again, because u0 is a decreasing function (u00 < 0), this implies that WL < WN , which
in turn implies that X < L. Thus if the premium exceeds the fair premium, less than
full insurance would be purchased.
43
3. Choice under uncertainty
Figure 3.2: The vN–M utility function for a risk-neutral individual. Note that the function
is linear and u(E(G)) = E(U (G)) so that the agent is indifferent between a fair gamble
and the safe alternative of 15.
Figure 3.2 shows the vN–M utility function for a risk-neutral agent. The figure refers to
the gamble introduced in the section on risk aversion (either keep 15 or invest in a fair
gamble yielding 20 with probability 0.5, and 10 with probability 0.5).
A risk-loving agent, on the other hand, prefers a risky bet to a safe alternative when
they have the same expected outcome. In other words, a risk-loving agent would prefer
to accept a fair gamble. As Figure 3.3 below shows, for a risk-loving agent, the CE of a
gamble is higher than the expected value of the gamble (you would have to pay a
risk-loving agent to give up a risky gamble in favour of the safe alternative of getting
the expected value of the gamble).
Figure 3.3 shows the vN–M utility function for a risk-loving agent.
44
3.8. The Arrow–Pratt measure of risk aversion
Figure 3.3: The vN–M utility function for a risk-loving individual. Note that the function
is convex and u(E(G)) < E(U (G)) so that the agent prefers a fair gamble to the safe
wealth of 15.
positive risk measure under risk aversion. These help to interpret the Arrow–Pratt
measure of risk aversion, which is given by:
u00
ρ=− 0.
u
That is, the Arrow–Pratt measure of risk aversion is −1 times the ratio of the second
derivative and the first derivative of the vN–M utility function. This is the most
common measure of risk aversion. There are other measures, which you will encounter
in Masters level courses.
It can be shown that the larger the Arrow–Pratt measure of risk aversion, the more
small gambles an individual will take. A derivation of this result must await a Masters
level course as well.
As noted above, for a risk-averse individual, u00 < 0, so the minus sign in front makes
the measure a positive number. For a risk-neutral agent, u00 = 0 so that ρ = 0, and for a
risk-loving agent u00 > 0 so that the measure is negative.
Example 3.1 Let us calculate the Arrow–Pratt measure for different specifications
of the vN–M utility function.
45
3. Choice under uncertainty
(c) Next, suppose u(W ) = −e−α . Then u0 (W ) = αe−α and u00 (W ) = −α2 e−α .
Therefore, ρ = α. In this case the degree of risk aversion does not depend on the
wealth level.
46
3.11. Test your knowledge and understanding
2. Suppose u(W ) = −1/W . What is the risk attitude of this person? Calculate the
Arrow–Pratt measure of risk aversion for this preference.
3. Suppose an agent has vN–M utility function u(W ). Under what conditionp would
a + bu(W ) also be a valid vN–M utility function for this agent? Would u(W ) be
a valid vN–M utility function for this agent?
4. Suppose u(W ) = ln W for an agent. The agent faces the following gamble: with
probability 0.5 wealth is 100, and with probability 0.5 a loss occurs so that wealth
becomes 64. The agent can buy any amount of insurance: a coverage of X can be
purchased by paying premium rX.
(a) Work out the insurance coverage X that the agent would optimally purchase
as a function of r.
(b) Plot the optimal X as a function of r.
(c) Calculate the value of r for which full insurance is purchased.
(d) Calculate the value of r for which no insurance is purchased.
47
3. Choice under uncertainty
48
Chapter 4
Game theory
4.1 Introduction
In many economic situations agents must act strategically by taking into account the
behaviour of others. Game theory provides a set of tools that enables you to analyse
such situations in a logically coherent manner. For each concept introduced, you should
try to understand why it makes sense as a tool of analysis and (this is much harder) try
to see what its shortcomings might be. This is not the right place to ask questions such
as ‘what is the policy-relevance of this concept?’. The concepts you come across here are
just tools, and that is the spirit in which you should learn them. As you will see, some
of these concepts are used later in this course (as well as in a variety of other economics
courses that you might encounter later) to analyse certain types of economic
interactions.
explain why Nash equilibrium is the central solution concept and explain the
importance of proving existence
explain the idea of refining Nash equilibria in extensive-form games using backward
induction and subgame perfection
49
4. Game theory
explain the multiplicity of equilibria in repeated games and state the folk theorem
for the Prisoners’ Dilemma game.
50
4.3. Simultaneous-move or normal-form games
Suppose Si denotes the set of strategies of player i. In the example above, S1 = {U, D}
and S2 = {L, R}. Let si denote a strategy of i (that is, si is in the set Si ). If there are n
players, a strategy profile is (s1 , s2 , . . . , sn ). For any such strategy profile, there is a
payoff for each player. Let ui (s1 , s2 , . . . , sn ) denote the payoff of player i.
Continuing the example above, suppose u1 ({U, L}) = u1 ({D, R}) = 1 and
u1 ({D, L}) = u1 ({U, R}) = 2. Furthermore, suppose u2 ({U, L}) = u2 ({D, R}) = 2,
u2 ({D, L}) = 3 and u2 ({U, R}) = 1.
We write this in a convenient matrix form (known as the normal form) as follows. The
first number in each cell is the payoff of player 1 and the second number is the payoff of
player 2. Note that player 1 chooses rows and player 2 chooses columns.
Player 2
L R
Player 1 U 1, 2 2, 1
D 2, 3 1, 2
It is sometimes useful to write the strategy profile (s1 , s2 , . . . , sn ) as (si , s−i ), where s−i
is the profile of strategies of all players other than player i. So:
(the ith element is missing). With this notation, we can write the payoff of player i as
ui (si , s−i ).
Player 2
C D
Player 1 C 2, 2 0, 3
D 3, 0 1, 1
Here each player has a dominant strategy, D. This is the well-known Prisoners’
Dilemma game. Rational players, playing in rational self-interest, get locked into a
51
4. Game theory
Dominant strategy
ui (s∗i , s−i ) > ui (si , s−i ) for all si different from s∗i and for all s−i .
That is, s∗i performs better than any other strategy of player i no matter what others
are playing.
Even if a player does not have a dominant strategy, he might have one or more
dominated strategies. A dominated strategy for i is a strategy of i (say si ) that yields a
lower payoff compared to another strategy (say s0i ) irrespective of what others are
playing. In other words, the payoff of i from playing si is always (i.e. under all possible
choices of other players) lower than the payoff from playing s0i . Since si is a dominated
strategy, i would never play this strategy. Thus we can eliminate dominated strategies.
Indeed, we can eliminate such strategies not just once, but in an iterative fashion.
If in some game, all strategies except one for each player can be eliminated by
iteratively eliminating dominated strategies, the game is said to be dominance solvable.
Consider the game in Section 4.3. Note that no strategy is dominant for player 1, but
for player 2 L dominates R. So we can eliminate the possibility of player 2 playing R.
Once we do this, in the remaining game, for player 1 D dominates U (2 is greater than
1). So we can eliminate U . We are then left with (D, L), which is the equilibrium by
iteratively eliminating dominated strategies. The game is dominance solvable.
Here is another example of a dominance solvable game. We find the equilibrium of this
game by iteratively eliminating dominated strategies.
Player 2
Left Middle Right
Top 4, 3 2, 7 0, 4
Player 1 Middle 5, 5 5, −1 −4, −2
Bottom 3, 5 1, 5 −1, 6
52
4.3. Simultaneous-move or normal-form games
3. In the remaining game, for player 1, Top is dominated by Middle. Eliminate Top.
Player 2
A2 B2 C2
A1 3, 1 1, 3 4, 2
Player 1 B1 1, 0 3, 1 3, 0
C1 2, 3 2, 0 3, 2
As noted above, the problem with dominance criteria is that they apply only to some
games. For games that do not have dominant or dominated strategies, the idea of
deriving an equilibrium using dominance arguments does not work. If we cannot derive
an equilibrium by using dominant strategies or by (iteratively) eliminating dominated
strategies, how do we proceed?
If we want to derive an equilibrium that does not rely on specific features such as
dominance, we need a concept of equilibrium that applies generally to all games. As we
show below, a Nash equilibrium (named after the mathematician John Nash) is
indeed such a solution concept.
Before proceeding further, we need to clarify something about the nature of strategies.
In the discussion above, we identified strategies with single actions. For example, in the
Prisoners’ Dilemma game, we said each player has the strategies C and D. However,
this is not a full description of strategies. A player could also do the following: play C
with probability p and play D with probability (1 − p), where p is some number
between 0 and 1. Such a strategy is called a ‘mixed’ strategy; while a strategy that just
chooses one action (C or D) is called a ‘pure’ strategy.
We start by analysing Nash equilibrium under pure strategies. Later we introduce
mixed strategies. We then note that one can prove an existence result: all games have at
least one Nash equilibrium (in either pure or mixed strategies). This is why Nash
equilibrium is the central solution concept in game theory.
53
4. Game theory
A strategy profile (s∗1 , s∗2 , . . . , s∗n ) is a Nash equilibrium (in pure strategies) if it is a
mutual best response. In other words, for every player i, the strategy s∗i is a best
response to s∗−i (as explained above, this is the strategy profile of players other than i).
In yet other words, if (s∗1 , s∗2 , . . . , s∗n ) is a Nash equilibrium, it must satisfy the property
that given the strategy profile s∗−i of other players, player i cannot improve his payoff by
replacing s∗i with any other strategy.
A more formal definition is as follows.
To find out the Nash equilibrium of the game above, we must look for the mutual best
responses. Let us check the best response of each player. Player 1’s best response is as
follows:
Note from these that the only mutual best response is (B1 , B2 ). This is the only Nash
equilibrium in this game.
You could also check as follows:
If player 1 plays B1 , player 2’s best response is B2 . If player 2 plays B2 , player 1’s
best response is B1 . Therefore, (B1 , B2 ) is a Nash equilibrium.
From the three steps above, we can conclude that (B1 , B2 ) is the only Nash equilibrium.
54
4.3. Simultaneous-move or normal-form games
Let us also do a slightly different exercise. Suppose you want to check if a particular
strategy profile is a Nash equilibrium. Suppose you want to check if (A1 , C2 ) is a Nash
equilibrium. You should check as follows.
If player 2 plays C2 , player 1 cannot do any better by changing strategy from A1 (4 is
better than 3 from B1 or 3 from C1 ). However, player 2 would not want to stay at
(A1 , C2 ) since player 2 can do better by switching to B2 (3 from B2 is better than 2
from C2 ). We can therefore conclude that (A1 , C2 ) is not a Nash equilibrium.
You can similarly check that all boxes other than (B1 , B2 ) have the property that some
player has an incentive to switch to another box. However, if the players are playing
(B1 , B2 ) no player has an incentive to switch away. Neither player can do better by
switching given what the other player is playing. Since player 2 is playing B2 , player 1
gets 3 from B1 which is better than 1 from A1 or 2 from C1 . Since player 1 is playing
B1 , player 2 gets 1 from B2 which is better than 0 from A2 or C2 . Therefore (B1 , B2 ) is
a Nash equilibrium.
Nash equilibrium is not necessarily unique. Consider the following game.
Player 2
A B
A 2, 1 0, 0
Player 1 B 0, 0 1, 2
Note there are multiple pure strategy Nash equilibria. Both (A, A) and (B, B) are Nash
equilibria.
Note that while a dominant strategy equilibrium is also a Nash equilibrium, Nash
equilibrium does not require dominance. However, the greater scope of Nash equilibrium
comes at a cost: it places greater rationality requirements on players. To play (B1 , B2 ),
player 1 must correctly anticipate that player 2 is going to play B2 . Such a requirement
is even more problematic when there are multiple Nash equilibria. On the other hand, if
players have dominant strategies, they do not need to think at all about what others are
doing. A player would simply play the dominant strategy since it is a best response no
matter what others do. This is why a dominant strategy equilibrium (or one achieved
through iterative elimination of dominated strategies) is more convincing than a Nash
equilibrium. However, as noted before, many games do not have dominant or dominated
strategies, and are therefore not dominance solvable. We need a solution concept that
applies generally to all games, and Nash equilibrium is such a concept.
Player 2
A2 B2
A1 3, 1 2, 3
Player 1 B1 2, 1 3, 0
55
4. Game theory
Notice that this game has no pure strategy Nash equilibrium. However, as you will see
below, the game does have a Nash equilibrium in mixed strategies.
Let us first define a mixed strategy.
Mixed strategy
In the game above, A1 and B1 are the pure strategies of player 1. A mixed strategy of
player 1 could be A1 with probability 1/3, and B1 with probability 2/3. Notice that a
pure strategy is only a special case of a mixed strategy.
A Nash equilibrium can then be defined in the usual way: a profile of mixed strategies
that constitute a mutual best response.
A mutual best response in mixed strategies has an essential property that makes it easy
to find mixed strategy Nash equilibria. Let us consider games with two players to
understand this property.
Suppose we have an equilibrium in which both players play strictly mixed strategies:
player 1 plays A1 with probability p and B1 with probability (1 − p) where 0 < p < 1,
and player 2 plays A2 with probability q and B2 with probability (1 − q) where
0 < q < 1.
In this case, whenever player 1 plays A1 , she gets an expected payoff of:
What must be true of these expected payoffs that player 1 gets from playing A1 and
B1 ? Suppose π1 (A1 ) > π1 (B1 ). Then clearly player 1 should simply play A1 , rather than
any strictly mixed strategy, to maximise her payoff. In other words, player 1’s best
response in this case would be to choose p = 1, rather than a strictly mixed strategy
p < 1. But then we do not have a mixed strategy Nash equilibrium.
Similarly, if π1 (A1 ) < π1 (B1 ), player 1’s best response would be to choose p = 0 (i.e. just
to play B1 ), and again we cannot have a mixed strategy Nash equilibrium.
So if player 1 is going to play a mixed strategy in equilibrium it must be that she is
indifferent between the two strategies. How does such indifference come about? This is
down to player 2’s strategy choice. Player 2’s choice of q must be such that player 1 is
indifferent between playing A1 or B1 . In other words, in equilibrium q must be such
that π1 (A1 ) = π1 (B1 ), i.e. we have:
3q + 2(1 − q) = 2q + 3(1 − q)
56
4.3. Simultaneous-move or normal-form games
to make player 2 indifferent between A2 and B2 . In other words, player 1’s choice of p is
such that π2 (A2 ) = π2 (B2 ), i.e. we have:
1 = 3p
Figure 4.1 below shows these best response functions and shows the equilibrium point
(where the two best response functions intersect).
Figure 4.1: The best-response functions. They cross only at E, which is the mixed strategy
Nash equilibrium. There are no pure strategy Nash equilibria in this case.
57
4. Game theory
Activity 4.1 Find the mixed strategy Nash equilibrium in the following game. Also
show all Nash equilibria of the game in a diagram by drawing the best response
functions.
Player 2
A B
A 2, 1 0, 0
Player 1 B 0, 0 1, 2
Existence theorem
Every game with a finite number of players and finite strategy sets has at least one
Nash equilibrium.
Nash proved the existence theorem for his equilibrium concept using a mathematical
result called a ‘fixed-point theorem’. Take any strategy profile and compute the best
response to it for every player. So the best response is another strategy profile. Suppose
we do this for every strategy profile. So long as certain conditions are satisfied, a
fixed-point theorem says that there is going to be at least one strategy profile which is a
best response to itself. This is, of course, a Nash equilibrium. Thus upon setting up the
strategy sets and the best response functions properly, a fixed-point theorem can be
used to prove existence. You will see a formal proof along these lines if you study game
theory at more advanced levels. Here, let us point out the importance of this result.
The existence theorem is indeed very important. It tells us that no matter what game
we look at, we will always be able to derive at least one Nash equilibrium. If existence
did not hold for some equilibrium concept (for example, games do not necessarily have a
dominant strategy equilibrium), we could derive wonderful properties of that concept,
but we could not be sure such derivations would be of any use. The particular game
58
4.4. Sequential-move or extensive-form games
that we confront might not have an equilibrium at all. But being able to prove existence
for Nash equilibrium removes such problems. Indeed, as noted before as well, this is
precisely what makes Nash equilibrium the main solution concept for
simultaneous-move games.
59
4. Game theory
For the sake of brevity of notation, we write these as follows. Just as we read words
from left to right, we read strategies from left to right. So we write the strategy ‘if
player 1 plays a1 , play b2 and if player 1 plays a2 , play b1 ’ as b2 b1 . Reading from left to
right, this implies that the plan is to play b2 at the left node and play b1 at the right
node. This is precisely what the longer specification says.
So the strategy set of player 2 is {(b1 b1 ), (b1 b2 ), (b2 b1 ), (b2 b2 )}.
Suppose instead of 2 actions, player 2 could choose between b1 , b2 and b3 at each node.
In that case, player 2 would have 3 × 3 = 9 strategies.
60
4.4. Sequential-move or extensive-form games
Suppose player 1 had 3 strategies a1 , a2 and a3 , and after each of these, player 2 could
choose between b1 and b2 . Then player 2 would have 2 × 2 × 2 = 8 strategies.
Player 2
b1 b1 b1 b2 b2 b1 b2 b2
Player 1 a1 3, 1 3, 1 1, 0 1, 0
a2 4, 1 0, 1 4, 1 0, 1
Note that if we pair, say, a1 with b2 b1 , only the first component of player 2’s strategy is
relevant for the payoff. In other words, since player 1 plays a1 , the payoff is generated by
player 2’s response to a1 , which in this case is b2 . Similarly, if we pair a2 with b2 b1 , the
second component of player 2’s strategy is relevant for the payoff. Since player 1 plays
a2 , we need player 2’s response to a2 , which in this case is b1 , to determine the payoff.
Once we write down the normal form, it is easy to find Nash equilibria. Here let us only
consider pure strategy Nash equilibria. There are three pure strategy Nash equilibria in
this game. Finding these is left as an exercise.
Example 4.1 Find the pure strategy Nash equilibria of the extensive-form game
above.
It is easiest to check each box. If we start at the top left-hand box, player 1 would
switch to a2 . So this is not a Nash equilibrium. From (a2 , b1 b1 ) no player can do
better by deviating. Therefore, (a2 , b1 b1 ) is a Nash equilibrium.
Next try (a1 , b1 b2 ). This is indeed a Nash equilibrium. Note that you must write
down the full strategy of player 2. It is not enough to write (a1 , b1 ). Unless we know
what player 2 would have played in the node that was not reached (in this case the
node after a2 was not reached), we cannot determine whether a strategy is part of a
Nash equilibrium. So while (a1 , b1 b2 ) is indeed a Nash equilibrium, (a1 , b1 b1 ) is not.
Finally, (a2 , b2 b1 ) is also a Nash equilibrium. These are the three pure strategy Nash
equilibria of the game.
61
4. Game theory
player does not observe some past moves, what he believes took place becomes
important. We do not study these problems here – the analysis below simply shows you
how to represent situations of imperfect information in some simple cases.
Consider the extensive-form game introduced at the start of this section. Suppose at the
time of making a decision, player 2 does not know what strategy player 1 has chosen.
Since player 2 does not know what player 1 has chosen, at the time of taking an action
player 2 does not know whether he is at the left node or at the right node. To capture
this situation of imperfect information in our game-tree, we say that the two decision
nodes of player 2 are in an information set. We represent this information set as in
Figure 4.3: by connecting the two nodes by a dotted line (another standard way to do
this is to draw an elliptical shape around the two nodes – you will see this in N&S).
Note that player 2 knows he is at the information set (after player 1 moves), but does
not know where he is in the information set (i.e. he does not know what player 1 has
chosen). Since player 2 cannot distinguish between the two nodes inside his information
set, he cannot take different actions at the two nodes. Therefore, the strategy set of 2 is
simply {b1 , b2 }. In other words, now, for both players the strategy set coincides with the
action set. This is not surprising: since player 2 takes an action without knowing what
player 1 has done, the game is the same as a simultaneous-move game. Indeed, the
normal form of the game above coincides with a game in which the two players choose
strategies simultaneously. This is shown below. Now the Nash equilibrium is simply
(a2 , b1 ).
Player 2
b1 b2
a1 3, 1 1, 0
Player 1 a2 4, 1 0, 1
62
4.5. Incredible threats in Nash equilibria and subgame perfection
Firm I
A F
In 2, 1 −1, −2
Firm E Out 0, 2 0, 2
Note that there are two pure strategy Nash equilibria: (In, A) and (Out, F). The latter
equilibrium involves an incredible threat. Clearly, if the entrant does decide to enter the
63
4. Game theory
market, the incumbent has no incentive to choose F. Hence the threat of F is incredible.
Yet, Nash equilibrium cannot preclude this possibility. Out is the best response to F,
and once Firm E decides to stay out, anything (and in particular F) is a best response
for Firm I.
The game in Figure 4.5 presents another example.
When you write the normal form and work out the Nash equilibria, you should see
that (R, rr) is a Nash equilibrium. Look at the game above and see that this
involves an incredible threat. Player 2’s strategy involves playing r after L. Player
1’s strategy is taking a best response given this, and so player 1 is playing R. Given
that player 1 is playing R, the threat is indeed a best response for player 2 (indeed,
given that player 1 plays R, anything that player 2 can choose after L is trivially a
best response since it does not change the payoff, but, of course, not every choice
would lead to an equilibrium in which player 1’s best response is R).
64
4.5. Incredible threats in Nash equilibria and subgame perfection
Subgame
A subgame is a part of a game that starts from a node which is a singleton (i.e. a
subgame does not start at an information set), and includes all successors of that node.
If one node in an information set belongs to a subgame, so do all other nodes in that
information set. In other words, you cannot cut an information set so that only part of
it belongs to a subgame. That would clearly alter the information structure of the
game, which is not allowed.
We can now define a subgame perfect equilibrium.
65
4. Game theory
What player 2 plays at the unreached node is crucial. If player 2 played ` after L, R
would not be the optimal choice. Therefore, you must specify player 2’s full strategy
and identify (R, `r) as the SPNE.
In these games, the SPNE is unique, but it need not be. The next activity presents an
example.
Activity 4.3 Derive the pure strategy subgame perfect Nash equilibria of the game
in Figure 4.2.
66
4.5. Incredible threats in Nash equilibria and subgame perfection
decides between A and B, and player 2 decides between C and D. When player 2 makes
his decision, he knows that player 1 has decided to come in (if not then player 2 would
not have been asked to play), but without knowing what player 1 has chosen between A
and B. In other words, the situation is just as if once player 1 comes in, player 1 and
player 2 play a simultaneous-move game (as the game structure shows, they do not
move simultaneously – player 1 moves before player 2, but since player 2 has no
knowledge of player 1’s move, it is similar to the decision problem faced in a
simultaneous move game).
1. Pure strategy Nash equilibria. Let us first identify the pure strategy Nash
equilibria. Note that player 1 has 4 strategies: Out A, Out B, In A and In B, while
player 2 has 2 strategies: C and D. You might think strategies like Out A do not make
sense, but in game theory we try to model the thought process of players, and even if
player 1 stays out, she would do so only after thinking about what she would have done
had she entered. Strategies reflect such thinking (it is as if player 1 is saying ‘I have
decided to finally stay out, but had I come in I would have chosen A’).
Let us now write down the normal form of the game.
Player 2
C D
Out A 1, 3 1, 3
Player 1 Out B 1, 3 1, 3
In A −2, −2 2, 0
In B 0, 2 −5, −5
You should be able to see from this that the pure strategy Nash equilibria are
(Out A, C), (Out B, C) and (In A, D).
67
4. Game theory
2. Pure strategy subgame perfect Nash equilibria. Note that backward induction
does not work here: we cannot fold back given the information set of player 2. However,
subgame perfection still works. Let us see how applying subgame perfection can refine
the set of Nash equilibria.
Note that apart from the whole game, there is just one strict subgame, which starts at
the node after player 1 chooses In. Below we write down the normal form of the
subgame.
Player 2
C D
Player 1 A −2, −2 2, 0
B 0, 2 −5, −5
As you can see, the subgame has two pure strategy Nash equilibria: (B, C) and (A, D).
If (B, C) is played in the subgame, player 1 compares 1 (from Out) with 0 (from In
followed by (B, C)) and decides to stay out. Therefore, a SPNE of the whole game is
(Out B, C).
If, on the other hand, (A, D) is played in the subgame, player 1 compares 1 with 2 and
decides to come in. Therefore, another SPNE of the whole game is (In A, D).
It follows that the pure strategy SPNE of the whole game are (Out B, C) and (In A, D).
Another way to derive these is as follows. Since the set of SPNE is a subset of the set of
Nash equilibria, and since (B, C) and (A, D) are the Nash equilibria in the subgame, it
must be that any Nash equilibria of the whole game that involves playing either (B, C)
and (A, D) in the subgame are subgame perfect. Considering the set of Nash equilibria
derived above, we can immediately infer that (Out A, C) is Nash but not subgame
perfect, while the other two are subgame perfect.
Player 2
C D
Player 1 C 2, 2 0, 3
D 3, 0 1, 1
In a one-shot game, rational players simply play their dominant strategies. So (D, D) is
the only possible equilibrium. Suppose the game is repeated. Can we say something
about the behaviour of players in such ‘supergames’ that differs from the behaviour in
the one-shot game?
First, consider the case of a finite number of repetitions. Say the game is played twice.
Would anything change? The answer is no. In the second round, players simply face a
one-shot game and they would definitely play their dominant strategies. Given that
(D, D) will be played in the next period, playing anything other than D today makes no
sense. Therefore, in each period players would play (D, D). But this logic extends to any
68
4.6. Repeated Prisoners’ Dilemma
finite number of repetitions. If the game is played a 100 times, in the last period (D, D)
will be played. This implies that (D, D) will be played in the 99th period, and so on.
While the logic is inescapable, actual behaviour in laboratory settings differs from this.
Faced with a large finite number of repetitions, players do cooperate for a while at least.
Therefore, it is our modelling that is at fault. To escape from the logic of backward
induction, we can assume that when a game is repeated many times, players play them
as if the games are infinitely repeated. In that case, we must apply forward-looking logic
as there is no last period from which to fold backwards.
(A quick note: you should be aware that there are other games with multiple Nash
equilibria where some cooperation can be sustained even under a finite number of
repetitions. You will encounter these in more advanced courses. Here we only consider
the repeated Prisoners’ Dilemma.)
Let us now analyse an infinitely repeated Prisoners’ Dilemma game.
First, we need to have an appropriate notion of payoffs in the infinitely repeated game.
Each player plays an action (in this case either C or D) in each period. So in each
period, the players end up playing one of the four possible action profiles (C, C), (C, D),
(D, C) or (D, D). Let at denote the action profile played in period t. Then in period t,
player i receives the payoff ui (at ). The payoff of player i in the repeated game is simply
the discounted present value of the stream of payoffs.
Let δ denote the common discount factor across players, where 0 < δ < 1. If today’s
date is 0, and a player receives x in period t, the present value of that payoff is δ t x. The
discount factor can reflect players’ time preference. This can also arise from a simple
rate of interest calculation, in which case δ can be interpreted as 1/(1 + r), where r is the
rate of interest. Note that higher values of δ indicate that players are more patient (i.e.
value future payoffs more). If δ is very low, the situation is almost like a one-shot game,
since players only value today’s payoff, and place very little value on any future payoff.
Given such discounting, the payoff of player i in the repeated game is:
ui (a0 ) + δui (a1 ) + δ 2 ui (a2 ) + · · · .
More concisely, the payoff is:
∞
X
δ t ui (at ).
t=0
If the payoff is the same every period (x, say), this becomes:
x
x(1 + δ + δ 2 + · · · ) = .
1−δ
69
4. Game theory
Trigger strategy
Start by playing C (that is, cooperate at the very first period, when there is no
history yet).
In period t > 1:
• if (C, C) was played last period, play C
• if anything else was played last period, play D.
Suppose each player follows this strategy. Note that cooperation (playing (C, C)) would
work only until someone deviates to D. After the very first deviation, each player
switches to D. Since anything other than (C, C) implies playing (D, D) next period,
once a switch to (D, D) has been made, there is no way back: the players must play
(D, D) forever afterwards. This is why this is a trigger strategy.
Another way of stating the trigger strategy is to write in terms of strategy profiles.
In period t:
• if (C, C) is played in t − 1, play (C, C)
• otherwise play (D, D).
Let us see if this will sustain cooperation. Suppose a player deviates in period t. We
only need to consider what happens from t onwards. The payoff starting at period t is
given by:
δ
3 + δ + δ2 + · · · = 3 + .
1−δ
If the player did not deviate in period t, the payoff from t onwards would be:
2
2 + 2δ + 2δ 2 + · · · = .
1−δ
For deviation to be suboptimal, we need:
2 δ
>3+
1−δ 1−δ
which implies:
1
δ> .
2
Thus if the players are patient enough, cooperation can be sustained in equilibrium. In
other words, playing (C, C) always can be the outcome of an equilibrium if the discount
factor δ is at least 1/2.
70
4.6. Repeated Prisoners’ Dilemma
For example, note that always playing (D, D) is an equilibrium no matter what the
value of δ is. Each player simply adopts the strategy ‘play D initially, and at any period
t > 1, play D irrespective of history’. Note that both players adopting this strategy is a
mutual best response. Therefore, we can sustain (1, 1) in equilibrium. In fact, by using
suitable strategies, we can sustain many more – in fact infinitely more – payoffs as
equilibrium outcomes. For the Prisoners’ Dilemma game, we will describe the set of
sustainable payoffs below.
The result about the large set of payoffs that can be sustained as equilibrium outcomes
is known as the ‘folk theorem’. These types of results were known to many game
theorists from an early stage of development of non-cooperative game theory. While
formal proofs were written down later, we cannot really trace the source of the idea,
which explains the name.
Here we state a folk theorem adapted to the repeated Prisoners’ Dilemma game. To
state this, we will need to compare payoffs in the repeated game to payoffs in the
one-shot game that is being repeated. The easiest way to do that is to normalise the
repeated game payoff by multiplying by (1 − δ). Then if a player gets 2 every period,
the repeated game payoff is (1 − δ) × 2/(1 − δ) = 2. As you can see, this normalisation
implies that the set of normalised repeated game payoffs now coincide with the set of
payoffs in the underlying one-shot game. So now we can just look at the set of payoffs of
the one-shot game and ask which of these are sustainable as the normalised payoff in
some equilibrium of the repeated game.
For the rest of this section, whenever we mention a repeated game payoff, we always
refer to normalised payoffs. Note that in this game, a player can always get at least 1 by
simply playing D. It follows that a player must get at least 1 as a (normalised) repeated
game payoff.
To see the whole set of payoffs that can be sustained, let us plot the payoffs from the
four different pure strategy profiles. These are shown in Figure 4.8 below. Now join the
payoffs and form a convex set as shown in the figure. We now have a set of payoffs that
can arise from pure or mixed strategies.
The Folk theorem is the following claim. Consider any pair of payoffs (π1 , π2 ) such
that πi > 1 for i = 1, 2. Any such payoff can be supported as an equilibrium payoff for
high enough δ.
As noted above, for the Prisoners’ Dilemma game we can also sustain the payoff (1, 1)
as an equilibrium outcome irrespective of the value of δ.
The set of payoffs that can be supported as equilibrium payoffs in our example is shown
as the shaded part in Figure 4.8.
(a) Find conditions on the discount factor under which cooperation can be
sustained in the repeated game in which the above game is repeated infinitely.
71
4. Game theory
Figure 4.8: The set of payoffs that can be supported as equilibrium payoffs under an
infinitely-repeated game.
(a) First, note that player 2 has no incentive to deviate from (C, C). To ensure that
player 1 does not deviate, consider the following strategy profile. Play (C, C)
initially. At any period t > 0, if (C, C) has been played in the last period, play
(C, C). Otherwise, switch to (D, D).
Under this strategy profile, player 1 will not deviate if:
δ 3
7+2× 6
1−δ 1−δ
which implies δ > 4/5.
(b) We want to support alternating between (C, C) and (D, D), starting with
(C, C) in period 0, as an equilibrium.
Note first that player 2 has no incentive to deviate in odd or even periods.
Player 1 cannot gain by a one-shot deviation in odd periods, when (D, D) is
supposed to be played. So the only possible deviation is by player 1 in even
periods, when (C, C) is supposed to be played.
To prevent such a deviation, consider the following strategy profile.
• Start by playing (C, C) in period 0.
• In any odd period t (where t = 1, 3, 5, . . .) play (D, D) (irrespective of
history).
72
4.6. Repeated Prisoners’ Dilemma
Note that this is a version of the trigger strategy. After any deviation from
cooperation in even periods, (D, D) is triggered forever.
If player 1 does not deviate in any even period t, player 1’s payoff (t onwards) is:
Vt = 3 + 2δ + 3δ 2 + 2δ 3 + · · ·
= 3(1 + δ 2 + δ 4 + · · · ) + 2δ(1 + δ 2 + δ 4 + · · · )
3 + 2δ
= .
1 − δ2
If player 1 does deviate in even period t, player 1’s payoff (t onwards) is:
δ
Vtdev = 7 + 2δ + 2δ 2 + · · · = 7 + 2 × .
1−δ
Therefore, player 1 prefers not to deviate in either period 0 or in any even
period if:
3 + 2δ δ
> 7 + 2 ×
1 − δ2 1−δ
which simplifies to 5δ 2 − 4 > 0, implying:
r
4
δ> ≈ 0.89.
5
Note also the repeated game payoff generated in this equilibrium. To see this, first
normalise the payoff by multiplying by (1 − δ). The normalised payoff of player 1
starting any even period is:
3 + 2δ 3 + 2δ
(1 − δ) × 2
= .
1−δ 1+δ
Similarly, the normalised payoff of player 1 starting any odd period is
(2 + 3δ)/(1 + δ). Note that either payoff goes to 5/2 as δ → 1.
For player 2, the normalised payoff from the equilibrium is (2 + δ)/(1 + δ) starting
any even period, and (1 + 2δ)/(1 + δ) starting any odd period. Note that either
payoff goes to 3/2 as δ → 1.
In other words, this exercise shows you an example of an equilibrium that sustains a
payoff in the interior of the set of payoffs which is sustainable according to the folk
theorem (which, in this case, is anything strictly above (2, 1), or the point (2, 1)
itself).
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4. Game theory
explain why Nash equilibrium is the central solution concept and explain the
importance of proving existence
explain the idea of refining Nash equilibria in extensive-form games using backward
induction and subgame perfection
explain the multiplicity of equilibria in repeated games and state the folk theorem
for the Prisoners’ Dilemma game.
Player 2
A2 B2 C2
A1 3, 3 −1, 4 0, 5
Player 1 B1 2, 1 3, 2 −1, 0
C1 −1, 0 0, 1 1, 0
2. Identify actions and strategies of each player in each of the following games (Figure
4.9 to Figure 4.11).
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4.8. Test your knowledge and understanding
75
4. Game theory
(a) Write down the actions and strategies for each player.
(b) Identify the pure and mixed strategy Nash equilibria.
(c) Identify the pure and mixed strategy subgame perfect Nash equilibria.
(a) Write down the actions and strategies for each player.
(b) Identify the pure strategy Nash equilibria.
(c) Identify the pure strategy subgame perfect Nash equilibria.
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4.8. Test your knowledge and understanding
(a) Write down the actions and strategies for each player.
(b) Identify the pure strategy Nash equilibria.
(c) Identify the pure strategy subgame perfect Nash equilibria.
6. Find the pure strategy subgame perfect Nash equilibria for the game in Figure 4.9
in Question 2.
7. Suppose the following game is repeated infinitely. The players have a common
discount factor δ, where 0 < δ < 1.
Player 2
C D
Player 1 C 3, 2 0, 3
D 5, 0 2, 1
(a) Find conditions on the discount factor under which cooperation (which implies
playing (C, C) in each period) can be sustained as a subgame perfect Nash
equilibrium of the infinitely-repeated game. Your answer must specify the
strategies of players clearly.
(b) In a diagram, show the set of payoffs that can be supported in a repeated
game equilibrium according to the folk theorem.
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4. Game theory
78