Topic 1: Game theory (2019-20)

1 What is a game?

A formal representation of a situation in which decision makers interact in

a setting of strategic interdependence.
To describe such a situation we need to know the following:
(i) Who are the players?
(ii) The rules: who moves when? What do they know when they move?
What actions each player can take?
(iii) For each possible set of actions by the players, what is the outcome of
the game and what are the payoffs to the players?
An example: Matching Pennies
Definition: A zero-sum game: what one player wins, the other player loses.

2 The extensive form representation of a game

Game tree and decision nodes → game A1

2.1 Imperfect information and information sets

When the players are able to observe all the previous moves by their rivals:
Games of perfect information. When the players are not able to observe all the
previous moves by their rivals: Games of imperfect information.
→ game A1 (perfect information) and game A2 (imperfect information)
An information set is a set of one or more decision nodes such that when
it has several nodes, play has reached one of them and it is that player’s turn
to move, she does not know which of these nodes she is actually at (hence, she
takes an action without knowing the node in which the game actually is).

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 A listing of all player ’s information sets gives a listing of all of the possible
distinguishable situations in which i might be called upon to move.
Definition 7.C.1: A game is one of perfect information if each information
set contains a single decision node. Otherwise, it is a game of imperfect
information.

2.2 The players’ strategies

A strategy for player  is a complete contingency plan specifying how  will

move in every possible distinguishable circumstance → How she plans to move
at each one of her information sets.
Examples: Strategies in game A2.

3 The normal form representation of a game

Another way to represent a game is simply to specify the possible strategies

available to each player and the payoff profile that results from any given profile
of strategies chosen by the players.
Definition 7.D.2: For a game with  players, the normal form
representation Γ specifies for each player  a set of strategies  (with  ∈  )
and a payoff function  (1    ) giving the utility levels associated with
the outcome arising from strategies (1    ). Formally, we write Γ =
[ { }  { ()}].
Example: Matching pennies.

3.1 Randomized choices

Up to now we have assumed that players make their choices with certainty
(pure strategies). What about the possibility that player  chooses strategy 
with probability 1/2 and strategy  with probability 1/2?
Definition 7.E.1: Given player ’s (finite) set  of pure strategies, a mixed
strategy for player ,  :  → [0; 1], assigns to each pure strategy  ∈  a
X
probability   ( ) ≥ 0 that it will be played, where   ( ) = 1.
 ∈
Let us denote the set of mixed strategies for player  as ∆( ).

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 When the players use mixed strategies the induced outcome is random,
leading to probability distributions over terminal nodes. If the axioms of
Expected Utility Theory are fulfilled then we obtain ’s expected utility
multiplying the utility/payoff that  gets from outcome 1 by the probability
that 1 will be the final outcome, doing the same for 2 , etc. and adding these
products together.

4 Simultaneous-move games
4.1 Dominant and dominated strategies

Predictions based on the fact that players never use dominated strategies.
To begin we consider only pure strategies.
Consider the game Prisoner’s Dilemma.
What should we expect?→"Confess" is each player’s best strategy regardless
of the other player’s strategy! → strictly dominant strategy.
Definition 8:B.1: A strategy  ∈  is a strictly dominant strategy for
player  in game Γ = [ { }  { ()}] if ∀0 6=  , we have:

 (  − )   (0  − )

for all − ∈ − .

The pair of strategies ("Confess", "Confess") involves the players using
strictly dominant strategies. However, both players would be better if both
select “Don’t confess”. The players do not internalize how their choices affect
others.
Example: Oil producers.

In many games the players do not have a strictly dominant strategy.

However, we can still use the concept of dominance to eliminate some
strategies as possible choices. We should expect that none of the players will
use a dominated strategy.
Definition 8.B.2: A strategy  ∈  is strictly dominated for player  in
game Γ = [ { }  { ()}] if there exists another strategy 0 ∈  s.t. for all
− ∈ − :
 (0  − )   (  − )

Here, strategy 0 strictly dominates strategy  .

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 Example 8.B.1.
Weakly dominant strategy and weakly dominated strategy: ≥ instead of 
in Definitions 8.B.1 and 8.B.2 with strict inequality for some − .
Allowing for mixed strategies:
Definition 8.B.4: A strategy   ∈ ∆( ) is strictly dominated for player 
in game Γ = [ {∆( )}  { ()}] if there exists another strategy  0 ∈ ∆( )
s.t. for all  − ∈ Π6= ∆( ):

 (0  − )   (    − )

Here, strategy  0 strictly dominates strategy   . As there are mixed strategies

involved it is understood that  (    − ) represents the expected utility of player
 when he uses startegy   and his rivals strategies are − .
If a pure strategy is strictly dominated then any mixed strategy including
that pure strategy is also strictly dominated.

4.2 Iterated deletion of strictly dominated strategies

It is unusual to have a game where the elimination of strictly dominated

strategies leads to a unique prediction. However, we can push the logic of
eliminating strictly dominated strategies further: iterated deletion of strictly
dominated strategies → game A.3.
Players’ common knowledge of each others’ rationality and of the structure
of the game is required for acceptability of this iterated process of finding a
prediction for the solution of the game.
The order of deletion of strictly dominated strategies does not matter. If at
a given point several strategies (of one or several players) are strictly dominated,
then we can eliminate them all at once or in any sequence without changing the
set of strategies that we ultimately end up with.
Pure strategies strictly dominated by a mixed strategy may also be
eliminated: Figure 8.B.5. Moreover, a mixed strategy may be strictly dominated
by a pure strategy (modification of Figure 8.B.5). We can proceed through
iterated deletion of strictly dominated (pure and mixed) strategies. → Note
that a mixed strategy of a player that uses a strictly dominated pure strategy
is also strictly dominated.
Proposition 8.B.1: A strategy  ∈  is strictly dominated for player  in
game Γ = [ {∆( )}  { ()}] if there exists another strategy  0 ∈ ∆( ) s.t.

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for all − ∈  :
 (0  − )   (   − )

From Proposition 8.B.1 it follows that to find the strictly dominated pure
strategies of a player it is enough to consider the pure strategies of rivals. It
would be redundant to consider also the mixed strategies of rivals.
The iterative deletion of strictly dominated strategies can proceed in two
stages: First iteratively eliminate dominated pure strategies and then eliminate
dominated mixed strategies built using the remaining pure strategies.

4.3 Rationalizable strategies

We use the players’ rationality and common knowledge about rationality

and the game as a whole to develop the concept of rationalizable strategies. We
also consider mixed strategies.
Definition 8.C.1: In game Γ = [ { }  { ()}], strategy   is a best
response for player  to his rivals’ strategies  − if:

 (  − ) ≥  ( 0   − )

for all  0 ∈ ∆( ). Strategy   is never a best response if there is no  − for

which   is a best response.
Hence, strategy   is a best response to − if it is an optimal choice when
player i conjectures that his opponents will play  − . A strategy   may be a
best response to  − and not be a best response to 0− .
Player ’s strategy   is never a best response if there is no belief that  may
hold about his rivals’ strategy choices − that justifies choosing   . A player
that wants to maximize his expected utility should not play a strategy that is
never a best response.
A strictly dominant strategy is always a best response. A strictly dominated
strategy is never a best response.
Definition 8.C.2: In game Γ = [ { }  { ()}] the strategies in ∆( )
that survive the iterated removal of strategies that are never a best response are
known as player ’s rationalizable strategies. → These strategies are not justified
or rationalized on conjectures that imply at a given point that a player will play
a strategy that is never a best response.
Example 8.C.1.
→ game A.4.

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 The order of removal of strategies that are never a best response can be
shown not to affect the set of strategies that remain at the end.
The set of rationalizable strategies is at least as small as the set of strategies
surviving iterated deletion of strictly dominated strategies (as a strategy that
is strictly dominated is never a best response). The concept of rationalizable
strategies can help us to further narrow the set of “plausible” strategies when
the number of players is greater than 2. If there are only 2 players the set of
strategies that survive the iterated removal of strategies that are never a best
response is the same as the set of strategies that survive the iterated removal of
dominated strategies.
The iterated deletion of strategies that are never a best response may not
lead to a unique prediction. A player may have several or many rationalizable
strategies.

4.4 Nash equilibrium

Nash solution concept is widely used.

Let’s initially ignore mixed strategies.
Definition 8.D.1: A strategy profile  = (1    ) constitutes a Nash
equilibrium (NE) in game Γ = [ { }  { ()}] if for every  = 1  :

 (  − ) ≥  (0  − )

for all 0 ∈  .

In a NE each player’s strategy choice is a best response to the strategies
actually played by his rivals.
With "rationalizability" we required that a rationalizable strategy of each
player be a best response to some reasonable conjecture or belief about what
his rivals will be playing. NE makes the additional requirement that players be
correct in their beliefs.
Example 8.D.1 and Example 8.D.2 (8.C.1).
No player wants to deviate from a NE. However, in a situation that is not a
NE there exists at least one player that wants to change his strategy.
The set of NE is smaller than or equal to the set of possible strategy profiles
involving rationalizable strategies → NE is often a sharper prediction.
There may be several NE in a game → game A.5.

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 Mixed strategy NE → Definition 8.D.2: A mixed strategy profile  =
( 1     ) constitutes a Nash equilibrium in game Γ = [ { }  { ()}] if for
every  = 1  :
 (  − ) ≥  ( 0   − )

for all  0 ∈ ∆( ).

Example 8.D.4.
In any mixed strategy NE the players are indifferent about playing their
equilibrium (mixed) strategy and about playing any of the pure strategies with
a positive probability in that equilibrium strategy. This implies that to check
deviations from NE we only have to check deviations to pure strategies.

Existence of NE: Proposition 8.D.2: Every game Γ = [ { }  { ()}]
in which the sets 1    have a finite number of elements has a mixed strategy
Nash equilibrium.
In economic applications often strategies naturally modeled as continuous
variables (prices, quantities,...). Existence of of a pure strategy NE in those
settings:
Proposition 8.D.3: A NE exists in game Γ = [ { }  { ()}] if for all
 = 1  :
i)  is a nonempty, convex and compact subset of some Euclidean space


ii)  (1  2    ) is continuous in (1  2    ) and quasiconcave in  .

4.5 Games of incomplete information (Bayesian games)

Until now we have assumed that each player has all relevant information
about his opponents available strategies and payoffs at any outcome that
may result from the strategies selected by the players → games of complete
information.
In many situations this is a strong assumption.
In a game of incomplete information player  may not know the exact payoff
accruing to other players following some outcome.
The approach we use to tackle the problem of incomplete information is to
imagine that each player’s type is determined by a random variable and that
the realization of player ’s random variable is observed only by . The other
players have beliefs about player ’s type.

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 In a Bayesian game, each player  has a payoff function  (  −   ), where
 is his type.
A pure strategy for player  in a Bayesian game is a function  ( ) (or
decision rule) that gives the player’s choice for each realization of his type  .
That choice also depends on player ’s beliefs about the types of the rest of
players.
A (pure strategy) Bayesian NE for a Bayesian game is a profile of decision
rules (1 ()   ()) where each player, for each type that he might end up
having, gives the best response to the expected strategies of the other players
according to that player’s beliefs about the types of the others.
Example→ game A.6
Existence of Bayesian  : Every game Γ = [ { }  { (  )}] in which
the sets 1    have a finite number of elements and the number of possible
types for each player is finite has (at least) a mixed strategy Bayesian Nash
equilibrium.
Example: exchange of envelops with money: 20, 40, 80, 160, 320 or 640
euros.

4.5.1 An auction as a Bayesian game

- Auctioneer: seller or buyer; owner or agent

- Bidders: valuation (highest amount willing to pay)→ bid
- An auction is an allocation mechanism with an explicit set of rules that
determines, taking into account only the bids of bidders, the winner of the
auction and the price paid (or received) by that winner of the auction
- Asymmetry of information:
→ Auctioneer does not know valuations of bidders: auction reveals
information about bidders’ valuations
→ Each bidder knows her valuation and has some beliefs on the valuations
(on the types) of the other bidders
- Sealed-bid first price auction:
→ bids have to be made in sealed envelopes before some fixed day and time
→ the winner is the bidder with the highest bid and pays a price equal to
his bid
→ procurement auctions (tendering)
- Bidding in the sealed-bid first-price auction:
→ each bidder makes a bid smaller than her valuation

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 → each bidder selects the bid that maximizes her expected surplus (if she is
risk neutral) or her expected utility (if she is risk averse)
→ with a greater bid the probability of winning increases but the surplus
obtained in the case of winning decreases: there is a trade-off here
→ the bid function:  =  ( ) where  valuation,  bid and  increasing
( =  ( ): pure strategy of  as a function of her valuation or type)
→  bidders: bidder  selects  that solves:

max( −  ) Pr( )


where Pr( ) is the probability of winning the auction with a bid equal to
 . If bidders  believes that the bid function for player , with  6= , is  ( )
it follows that:
Pr( ) = Pr( ( )    ∀ 6= ) = Pr(  −1 ( ) ∀ 6= )

= Π6= Pr(  −1 ( ))

Hence, Pr( ) depends on the number of bidders. Moreover, Pr( )

takes into account the beliefs of bidder  about the probability distributions of
valuations (of types) of the rest of bidders: for instance, the probability that
 is smaller than the number −1 ( )) depends on the beliefs of  about the
probability distribution of the valuation of .
A Bayesian NE is obtained when each bidder  solves: max ( −
 ) Pr( ).

5 Dynamic games

Extensive form: There may be imperfect information. But there is complete

information.
Sequential decision: Player ’s strategy should specify optimal actions at
every information set where  is called upon to move.
Sequential rationality at equilibrium: If  finds herself at an information set
 her action at  must be optimal for the "continuation game" starting at .
“Empty threats” are not chosen by . → This gives us a reduced extensive form
game.

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5.1 Dynamic games with perfect information
Example 9.B.1
In a game of perfect information start by determining the optimal actions
for moves at the final decision nodes in the tree. Next, given that these actions
will be taken, we can do the same at the second to last decision nodes, etc.
This procedure, which involves solving first for optimal behaviour at the
"end" of the game and then determine what optimal behaviour is earlier in
the game given the anticipation of that latter behaviour, is known as backward
induction. Backward induction is thus intimately linked to the idea of sequential
rationality.
Example 9.B.2.
Example: small balloons and shots.

Proposition 9.B.1. (Zermelo’s Theorem) Every finite game of perfect

information in extensive form has a pure strategy   that can be derived
through backward induction. Moreover, if no player has the same payoffs at
any two terminal nodes, then there is a unique   that can be derived in this
manner.
Proposition 9.B.1 implies the existence of a pure strategy   (sequentially
rational) in all finite games of perfect information.

5.2 Dynamic games with imperfect information: Subgame

perfect Nash equilibria

How do we identify   that satisfy the principle of sequential rationality

in games of imperfect information? The requirement of sequential rationality is
captured by using the notion of a subgame perfect Nash equilibrium:
Definition 9.B.1. A subgame of an extensive form game Γ is a subset of
the game having the following properties:
(i) It begins with an information set containing a single decision node,
contains all the decision nodes that are successors of this node, and contains
only these nodes.
(ii) If decision node  is in the subgame then every 0 ∈ () is also, where
() is the information set that contains decision node .
Examples of subgames
A subgame is a game in its own right.

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 Definition 9.B.2. A profile of strategies = ( 1     ) in an -player
extensive form game Γ is a subgame perfect   (  ) if it induces a  
in every subgame of Γ .
We can apply a generalized backward induction method for games of
imperfect information to obtain the   : starting from the end of game
substitute each subgame where there is imperfect information by the   of
that subgame and proceed backwards (if there are several   in one of such
subgames then a    will be obtained for each of those  ).
Example of subgame perfect Nash equilibrium in a game of imperfect
information.
Existence of   : Every finite game of imperfect information in extensive
form has a pure strategy   . Moreover, if no player has the same payoffs
at any two terminal nodes, then there is a unique   that can be derived in
this manner.

In finite games of perfect information every decision node initiates a subgame

(the game as a whole is also a subgame). Hence, in finite games of perfect
information    coincides with   that can be derived through backward
induction.

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