ECON333 Handouts PDF

Game Theory: Definition and Assumptions
Game Theory and Strategy Game theory studies strategic interactions within a group of
Introduction individuals
◮ Actions of each individual have an effect on the outcome
◮ Individuals are aware of that fact
Levent Koçkesen Individuals are rational
◮ have well-defined objectives over the set of possible outcomes
Koç University ◮ implement the best available strategy to pursue them
Rules of the game and rationality are common knowledge
Levent Koçkesen (Koç University) Introduction 1 / 10 Levent Koçkesen (Koç University) Introduction 2 / 10
Example Example: A Single Person Decision Problem

Ali is an investor with $100
State
Good Bad
10 people go to a restaurant for dinner
Bonds 10% 10%
Order expensive or inexpensive fish? Stocks 20% 0%
◮ Expensive fish: value = 18, price = 20
◮ Inexpensive fish: value = 12, price = 10 Which one is better?
Everbody pays own bill Probability of the good state p
◮ What do you do? Assume that Ali wants to maximize the amount of money he has at
◮ Single person decision problem the end of the year.
Total bill is shared equally Bonds: $110
◮ What do you do? Stocks: average (or expected) money holdings:
◮ It is a GAME
p × 120 + (1 − p) × 100 = 100 + 20 × p
If p > 1/2 invest in stocks
If p < 1/2 invest in bonds
An Investment Game Entry Game
Ali again has two options for investing his $100: Strategic (or Normal) Form Games
◮ invest in bonds ◮ used if players choose their strategies without knowing the choices of
⋆ certain return of 10% others
◮ invest it in a risky venture Extensive Form Games
⋆ successful: return is 20% ◮ used if some players know what others have done when playing
⋆ failure: return is 0%
◮ venture is successful if and only if total investment is at least $200
There is one other potential investor in the venture (Beril) who is in Ali
the same situation as Ali
They cannot communicate and have to make the investment decision B V
without knowing the decisions of each other Beril Beril
Beril B V B V
Bonds Venture
Bonds 110, 110 110, 100 110, 110 110, 100 100, 110 120, 120
Ali
Venture 100, 110 120, 120
Investment Game with Incomplete Information The Dating Game

Ali takes Beril out on a date
Beril wants to marry a smart guy but does not know whether Ali is
smart
Some players have private (and others have incomplete) information She believes that he is smart with probability 1/3
Ali is not certain about Beril’s preferences. He believes that she is Ali decides whether to be funny or quite
◮ Normal with probability p Observing Ali’s demeanor, Beril decides what to do
◮ Crazy with probability 1 − p
2, 1 1, 1
marry marry
quite A funny
Beril Beril
Bonds Venture Bonds Venture
dump dump
Bonds 110, 110 110, 100 Bonds 110, 110 110, 120 0, 0 (1/3) smart −1, 0
Ali
Venture 100, 110 120, 120 Venture 100, 110 120, 120
B Nature B
Normal (p) Crazy (1 − p)
2, 0 (2/3) dumb −1, 0
marry marry
quite A funny
dump dump
0, 1 −3, 1
Game Forms Outline of the Course
1. Strategic Form Games
2. Dominant Strategy Equilibrium and Iterated Elimination of
Dominated Actions
Information
3. Nash Equilibrium: Theory
4. Nash Equilibrium: Applications
4.1 Auctions
Complete Incomplete 4.2 Buyer-Seller Games
4.3 Market Competition
Strategic Form Strategic Form 4.4 Electoral Competition
Simultaneous
Games with Games with 5. Mixed Strategy Equilibrium
Complete Incomplete
6. Games with Incomplete Information and Bayesian Equilibrium
Information Information
7. Auctions
8. Extensive Form Games: Theory
Moves
8.1 Perfect Information Games and Backward Induction Equilibrium
8.2 Imperfect Information Games and Subgame Perfect Equilibrium
Extensive Form Extensive Form 9. Extensive Form Games: Applications
Games with Games with
Sequential 9.1 Stackelberg Duopoly
Complete Incomplete
Information Information 9.2 Bargaining
9.3 Repeated Games
10. Extensive Form Games with Incomplete Information
10.1 Perfect Bayesian Equilibrium
10.2 Signaling Games
Split or Steal
Game Theory
Strategic Form Games
Levent Koçkesen
Koç University
Levent Koçkesen (Koç University) Strategic Form Games 1 / 48 Levent Koçkesen (Koç University) Strategic Form Games 2 / 48
Split or Steal Split or Steal
Van den Assem, Van Dolder, and Thaler, “Split or Steal? Cooperative
Behavior When the Stakes Are Large” Management Science, 2012.
Individual players on average choose “split” 53 percent of the time
Propensity to cooperate is surprisingly high for consequential amounts
Less likely to cooperate if opponent has tried to vote them off
previously
◮ Evidence for reciprocity
Young males are less cooperative than young females
Old males are more cooperative than old females
Split or Steal Strategic Form Games
It is used to model situations in which players choose strategies
without knowing the strategy choices of the other players
Also known as normal form games
Sarah A strategic form game is composed of
Steal Split 1. Set of players: N
Steal 0, 0 100, 0
Steve 2. A set of strategies: Ai for each player i
Split 0, 100 50, 50
3. A payoff function: ui : A → R for each player i
Set of Players N = {Sarah, Steve}
G = (N, {Ai }i∈N , {ui }i∈N )
Set of actions: ASarah = ASteve = {Steal, Split}
Payoffs An outcome a = (a1 , ..., an ) is a collection of actions, one for each
player
◮ Also known as an action profile or strategy profile
outcome space
A = {(a1 , ..., an ) : ai ∈ Ai , i = 1, ..., n}
Prisoners’ Dilemma Contribution Game
Everybody starts with 10 TL

You decide how much of 10 TL to contribute to joint fund
Player 2
Amount you contribute will be doubled and then divided equally
c n
among everyone
c −5, −5 0, −6
Player 1 I will distribute slips of paper that looks like this
n −6, 0 −1, −1
Name:
N = {1, 2}
A1 = A2 = {c, n} Your Contribution:
A = {(c, c), (c, n), (n, c), (n, n)}
Write your name and an integer between 0 and 10
u1 (c, c) = −5, u1 (c, n) = 0, etc.
We will collect them and enter into Excel
We will choose one player randomly and pay her
Click here for the EXCEL file
Example: Price Competition Example: Price Competition
N = {T, W }
Toys“R”Us and Wal-Mart have to decide whether to sell a particular W AT = AW = {H, L}
toy at a high or low price H L
uT (H, H) = 10
They act independently and without knowing the choice of the other H 10, 10 2, 15
T uW (H, L) = 15
store L 15, 2 5, 5
etc.
We can write this game in a bimatrix format What should Toys“R”Us play?
Does that depend on what it thinks Wal-Mart will do?
Wal-Mart
Low is an example of a dominant strategy
High Low
High 10, 10 2, 15 it is optimal independent of what other players do
Toys“R”Us
Low 15, 2 5, 5 How about Wal-Mart?
(L, L) is a dominant strategy equilibrium
Dominant Strategies Dominant Strategy Equilibrium

a−i = profile of actions taken by all players other than i
A−i = the set of all such profiles If every player has a (strictly or weakly) dominant strategy, then the
corresponding outcome is a (strictly or weakly) dominant strategy
An action ai strictly dominates bi if equilibrium.
ui (ai , a−i ) > ui (bi , a−i ) for all a−i ∈ A−i

W W
ai weakly dominates action bi if H L H L
H 10, 10 2, 15 H 10, 10 5, 15
T T
ui (ai , a−i ) ≥ ui (bi , a−i ) for all a−i ∈ A−i L 15, 2 5, 5 L 15, 5 5, 5
and
ui (ai , a−i ) > ui (bi , a−i ) for some a−i ∈ A−i L strictly dominates H L weakly dominates H
(L,L) is a strictly dominant (L,L) is a weakly dominant
strategy equilibrium strategy equilibrium
An action ai is strictly dominant if it strictly dominates every action in Ai .
It is called weakly dominant if it weakly dominates every action in Ai .
Dominant Strategy Equilibrium Guess the Average
We will play a game

I will distribute slips of paper that looks like this
A reasonable solution concept Name:

It only demands the players to be rational Your guess:
It does not require them to know that the others are rational too
But it does not exist in many interesting games Write your name and a number between 0 and 100
We will collect them and enter into Excel
The number that is closest to half the average wins
Winner gets 6TL (in case of a tie we choose randomly)
Beauty Contest Beauty Contest

The Beauty Contest Thats Shaking Wall St., ROBERT J. SHILLER, NYT
3/9/2011
John Maynard Keynes supplied the answer in 1936, in “The Gen-
eral Theory of Employment Interest and Money,” by comparing
the stock market to a beauty contest. He described a newspaper
contest in which 100 photographs of faces were displayed. Readers
were asked to choose the six prettiest. The winner would be the New York Times online version
reader whose list of six came closest to the most popular of the
combined lists of all readers.
The best strategy, Keynes noted, isn’t to pick the faces that are
your personal favorites. It is to select those that you think others
will think prettiest. Better yet, he said, move to the “third degree”
and pick the faces you think that others think that still others
think are prettiest. Similarly in speculative markets, he said, you
win not by picking the soundest investment, but by picking the
investment that others, who are playing the same game, will soon
bid up higher.
Price Matching Price Matching
Toys“R”Us web page has the following advertisement
Wal-Mart
High Low M atch
High 10, 10 2, 15 10, 10
Toys“R”us Low 15, 2 5, 5 5, 5
M atch 10, 10 5, 5 10, 10
Is there a dominant strategy for any of the players?

There is no dominant strategy equilibrium for this game
So, what can we say about this game?
Sounds like a good deal for customers
How does this change the game?
Price Matching Price Matching

Therefore we have the following “effective” game
Wal-Mart
High Low M atch
High 10, 10 2, 15 10, 10 Wal-Mart
Toys“R”us Low 15, 2 5, 5 5, 5 Low M atch
M atch 10, 10 5, 5 10, 10 Low 5, 5 5, 5
Toys“R”us
M atch 5, 5 10, 10
High is weakly dominated and Toys“R”us is rational
◮ Toys“R”us should not use High Low becomes a weakly dominated strategy for both
High is weakly dominated and Wal-Mart is rational Both companies will play Match and the prices will be high
◮ Wal-Mart should not use High The above procedure is known as Iterated Elimination of Dominated
Each knows the other is rational Strategies (IEDS)
◮ Toys“R”us knows that Wal-Mart will not use High
◮ Wal-Mart knows that Toys“R”us will not use High To be a good strategist try to see the world from the perspective of your
◮ This is where we use common knowledge of rationality rivals and understand that they will most likely do the same
Dominated Strategies Iterated Elimination of Dominated Strategies
A “rational” player should never play an action when there is another

action that gives her a higher payoff irrespective of how the others
Common knowledge of rationality justifies eliminating dominated
play
strategies iteratively
We call such an action a dominated action
This procedure is known as Iterated Elimination of Dominated
Strategies
An action ai is strictly dominated by bi if
If every strategy eliminated is a strictly dominated strategy
ui (ai , a−i ) < ui (bi , a−i ) for all a−i ∈ A−i . ◮ Iterated Elimination of Strictly Dominated Strategies
If IESDS leads to a unique outcome, we call the game dominance
ai is weakly dominatedby bi if solvable
ui (ai , a−i ) ≤ ui (bi , a−i ) for all a−i ∈ A−i If at least one strategy eliminated is a weakly dominated strategy
◮ Iterated Elimination of Weakly Dominated Strategies
while
ui (ai , a−i ) < ui (bi , a−i ) for some a−i ∈ A−i .
IESDS vs. IEWDS Effort Game
You choose how much effort to expend for a joint project

◮ An integer between 1 and 7
Order of elimination does not matter in IESDS
The quality of the project depends on the smallest effort: e
It matters in IEWDS ◮ Weakest link
L R Effort is costly
U 3, 1 2, 0
M 4, 0 1, 1 If you choose e your payoff is
D 4, 4 2, 4
6 + 2e − e
Start with U
Start with M We will randomly choose one round and one student and pay her
Enter your name and effort choice
Effort Game: 2 people 2 effort level Nash Equilibrium
L H Nash equilibrium is a strategy profile (a collection of strategies, one

L 7, 7 7, 1 for each player) such that each strategy is a best response (maximizes
H 1, 7 13, 13 payoff) to all the other strategies
Is there a dominant strategy? An outcome a∗ = (a∗1 , ..., a∗n ) is a Nash equilibrium if for each player i
What are the likely outcomes? ui (a∗i , a∗−i ) ≥ ui (ai , a∗−i ) for all ai ∈ Ai
If you expect the other to choose L, what is your best strategy (best
response)? Nash equilibrium is self-enforcing: no player has an incentive to
If you expect the other to choose H, what is your best strategy (best deviate unilaterally
response)? One way to find Nash equilibrium is to first find the best response
correspondence for each player
(L, L) is an outcome such that
◮ Best response correspondence gives the set of payoff maximizing
◮ Each player best responds, given what she believes the other will do
◮
strategies for each strategy profile of the other players
Their beliefs are correct
... and then find where they “intersect”
It is a Nash equilibrium
Nash Equilibrium Best Response Correspondence
The best response correspondence of player i is given by
Bi (a−i ) = {ai ∈ Ai : ui (ai , a−i ) ≥ ui (bi , a−i ) for all bi ∈ Ai }.

L H
Bi (a−i ) is a set and may not be a singleton
L 7, 7 7, 1
H 1, 7 13, 13 In the effort game
L H
Set of Nash equilibria = {(L, L), (H, H)} L 7, 7 7, 1
H 1, 7 13, 13
B1 (L) = {L} B1 (H) = {H}
B2 (L) = {L} B2 (H) = {H}
The Bar Scene The Bar Scene
Blonde Brunette
Blonde 0, 0 2, 1
Brunette 1, 2 1, 1
See S. Anderson and M. Engers: Participation Games: Market Entry,

Coordination, and the Beautiful Blonde, Journal of Economic
Behavior and Organization, 2007
Stag Hunt Stag Hunt
Jean-Jacques Rousseau in A Discourse on Inequality

If it was a matter of hunting a deer, everyone well realized that he
must remain faithful to his post; but if a hare happened to pass
Set of Nash equilibria:
within reach of one of them, we cannot doubt that he would have
gone off in pursuit of it without scruple...
N(SH) = {(S, S), (H, H)}
Stag Hare What do you think?

Stag 2, 2 0, 1
Hare 1, 0 1, 1
How would you play this game?
Nash Demand Game Optimization
Let f : Rn → R and D ⊂ Rn . A constrained optimization problem is
max f (x) subject to x ∈ D

Each of you will be randomly matched with another student
You are trying to divide 10 TL
Each writes independently how much she wants (in multiples of 1 TL) f is the objective function
If two numbers add up to greater than 10 TL each gets nothing D is the constraint set
Otherwise each gets how much she wrote A solution to this problem is x ∈ D such that
Write your name and demand on the slips f (x) ≥ f (y) for all y ∈ D
I will match two randomly
Choose one pair randomly and pay them Such an x is called a maximizer
Click here for the EXCEL file The set of maximizers is denoted
argmax{f (x)|x ∈ D}
Similarly for minimization problems

A Graphical Example
Example
f (x)
max x3 − 3x2 + 2x + 1 subject to 0.1 ≤ x ≤ 2.5
f (x)
D
x ∗ x
0.1 2.5 x
A Simple Case
Example
Let f : R → R and consider the problem maxx∈[a,b] f (x).
max −(x − 1)2 + 2 s.t. x ∈ [0, 2].
f (x)
f (x)
f ′ (x∗ ) = 0
f ′ (x∗∗ ) = 0
x
a x∗ x∗∗ b x
We call a point x∗ such that f ′ (x∗ ) = 0 a critical point.
Interior Optima Recipe for solving the simple case
Theorem
Let f : R → R and suppose a < x∗ < b is a local maximum (minimum) of Let f : R → R be a differentiable function and consider the problem
f on [a, b]. Then, f ′ (x∗ ) = 0. maxx∈[a,b] f (x). If the problem has a solution, then it can be found by the
following method:
Known as first order conditions 1. Find all critical points: i.e., x∗ ∈ [a, b] s.t. f ′ (x∗ ) = 0
Only necessary for interior local optima 2. Evaluate f at all critical points and at boundaries a and b
◮ Not necessary for global optima
◮ Not sufficient for local optima.
3. The one that gives the highest f is the solution
To distinguish between interior local maximum and minimum you can We can use Weierstrass theorem to determine if there is a solution
use second order conditions Note that if f ′ (a) > 0 (or f ′ (b) < 0), then the solution cannot be at
Theorem a (or b)
Let f : R → R and suppose a < x∗ < b is a local maximum (minimum) of
f on [a, b]. Then, f ′′ (x∗ ) ≤ 0 (f ′′ (x∗ ) ≥ 0).
Example Example
max x2 s.t. x ∈ [−1, 2]. max −(x − 1)2 + 2 s.t. x ∈ [0, 2].
Solution Solution
f is continuous and [0, 2] is compact. Therefore, the problem has a
x2 is continuous and [−1, 2] is closed and bounded, and hence compact.
solution. f ′ (x) = −2(x − 1) = 0 is solved at x = 1, which is the only
Therefore, by Weierstrass theorem the problem has a solution.
critical point. We have f (1) = 2, f (0) = 1, f (2) = 1. Therefore, 1 is the
f ′ (x) = 2x = 0 is solved at x = 0, which is the only critical point. We
global maximum. Note that f ′ (0) > 0 and f ′ (2) < 0 and hence we could
have f (0) = 0, f (−1) = 1, f (2) = 4. Therefore, 2 is the global maximum.
have eliminated 0 and 2 as candidates.
f (x) f (x)
x
x
What is the solution if the constraint set is [−1, 0.5]?

Recipe for general problems Cournot Duopoly

Two firms competing by choosing how much to produce
Generalizes to f : Rn → R and the problem is Augustine Cournot (1838)
max f (x) subject to x ∈ D Inverse demand function
(
a − b(q1 + q2 ), q1 + q2 ≤ a/b
∗ ∗
p(q1 + q2 ) =
◮ Find critical points x ∈ D such that Df (x ) = 0 0, q1 + q2 > a/b
◮ Evaluate f at the critical points and the boundaries of D
◮ Choose the one that give the highest f Cost function of firm i = 1, 2
Important to remember that solution must exist for this method to
ci (qi ) = cqi
work
In more complicated problems evaluating f at the boundaries could where a > c ≥ 0 and b > 0
be difficult Therefore, payoff function of firm i = 1, 2 is given by
For such cases we have the method of the Lagrangean (for equality (
constraints) and Kuhn-Tucker conditions (for inequality constraints) (a − c − b(q1 + q2 ))qi , q1 + q2 ≤ a/b
ui (q1 , q2 ) =
−cqi , q1 + q2 > a/b
Claim
Best response correspondence of firm i 6= j is given by
( a−c−bq
j
, qj < a−c Claim
Bi (qj ) = 2b b
0, qj ≥ a−c The set of Nash equilibria of the Cournot duopoly game is given by
b

a−c a−c
Proof. N(G) = ,
3b 3b
If q2 ≥ a−c
b , then u1 (q1 , q2 ) < 0 for any q1 > 0. Therefore, q1 = 0 is
the unique payoff maximizer. Proof.
If q2 < a−c
b , then the best response cannot be q1 = 0 (why?). Suppose (q1∗ , q2∗ ) is a Nash equilibrium and qi∗ = 0. Then,
Furthermore, it must be the case that q1 + q2 ≤ a−c a
b ≤ b , for qj∗ = (a − c)/2b < (a − c)/b. But, then qi∗ ∈ / Bi (qj∗ ), a contradiction.
otherwise u1 (q1 , q2 ) < 0. So, the following first order condition must Therefore, we must have 0 < qi∗ < (a − c)/b, for i = 1, 2. The rest follows
hold from the best response correspondences.
∂u1 (q1 , q2 )
= a − c − 2bq1 − bq2 = 0
∂q1
Similarly for firm 2.

Cournot Nash Equilibrium Cournot Oligopoly

In equilibrium each firm’s profit is
q2
(a − c)2
a−c
9b
b
B1 (q2 ) Is there a way for these two firms to increase profits?
What if they form a cartel?
They will maximize
U (q1 + q2 ) = (a − c − b(q1 + q2 ))(q1 + q2 )
a−c
2b Optimal level of total production is
Nash Equilibrium a−c
a−c
3b q1 + q2 =
2b
Half of the maximum total profit is
B2 (q1 )
(a − c)2
q1
a−c
3b
a−c
2b
a−c
b
8b
Is the cartel stable?

page.1 page.2
Outline
Game Theory
1 Auctions
Strategic Form Games: Applications
Levent Koçkesen 2 Price Competition Models
Koç University
3 Elections
page.3 page.4
Auctions Auction Formats
Many economic transactions are conducted through auctions 1. Open bid auctions
treasury bills art work 1.1 ascending-bid auction
⋆ aka English auction
foreign exchange antiques ⋆ price is raised until only one bidder remains, who wins and pays the
publicly owned companies cars final price
1.2 descending-bid auction
mineral rights houses ⋆ aka Dutch auction
airwave spectrum rights government contracts ⋆ price is lowered until someone accepts, who wins the object at the
current price
Also can be thought of as auctions 2. Sealed bid auctions
takeover battles 2.1 first price auction
⋆ highest bidder wins; pays her bid
queues
2.2 second price auction
wars of attrition ⋆ aka Vickrey auction
lobbying contests ⋆ highest bidder wins; pays the second highest bid
page.5 page.6
Auction Formats Strategically Equivalent Formats
Open Bid Sealed Bid
Auctions also differ with respect to the valuation of the bidders English Auction ! Second Price
1. Private value auctions
◮ each bidder knows only her own value
◮ artwork, antiques, memorabilia
Dutch Auction ! First Price
2. Common value auctions
◮ actual value of the object is the same for everyone
◮ bidders have different private information about that value
◮ oil field auctions, company takeovers We will study sealed bid auctions
For now we will assume that values are common knowledge
◮ value of the object to player i is vi dollars
For simplicity we analyze the case with only two bidders
Assume v1 > v2 > 0
page.7 page.8
Second Price Auctions Second Price Auctions
I. Bidding your value weakly dominates bidding higher
Highest bidder wins and pays the second highest bid
In case of a tie, the object is awarded to player 1
Strategic form: 20
Suppose your value is $10 but you bid $15. Three cases:
1. N = {1, 2}
1. The other bid is higher than $15 (e.g. $20)
2. A1 = A2 = R+ ◮ You loose either way: no difference
3. Payoff functions: For any (b1 , b2 ) ∈ R2+ 2. The other bid is lower than $10 (e.g. $5)
15 bid
( ◮ You win either way and pay $5: no difference
v1 − b2 , if b1 ≥ b2 , 12
u1 (b1 , b2 ) = 3. The other bid is between $10 and $15 (e.g. $12)
0, otherwise. 10 value
◮ You loose with $10: zero payoff
◮ You win with $15: loose $2
(
v2 − b1 , if b2 > b1 ,
u2 (b1 , b2 ) = 5
0, otherwise.
page.9 page.10
Second Price Auctions First Price Auctions
II. Bidding your value weakly dominates bidding lower
Highest bidder wins and pays her own bid
In case of a tie, the object is awarded to player 1
Suppose your value is $10 but you bid $5. Three cases:
1. The other bid is higher than $10 (e.g. $12) Strategic form:
◮ You loose either way: no difference 12 1. N = {1, 2}
2. The other bid is lower than $5 (e.g. $2) 2. A1 = A2 = R+
◮ You win either way and pay $2: no difference 10 value 3. Payoff functions: For any (b1 , b2 ) ∈ R2+
3. The other bid is between $5 and $10 (e.g. $8) (
◮ You loose with $5: zero payoff v1 − b1 , if b1 ≥ b2 ,
◮ You win with $10: earn $2 8 u1 (b1 , b2 ) =
0, otherwise.
Weakly dominant strategy equilibrium = (v1 , v2 ) (

5 bid
v2 − b2 , if b2 > b1 ,
u2 (b1 , b2 ) =
0, otherwise.
There are many Nash equilibria. For example (v1 , 0) 2
page.11 page.12
Nash Equilibria of First Price Auctions Necessary Conditions
Let (b∗1 , b∗2 ) be a Nash equilibrium. Then,
1. Player 1 wins: b∗1 ≥ b∗2
There is no dominant strategy equilibrium Proof

Suppose not: b∗1 < b∗2 . Two possibilities:
How about Nash equilibria?
We can compute the best response correspondences 1.1 b∗2 ≤ v2 : Player 1 could bid v2 and obtain a strictly higher payoff
or we can adopt a direct approach 1.2 b∗2 > v2 : Player 2 has a profitable deviation: bid zero
◮ You first find the necessary conditions for a Nash equilibrium
Contradicting the hypothesis that (b∗1 , b∗2 ) is a Nash equilibrium.
⋆ If a strategy profile is a Nash equilibrium then it must satisfy these
conditions 2. b∗1 = b∗2
◮ Then you find the sufficient conditions
⋆ If a strategy profile satisfies these conditions, then it is a Nash Proof
equilibrium Suppose not: b∗1 > b∗2 . Player 1 has a profitable deviation: bid b∗2
3. v2 ≤ b∗1 ≤ v1
Proof
Exercise
page.13 page.14
Sufficient Conditions Price Competition Models
So, any Nash equilibrium (b∗1 , b∗2 ) must satisfy Quantity (or capacity) competition: Cournot Model
◮ Augustine Cournot (1838)
v2 ≤ b∗1 = b∗2 ≤ v1 .
Price Competition: Bertrand Model
◮ Joseph Bertrand (1883)
Is any pair (b∗1 , b∗2 ) that satisfies these inequalities an equilibrium?
Two main models:
Set of Nash equilibria is given by 1. Bertrand Oligopoly with Homogeneous Products
2. Bertrand Oligopoly with Differentiated Products
{(b1 , b2 ) : v2 ≤ b1 = b2 ≤ v1 }
page.15 page.16
Bertrand Duopoly with Homogeneous Products Nash Equilibrium
Two firms, each with unit cost c ≥ 0 Suppose P1∗ , P2∗ is a Nash equilibrium. Then
They choose prices
◮ The one with the lower price captures the entire market 1. P1∗ , P2∗ ≥ c. Why?
◮ In case of a tie they share the market equally 2. At least one charges c
Total market demand is equal to one (not price sensitive) ◮ P1∗ > P2∗ > c?
◮ P2∗ > P1∗ > c?
Strategic form of the game:
◮ P1∗ = P2∗ > c?
1. N = {1, 2}
3. P2∗ > P1∗ = c?
2. A1 = A2 = R+
3. Payoff functions: For any (P1 , P2 ) ∈ R2+ 4. P1∗ > P2∗ = c?
 The only candidate for equilibrium is P1∗ = P2∗ = c, and it is indeed an

P1 − c, if P1 < P2 ,
equilibrium.
u1 (P1 , P2 ) = P12−c , if P1 = P2 ,


0, if P1 > P2 . The unique Nash equilibrium of the Bertrand game is (P1∗ , P2∗ ) = (c, c)


P2 − c, if P2 < P1 , What if unit cost of firm 1 exceeds that of firm 2?
u2 (P1 , P2 ) = P22−c , if P2 = P1 ,

 What if prices are discrete?
0, if P2 > P1 .
page.17 page.18
Bertrand Duopoly with Differentiated Products A Model of Election
Spatial Voting Models
Two firms with products that are imperfect substitutes Candidates choose a policy
◮ 10% tax rate vs. 25% tax rate
The demand functions are ◮ pro-EU vs anti-EU
Q1 (P1 , P2 ) = 10 − αP1 + P2 Only goal is to win the election

◮ preferences: win ≻ tie ≻ lose
Q2 (P1 , P2 ) = 10 + P1 − αP2 Voters have ideal positions over the issue
◮ one voter could have 15% as ideal tax rate, another 45%
Assume that α > 1
One-dimensional policy space: [0, 1]
Unit costs are c
Identify each voter with her ideal position t ∈ [0, 1]
Exercise Voters’ preferences are single peaked
◮ They vote for that candidate whose position is closest to their ideal
Formulate as a strategic form game and find its Nash equilibria.
point
Society is a continuum and voters are distributed uniformly over [0, 1]
page.19 page.20
Strategic Form of the Game
Nash Equilibrium
1. N = {1, 2} Suppose p∗1 , p∗2 is a Nash equilibrium. Then
2. A1 = A2 = [0, 1] 1. Outcome must be a tie

◮ Whatever your opponent chooses you can always guarantee a tie
3. 
 2. p∗1 6= p∗2 ?
1, if i wins
ui (p1 , p2 ) = 12 , if there is a tie


0, if i loses 0 p1 1/2 p2 1
3. p∗1 = p∗2 6= 1/2?
Say the two candidates choose 0 < p1 < p2 < 1
p2
Vote for 1 Vote for 2
0 p1 1/2 1
The only candidate for equilibrium is p∗1 = p∗2 = 1/2, which is indeed an
0 p1 p1 +p2 p2 1
2 equilibrium.
The unique Nash equilibrium of the election game is (p∗1 , p∗2 ) = (1/2, 1/2)
page.21
Other Election Models
This result generalizes to models with more general distributions

Equilibrium is for each party to choose the median position
◮ Known as the median voter theorem
Other Models
Models with participation costs
Models with more than two players
Models with multidimensional policy space
Models with ideological candidates
Levent Koçkesen (Koç University) Strategic Form Games 21 / 21

page.1 page.2
Matching Pennies
Player 2
H T
H −1, 1 1, −1
Game Theory Player 1
T 1, −1 −1, 1
Mixed Strategies
How would you play?
Levent Koçkesen
Goalie
Koç University Lef t Right
Lef t −1, 1 1, −1
Kicker
Right 1, −1 −1, 1
No solution?
You should try to be unpredictable
Choose randomly
Levent Koçkesen (Koç University) Mixed Strategies 1 / 18 Levent Koçkesen (Koç University) Mixed Strategies 2 / 18
page.3 page.4
Drunk Driving Drunk Driving
Chief of police in Istanbul concerned about drunk driving.
He can set up an alcohol checkpoint or not
◮
Let’s work with numbers:
a checkpoint always catches drunk drivers
◮ but costs c
f = 2, c = 1, d = 4, r = 2, a = 1
You decide whether to drink wine or cola before driving.
◮ Value of wine over cola is r So, the game becomes:
◮ Cost of drunk driving is a to you and f to the city
⋆ incurred only if not caught Police
◮ if you get caught you pay d Check No
Wine −2, −1 1, −2
You
Police Cola 0, −1 0, 0
Check No
Wine r − d, −c r − a, −f What is the set of Nash equilibria?
You
Cola 0, −c 0, 0
Assume: f > c > 0; d > r > a ≥ 0

page.5 page.6
Mixed Strategy Equilibrium Mixed Strategy Equilibrium
A mixed strategy is a probability distribution over the set of actions.

You drink wine with probability 1/2
The police chooses to set up checkpoints with probability 1/3 What should the police do?
What should you do? ◮ If he sets up checkpoints he gets expected payoff of −1
◮ ◮ If he does not
If you drink cola you get 0 1 1
◮ If you drink wine you get −2 with prob. 1/3 and 1 with prob. 2/3 × (−2) + × 0 = −1
⋆
2 2
What is the value of this to you?
⋆ ◮ The police is indifferent between setting up checkpoints and not, as
We assume the value is the expected payoff:
well as any mixed strategy
1 2
× (−2) + × 1 = 0
3 3 Your strategy is a best response to that of the police and conversely
◮ You are indifferent between Wine and Cola We have a Mixed Strategy Equilibrium
◮ You are also indifferent between drinking Wine and Cola with any
probability
page.7 page.8
Mixed Strategy Equilibrium Mixed Strategy Equilibrium
In a mixed strategy equilibrium every action played with positive

probability must be a best response to other players’ mixed strategies
The police’s expected payoff to
◮ Checkpoint is −1
In particular players must be indifferent between actions played with ◮ Not is p × (−2) + (1 − p) × 0 = −2p
positive probability
Indifference condition
Your probability of drinking wine p
−1 = −2p
The police’s probability of setting up checkpoints q
implies p = 1/2
Your expected payoff to
◮ Wine is q × (−2) + (1 − q) × 1 = 1 − 3q (p = 1/2, q = 1/3) is a mixed strategy equilibrium
◮ Cola is 0 Since there is no pure strategy equilibrium, this is also the unique Nash
Indifference condition equilibrium
0 = 1 − 3q
implies q = 1/3
page.9 page.10
Hawk-Dove Mixed and Pure Strategy Equilibria
Player 2
H D How do you find the set of all (pure and mixed) Nash equilibria?
H 0, 0 6, 1 In 2 × 2 games we can use the best response correspondences in
Player 1
D 1, 6 3, 3 terms of the mixed strategies and plot them
Consider the Battle of the Sexes game
How would you play?
What could be the stable population composition? Player 2
Nash equilibria? m o
◮ (H, D) m 2, 1 0, 0
◮ (D, H) Player 1
o 0, 0 1, 2
How about 3/4 hawkish and 1/4 dovish?
◮ On average a dovish player gets (3/4) × 1 + (1/4) × 3 = 3/2 Denote Player 1’s strategy as p and that of Player 2 as q (probability
◮ A hawkish player gets (3/4) × 0 + (1/4) × 6 = 3/2
◮
of choosing m)
No type has an evolutionary advantage
This is a mixed strategy equilibrium
page.11 page.12
m o What is Player 1’s best response? m o What is Player 2’s best response?
m 2, 1 0, 0 Expected payoff to m 2, 1 0, 0 Expected payoff to
o 0, 0 1, 2 ◮ m is 2q o 0, 0 1, 2 ◮ m is p
◮ o is 1 − q ◮ o is 2(1 − p)
If 2q > 1 − q or q > 1/3 If p > 2(1 − p) or p > 2/3
◮ best response is m (or equivalently p = 1) ◮ best response is m (or equivalently q = 1)
If 2q < 1 − q or q < 1/3 If p < 2(1 − p) or p < 2/3
◮ best response is o (or equivalently p = 0) ◮ best response is o (or equivalently q = 0)
If 2q = 1 − q or q = 1/3 If p = 2(1 − p) or p = 2/3
◮ he is indifferent ◮ she is indifferent
◮ best response is any p ∈ [0, 1] ◮ best response is any q ∈ [0, 1]
Player 1’s best response correspondence: Player 2’s best response correspondence:
 
{1} , if q > 1/3
 {1} , if p > 2/3

B1 (q) = [0, 1], if q = 1/3 B2 (p) = [0, 1], if p = 2/3

 

{0} , if q < 1/3 {0} , if p < 2/3
page.13 page.14
Dominated Actions and Mixed Strategies
Up to now we tested actions only against other actions

 An action may be undominated by any other action, yet be
{1} , if q > 1/3
dominated by a mixed strategy
B1 (q) = [0, 1], if q = 1/3 q
B2 (p)

 Consider the following game
{0} , if q < 1/3
1 b
B1 (q)
L R
 T 1, 1 1, 0

{1} , if p > 2/3
M 3, 0 0, 3
B2 (p) = [0, 1], if p = 2/3

 B 0, 1 4, 0
{0} , if p < 2/3 1/3 b
No action dominates T
b
Set of Nash equilibria 0 2/3 1 p But mixed strategy (α1 (M ) = 1/2, α1 (B) = 1/2) strictly dominates
T
{(0, 0), (1, 1), (2/3, 1/3)}
A strictly dominated action is never used with positive probability in a
mixed strategy equilibrium
page.15 page.16
Dominated Actions and Mixed Strategies What if there are no strictly dominated actions?
An easy way to figure out dominated actions is to compare expected L R
payoffs T 2, 0 2, 1
Let player 2’s mixed strategy given by q = prob(L) M 3, 3 0, 0
B 0, 1 3, 0
Denote player 2’s mixed strategy by q = prob(L)
L R
u1 (T, q) = 1 u1 (T, q) = 2, u1 (M, q) = 3q, u1 (B, q) = 3(1 − q)
T 1, 1 1, 0
M 3, 0 0, 3 u1 (M, q) = 3q
B 0, 1 4, 0 u1 (B, q) = 4(1 − q) u1 (., q) Pure strategy Nash eq. (M, L)
u1 (., q) Mixed strategy equilibria?
4 u1 (B, q)
An action is a never best 3
u1 (B, q)
u1 (M, q)
◮ Only one player mixes? Not possible
response if there is no belief (on ◮ Player 1 mixes over {T, M, B}? Not possible
2 u1 (T, q)
3 u1 (M, q) A−i ) that makes that action a 3/2
◮ Player 1 mixes over {M, B}? Not possible
best response ◮ Player 1 mixes over {T, B}? Let p = prob(T )
2
12/7
T is a never best response q = 1/3, 1 − p = p → p = 1/2
◮ Player 1 mixes over {T, M }? Let p = prob(T )
1 u1 (T, q)
An action is a NBR iff it is 0 1 q
1/3 1/2 2/3
q = 2/3, 3(1 − p) = p → p = 3/4
0 q strictly dominated
4/7
0 1
page.17 page.18
Real Life Examples? Penalty Kick
L R
L 58, 42 95, 5
R 93, 7 70, 30
Ignacio Palacios-Huerta (2003): 5 years’ worth of penalty kicks
Kicker must be indifferent
Empirical scoring probabilities
58p + 95(1 − p) = 93p + 70(1 − p) ⇒ p = 0.42
L R
L 58, 42 95, 5 Goal keeper must be indifferent
R 93, 7 70, 30
42q + 7(1 − q) = 5q + 30(1 − q) ⇒ q = 0.39
R is the natural side of the kicker
What are the equilibrium strategies?
Theory Data
Kicker 39% 40%
Goallie 42% 42%
Also see Walker and Wooders (2001): Wimbledon

page.1 page.2
Games with Incomplete Information
Some players have incomplete information about some components of
the game
◮ Firm does not know rival’s cost
Game Theory ◮ Bidder does not know valuations of other bidders in an auction
Strategic Form Games with Incomplete Information We could also say some players have private information
What difference does it make?
Suppose you make an offer to buy out a company
Levent Koçkesen
If the value of the company is V it is worth 1.5V to you
Koç University The seller accepts only if the offer is at least V
If you know V what do you offer?
You know only that V is uniformly distributed over [0, 100]. What
should you offer?
Enter your name and your bid
Levent Koçkesen (Koç University) Bayesian Games 1 / 15 Levent Koçkesen (Koç University) Bayesian Games 2 / 15
page.3 page.4
Bayesian Games Bayesian Games
We will first look at incomplete information games where players
move simultaneously
◮ Bayesian games
Later on we will study dynamic games of incomplete information
What is new in a Bayesian game?
Each player has a type: summarizes a player’s private information Incomplete information can be anything about the game
◮ Type set for player i: Θi ◮ Payoff functions
⋆ A generic type: θi ◮ Actions available to others
◮ Set of type profiles: Θ = ×i∈N Θi ◮ Beliefs of others; beliefs of others’ beliefs of others’...
⋆ A generic type profile: θ = {θ1 , θ2 , . . . , θn }
Each player has beliefs about others’ types Harsanyi showed that introducing types in payoffs is adequate
◮ pi : Θi → △ (Θ−i )
◮ pi (θ−i |θi )
Players’ payoffs depend on types
◮ ui : A × Θ → R
◮ ui (a|θ)
Different types of same player may play different strategies
◮ ai : Θi → Ai
◮ αi : Θi → △ (Ai )
page.5 page.6
Bayesian Equilibrium Bank Runs
You (player 1) and another investor (player 2) have a deposit of $100

each in a bank
If the bank manager is a good investor you will each get $150 at the
Bayesian equilibrium is a collection of strategies (one for each type of each end of the year. If not you loose your money
player) such that each type best responds given her beliefs about other You can try to withdraw your money now but the bank has only $100
players’ types and their strategies cash
◮ If only one tries to withdraw she gets $100
Also known as Bayesian Nash or Bayes Nash equilibrium ◮ If both try to withdraw they each can get $50
You believe that the manager is good with probability q
Player 2 knows whether the manager is good or bad
You and player 2 simultaneously decide whether to withdraw or not
page.7 page.8
Bank Runs Separating Equilibria
W N W N
The payoffs can be summarized as follows W 50, 50 100, 0 W 50, 50 100, 0
N 0, 100 150, 150 N 0, 100 0, 0
W N W N Good q Bad (1 − q)
W 50, 50 100, 0 W 50, 50 100, 0

1. (Good: W, Bad: N)
N 0, 100 150, 150 N 0, 100 0, 0 ◮ Not possible since W is a dominant strategy for Bad
Good q Bad (1 − q) 2. (Good: N, Bad: W)
Player 1’s expected payoffs
Two Possible Types of Bayesian Equilibria W: q × 100 + (1 − q) × 50
N: q × 150 + (1 − q) × 0
1. Separating Equilibria: Each type plays a different strategy Two possibilities
2. Pooling Equilibria: Each type plays the same strategy 2.1 q < 1/2: Player 1 chooses W. But then player 2 of Good type must
play W, which contradicts our hypothesis that he plays N
2.2 q ≥ 1/2: Player 1 chooses N. The best response of Player 2 of Good
How would you play if you were Player 2 who knew the banker was type is N, which is the same as our hypothesis
bad?
Separating Equilibrium
Player 2 always withdraws in bad state
q < 1/2: No separating equilibrium
q ≥ 1/2: Player 1: N, Player 2: (Good: N, Bad: W)
page.9 page.10
Pooling Equilibria Cournot Duopoly with Incomplete Information about Costs
W N W N
W 50, 50 100, 0 W 50, 50 100, 0
N 0, 100 150, 150 N 0, 100 0, 0
Two firms. They choose how much to produce qi ∈ R+
Good q Bad (1 − q)
Firm 1 has high cost: cH
1. (Good: N, Bad: N) Firm 2 has either low or high cost: cL or cH
◮ Not possible since W is a dominant strategy for Bad Firm 1 believes that Firm 2 has low cost with probability µ ∈ [0, 1]
2. (Good: W, Bad: W) payoff function of player i with cost cj
Player 1’s expected payoffs
W: q × 50 + (1 − q) × 50 ui (q1 , q2 , cj ) = (a − (q1 + q2 )) qi − cj qi
N: q × 0 + (1 − q) × 0
Player 1 chooses W. Player 2 of Good type’s best response is W. Strategies:
Therefore, for any value of q the following is the unique q1 ∈ R+ q2 : {cL , cH } → R+
Pooling Equilibrium
Player 1: W, Player 2: (Good: W, Bad: W)
If q < 1/2 the only equilibrium is a bank run

page.11 page.12
Complete Information Complete Information
Firm 1
max (a − (q1 + q2 )) q1 − cH q1
q1 Nash Equilibrium
Best response correspondence
If Firm 2’s cost is cH
a − cH
a − q2 − cH q1 = q2 =
BR1 (q2 ) = 3
2
If Firm 2’s cost is cL
Firm 2
max (a − (q1 + q2 )) q2 − cj q2 a − cH − (cH − cL )
q2 q1 =
3
Best response correspondences a − cH + (cH − cL )
q2 =
a − q1 − cL 3
BR2 (q1 , cL ) =
2
a − q1 − cH
BR2 (q1 , cH ) =
2
page.13 page.14
Incomplete Information Bayesian Equilibrium
Firm 2
max (a − (q1 + q2 )) q2 − cj q2
q2
Best response correspondences

a − q1 − cL a − cH − µ(cH − cL )
BR2 (q1 , cL ) = q1 =
2 3
a − q1 − cH a − cL + (cH − cL ) cH − cL
BR2 (q1 , cH ) = q2 (cL ) = − (1 − µ)
2 3 6
a − cH cH − cL
Firm 1 maximizes q2 (cH ) = +µ
3 6
µ{[a − (q1 + q2 (cL ))] q1 − cH q1 }
Is information good or bad for Firm 1?
+ (1 − µ){[a − (q1 + q2 (cH ))] q1 − cH q1 }
Does Firm 2 want Firm 1 to know its costs?
Best response correspondence
a − [µq2 (cL ) + (1 − µ)q2 (cH )] − cH
BR1 (q2 (cL ), q2 (cH )) =
2
page.15
Complete vs. Incomplete Information
Complete Information Incomplete Information

q2 q2
a − cH a − cH
BR1 (q2 )
a−cL
2
BR2 (q1 , cL )
q2 (cL )
a−cH E[q2 ]
2
q2 (cH )
BR2 (q1 , cH )
q1 q1
a−cH a − cH a − cL q1 a−cH a − cH a − cL
2 2
Levent Koçkesen (Koç University) Bayesian Games 15 / 15

Outline Auction Formats Equivalent Formats
1 Auctions: Examples
English auction has the same equilibrium as Second Price auction
Game Theory 2 Auction Formats Auctions also differ with respect to the valuation of the bidders This is true only if values are private
Auctions 1. Private value auctions Stronger equivalence between Dutch and First Price auctions
3 Auctions as a Bayesian Game ◮ each bidder knows only her own value
Open Bid Sealed Bid
◮ artwork, antiques, memorabilia
Levent Koçkesen 4 Second Price Auctions 2. Common value auctions Strategically Equivalent
Dutch Auction First Price
◮ actual value of the object is the same for everyone
Koç University
5 First Price Auctions ◮ bidders have different private information about that value
◮ Same Equilibrium
oil field auctions, company takeovers English
Second Price
6 Common Value Auctions Auction in Private Values
7 Auction Design
Levent Koçkesen (Koç University) Auctions 1 / 27 Levent Koçkesen (Koç University) Auctions 2 / 27 Levent Koçkesen (Koç University) Auctions 5 / 27 Levent Koçkesen (Koç University) Auctions 6 / 27
Auctions Auction Formats Independent Private Values Auctions as a Bayesian Game
Many economic transactions are conducted through auctions 1. Open bid auctions set of players N = {1, 2, . . . , n}
treasury bills art work 1.1 ascending-bid auction type set Θi = [v, v̄] , v ≥ 0
⋆ aka English auction
foreign exchange antiques ⋆ price is raised until only one bidder remains, who wins and pays the action set, Ai = R+
publicly owned companies cars final price Each bidder knows only her own valuation beliefs
1.2 descending-bid auction Valuations are independent across bidders ◮ opponents’ valuations are independent draws from a distribution
mineral rights houses ⋆ aka Dutch auction
Bidders have beliefs over other bidders’ values function F
airwave spectrum rights government contracts ⋆ price is lowered until someone accepts, who wins the object at the ◮ F is strictly increasing and continuous
current price Risk neutral bidders
Also can be thought of as auctions ◮ If the winner’s value is v and pays p, her payoff is v − p
payoff function
2. Sealed bid auctions
(
takeover battles 2.1 first price auction vi −P (a)
, if aj ≤ ai for all j 6= i, and |{j : aj = ai }| = m
⋆ ui (a, v) = m
queues highest bidder wins; pays her bid
2.2 second price auction
0, if aj > ai for some j 6= i
wars of attrition ⋆ aka Vickrey auction
lobbying contests ⋆ highest bidder wins; pays the second highest bid ◮ P (a) is the price paid by the winner if the bid profile is a
Second Price Auctions Second Price Auctions First Price Auctions Bayesian Equilibrium of First Price Auctions
I. Bidding your value weakly dominates bidding higher
Only 2 bidders
Only one 4.5G license will be sold You are player 1 and your value is v > 0
There are 10 groups Highest bidder wins and pays her bid You believe the other bidder’s value is uniformly distributed over [0, 1]
Suppose your value is $10 but you bid $15. Three cases: 20
I generated 10 random values between 0 and 100 Would you bid your value? You believe the other bidder uses strategy β(v2 ) = av2
I will now distribute the values: Keep these and don’t show it to 1. There is a bid higher than $15 (e.g. $20) What happens if you bid less than your value?
◮ You loose either way: no difference
Highest possible bid by the other = a: Optimal bid ≤ a
anyone until the end of the experiment 15 bid ◮ You get a positive payoff if you win
2. 2nd highest bid is lower than $10 (e.g. $5) ◮
Your expected payoff if you bid b
I will now distribute paper slips where you should enter your name, But your chances of winning are smaller
◮ You win either way and pay $5: no difference ◮ Optimal bid reflects this tradeoff
value, and bid 12 (v − b)prob(you win) = (v − b)prob(b > av2 )
3. 2nd highest bid is between $10 and $15 (e.g. $12) Bidding less than your value is known as bid shading
Highest bidder wins, pays the second highest bid 10 value = (v − b)prob(v2 < b/a)
◮ You loose with $10: zero payoff
I will pay the winner her net payoff: value - price ◮ You win with $15: loose $2 b
= (v − b)
Click here for the EXCEL file a
5
Second Price Auctions First Price Auctions Bayesian Equilibrium of First Price Auctions Bayesian Equilibrium of First Price Auctions
II. Bidding your value weakly dominates bidding lower n bidders
You are player 1 and your value is v > 0
Only one 4.5G license will be sold Your expected payoff if you bid b You believe the other bidders’ values are independently and uniformly
Suppose your value is $10 but you bid $5. Three cases: distributed over [0, 1]
There are 10 groups
1. There is a bid higher than $10 (e.g. $12) b You believe the other bidders uses strategy β(vi ) = avi
◮ 12 I generated 10 random values between 0 and 100 (v − b)
You loose either way: no difference a Highest bid of the other players = a: Optimal bid b ≤ a
2. 2nd highest bid is lower than $5 (e.g. $2) I will now distribute the values: Keep these and don’t show it to
The critical value is found by using FOC: Your expected payoff if you bid b
◮ You win either way and pay $2: no difference 10 value anyone until the end of the experiment
I will now distribute paper slips where you should enter your name, b v−b v (v − b)prob(you win)
3. 2nd highest bid is between $5 and $10 (e.g. $8)
value, and bid − + =0⇒b=
◮ You loose with $5: zero payoff a a 2
◮ You win with $10: earn $2 8 Highest bidder wins, pays her bid
This gives a higher payoff than the boundary b = 0 (v − b)prob(b > av2 and b > av3 . . . and b > avn )
I will pay the winner her net payoff: value - price
5 bid Bidding half the value is a Bayesian equilibrium
Click here for the EXCEL file This is equal to
2 (v−b)prob(b > av2 )prob(b > av3 ) . . . prob(b > avn ) = (v−b)(b/a)n−1
Bayesian Equilibrium of First Price Auctions Which One Brings More Revenue? Common Value Auctions and Winner’s Curse Common Value Auctions
Suppose everybody, including you, bids their estimate and you are the
winner
Your expected payoff if you bid b
Second Price What did you just learn?
(v − b)(b/a)n−1 ◮ Bidders bid their value Your estimate must have been larger than the others’ Auction formats are not equivalent in common value auctions
◮ Revenue = second highest bid
The true value must be smaller than your estimate Open bid auctions provide information and ameliorates winner’s curse
FOC: First Price ◮ Bids are more aggressive
v−b You overpaid
−(b/a)n−1 + (n − 1) (b/a)n−2 = 0 ◮ Bidders bid less than their value Sealed bid auctions do not provide information
a ◮ Revenue = highest bid This is known as Winner’s Curse
◮ Bids are more conservative
Solving for b Which one is better? Optimal strategies are complicated
n−1
b= v Turns out it doesn’t matter Bidders bid much less than their value to prevent winner’s curse
n
To prevent winner’s curse

Base your bid on expected value conditional on winning
Which One Brings More Revenue? Common Value Auctions Auction Design: Failures Auction Design: Failures
New Zeland Spectrum Auction (1990) Australian TV Licence Auction (1993)
◮ Two satellite-TV licences
Value of 4.5G license = v ◮ Used second price auction with no reserve price
◮ Used first price auction
◮ Uniform between 0 and 100 ◮ Estimated revenue NZ$ 240 million
◮ Huge embarrasment
Revenue Equivalence Theorem You observe v + x
◮ Actual revenue NZ$36 million
Any auction with independent private values with a common distribution ◮ x ∼ N (0, 10) High bidders had no intention of paying
in which ◮ x is between −20 and 20 with 95% prob. Some extreme cases They bid high just to guarantee winning
I generated a signal for each of 10 groups Winning Bid Second Highest Bid They also bid lower amounts at A$5 million intervals
1. the number of the bidders are the same and the bidders are
They defaulted
risk-neutral, I will now distribute the values: Keep these and don’t show it to NZ$100,000 NZ$6,000 ◮ licences had to be re-awarded at the next highest bid
2. the object always goes to the buyer with the highest value, anyone until the end of the experiment NZ$7,000,000 NZ$5,000 ◮ those bids were also theirs
I will now distribute paper slips where you should enter your name, NZ$1 None
3. the bidder with the lowest value expects zero surplus, Outcome after a series of defaults
Source: John McMillan, “Selling Spectrum Rights,” Journal of Economic Perspectives, Summer 1994
value, and bid Initial Bid Final Price
yields the same expected revenue.
Highest bidder wins, pays the second highest bid A$212 mil. A$117 mil.
Problems
I will pay the winner her net payoff: value - price ◮ Second price format politically problematic
A$177 mil. A$77 mil.
Click here for the EXCEL file ⋆ Public sees outcome as selling for less than its worth
Source: John McMillan, “Selling Spectrum Rights,” Journal of Economic Perspectives, Summer 1994
◮ No reserve price Problem: No penalty for default

Auction Design: Failures Auction Design

Turkish GSM licence auction
Good design depends on objective
April 2000: Two GSM 1800 licences to be auctioned
◮ Revenue
Auction method: ◮ Efficiency
1. Round 1: First price sealed bid auction ◮ Other
2. Round 2: First price sealed bid auction with reserve price
⋆ Reserve price is the winning bid of Round 1 One common objective is to maximize expected revenue
Bids in the first round In the case of private independent values with the same number of
Bidder Bid Amount risk neutral bidders format does not matter
Is-Tim $2.525 bil. Auction design is a challenge when
Dogan+ $1.350 bil. ◮ values are correlated
Genpa+ $1.224 bil. ◮ bidders are risk averse
Koc+ $1.207 bil. Other design problems
Fiba+ $1.017 bil. ◮ collusion
Bids in the second round: NONE! ◮ entry deterrence
◮ reserve price
Problem: Facilitates entry deterrence
Levent Koçkesen (Koç University) Auctions 25 / 27 Levent Koçkesen (Koç University) Auctions 26 / 27
Auction Design
Correlated values: Ascending bid auction is better

Risk averse bidders
◮ Second price auction: risk aversion does not matter
◮ First price auction: higher bids
Collusion: Sealed bid auctions are better to prevent collusion
Entry deterrence: Sealed bid auctions are better to promote entry
A hybrid format, such as Anglo-Dutch Auction, could be better.
Anglo-Dutch auction has two stages:
1. Ascending bid auction until only two bidders remain
2. Two remaining bidders make offers in a first price sealed bid auction
Levent Koçkesen (Koç University) Auctions 27 / 27

page.1 page.2
Extensive Form Games
Strategic form games are used to model situations in which players

Game Theory choose strategies without knowing the strategy choices of the other
Extensive Form Games players
In some situations players observe other players’ moves before they
move
Levent Koçkesen
Removing Coins:
◮ There are 21 coins
Koç University
◮ Two players move sequentially and remove 1, 2, or 3 coins
◮ Winner is who removes the last coin(s)
◮ We will determine the first mover by a coin toss
◮ Volunteers?
Levent Koçkesen (Koç University) Extensive Form Games 1 / 20 Levent Koçkesen (Koç University) Extensive Form Games 2 / 20
page.3 page.4
Entry Game Extensive Form Games
Kodak is contemplating entering the instant photography market and

Polaroid can either fight the entry or accommodate Strategic form has three ingredients:
◮ set of players
K ◮ sets of actions
◮ payoff functions
Out In Extensive form games provide more information
P ◮ order of moves
◮ actions available at different points in the game
0, 20
◮ information available throughout the game
F A
Easiest way to represent an extensive form game is to use a game tree
−5, 0 10, 10
page.5 page.6
Game Trees Extensive Form Game Strategies
What’s in a game tree?

A pure strategy of a player specifies an action choice at each decision node
nodes of that player
◮
K
decision nodes
◮ initial node K
◮ terminal nodes Out In
branches P
Out In Kodak’s strategies
0, 20
player labels P ◮ SK = {Out, In}
F A
action labels 0, 20 Polaroid’s strategies
payoffs F A ◮ SP = {F, A}
−5, 0 10, 10
information sets
◮ to be seen later −5, 0 10, 10
page.7 page.8
Extensive Form Game Strategies Backward Induction Equilibrium
K
What should Polaroid do if
1 C 2 C 1 C Kodak enters?
2, 4 Out In
Given what it knows about
P
Polaroid’s response to entry,
0, 20
S S S what should Kodak do?
F A
This is an example of a
backward induction equilibrium
1, 0 0, 2 3, 1 −5, 0 10, 10
At a backward induction equilibrium each player plays optimally at
every decision node in the game tree (i.e., plays a sequentially rational
S1 = {SS, SC, CS, CC} strategy)
S2 = {S, C} (In, A) is the unique backward induction equilibrium of the entry
game
page.9 page.10
Backward Induction Equilibrium Power of Commitment
1 C 2 C 1 C
2, 4
K
Remember that (In, A) is the
S S S unique backward induction
Out In
equilibrium of the entry game.
P
Polaroid’d payoff is 10.
1, 0 0, 2 3, 1 0, 20
Suppose Polaroid commits to
F A
fight (F ) if entry occurs.
What would Kodak do? −5, 0 10, 10
What should Player 1 do if the game reaches the last decision node?
Given that, what should Player 2 do if the game reaches his decision Outcome would be Out and Polaroid would be better off
node? Is this commitment credible?
Given all that what should Player 1 do at the beginning?
Unique backward induction equilibrium (BIE) is (SS, S)
Unique backward induction outcome (BIO) is (S)
page.11 page.12
Dr. Strangelove
A U.S. air force base commander orders US

thirty four B-52’s to launch a nuclear What is the outcome if the U.S. doesn’t
attack on Soviet Union know the existence of the doomsday
Attack Don’t
device?
He shuts off all communications with
What is the outcome if it does?
the planes and with the base USSR
Commitment must be observable
U.S. president invites the Russian What if USSR can un-trigger the 0, 0
ambassador to the war room and device? Retaliate Don’t
explains the situation Commitment must be irreversible
They decide to call the Russian
−4, −4 1, −2
president Dimitri
Thomas Schelling
The power to constrain an adversary depends upon the power to bind
oneself.
page.13 page.14
Credible Commitments: Burning Bridges Strategic Form of an Extensive Form Game
If you want to apply a strategic form solution concept

In non-strategic environments having more options is never worse ◮ Nash equilibrium
Not so in strategic environments ◮ Dominant strategy equilibrium
◮ IEDS
You can change your opponent’s actions by removing some of your
options Analyze the strategic form of the game
1066: William the Conqueror ordered his soldiers to burn their ships
after landing to prevent his men from retreating Strategic form of an extensive form game
1519: Hernn Corts sank his ships after landing in Mexico for the same 1. Set of players: N
reason and for each player i
2. The set of strategies: Si
Sun-tzu in The Art of War, 400 BC 3. The payoff function:
At the critical moment, the leader of an army acts like one who has ui : S → R
climbed up a height, and then kicks away the ladder behind him.
where S = ×i∈N Si is the set of all strategy profiles.
page.15 page.16
Strategic Form of an Extensive Form Game Extensive Form Games with Imperfect Information
1. N = {K, P } K We have seen extensive form games with perfect information
◮ Every player observes the previous moves made by all the players
2. SK = {Out, In}, SP = {F, A}
Out In What happens if some of the previous moves are not observed?
3. Payoffs in the bimatrix P We cannot apply backward induction algorithm anymore
P 0, 20 Consider the following game between Kodak and Polaroid
F A F A
Out 0, 20 0, 20 Kodak doesn’t know whether K
K Polaroid will fight or
In −5, 0 10, 10 −5, 0 10, 10
accommodate Out In
Set of Nash equilibria = {(In, A), (Out, F )} The dotted line is an P
(Out, F ) is sustained by an incredible threat by Polaroid information set: 0, 20
◮ a collection of decision nodes F A
Backward induction equilibrium eliminates equilibria based upon
that cannot be distinguished
incredible threats K K
by the player
Nash equilibrium requires rationality F A F A
We cannot determine the
Backward induction requires sequential rationality optimal action for Kodak at
◮ Players must play optimally at every point in the game that information set −5, −5 5, 15 15, 5 10, 10
page.17 page.18
Subgame Perfect Equilibrium Subgame Perfect Equilibrium
We will introduce another solution concept: Subgame Perfect Equilibrium
Definition Extensive form game strategies
A subgame is a part of the game tree such that A pure strategy of a player specifies an action choice at each information
1. it starts at a single decision node, set of that player
2. it contains every successor to this node,
3. if it contains a node in an information set, then it contains all the Definition
nodes in that information set. A strategy profile in an extensive form game is a subgame perfect
equilibrium (SPE) if it induces a Nash equilibrium in every subgame of the
This is a subgame This is not a subgame game.
P P
To find SPE
F A A 1. Find the Nash equilibria of the “smallest” subgame(s)
K K K 2. Fix one for each subgame and attach payoffs to its initial node
F A F A F A 3. Repeat with the reduced game
−5, −5 5, 15 15, 5 10, 10 15, 5 10, 10
page.19 page.20
Subgame Perfect Equilibrium Subgame Perfect Equilibrium
Consider the following game The “smallest” subgame Its strategic form
K P
P
F A
Out In F A
K K
F −5, −5 8, 5
K
P F A F A A 5, 8 10, 10
0, 20
−5, −5 5, 8 8, 5 10, 10
F A
K K Nash equilibrium of the subgame is (A,A)

Reduced subgame is
F A F A K
Out In
−5, −5 5, 8 8, 5 10, 10 0, 20 10, 10
Its unique Nash equilibrium is (In)

Therefore the unique SPE of the game is ((In,A),A)
A Simple Game
You have 10 TL to share

A makes an offer
Game Theory ◮ x for me and 10 − x for you
Extensive Form Games: Applications If B accepts
◮ A’s offer is implemented
Levent Koçkesen If B rejects
◮ Both get zero
Koç University Half the class will play A (proposer) and half B (responder)
◮ Proposers should write how much they offer to give responders
◮ I will distribute them randomly to responders
⋆ They should write Yes or No
Levent Koçkesen (Koç University) Extensive Form Games: Applications 1 / 23 Levent Koçkesen (Koç University) Extensive Form Games: Applications 2 / 23
Ultimatum Bargaining Subgame Perfect Equilibrium of Ultimatum Bargaining

We can use backward induction
B’s optimal action
◮ x < 1 → accept
A
◮ x = 1 → accept or reject
Two players, A and B, bargain
over a cake of size 1 1. Suppose in equilibrium B accepts any offer x ∈ [0, 1]
x ◮ What is the optimal offer by A? x = 1
Player A makes an offer ◮ The following is a SPE
x ∈ [0, 1] to player B B
x∗ = 1
If player B accepts the offer
(Y ), agreement is reached s∗B (x) = Y for all x ∈ [0, 1]
Y N
◮ A receives x
◮ B receives 1 − x 2. Now suppose that B accepts if and only if x < 1
◮ What is A’s optimal offer?
If player B rejects the offer (N ) x, 1 − x 0, 0
⋆ x = 1?
both receive zero ⋆ x < 1?
Unique SPE
x∗ = 1, s∗B (x) = Y for all x ∈ [0, 1]
Bargaining Bargaining
Two individuals, A and B, are trying to share a cake of size 1
If A gets x and B gets y,utilities are uA (x) and uB (y)
Bargaining outcomes depend on many factors If they do not agree, A gets utility dA and B gets dB
◮ Social, historical, political, psychological, etc.
What is the most likely outcome?
Early economists thought the outcome to be indeterminate uB
John Nash introduced a brilliant alternative approach
1
◮ Axiomatic approach: A solution to a bargaining problem must satisfy
certain “reasonable” conditions
⋆ These are the axioms
◮ How would such a solution look like?
◮ This approach is also known as cooperative game theory
dB
Later non-cooperative game theory helped us identify critical strategic
considerations
dA 1 uA
Bargaining Bargaining
Let’s simplify the problem How about now? dA = 0.3, dB = 0.4
uA (x) = x, and uB (x) = x
uB
dA = dB = 0
1 45◦
A and B are the same in every other respect
What is the most likely outcome?
uB
0.55
0.4
1 ◦
45
0.3 0.45 1 uA
0.5 Let x be A’s share. Then

1 − x − 0.4
Slope = 1 =
x − 0.3
or x = 0.45
(dA , dB ) 0.5 1 uA So A gets 0.45 and B gets 0.55
Bargaining Bargaining: Axiomatic Approach
In general A gets
John Nash (1950): The Bargaining Problem, Econometrica
1
dA + (1 − dA − dB ) 1. Efficiency
2 ⋆ No waste
B gets 2. Symmetry
⋆ If bargaining problem is symmetric, shares must be equal
1 3. Scale Invariance
dB + (1 − dA − dB )
2 ⋆ Outcome is invariant to linear changes in the payoff scale
4. Independence of Irrelevant Alternatives
But why is this reasonable? ⋆ If you remove alternatives that would not have been chosen, the
Two answers: solution does not change
1. Axiomatic: Nash Bargaining Solution
2. Non-cooperative: Alternating offers bargaining game
Nash Bargaining Solution Alternating Offers Bargaining

What if parties have different bargaining powers?
Two players, A and B, bargain over a cake of size 1
Remove symmetry axiom
At time 0, A makes an offer xA ∈ [0, 1] to B
Then A gets ◮ If B accepts, A receives xA and B receives 1 − xA
◮ If B rejects, then
xA = dA + α(1 − dA − dB )
at time 1, B makes a counteroffer xB ∈ [0, 1]
◮ If A accepts, B receives xB and A receives 1 − xB
B gets
◮ If A rejects, he makes another offer at time 2
xB = dB + β(1 − dA − dB ) This process continues indefinitely until a player accepts an offer
If agreement is reached at time t on a partition that gives player i a
α, β > 0 and α + β = 1 represent bargaining powers share xi
If dA = dB = 0 ◮ player i’s payoff is δit xi
◮ δi ∈ (0, 1) is player i’s discount factor
xA = α and xB = β
If players never reach an agreement, then each player’s payoff is zero
A
Alternating Offers Bargaining

xA
B
Stationary No-delay Equilibrium A
Y N
1. No Delay: All equilibrium offers are accepted xA
B
B
xA , 1 − xA
2. Stationarity: Equilibrium offers do not depend on time
Y N
xB Let equilibrium offers be (x∗A , x∗B ) B
What does B expect to get if she rejects x∗A ?

xA , 1 − xA
A xB
◮ δB x∗B A
Y N
Therefore, we must have Y N
A A
δA (1 − xB ), δB xB
1 − x∗A = δB x∗B δA (1 − xB ), δB xB
xA
xA
B
B Similarly
1 − x∗B = δA x∗A Y N
A
Y N
2 x , δ 2 (1 − x )
δA A B A
A
2 x , δ 2 (1 − x )
δA A B A
Alternating Offers Bargaining Properties of the Equilibrium

Bargaining Power
There is a unique solution
Player A’s share
1 − δB 1 − δB
x∗A = πA = x∗A =
1 − δA δB 1 − δA δB
1 − δA Player B’s share
x∗B = δB (1 − δA )
1 − δA δB πB = 1 − x∗A =
1 − δA δB
There is at most one stationary no-delay SPE
Still have to verify there exists such an equilibrium Share of player i is increasing in δi and decreasing in δj
The following strategy profile is a SPE Bargaining power comes from patience
Example
Player A: Always offer x∗A , accept any xB with 1 − xB ≥ δA x∗A
Player B: Always offer x∗B , accept any xA with 1 − xA ≥ δB x∗B δA = 0.9, δB = 0.95 ⇒ πA = 0.35, πB = 0.65
Properties of the Equilibrium Capacity Commitment: Stackelberg Duopoly
Remember Cournot Duopoly model?

First mover advantage ◮ Two firms simultaneously choose output (or capacity) levels
◮ What happens if one of them moves first?
If players are equally patient: δA = δB = δ
⋆ or can commit to a capacity level?
1 δ The resulting model is known as Stackelberg oligopoly
πA = > = πB
1+δ 1+δ ◮ After the German economist Heinrich von Stackelberg in Marktform
und Gleichgewicht (1934)
First mover advantage disappears as δ → 1
The model is the same except that, now, Firm 1 moves first
1
lim πi = lim πB = Profit function of each firm is given by
δ→1 δ→1 2
ui (Q1 , Q2 ) = (a − b(Q1 + Q2 ))Qi − cQi
Nash Equilibrium of Cournot Duopoly Cournot Best Response Functions
Best response correspondences: Q2

a
a − c − bQ2 b
Q1 =
2b
a−c
b
a − c − bQ1 B1
Q2 =
2b
Nash equilibrium:
a−c
a−c a−c 2b
(Qc1 , Qc2 ) = , a−c b
3b 3b 3b
In equilibrium each firm’s profit is B2

(a − c)2 a−c a−c a−c a Q1
π1c = π2c = 3b 2b b b
9b
Stackelberg Model Backward Induction Equilibrium of Stackelberg Game
The game has two stages:
Sequential rationality of Firm 2 implies that for any Q1 it must play a
1. Firm 1 chooses a capacity level Q1 ≥ 0 best response:
2. Firm 2 observes Firm 1’s choice and chooses a capacity Q2 ≥ 0 a − c − bQ1
Q2 (Q1 ) =
1 2b
Firms 1’s problem is to choose Q1 to maximize:
Q1 [a − b(Q1 + Q2 (Q1 ))]Q1 − cQ1

2 given that Firm 2 will best respond.
Therefore, Firm 1 will choose Q1 to maximize
Q2
a − c − bQ1
[a − b(Q1 + )]Q1 − cQ1
2b
u1 , u2 This is solved as
a−c
Q1 =
2b
ui (Q1 , Q2 ) = (a − b(Q1 + Q2 ))Qi − cQi
Backward Induction Equilibrium of Stackelberg Game

Backward Induction Equilibrium
a−c
Qs1 =
2b
a − c − bQ1
Qs2 (Q1 ) =
2b
Backward Induction Outcome

a−c a−c Firm 1 commits to an aggressive
Qs1 = > = Qc1
2b 3b strategy
a−c a−c
Qs2 = < = Qc2
4b 3b
Equilibrium Profits
(a − c)2 (a − c)2
π1s = > = π1c There is first mover advantage
8b 9b
(a − c)2 (a − c)2
π2s = < = π2c
16b 9b
Levent Koçkesen (Koç University) Extensive Form Games: Applications 23 / 23
page.1 page.2
Repeated Games
Many interactions in the real world have an ongoing structure

◮ Firms compete over prices or capacities repeatedly
Game Theory In such situations players consider their long-term payoffs in addition
to short-term gains
Repeated Games
This might lead them to behave differently from how they would in
one-shot interactions
Levent Koçkesen Consider the following pricing game in the DRAM chip industry
Koç University Samsung
High Low
High 2, 2 0, 3
Micron
Low 3, 0 1, 1
What happens if this game is played only once?
What do you think might happen if played repeatedly?
Levent Koçkesen (Koç University) Repeated Games 1 / 32 Levent Koçkesen (Koç University) Repeated Games 2 / 32
page.3 page.4
Dynamic Rivalry Implicit Collusion
Could firms collude without explicitly fixing prices?

If a firm cuts its price today to steal business, rivals may retaliate in
the future, nullifying the “benefits” of the original price cut There must be some reward/punishment mechanism to keep firms in
In some concentrated industries prices are maintained at high levels line
◮ U.S. steel industry until late 1960s Repeated interaction provides the opportunity to implement such
◮ U.S. cigarette industry until early 1990s mechanisms
In other similarly concentrated industries there is fierce price For example Tit-for-Tat Pricing: mimic your rival’s last period price
competition A firm that contemplates undercutting its rivals faces a trade-off
◮ Costa Rican cigarette industry in early 1990s ◮ short-term increase in profits
◮ U.S. airline industry in 1992 ◮ long-term decrease in profits if rivals retaliate by lowering their prices
When and how can firms sustain collusion? Depending upon which of these forces is dominant collusion could be
They could formally collude by discussing and jointly making their sustained
pricing decisions
What determines the sustainability of implicit collusion?
◮ Illegal in most countries and subject to severe penalties
Repeated games is a model to study these questions
page.5 page.6
Repeated Games Payoffs
Players play a stage game repeatedly over time
If there is a final period: finitely repeated game If starting today a player receives an infinite sequence of payoffs
If there is no definite end period: infinitely repeated game
◮ We could think of firms having infinite lives u1 , u2 , u3 , . . .
◮ Or players do not know when the game will end but assign some
probability to the event that this period could be the last one The payoff consequence is
Today’s payoff of $1 is more valuable than tomorrow’s $1
◮ This is known as discounting (1 − δ)(u1 + δu2 + δ2 u3 + δ3 u4 · · · )
◮ Think of it as probability with which the game will be played next
period Example: Period payoffs are all equal to 2
◮ ... or as the factor to calculate the present value of next period’s payoff
(1 − δ)(2 + δ2 + δ2 2 + δ3 2 + · · · ) = 2(1 − δ)(1 + δ + δ2 + δ3 + · · · )
Denote the discount factor by δ ∈ (0, 1)
1
In PV interpretation: if interest rate is r = 2(1 − δ)
1−δ
1 = 2
δ=
1+r
page.7 page.8
Repeated Game Strategies Equilibria of Repeated Games
Strategies may depend on history There is no end period of the game
Cannot apply backward induction type algorithm
Samsung We use One-Shot Deviation Property to check whether a strategy
High Low profile is a subgame perfect equilibrium
High 2, 2 0, 3
Micron
Low 3, 0 1, 1 One-Shot Deviation Property
A strategy profile is an SPE of a repeated game if and only if no player can
Tit-For-Tat gain by changing her action after any history, keeping both the strategies
◮ Start with High of the other players and the remainder of her own strategy constant
◮ Play what your opponent played last period
Grim-Trigger (called Grim-Trigger II in my lecture notes) Take an history
◮ Start with High
◮
For each player check if she has a profitable one-shot deviation (OSD)
Continue with High as long as everybody always played High
◮ If anybody ever played Low in the past, play Low forever Do that for each possible history
What happens if both players play Tit-For-Tat? If no player has a profitable OSD after any history you have an SPE
If there is at least one history after which at least one player has a
How about Grim-Trigger?
profitable OSD, the strategy profile is NOT an SPE
page.9 page.10
Grim-Trigger Strategy Profile
There are two types of histories Histories in which somebody played Low in some period
1. Histories in which everybody always played High Payoff to G-T
2. Histories in which somebody played Low in some period
(1 − δ)(1 + δ + δ2 + δ3 + · · · ) = 1
Histories in which everybody always played High
Payoff to G-T Payoff to OSD (play High today and go back to G-T tomorrow)
(1 − δ)(2 + δ2 + δ2 2 + δ3 2 + · · · ) = 2(1 − δ)(1 + δ + δ2 + δ3 + · · · ) (1 − δ)(0 + δ + δ2 + δ3 + · · · ) = (1 − δ)δ(1 + δ + δ2 + δ3 + · · · )
= 2 = δ
Payoff to OSD (play Low today and go back to G-T tomorrow)
OSD is NOT profitable for any δ

(1 − δ)(3 + δ + δ2 + δ3 + · · · ) = (1 − δ)(3 + δ(1 + δ + δ2 + δ3 + · · ·
= 3(1 − δ) + δ For any δ ≥ 1/2 Grim-Trigger strategy profile is a SPE
We need
2 ≥ 3(1 − δ) + δ or δ ≥ 1/2
page.11 page.12
Forgiving Trigger Forgiving Trigger Strategy
Cooperative Phase
Grim-trigger strategies are very fierce: they never forgive Payoff to F-T = 2
Can we sustain cooperation with limited punishment Payoff to OSD Outcome after a OSD
◮ For example: punish for only 3 periods
(L, H), (L, L), (L, L), . . . , (L, L), (H, H), (H, H), . . .
| {z }
Forgiving Trigger Strategy k times
Cooperative phase: Start with H and play H if Corresponding payoff

◮ everybody has always played H (1 − δ)[3 + δ + δ2 + . . . + δk + 2δk+1 + 2δk+2 + . . .] = 3 − 2δ + δk+1
◮ or k periods have passed since somebody has played L
Punishment phase: Play L for k periods if
◮ somebody played L in the cooperative phase No profitable one-shot deviation in the cooperative phase if and only if
We have to check whether there exists a one-shot profitable deviation 3 − 2δ + δk+1 ≤ 2

after any history or
or in any of the two phases δk+1 − 2δ + 1 ≤ 0
It becomes easier to satisfy this as k becomes large
page.13 page.14
Forgiving Trigger Strategy Imperfect Detection
Punishment Phase
Suppose there are k′ ≤ k periods left in the punishment phase.
Play F-T We have assumed that cheating (low price) can be detected with
absolute certainty
(L, L), (L, L), . . . , (L, L), (H, H), (H, H), . . . In reality actions may be only imperfectly observable
| {z }
◮ Samsung may give a secret discount to a customer
k ′ times
Your sales drop
Play OSD ◮ Is it because your competitor cut prices?
◮ Or because demand decreased for some other reason?
(H, L), (L, L), . . . , (L, L), (H, H), (H, H), . . .
| {z } If you cannot perfectly observe your opponent’s price you are not sure
k ′ times
If you adopt Grim-Trigger strategies then you may end up in a price
F-T is better war even if nobody actually cheats
You have to find a better strategy to sustain collusion
Forgiving Trigger strategy profile is a SPE if and only if
δk+1 − 2δ + 1 ≤ 0
page.15 page.16
Imperfect Detection Imperfect Detection
For simplicity let’s make payoff to (Low,Low) zero for both firms
If your competitor cuts prices it is more likely that your sales will be
lower Samsung
Adopt a threshold trigger strategy: Determine a threshold level of High Low
sales s and punishment length T Micron High 2,2 -1,3
◮ Start by playing High Low 3,-1 0,0
◮ Keep playing High as long as sales of both firms are above s
◮ The first time sales of either firm drops below s play Low for T Denote the discounted sum of expected payoff (NPV) to threshold
periods; and then restart the strategy trigger strategy by v

pH : probability that at least one firm’s sales is lower than s even v = 2 + δ (1 − pH )v + pH δT v
when both firms choose high prices
We can solve for v
pL : probability that the other firm’s sales are lower than s when one 2
firm chooses low prices v=
1 − δ [(1 − pH ) + pH δT ]
pL > pH
Value decreases as
pH and pL depend on threshold level of sales s ◮ Threshold increases (pH increases)
◮ Higher the threshold more likely the sales will fall below the threshold ◮ Punishment length increases
◮ Therefore, higher the threshold higher are pH and pL You don’t want to trigger punishment too easily or punish too harshly
page.17 page.18
Imperfect Detection How to Sustain Cooperation?
Main conditions
What is the payoff to cheating? Future is important
It is easy to detect cheaters
3 + δ (1 − pL )v + pL δT v
Firms are able to punish cheaters
Threshold grim trigger is a SPE if
What do you do?

2 + δ (1 − pH )v + pH δT v ≥ 3 + δ (1 − pL )v + pL δT v 1. Identify the basis for cooperation
◮ Price
that is ◮ Market share
δv(1 − δT )(pL − pH ) > 1 ◮ Product design
It is easier to sustain collusion with harsher punishment (higher T ) 2. Share profits so as to guarantee participation
although it reduces v 3. Identify punishments
◮ Strong enough to deter defection
The effect of the threshold s is ambiguous: an increase in s
◮ But weak enough to be credible
◮ decreases v
◮ may increase pL − pH 4. Determine a trigger to start punishment
5. Find a method to go back to cooperation
page.19 page.20
Lysine Cartel: 1992-1995 Cartel Behavior
John M. Connor (2002): Global Cartels Redux: The Amino Acid
Lysine Antitrust Litigation (1996)
This is a case of an explicit collusion - a cartel
Archer Daniels Midland (ADM) and four other companies charged
April 1990: A, KH and S started meetings
with fixing worldwide lysine (an animal feed additive) price
June 1992: five firm oligopoly formed a trade association
Before 1980s: the Japanese duopoly, Ajinomoto and Kyowa Hakko
Multiparty price fixing meetings amongst the 5 corporations
Expansion mid 1970s to early 1980s to America and Europe
Early 1993: a brief price war broke out
In early 1980s, South Korean firm, Sewon, enters the market and
expands to Asia and Europe 1993: establishment of monthly reporting of each company’s sales
1986 - 1990: US market divided 55/45% btw. Ajinomoto and Kyowa Prices rose in this period from 0.68 to 0.98, fell to 0.65 and rose
Hakko again to above 1$
Prices rose to $3 per pound ($1-$2 btw 1960 and 1980)
In early 1991 ADM and Cheil Sugar Co turned the lysine industry into
a five firm oligopoly
Prices dropped rapidly due to ADMs aggressive entry as a result of its
excess capacity
page.21 page.22
Cartel Meetings Caught on Tape Cartel Meetings Caught on Tape
Whitacre secretly gathers hundreds of hours of video and audio over

several years to present to the FBI
Documents here:
http://www.usdoj.gov/atr/public/speeches/4489.htm
http://www.usdoj.gov/atr/public/speeches/212266.htm
Criminal investigation resulted in fines and prison sentences for
executives of ADM
Foreign companies settled with the United States Department of
Justice Antitrust Division
Mark Whitacre, a rising star at ADM, blows the whistle on the Whitacre was later charged with and pled guilty to committing a $9
companys price-fixing tactics at the urging of his wife Ginger million fraud that occurred during the same time period he was
In November 1992, Whitacre confesses to FBI special agent Brian working for the FBI
Shepard that ADM executives including Whitacre himself had
routinely met with competitors to fix the price of lysine
page.23 page.24
Cartel Meetings Caught on Tape Stickleback Fish
1. Identify the basis for cooperation

◮ Price
◮ Market share
2. Share profits so as to guarantee participation
◮ There is an annual budget for the cartel that allocates projected
demand among the five When a potential predator appears, one or more sticklebacks
◮ Prosecutors captured a scoresheet with all the numbers approach to check it out
◮ Those who sold more than budget buy from those who sold less than This is dangerous but provides useful information
budget ◮ If hungry predator, escape
3. Identify punishments ◮ Otherwise stay
◮ Retaliation threat by ADM taped in one of the meetings Milinski (1987) found that they use Tit-for-Tat like strategy
◮ ADM has credibility as punisher: low-cost/high-capacity ◮ Two sticklebacks swim together in short spurts toward the predator
◮ Price cuts: 1993 price war?
Cooperate: Move forward
Defect: Hang back
page.25 page.26
Stickleback Fish Vampire Bats
Milinski also run an ingenious experiment

Used a mirror to simulate a cooperating or defecting stickleback
When the mirror gave the impression of a cooperating stickleback
◮ The subject stickleback move forward
When the mirror gave the impression of a defecting stickleback
◮ The subject stickleback stayed back Vampire bats (Desmodus rotundus) starve after 60 hours
They feed each other by regurgitating
Is it kin selection or reciprocal altruism?
◮ Kin selection: Costly behavior that contribute to reproductive success
of relatives
Wilkinson, G.S. (1984), Reciprocal food sharing in the vampire bat,
Nature.
◮ Studied them in wild and in captivation
page.27 page.28
Vampire Bats Medieval Trade Fairs
If a bat has more than 24 hours to starvation it is usually not fed In 12th and 13th century Europe long distance trade took place in
◮ Benefit of cooperation is high fairs
Primary social unit is the female group Transactions took place through transfer of goods in exchange of
◮ They have opportunities for reciprocity promissory note to be paid at the next fair
Adult females feed their young, other young, and each other Room for cheating
◮ Does not seem to be only kin selection
No established commercial law or state enforcement of contracts
Unrelated bats often formed a buddy system, with two individuals
feeding mostly each other Fairs were largely self-regulated through Lex mercatoria, the
”merchant law”
◮ Reciprocity
◮ Functioned as the international law of commerce
Also those who received blood more likely to donate later on ◮ Disputes adjudicated by a local official or a private merchant
If not in the same group, a bat is not fed ◮ But they had very limited power to enforce judgments
◮ If not associated, reciprocation is not very likely Has been very successful and under lex mercatoria, trade flourished
It is not only kin selection How did it work?
page.29 page.30
Medieval Trade Fairs Medieval Trade Fairs
If two merchants interact repeatedly honesty can be sustained by

What prevents cheating by a merchant? trigger strategy
Could be sanctions by other merchants In the case of trade fairs, this is not necessarily the case
But then why do you need a legal system? Can modify trigger strategy
◮ Behave honestly iff neither party has ever cheated anybody in the past
What is the role of a third party with no authority to enforce
judgments? Requires information on the other merchant’s past
There lies the role of the third party
page.31 page.32
Medieval Trade Fairs Medieval Trade Fairs
If the cost of querying and appeal are not too high and players are
Milgrom, North, and Weingast (1990) construct a model to show how sufficiently patient the following strategy is a subgame perfect
this can work equilibrium:
The stage game: 1. A trader querries if he has no unpaid judgments
2. If either fails to query or if query establishes at least one has unpaid
1. Traders may, at a cost, query the judge, who publicly reports whether
judgement play Cheat, otherwise play Honest
any trader has any unpaid judgments
3. If both queried and exactly one cheated, victim appeals
2. Two traders play the prisoners’ dilemma game
4. If a valid appeal is filed, judge awards damages to victim
3. If queried before, either may appeal at a cost
5. Defendant pays judgement iff he has no other unpaid judgements
4. If appealed, judge awards damages to the plaintiff if he has been
honest and his partner cheated This supports honest trade
5. Defendant chooses to pay or not An excellent illustration the role of institutions
6. Unpaid judgments are recorded by the judge ◮ An institution does not need to punish bad behavior, it just needs to
help people do so
page.1 page.2
Extensive Form Games with Incomplete Information
We have seen extensive form games with perfect information

◮ Entry game
Game Theory And strategic form games with incomplete information
Extensive Form Games with Incomplete Information ◮ Auctions
Many incomplete information games are dynamic
Levent Koçkesen There is a player with private information
Koç University
Signaling Games: Informed player moves first
◮ Warranties
◮ Education
Screening Games: Uninformed player moves first
◮ Insurance company offers contracts
◮ Price discrimination
Levent Koçkesen (Koç University) Signaling Games 1 / 27 Levent Koçkesen (Koç University) Signaling Games 2 / 27
page.3 page.4
Signaling Examples Signaling Games: Used-Car Market
Used-car dealer You want to buy a used-car which may be either good or bad (a
◮
lemon)
How do you signal quality of your car?
◮ Issue a warranty A good car is worth H and a bad one L dollars
An MBA degree You cannot tell a good car from a bad one but believe a proportion q
◮ How do you signal your ability to prospective employers? of cars are good
◮ Get an MBA The car you are interested in has a sticker price p
Entrepreneur seeking finance
The dealer knows quality but you don’t
◮ You have a high return project. How do you get financed?
◮ Retain some equity The bad car needs additional work that costs c to make it look like
Stock repurchases good
◮ Often result in an increase in the price of the stock The dealer decides whether to put a given car on sale or not
◮ Manager knows the financial health of the company You decide whether to buy or not
◮ A repurchase announcement signals that the current price is low
Assume
Limit pricing to deter entry
H>p>L
◮ Low price signals low cost
page.5 page.6
Signaling Games: Used-Car Market Signaling Games: Used-Car Market
p, H − p p, H − p
Yes
Yes
Hold D Offer
Hold D Offer 0, 0
0, 0
No
good (q) 0, 0
No
good (q) 0, 0
Nature Y
bad (1 − q) p − c, L − p
Nature Y Yes
0, 0
(1 − q) p − c, L − p Hold D Offer
bad
Yes No
−c, 0
0, 0
Hold D Offer
Dealer will offer the bad car if you will buy
No
−c, 0
You will buy if the car is good
We have to introduce beliefs at your information set
We cannot apply backward induction
◮
Given beliefs we want players to play optimally at every information
No final decision node to start with
set
We cannot apply SPE ◮ sequential rationality
◮ There is only one subgame - the game itself We want beliefs to be consistent with chance moves and strategies
We need to develop a new solution concept ◮ Bayes Law gives consistency
page.7 page.8
Bayes Law Bayes Law
Suppose a fair die is tossed once and consider the following events: Given two events A and B such that P (B) 6= 0 we have
A: The number 4 turns up.
B: The number observed is an even number. P (A and B)
P (A | B) =
The sample space and the events are P (B)
Note that since
S = {1, 2, 3, 4, 5, 6} P (A and B) = P (B | A) P (A)
A = {4} We have
P (B | A) P (A)
B = {2, 4, 6} P (A | B) =
P (B)
Ac : complement of A
P (A) = 1/6, P (B) = 1/2 P (B) = P (B | A) P (A) + P (B | Ac ) P (Ac )
Suppose we know that the outcome is an even number. What is the Therefore,
probability that the outcome is 4? We call this a conditional probability
P (B | A) P (A)
P (A | B) =
1 P (B | A) P (A) + P (B | Ac ) P (Ac )
P (A | B) =
3 The probability P (A) is called the prior probability and P (A | B) is called
the posterior probability.
page.9 page.10
Bayes Law: Example Bayes Law
p, H − p
A machine can be in two possible states: good (G) or bad (B) Hold D Offer
Yes
0, 0
It is good 90% of the time
The item produced by the machine is defective (D) good (q)
No
0, 0
◮ 1% of the time if it is good

Nature Y
◮ 10% of the time if it is bad
What is the probability that the machine is good if the item is bad (1 − q)
Yes
p − c, L − p
defective? 0, 0
Hold D Offer
No
−c, 0
P (G) = 0.9, P (B) = 1 − 0.9 = 0.1, P (D | G) = 0.01, P (D | B) = 0.1 Dealer’s strategy: Offer if good; Hold if bad
Therefore, by Bayes’ Law What is your consistent belief if you observe the dealer offer a car?
P (offer and good)
P (D | G) P (G)
P (good|offer) =
P (G | D) = P (offer)
P (D | G) P (G) + P (D | B) P (B)
0.01 × 0.9
P (offer|good)P (good)
= =
0.01 × 0.9 + 0.10 × 0.1 P (offer|good)P (good) + P (offer|bad)P (bad)
.00 9 ∼ 1×q
= = . 47
.0 19 =
1 × q + 0 × (1 − q)
In this example the prior probability that the machine is in a good
= 1
condition is 0.90, whereas the posterior probability is 0.47.
page.11 page.12
Strategies and Beliefs Perfect Bayesian Equilibrium
Sequential Rationality
At each information set, strategies must be optimal, given the beliefs and
A solution in an extensive form game of incomplete information is a
subsequent strategies
collection of
1. A behavioral strategy profile Weak Consistency
2. A belief system Beliefs are determined by Bayes Law and strategies whenever possible
We call such a collection an assessment
The qualification “whenever possible” is there because if an information
A behavioral strategy specifies the play at each information set of the
set is reached with zero probability we cannot use Bayes Law to determine
player
◮
beliefs at that information set.
This could be a pure strategy or a mixed strategy
A belief system is a probability distribution over the nodes in each Perfect Bayesian Equilibrium
information set An assessment is a PBE if it satisfies
1. Sequentially rationality
2. Weak Consistency
page.13 page.14
Back to Used-Car Example Pooling Equilibria
p, H − p
Yes
Hold D Offer
0, 0
p, H − p No
good (q) 0, 0
Yes
Hold D Offer
0, 0 Nature Y
No bad (1 − q) p − c, L − p
good (q) 0, 0 Yes
0, 0
Hold D Offer
Nature Y
No
−c, 0
bad (1 − q) p − c, L − p
Yes
Both types Offer
0, 0
Hold D Offer
What does Bayes Law imply about your beliefs?
No
−c, 0
P (offer and good)
P (good|offer) =
As in Bayesian equilibria we may look for two types of equilibria: P (offer)
P (offer|good)P (good)
1. Pooling Equilibria: Good and Bad car dealers play the same strategy =
P (offer|good)P (good) + P (offer|bad)P (bad)
2. Separating Equilibrium: Good and Bad car dealers play differently 1×q
= =q
1 × q + 1 × (1 − q)
Makes sense?
page.15 page.16
Pooling Equilibria: Both Types Offer Pooling Equilibria: Both Types Hold
If you buy a car with your prior beliefs your expected payoff is You must be saying No
◮ Otherwise Good car dealer would offer
V = q × (H − p) + (1 − q) × (L − p) ≥ 0
Under what conditions would you say No?
What does sequential rationality of seller imply? P (good|of f er) × (H − p) + (1 − P (good|of f er)) × (L − p) ≤ 0
You must be buying and it must be the case that What does Bayes Law say about P (good|of f er)?
p≥c Your information set is reached with zero probability
◮ You cannot apply Bayes Law in this case
So we can set P (good|of f er) = 0
Under what conditions buying would be sequentially rational?
V ≥0 Pooling Equilibrium II
The following is a PBE
Pooling Equilibrium I
Behavioral Strategy Profile: (Good: Hold, Bad: Hold),(You: No)
If p ≥ c and V ≥ 0 the following is a PBE
Belief System: P (good|of f er) = 0
Behavioral Strategy Profile: (Good: Offer, Bad: Offer),(You: Yes)
Belief System: P (good|of f er) = q This is complete market failure: a few bad apples (well lemons) can ruin a
market
page.17 page.18
Separating Equilibria Separating Equilibria
Good:Offer and Bad:Hold Good:Hold and Bad:Offer
What does Bayes Law imply about your beliefs? What does Bayes Law imply about your beliefs?
P (good|of f er) = 1 P (good|of f er) = 0
What does you sequential rationality imply? What does you sequential rationality imply?
◮ You say Yes ◮ You say No
Is Good car dealer’s sequential rationality satisfied?
Is Good car dealer’s sequential rationality satisfied?
◮ Yes ◮ Yes
Is Bad car dealer’s sequential rationality satisfied?
Is Bad car dealer’s sequential rationality satisfied?
◮ Yes if p ≤ c
◮ No
Separating Equilibrium I
There is no PBE in which Good dealer Holds and Bad dealer Offers
If p ≤ c the following is a PBE
Behavioral Strategy Profile: (Good: Offer, Bad: Hold),(You: Yes) If p > c and V < 0 only equilibrium is complete market failure: even the
Belief System: P (good|of f er) = 1 good cars go unsold.
page.19 page.20
Mixed Strategy Equlilibrium Mixed Strategy Equilibrium
The following is a little involved so let’s work with numbers What does Bayes Law imply?
H = 3000, L = 0, q = 0.5, p = 2000, c = 1000 0.5 2

P (good|of f er) = =
0.5 + (1 − 0.5)b 3
Let us interpret player You as a population of potential buyers b = 0.5
Is there an equilibrium in which only a proportion x, 0 < x < 1, of Bad car dealers must be indifferent between Offer and Hold
them buy a used car?
What does sequential rationality of Good car dealer imply? x(2000 − 1000) + (1 − x)(−c) = 0
◮ Offer
or x = 0.5
What does sequential rationality of buyers imply?
◮ Bad car dealers must Offer with positive probability, say b Mixed Strategy Equilibrium
Buyers must be indifferent between Yes and No The following is a PBE
P (good|of f er)(3000 − 2000) + (1 − P (good|of f er))(0 − 2000) = 0 Behavioral Strategy Profile: (Good: Offer, Bad: Offer with prob.
1/2),(You: Yes with prob. 1/2)
P (good|of f er) = 2/3 Belief System: P (good|of f er) = 2/3
page.21 page.22
What is an MBA Worth? What is an MBA Worth?
There are two types of workers If employers can tell worker’s ability wages will be given by
◮ high ability (H): proportion q
◮ low ability (L): proportion 1 − q wH = H, wL = L
Output is equal to
◮ H if high ability
◮ L if low ability Nobody gets an MBA
Workers can choose to have an MBA (M) or just a college degree (C) Best outcome for high ability workers
College degree does not cost anything but MBA costs If employers can only see worker’s education, wage can only depend on
◮ cH if high ability education
◮ cL if low ability Employers need to form beliefs about ability in offering a wage
Assume
cL > H − L > cH wM = pM × H + (1 − pM ) × L
wC = pC × H + (1 − pC ) × L
There are many employers bidding for workers
◮ Wage of a worker is equal to her expected output where pM (pC ) is employers’ belief that worker is high ability if she
MBA is completely useless in terms of worker’s productivity! has an MBA (College) degree
page.23 page.24
Separating Equilibria Separating Equilibria
Only High ability gets an MBA Only Low ability gets an MBA
What does Bayes Law imply? What does Bayes Law imply?
pM = 1, pC = 0 pM = 0, pC = 1
What are the wages? What are the wages?

wM = H, wC = L wM = L, wC = H
What does High ability worker’s sequential rationality imply? What does High ability worker’s sequential rationality imply?
H − cH ≥ L H≥L
which is satisfied
What does Low ability worker’s sequential rationality imply? High ability worker is quite happy: she gets high wages and doesn’t
have to waste money on MBA
L ≥ H − cL
What does Low ability worker’s sequential rationality imply?
L − cL ≥ H
Combining
cH ≤ H − L ≤ cL which is impossible
which is satisfied by assumption Too bad for High ability workers: Low ability workers want to mimic
MBA is a waste of money but High ability does it just to signal her them
ability No such equilibrium: A credible signal of high ability must be costly
page.25 page.26
Pooling Equilibria Pooling Equilibria
Both get an MBA Neither gets an MBA
What does Bayes Law imply? What does Bayes Law imply?
pM = q, pC = indeterminate pC = q, pM = indeterminate
What are the wages? What are the wages?
wM = qH + (1 − q)L, wC = pC H + (1 − pC )L wC = qH + (1 − q)L, wM = pM H + (1 − pM )L
High ability worker’s sequential rationality imply High ability worker’s sequential rationality imply
qH + (1 − q)L − cH ≥ pC H + (1 − pC )L qH + (1 − q)L ≥ pM H + (1 − pM )L − cH
Low ability worker’s sequential rationality imply Low ability worker’s sequential rationality imply
qH + (1 − q)L − cL ≥ pC H + (1 − pC )L qH + (1 − q)L ≥ pM H + (1 − pM )L − cL
Since we assumed cL > H − L the last inequality is not satisfied These are satisfied if cH ≥ (pM − q)(H − L). If, for example, pM = q
No such equilibrium: It is not worth getting an MBA for low ability High ability workers cannot signal their ability by getting an MBA
workers if they cannot fool the employers. because employers do not think highly of MBAs
page.27
Signaling Recap
Signaling works only if
◮ it is costly
◮ it is costlier for the bad type
Warranties are costlier for lemons

MBA degree is costlier for low ability applicants
Retaining equity is costlier for an entrepreneur with a bad project
Stock repurchases costlier for management with over-valued stock
Low price costlier for high cost incumbent
Levent Koçkesen (Koç University) Signaling Games 27 / 27

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Game Theory: Definition and Assumptions

Example Example: A Single Person Decision Problem

Investment Game with Incomplete Information The Dating Game

Split or Steal Split or Steal

Prisoners’ Dilemma Contribution Game

Everybody starts with 10 TL

Dominant Strategies Dominant Strategy Equilibrium

ui (ai , a−i ) > ui (bi , a−i ) for all a−i ∈ A−i

We will play a game

A reasonable solution concept Name:

Beauty Contest Beauty Contest

Toys“R”Us web page has the following advertisement

Is there a dominant strategy for any of the players?

Price Matching Price Matching

A “rational” player should never play an action when there is another

IESDS vs. IEWDS Effort Game

You choose how much effort to expend for a joint project

L H Nash equilibrium is a strategy profile (a collection of strategies, one

Nash Equilibrium Best Response Correspondence

The best response correspondence of player i is given by

Bi (a−i ) = {ai ∈ Ai : ui (ai , a−i ) ≥ ui (bi , a−i ) for all bi ∈ Ai }.

See S. Anderson and M. Engers: Participation Games: Market Entry,

Stag Hunt Stag Hunt

Jean-Jacques Rousseau in A Discourse on Inequality

Stag Hare What do you think?

How would you play this game?

max f (x) subject to x ∈ D

Similarly for minimization problems

Interior Optima Recipe for solving the simple case

What is the solution if the constraint set is [−1, 0.5]?

Recipe for general problems Cournot Duopoly

Similarly for firm 2.

Cournot Nash Equilibrium Cournot Oligopoly

Is the cartel stable?

Levent Koçkesen 2 Price Competition Models

Open Bid Sealed Bid

Weakly dominant strategy equilibrium = (v1 , v2 ) (

There is no dominant strategy equilibrium Proof

Q1 (P1 , P2 ) = 10 − αP1 + P2 Only goal is to win the election

2. A1 = A2 = [0, 1] 1. Outcome must be a tie

This result generalizes to models with more general distributions

Levent Koçkesen (Koç University) Strategic Form Games 21 / 21

Assume: f > c > 0; d > r > a ≥ 0

A mixed strategy is a probability distribution over the set of actions.

In a mixed strategy equilibrium every action played with positive

Also see Walker and Wooders (2001): Wimbledon

You (player 1) and another investor (player 2) have a deposit of $100

W 50, 50 100, 0 W 50, 50 100, 0

If q < 1/2 the only equilibrium is a bank run

Best response correspondences

Complete Information Incomplete Information

Levent Koçkesen (Koç University) Bayesian Games 15 / 15

Auctions Auction Formats Independent Private Values Auctions as a Bayesian Game

To prevent winner’s curse

◮ No reserve price Problem: No penalty for default

Auction Design: Failures Auction Design

Correlated values: Ascending bid auction is better

Levent Koçkesen (Koç University) Auctions 27 / 27

Strategic form games are used to model situations in which players

Kodak is contemplating entering the instant photography market and

What’s in a game tree?

A U.S. air force base commander orders US

If you want to apply a strategic form solution concept