ECON1870

Game Theory & Applications: Review

Key Concepts
• Normal Form
This is a form of representing a game. It specifies the players in the game, the strategies available to
them, the payoffs that each player receives at any possible combination of strategies. It need not
be that the game is a simultaneous-move game. The game can be summarized by:
𝐺 = {𝑆! … 𝑆! ; 𝑢! … 𝑢! }. For example:
1\2 A B
A 1, 1 2, 2
B 2, 2 3, 3

• Prisoner’s Dilemma
A game of two players, in which the players have two possible strategies available:
𝑆 = 𝑁𝑜𝑡 𝐶𝑜𝑛𝑓𝑒𝑠𝑠, 𝐶𝑜𝑛𝑓𝑒𝑠𝑠 = {𝑁, 𝐶}. If both of the prisoners don’t confess they will only be
convicted of a minor transgression; if both confess then they will both do longer time; and if one
confesses and the other doesn’t, then the one that confesses will be set free and the other will
remain in prison.
1\2 N C
N -1, -1 -9, 0
C 0, -9 -6, -6
This game captures an important concept: that by serving their self-interest (i.e. wanting to be free)
the players end up worse off than they would’ve otherwise if they had stuck to their initial plan (of
not confessing).
• Strictly Dominated Strategy
Suppose there is a game such that, 𝐺 = {𝑆! , … , 𝑆! ; 𝑢! , … , 𝑢! } and a player has two feasible
strategies, s and s’. If for all s and s’, 𝑢! 𝑠 > 𝑢! (𝑠 ! ), then s’ is strictly dominated by playing s and no
rational player will ever play s’.
• Best Response
A strategy 𝑠!∗ is a BR for player i against another strategy profile 𝑠!!
∗
if:
∗
𝑢! 𝑠! , 𝑠!! ≤ 𝑢! 𝑠!∗ , 𝑠!!
∗
, ∀!! ∈!!
And we say that 𝑠!∗ = 𝐵𝑅! 𝑠!!
∗
.

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 • Nash Equilibrium
A strategy profile 𝑠!∗ , … , 𝑠!∗ is a NE if each of the players plays a strategy that is a best response
against that of his opponents. We define this as follows:
𝑠!∗ ∈ 𝐵𝑅! 𝑠!!
∗
, for each i ∈ N
• Iterated Elimination of Strictly Dominated Strategy
This is a process by which you eliminate all strategies that are strictly dominated for all of the
players in the game.
NB: If a strategy profile is a NE, then it survives Iterated Elimination of Strictly Dominated Strategies.
• Pareto Efficiency

• Mixed Strategy
This is a probability distribution over the strategy space available to that player. That is, you assign
a probability distribution (p, 1-p) to a strategy space S = (A, B). It captures the player’s belief that he
will play a given strategy. Formally:
For a game, 𝐺 = {𝑆! , … , 𝑆! ; 𝑢! , … , 𝑢! } and 𝑆! = {𝑠!! , … , 𝑠!" }, a mixed strategy is a probability
distribution, 𝑝! = (𝑝!! , 𝑝!! , … , 𝑝!" ), where: !!! 𝑝!" = 1.
• Mixed NE
A mixed strategy profile is a mixed NE if it is also a best response to the other players’ mixed
strategy. What makes it such that the mixed strategy is a BR?
! !

𝑝!! 𝑢! 𝑠!! , 𝑠!! ≥ 𝑝!! 𝑢! 𝑠!! ′, 𝑠!!

• Extensive Form
This is used to represent dynamic games (i.e. games in which players respond to the others’ moves
non-simultaneously) and specifies: the players in the game, when each player has the move, how
each player can move once they have the opportunity, what each player knows about their
opportunity to move, and the payoff they receive at each of the end-nodes.
• Information Set
In an extensive form game, it is a collection of decision nodes, such that:
i. Player i has to move at every node in the information set;
ii. Player i has the same set of action at each node in the information set.
• Perfect vs. Imperfect Information

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Under Perfect Information, at every node, the player knows all of the decisions that have been
made in the past. Therefore with perfect information there can only be one info set, i.e. the entire
game.
• NE in Extensive form
A strategy profile for a player i is a NE if it is a NE in the normal form. Under perfect information, we
can derive the unique NE using Backward Induction.
• Backward Induction
If we are using the extensive form for a dynamic game of perfect information, then we may resort
to BI as a means of finding the unique NE. The way to do this is to start at each terminal mode and
work backwards and at each decision node asking the question: how does this player at this node
maximize his payoff? Doing this throughout the whole game yields the NE.
• Subgame (in the extensive form game)
A subgame must:
i. Begin at a decision node that is a singleton information set (but not the game’s
first decision node)
ii. Includes all the decision and terminal nodes following in the game tree (but none
that do not follow from the initial node determined in (i).
• Subgame Perfect NE (SPNE)
A NE is a SPNE if the players’ strategies are a NE in each and all of the subgames of the game.
• Sustained cooperation (finitely vs. infinitely repeated games)
i. Finitely Repeated Games:
If we have some game, G, that is repeated a finite number T times, then we can deduce several
things about the extensive form of the repeated game, denoted G(T): each time we play the game
we can call this the stage game, i.e. a subgame of the larger game; second, that if G has a unique
NE, then G(T) will have a NE where the Ne of G is played at every stage of the game T times.
We can deduce this last property by BI, suppose we have the following (Prisoner’s Dilemma):
1\2 N C
N -1+X, -1+Y -4+X, Y
C X, -4+Y -3+X, -3+Y
This is the stage game at stage T and the player has accumulated the payoffs (X, Y), respectively in
past stages. The NE is still as in the Prisoner’s Dilemma, (C, C).

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Onto the stage game at (T-1), when we already know that in the final stage we will certainly play (C,
C) so we can add those payoffs to those today:
1\2 N C
N -4+X’, -4+Y’ -7+X’, Y’-3
C X’-3, -7+Y’ -6+X’, -6+Y’
The payoffs (X’, Y’) represent the payoffs the players receive at T-1. Therefore we see that the NE
remains the same, even anticipating the next stage in the game, the NE in the subgame
corresponds to the unique NE of the game. So by BI we arrive at the same NE as in the individual
stage games, despite this being a dynamic game.
ii. Infinitely Repeated Games:
A Grim Trigger Strategy reinforces cooperation among the players for a better outcome in an
indefinitely repeated game. The grim trigger forms a SPNE under a well-defined condition:
Suppose we have the following stage game:
1\2 A B
A 1, 1 5, 0
B 0, 5 4, 4
We set up the condition for player 1 to deviate from the agreed strategy (B, B) as follows:
! ∗ !! ! ! ∗ !! !
!!! ! ∗ !! !!! !!! ! ∗ !!
𝛿 ∗4+𝛿 ∗5+ 𝛿 ∗1> 𝛿 ∗4+𝛿 ∗4+ 𝛿 !!! ∗ 4
∗ !!
Simplifying the expression above by dividing by 𝛿 ! we get:
5 + 𝛿 + 𝛿 ! + ⋯ > 4 + 4𝛿 + 4𝛿 ! + ⋯
∞ ∞
!!!
⟺5+ 𝛿 ∗1> 𝛿 !!! ∗ 4
!!! !!!

Therefore Grim Trigger is the BR against Grim Trigger if and only if:
𝛿 4𝛿 3𝛿 𝟏
5+ ≤4+ ⟺1≤ ⟺𝜹≥
1−𝛿 1−𝛿 1−𝛿 𝟒
Note that we use the following result:
1
1 + 𝛿 + 𝛿! + ⋯ =
1−𝛿
• Cooperation between firms competing repeatedly

• Characteristic Function

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For a coalition, S, v(S) is the amount of members of S can share if they cooperate and v(S) is the
function.
• Core
The core of v is the set of all feasible payoff vectors, such that no coalition can improve upon it.
𝐶 𝑣 = { 𝑥! … 𝑥!
!
!
∈𝑅 : 1 𝑥! = 𝑣 𝑁 𝑎𝑛𝑑 2 𝑓𝑜𝑟 𝑎 𝑐𝑜𝑎𝑙𝑖𝑡𝑖𝑜𝑛 𝑆 𝑠𝑡𝑟𝑖𝑐𝑡𝑙𝑦 𝑠𝑚𝑎𝑙𝑙𝑒𝑟 𝑡ℎ𝑎𝑛 𝑁: 𝑥!
!∈!

≥ 𝑣 𝑆 }
Coalition V(1) V(2) V(3)
1 0 0 0
2 0 0 0
3 0 0 0
12 100 100 100
13 0 100 100
23 0 0 100
123 100 100 100

The Core in the case above would be as follows:
𝑥! + 𝑥! + 𝑥! = 100
𝑥! + 𝑥! ≥ 100
! 𝑥! + 𝑥! ≥ 100
𝐶 𝑣! = { 𝑥! , 𝑥! , 𝑥! ∈ 𝑅 , such that:
𝑥! + 𝑥! ≥ 0
𝑥! ≥ 0, 𝑥! ≥ 0, 𝑥! ≥ 0
Then pick for which values of 𝑥! , 𝑥! , 𝑥! the equations above hold, i.e. in this case: 𝑥! , 𝑥! , 𝑥! =
(100, 0, 0).
• Shapley Value and its Axioms
Shapley value associates a payoff vector to each Core Function, v: 𝜎: 𝑉 → 𝑅! .
It fulfills the following axioms:
(i) Efficiency: ∑𝜎! 𝑣 = 𝑣(𝑁), for all C.F. v.
(ii) Symmetry: 𝜎! 𝑣 = 𝜎! 𝑣 if i and j are substitutes in v.
(iii) Dummy: 𝜎! = 0 if i is a dummy player in v.
(iv) Additivity: 𝜎! 𝑣 + 𝑤 = 𝜎! 𝑣 + 𝜎! (𝑤)

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 Shapley Theorem: There exists a unique value 𝜎 that satisfies the four axioms and solves:

𝜎!!! 𝑣 = 𝛼 𝑠, 𝑛 ∙ [𝑣 𝑆 − 𝑣(𝑆\{𝑖})]
!⊂!
!!! ! !!! !
Where: 𝛼 𝑠, 𝑛 = !!

S=1 S=2 S=3 S=4 S=5

n=1 1 / / / /
n=2 1/2 1/2 / / /
n=3 1/3 1/6 1/3 / /
n=4 1/4 1/12 1/12 1/4 /
n=5 1/5 1/20 1/30 1/20 1/5

• Bayesian Game
This is a game of incomplete information, i.e. a game in which at least one of the players are
uncertain about another player’s payoff function.
• Strategy vs. Action in Bayesian Game
In a Bayesian game, a move by the player is called an Action; however it is different form a strategy
in a Bayesian game insofar as a strategy specifies the action that a player would take given a
particular type.
• Bayesian NE (BNE)
For a static Bayesian Game, 𝐺 = {𝐴! , … , 𝐴! ; 𝑇! , … , 𝑇! ; 𝑝! , … , 𝑝! ; 𝑢! , … , 𝑢! }, the strategies,
𝑠 = 𝑠!∗ , … , 𝑠!∗ are a pure strategy BNE if for each player i for each 𝑡! ∈ 𝑇! , 𝑠!∗ (𝑡! ) solves:
∗ ∗
max 𝑢! 𝑠!∗ 𝑡! , … , 𝑠!!! 𝑡!!! , 𝑎! , 𝑠!!! 𝑡!!! , … , 𝑠!∗ 𝑡! ; 𝑡 𝑝! (𝑡!! |𝑡! )
!! ∈!!
!!! ∈!!!

That is, all you need to do is maximize the expected payoff given the type and probability
distribution.
• Cournot Competition under incomplete information
Let: 𝐴! = 𝑅! = 𝐴! , 𝑇! = 𝑐 , 𝑇! = 𝑐! , 𝑐! . 𝜋! 𝑞! , 𝑞! , 𝑐, 𝑐! = 𝑎 − 𝑞! + 𝑞! − 𝑐 ∙ 𝑞!
Player 2 knows everything about his type; player 1 cannot distinguish between high or low costs.
𝜋! 𝑞! , 𝑞! , 𝑐, 𝑐! = 𝑎 − 𝑞! + 𝑞! − 𝑐 ∙ 𝑞!
𝜋! 𝑞! , 𝑞! , 𝑐! = 𝑎 − 𝑞! + 𝑞! − 𝑐! ∙ 𝑞!
𝜋! 𝑞! , 𝑞! , 𝑐, 𝑐! = 𝑎 − 𝑞! + 𝑞! − 𝑐! ∙ 𝑞!
BNE Solution:

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 (1) 𝑞!∗ max!! ∈!! {𝜃[𝑎 − (𝑞! + 𝑞!∗ (𝑐! ) − 𝑐] ∙ 𝑞! + (1 − 𝜃)[𝑎 − 𝑞! + 𝑞!∗ 𝑐! − 𝑐] ∙ 𝑞! }
(2) 𝑞!∗ 𝐶! max!! ∈!! [𝑎 − (𝑞!∗ + 𝑞! − 𝑐! ] ∙ 𝑞!
(3) 𝑞!∗ 𝐶! max [𝑎 − (𝑞!∗ + 𝑞! − 𝑐! ] ∙ 𝑞!
!! ∈!!

Combining all of these and solving:

𝑎 − 𝜃𝑞!∗ 𝐶! + 1 − 𝜃 𝑞!∗ 𝐶! − 𝑐
𝑞!∗ =
2
𝑞 − 𝑞!∗ − 𝑐! ∗ 𝑎 − 𝑞!∗ − 𝑐!
𝑞!∗ 𝐶! = ; 𝑞! 𝐶! =
2 2
Solving for BNE:
𝑎 + 𝑐 − 2𝑐
𝑞!∗ =
3
𝑎 + 𝑐 − 2𝑐! 𝜃 𝑎 + 𝑐 − 2𝑐! 1−𝜃
𝑞!∗ 𝑐! = + 𝑐! − 𝑐! ; 𝑞!∗ 𝑐! = + 𝑐! − 𝑐!
3 6 3 6
• First-price, Second-price and Double auction
(i) First-price Auction: An auction in which the players only bid once and the highest bidder
wins.
(ii) Second-price Auction: An auction in which the players bid simultaneously and secretly,
and the highest bid wins—but the winner pays only the second highest bid.
(iii) Double Auction: Buyers and sellers submit their bid and price, respectively. The bidders
that bid above or equal to the price submitted by the seller will win the bid.
• Perfect BNE
Each strategy of each player in the game should prescribe an optimal action set at each of his
information sets, given his beliefs at these information sets.
• Job Market Signaling
- A game with two players: the employer and the candidates for the job.
- Each candidate can be of two types (high or low). These indicate the applicant’s level of
productivity at work, but only the candidates know his type.
- In order to signal their level of productivity, he chooses a level of education, e; however, this
has a cost to the laborer something, proportionally to the amount of e he chooses.
- Firms then simultaneously offer up a wage w, and the candidate chooses the highest one.
- Payoffs: worker– 𝑤 − 𝑐 𝑡 𝑒 ! , and for the firm– 𝑦 𝑡 − 𝑤.

• Cheap Talk

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 - Unlike with the Job Market Signaling Case, there are no costs to this sort of signaling.
- Nature chooses a type for the sender – 𝑡 ∈ 𝑇 = 𝑡! , 𝑡! , … , 𝑡! , with some probability
distribution, p.
- The sender knows his type and decides on a message, M to send to the receiver.
- The receiver observes the message, but not the type and chooses an action – 𝑎 ∈ 𝐴 =
(𝑎! , … , 𝑎! ).
- The payoffs are independent of the message and depend on the type, t, and on the action,
a.
- Remark – Cheap talk is informative if the optimal action chosen by the receiver depends on
the message he receives.
- There is some PBNE where:
o Cheap talk isn’t informative.
o If preference orderings of the sender don’t vary with his type, then cheap talk is not
informative.
o If the receiver’s preferences over actions are completely opposed to the sender’s.