Chapter 13 – Part 1: Game Theory

Chapters 1-12: No strategic interaction between agents

• Consumer’s problem: prices are taken as given
• Cost minimization problem: output and input prices are taken
as given
• Competitive firm’s problem: choose output independently of
output decisions of other firms
Economic reality: normally payoffs depend on own choices as
well as choices of others
agents interact strategically
when they make choices. Examples:
1. You bargain over the price when buying a second-hand car
2. Market with few sellers. Profits of each seller depends on
your price quote and quotes of other sellers
3. Monopolistic market. Entry decision of potential entrant
depends on anticipated reaction incumbent monopolist
Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 1
 Introduction

Game Theory
• The way to model situations of strategic interaction
• Von Neumann and Morgenstern (1944)
• Enormous range of economic applications
• We only discuss non-cooperative game theory

Setup
• Defining and describing games
 The extensive-form representation (the ‘game tree’)
 The normal-form representation
• Equilibria (equilibriums, solutions) for games
 How do players actually play games?
 Dominant strategies, minimax strategies, etc
 Equilibrium concepts: Nash equilibrium, Equilibrium in dominant
strategies, Subgame perfect (Nash) equilibrium

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 2
 Describing Games

Defining and describing Games

Game (of strategy): the definition

• (Informal definition) A player is engaged in a game of strategy
if her payoff depends on her actions as well as on the actions
of the other players
 Player
agent
 Payoff
utility
 Payoffs of all agents together
the outcome (of the game)
 Example: A game of chess
 Example: Bargaining over buying a car
• (Formal definition) A game is comprised of a set of players
and an abstract set of ‘rules’ that (a) constraints the actions of
the players and (b) defines the outcome that follows from the
actions of the players

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 3
 Describing Games

Describing a game involves a description of

• The players
• Their possible actions
 The set of possible actions
 The sequence of actions
 The information the players have when they decide
• The outcome following the actions, i.e. payoffs for all players
This is the extensive-form representation of the game

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 4
 Describing Games

Another, equivalent way to describe a game

• The players
• Their possible strategies
• The outcome following these strategies
This is the normal-form or strategic-form representation
Notes
• A convenient way to describe the game in its extensive form
is to use a “game tree”
• If there are 2 players, a convenient way to describe the game
in its strategic form is to use a “matrix”
• Action = “move” ≠ strategy
• Strategy = “plan of action”
• Understanding the difference between action and strategy is
very important

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 5
 Describing Games

Example 1: A dynamic game; extensive-form representation

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 6
 Describing Games

Example 2: A simultaneous-move game; extensive-form repn.

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 Describing Games

Example 2: The normal-form representation

Toshiba

DOS Unix

IBM DOS (600,200) (100,100)

Unix (100, 100) (200,600)

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 8
 Describing Games

Class question: derive the normal-form representation of the

game of Example 1
• Underscores the difference between actions and strategies
 IBM has two different strategies and Toshiba four.

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 9
 Describing Games

There are a thousand ways to classify games

1. Games of perfect and imperfect information

• What information do the players have when they move?
• Game of perfect information
Every player knows all the
prior actions at all times
 Example 1 is a game of perfect information
• Game of imperfect information
At some stage some player
does not know all the prior actions
 Example 2 is a game of imperfect information
• Information sets

2. Simultaneous-move games vs dynamic games

• Dynamic game = sequential game (see section 13.9)
Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 10
 Another example

Example 3: The matching pennies game

• Simultaneous-move game
• Zero-sum game

Extensive-form Normal-form representation

representation Child 2

Heads Tails

Ch.1 Heads (-1,1) (1,-1)

Tails (1,-1) (-1,1)

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 11
 Class experiment

Class experiment: The Prisoner’s dilemma

• Experiment
 Imagine you manage either Ford or GM

General Motors

High price Low price

High price (2,2) (-1,3)

Ford
Low price (3,-1) (0,0)

 Write down your name and action/strategy {High price, Low

price} on piece of paper
 Seal your papers. I match players by random draws

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 12
 Solving games: the equilibrium

Equilibria of games

We have now mastered the skill to describe games

Question: How do players actually play games?
• Difficult question! You can only give an answer when you
know the psyche of the players

Economists
• Assume players consider only their own payoff
• Assume specific equilibrium concept (= “mindset”)
• Players play an equilibrium

Equilibrium of a game (= solution of a game): situation in

which no player wishes to change her strategy

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 13
 Solving games: the equilibrium

So, how do you find the equilibria of a game?

1. Make assumption about the mindset of the players. In formal
language: choose an equilibrium concept (solution concept)
2. Compute what is best for each player given this equilibrium
concept

We shall study three equilibrium concepts in Econ 203

• Dominant strategy equilibrium
• Nash equilibrium
• Subgame perfect Nash equilibrium

Note: In Econ 203 we focus on pure strategies, not on so-

called mixed strategies

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 14
 Equilibrium in dominant strategies

Dominant strategy equilibrium

• Players play dominant strategies: strategies that are best
independently of the choice of other players
• Example: the prisoner’s dilemma experiment
• Problem: normally there is no dominant strategy equilibrium
• Example: Player 2
Strategy 1 Strategy 2
Pl.1 Strategy 1 (4,4) (4,4)
Strategy 2 (0, 1) (6,3)

• Partial solution: assume a little more rationality
equilibrium

after elimination of dominated strategies
Elimination of dominated strategies
• In example above Strategy 1 is dominated by S2 for Player 2
Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 15
 Nash equilibrium

The Nash equilibrium (NE)

• Set of strategies (one for each player) such that no player

wishes to change her strategy given the strategies of the
other players
 The strategy of each player is a so-called best response to the
given strategies of the other players
• The Nash equilibrium :
Assume there are n players, and that each chooses
a strategy si , i = 1,...,n. Let the payoff of player i
with strategies ( s1 , s2 ,..., sn ) be π i ( s1 , s2 ,..., sn ).
The strategy choices ( s1* , s2* ,..., sn* ) are called a Nash equilibrium
if for all players i we have : π i ( s1* ,..., si* ,..., sn* ) ≥ π i ( s1* ,..., si ,..., sn* )
for all possible strategy choices si of player i.
Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 16
 Nash equilibrium

Example Nash equilibrium: a coordination game

• Who calls the other after the phone line disconnected?
Player 2

Call back Wait for other

Pl.1 Call back (0,0) (3,6)

Wait for (6,3) (0,0)

other

• Example points to drawback of Nash equilibrium
the

equilibrium need not be unique
• Another drawback of the Nash equilibrium
see next slide

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 17
 Subgame Perfect Nash Equilibrium (SPNE)

The subgame perfect Nash equilibrium

Limitation of the Nash equilibrium: Strategies of players can

be inconsistent: they can contain non-credible threats
• Example

Player 1: child
Left: go to practice
Right: throw fit
Player 2: parents
Left: persist
Right: give in

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 18
 Subgame Perfect Nash Equilibrium (SPNE)

Subgame Perfect Nash equilibrium

• Each player best responds to given strategies of others +
Strategies cannot contain non-credible threats
• Formally: SPNE = NE which is also NE in all of the
subgames

Q: How do I find a subgame perfect Nash equilibrium?

A: Take game tree and use method called backward induction
• Remember, that the SPNE is a set of strategies, not an
outcome or a sequence of actions

Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 19
 Subgame Perfect Nash Equilibrium (SPNE)

Example: Backward induction in action

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 Notes

How to find equilibria of games?

• Nash equilibria and equilibria in dominant strategies
use
the normal form representation whenever possible
• Subgame perfect Nash equilibria
always use game tree

Hints when studying this chapter

• Practice helps: Go through many examples and exercises
• Empathy helps: pretend you are the player when you think
about the player’s optimal action. The equilibrium concept
tells you how you think when you are that player
• Distinguish actions (moves) from strategies
• The most important equilibrium concepts are the Nash
equilibrium and subgame perfect Nash equilibrium
• Not on exam: “Minimax” strategies, 13.10 (contestable
markets), 13.12-13.14
Paul Schure, University of Victoria, Econ 203 Chapter 13 – Part 1: Game Theory Slide 21