STRATEGY

AN INTRODUCTION TO GAME THEORY

JOEL WATSON

University of California, San Diego

Third Edition

W. W. NORTON & COMPANY

NEW YORK • LONDON
 CONTENTS*

PREFACE xiii

1 INTRODUCTION 1
Noncooperative Game Theory 3
Contract and Cooperative Game Theory 4
The Meaning of "Game" 5

PART I: REPRESENTATIONS AND BASIC ASSUMPTIONS 7

2 THE EXTENSIVE FORM 9

Other Examples and Conventions 15
Guided Exercise 17
Exercises 18

3 STRATEGIES AND THE NORMAL FORM 22

Terminology and Notation for Strategies 23
The Normal Form 26
Classic Normal-Form Games 28
Interpretation of the Normal Form 30
Guided Exercise 31
Exercises 33

4 BELIEFS, MIXED STRATEGIES, AND EXPECTED PAYOFFS 37

Guided Exercise 39
Exercises 40

* Chapters in italics are applications chapters.

vii
viii Contents

5 GENERAL ASSUMPTIONS AND METHODOLOGY 42

Rationality 43
Common Knowledge 44
Overview of Solution Concepts 45
The Issue of Realism 46

PART II: ANALYZING BEHAVIOR IN STATIC SETTINGS 47

6 DOMINANCE AND BEST RESPONSE 49

Dominance 49
The First Strategic Tension and the Prisoners' Dilemma 52
The Concept of Efficiency 53
Best Response 54
Dominance and Best Response Compared 57
Weak Dominance 60
Guided Exercise 61
Exercises 63

7 RATIONALIZABILITY AND ITERATED DOMINANCE 67

The Second Strategic Tension 71
Guided Exercise 73
Exercises 74

8 LOCATION, PARTNERSHIP, AND SOCIAL UNREST 78

A Location Game 7g
A Partnership Game: Strategic Complementarities 81
Social Unrest gy
Guided Exercise gQ
Exercises g -j

9 NASH EQUILIBRIUM g5

Nash Equilibrium gy
Equilibrium of the Partnership Game 1 QQ
Coordination and Social Welfare n.
 Contents ix

The Third Strategic Tension 104

Congruous Sets 104
Aside: Experimental Game Theory 106
Guided Exercise 107
Exercises 108

10 OLIGOPOLY, TARIFFS, CRIME, AND VOTING 113

Cournot Duopoly Model 113
Bertrand Duopoly Model 115
Tariff Setting by Two Countries 117
A Model of Crime and Police 118
The Median Voter Theorem 118
Strategic Voting 120
Guided Exercise 123
Exercises 124

11 MIXED-STRATEGY NASH EQUILIBRIUM 132

Randomization in Sports 135
Technical Notes 136
Example: Duopoly with Capacity Constraints 137
Guided Exercise 140
Exercises 140

12 STRICTLY COMPETITIVE GAMES AND

SECURITY STRATEGIES 148
Guided Exercise 151
Exercises 152

13 CONTRACT, LAW, AND ENFORCEMENT

IN STATIC SETTINGS 154
Complete Contracting in Discretionary Environments 158
Contracting with Court-Imposed Breach Remedies 161
Guided Exercise 166
Exercises 167
X Contents

PART III: ANALYZING BEHAVIOR IN DYNAMIC SETTINGS 173

14 DETAILS OF THE EXTENSIVE FORM 175

Recalling the Strategy Definition 179
Guided Exercise 180
Exercises 181

15 SEQUENTIAL RATIONALITY AND SUBGAME PERFECTION 183

Incredible Threats in the Stackelberg Duopoly Game 184
Sequential Rationality 185
Backward Induction 186
Subgame Perfection 188
The SPE of the Stackelberg Duopoly Game 191
Technical Notes 192
Conditional Dominance and Forward Induction 195
Guided Exercise 198
Exercises 199

16 TOPICS IN INDUSTRIAL ORGANIZATION 204

Advertising and Competition 204
A Model of Limit Capacity 206
Dynamic Monopoly 209
Price Guarantees as a Commitment to High Prices 21 3
Dynamic Price Competition with Capacity Constraints 21 5
Guided Exercise 217
Exercises 21 9

17 PARLOR GAMES 224

Guided Exercise 226
226

18 BARGAINING PROBLEMS 230

Bargaining: Value Creation and Division 230
An Abstract Representation of Bargaining Problems 232
An Example 234
The Standard Bargaining Solution 236
A Note About Legal Default Rules 238
Guided Exercise
240
Exercises
241
 Contents xi

19 ANALYSIS OF SIMPLE BARGAINING GAMES 244

Ultimatum Games: Power to the Proposer 244
Two-Period, Alternating-Offer Games: Power to the Patient 246
Infinite-Period, Alternating-Offer Game 250
Multilateral B argaining 2 51
Guided Exercise 254
Exercises 255

20 GAMES WITH JOINT DECISIONS;

NEGOTIATION EQUILIBRIUM 259
Joint Decisions 260
Negotiation Equilibrium 262
Example: Contracting for High-Powered Incentives 263
Guided Exercise 265
Exercises 267

21 UNVERIFIABLE INVESTMENT, HOLD UP, OPTIONS,

AND OWNERSHIP 274
Hold-Up Example 275
Up-Front Contracting and Option Contracts 278
Asset Ownership 281
Guided Exercise 283
Exercises 285

22 REPEATED GAMES AND REPUTATION 291

A Two-Period Repeated Game 292
An Infinitely Repeated Game 297
The Equilibrium Payoff Set with Low Discounting 302
Guided Exercise 306
Exercises 307

23 COLLUSION, TRADE AGREEMENTS, AND GOODWILL 311

Dynamic Oligopoly and Collusion 311
Enforcing International Trade Agreements 313
Goodwill and Trading a Reputation 314
Guided Exercise 317
Exercises 318
xii Contents

PART IV: INFORMATION 325

24 RANDOM EVENTS AND INCOMPLETE INFORMATION 327

Guided Exercise 331
Exercises 332

25 RISK AND INCENTIVES IN CONTRACTING 336

Risk Aversion 336
A Principal-Agent Game 340
Guided Exercise 345
Exercises 346

26 BAYESIAN NASH EQUILIBRIUM AND RATIONALIZABILITY 350

Guided Exercise 353
Exercises 354

27 LEMONS, AUCTIONS, AND INFORMATION AGGREGATION 360

Markets and Lemons 360
Auctions 363
Information Aggregation 368
Guided Exercise 373
Exercises 374

28 PERFECT BAYESIAN EQUILIBRIUM 378

Conditional Beliefs about Types 379
Sequential Rationality 380
Consistency of Beliefs 381
Equilibrium Definition 382
Guided Exercise 3g4
Exercises 3gg

29 JOB-MARKET SIGNALING AND REPUTATION 392

Jobs and School 392
Reputation and Incomplete Information 395
Guided Exercise 3gg
Exercises 4QQ

APPENDICES 407

INDEX 4?7