Game Theory

Elements of Bayesian Nash Equilibrium:

A Bayesian Nash is a game of incomplete information. It is a strategy profile that maximizes
each players expected payoffs based on their own beliefs about the strategies of other players
in a game. The following are the elements of a Bayesian Nash Equilibrium:
1. A list of players and their types i.e., Type A and Type B, or State X or X’.
2. Incomplete information about what the players can do, and their possible actions based on
probabilities.
3. A description of what the players know when they act (probabilities assigned to each type of
player)
4. A specification of how the players’ actions lead to outcomes, and
5. A specification of the players’ preferences over outcomes.
R&D Model
Assumptions: Page 4
1. there is one dimensional index by which the technology can be measured
2. infinite progress cannot be made in one period.
3. there is no free lunch – if project is to move faster, costs are higher
4. gives winner a positive reward and the loser gets zero.
Note: Total profit for the patent winner is the value of the patent less the cost incurred; the loss
for the other firm is the R&D cost.

If its stage game has exactly one Nash equilibrium, how many subgame perfect equilibria
does a two-period, repeated game have? Explain. Would your answer change if there were T
periods, where T is any finite integer?
In period 2, subgame perfection requires play of the only Nash equilibrium of the stage game.
As there is only one Nash equilibrium of the stage game, selection of the Nash equilibrium to be
played in period 2 cannot influence incentives in period 1. Thus, the only subgame perfect
equilibrium is play of the Nash equilibrium of the stage game in both periods. For any finite T ,
the logic from the two period case applies, and the answer does not change.
Definitions
1. Common Knowledge of Rationality
Rationality is a very important assumption for individual behavior in game theory. Common
Knowledge of Rationality helps us to solve games by assuming that players are rational, and
their opponents are rational and that this piece of information is available to all the players in
the game; hence, it is common knowledge.
2. Dominated Strategy
A dominated strategy is a strategy that is never played in a game. This is because another
strategy might be better – or dominating. Since players are rational, they will never play a
dominated strategy. This strategy can be or two types:
Strictly Dominated i.e., all payoffs of the dominating strategy exceed the payoffs of the
dominated strategy.
Weakly Dominated i.e., some payoffs might be similar (not less) that that of a dominating
strategy and a minimum of one payoff exceeds the payoffs of a dominated strategy.
3. Nash Equilibrium: Nash equilibrium is a stable strategy profile in which no player has an
incentive to deviate from their chosen strategy after considering an opponent's choice. This is
the optimal outcome of the game.

4. Self-Interested Agents and Rational Behavior:

Self-Interested Agents only care about things that benefit them and have a Rational Behavior.
The agent’s actions are motivated by a self-interest of maximizing their own payoffs and to
make only the decisions that make them better off, and not worse off. Hence, in order for us to
solve games, the players in a game are assumed to be rational.

5. Information Sets: These are illustrated on a tree diagram with a dotted line or a circle. They
show the existence of an imperfect knowledge between the players and tell us that the
strategies or choices of the players have not been observed by the opponent.

6. Decision Nodes: These are all the points where a player must make a decision about how to
move further with the game; these also include the initial nodes in a game. Furthermore, the
number of decision nodes a player has determines the number of components in in that
player’s strategy. If a player has, for example, 2 decision notes, the strategy may look
something like Si = {AA, AB, BA, BB}.

7. Sequential Games: In a sequential game, the player observes the strategy played by the
opponent. The game moves in a sequence where i.e., Player 1 may take their turn after
observing the strategy of Player 2.

Bargaining Games
Question 1: Simple Game, No Discount Factor or Cost
Two players are trying to divide 100 dollars amongst themselves. In period 1, player 1 makes an
offer to player 2. If player 2 accepts this offer, the game ends and they both get payoffs as
suggested by player 1’s division. If player 2 rejects player 1’s offer, the game moves to period 2.
In period 2, player 2 makes an offer which player 1 can accept or reject. If player 1 accepts
player 2’s offer, they each get to keep an amount as suggested by player 2’s division. If Player 1
rejects player 2’s offer, the game moves to the final round. In this round player 1 makes an
offer which can either be accepted or rejected by player 2. Rejection leaves each player with
nothing. If player 2 accepts, they each get payoffs as suggested by player 1’s division.
Here are some additional guidelines. There is no discounting or costs. However, some money is
taken away from the players at the start of the 2nd and 3rd rounds. In particular, the players
have 2/3rd of the original amount (100 dollars) with them to bargain over at the start of round
2. At the start of round 3, they only have available, 1/3rd of the amount they had in period 1.
The rest of the amounts are donated to charity by a third party as punishment that these
players are taking too long to come up with an agreement.
Solve for all subgame perfect Nash equilibria for this bargaining game.
Amount = $100 in Round 1, 66 2/3 in Round 2 & 33 1/3 in Round 3
In a three-round bargaining game, we consider the second round as the first period, the third
round as period 2 and the first round as period 3. Since, Player 1 plays the last round she has a
greater power.
Since there is no discounting or cost, the game is straightforward. We start by considering
Round 2 and 3 as Periods 1 and 2, respectively. In round 3, Player 1 makes an offer of z = 0 to
Player 2. Because Player 2 is indifferent between accepting or rejecting the offer, and is
rational, it will accept the offer and the payoffs will be 33 1/3 to Player 1 & 0 to Player 2.
Now, because there is no discounting or cost attached to the payoffs, Player 2 will offer y = 33
1/3 to Player 1 in round 2. Applying the same concept of rationality here, Player 1 will accept
since she is indifferent between the two options. The Payoffs will be 33 1/3 for both the players
in this case.
Finally, Player 1 will offer of x = 33 1/3 to player to making her indifferent between accepting or
rejecting the offer; hence, she will accept and the payoffs to Player 1 and 2 will be 66 2/3 and
33 1/3, respectively.
Therefore, the Subgame Perfect Nash Equilibria (SPNE) is as follows:
Player 1 offers Player 2 x = 33 1/3 in round 1 (period 3) and Player 2 accepts it, with the payoffs
to Player 1 and 2 being 66 2/3 and 33 1/3, respectively.
If this does not happen, i.e., x < 33 1/3 and y < 33 1/ 3, then then game moves to round 3
(period 2) where Player 1 offers Player 2 z = 0 and Player 2 accepts it. Player 1 keeps the whole
of the remaining 33 1/3 in this case and the game comes to an end.
The following diagram illustrates this game.

Note: all payoff amounts are in Dollars ($)

Question 2: No Costs, Discount Factor

Two players are bargaining over a three-period bargaining model as discussed in class with
player 1 making offers in rounds 1 and 3. Player 2 makes an offer in round 2 only. Each player
has a common discount factor delta.
The two players are bargaining to split $20. They have three time periods available to them for
their bargaining game. At the end of round 3, if no agreement has been reached then player 1
receives $2 and player 2 receives $1 and the rest of the money is destroyed.
Find the subgame perfect Nash equilibrium outcome in the finite horizon model in which the
game ends after period 3.
Amount = $20, Rounds = 3, Discount Factor = 𝛿
Again, Player 1 plays the last round she has a greater power in this game as well. Player 1 will
therefore offer z = 1 to Player 2 in period 2, who will in turn be indifferent between accepting
and rejecting the offer. A rational player will only reject if playing that strategy makes him
better off; hence, Player 2 will accept the offer giving both the players a payoff of 19 and 1,
respectively.
For Player 1 to be indifferent between accepting and rejecting the offer in period 1, Player 2 will
offer y = 19𝛿 giving both the players a payoff of 19𝛿 and 20 -19𝛿, respectively. The 𝛿 accounts
for the time value or the discount factor.
In period 1, Player will offer x = (20 - 19𝛿)𝛿 to Player 2 for her to be indifferent between
accepting and rejecting the offer. This gives a payoff of 20 – (20 - 19𝛿)𝛿 to Player 1 and (20 -
19𝛿)𝛿 to Player 2.
Therefore, the Subgame Perfect Nash Equilibria (SPNE) is as follows:
Player 1 offers Player 2 x = (20 - 19δ)δ in round 1 (period 3) and Player 2 accepts it, with the
payoffs for both being 20 - (20 - 19𝛿)δ and (20 - 19𝛿)δ, respectively.
If this does not happen, i.e., x < (20 - 19δ)δ and y < 19δ, then then game moves to round 3
(period 2) where Player 1 offers Player 2 z = 1 and Player 2 accepts it. The payoffs then become
19δ2 and δ2, respectively. The game then ends here.
The following diagram illustrates this game.
Note: all payoff amounts are in Dollars ($)
 Bayes Nash
Points to Keep in Mind:
1. “Player 2 observes nature’s choice and Player 1 does not” means player 2 is of two types
2. If Player 2 is of two types then: Player 1 will play her strategies and we need to see Player
1’s payoffs and vice versa.
3. “Player 1 knows his type, but Player 2 does not” means Player 1 is of two types
4. “Nature chooses between the type of player 1 and player 2 has no information about the
type of player 1” means player 1 is of two types

Player 2 is of two types: p is unknown

Question 1: Player 2 observes nature’s choice whereas player 1 does not.
Consider the following Bayesian game played between two players.
Nature chooses between states A and B, where A is chosen with probability p. Player 2
observes nature’s choice whereas player 1 does not. The two players then play a
simultaneous move game with payoffs given below.

1/2 L R 1/2 L R
T 1,3 1,2 T 3,2 1,3
B 3,1 2,5 B 2,1 0,4
State A (p) State B (1 - p)
a. Suppose p= 0 , Solve for ALL Bayes Nash equilibria.
T,R = (1,3)
b. Solve for all PURE strategy Bayes Nash as a function of p.
Player 2 is of two types: Expected Payoffs of 1
Suppose Player 1 plays T:
Type A Player 2 will choose L and Type B Player 2 will choose R
For it to be a Bayes Nash, T ≥ B
p + 1 – p ≥ 3p + 0
1/3 ≥ p
Therefore, as long as 1/3 ≥ p T, LR is a PSBN
If Player 1 player B
Type A Player 2 will choose R and Type B Player 2 will choose R
For B, RR to be PSBN
2p + 0 ≥ p + 1 – p
p ≥ 1/2
Therefore, as long as p ≥ 1/2 B, RR is a PSBN
 Player 1 is of two types, p is known
Question 2: Player 1 knows his type but Player 2 does not. Player 2 believes that Player 1 can
be equally likely to be type A or Type B.
Consider the following Bayesian Game where Player 1 knows his type but Player 2 does not.
Player 2 believes that Player 1 can be equally likely to be type A or Type B. Solve for all pure
strategy Bayes Nash equilibrium/ia.
Expected Payoffs for Player 2: Because Player 1 is of two types.
1/2 L R 1/2 L R
U 1,1 0,0 U 0,0 0,0
D 0,0 0,0 D 0,0 2,2
Type A (0.5) Type B (0.5)
½ L R

UU 0.5 0

UD 0.5 1

DU 0 0

DD 0 1

We need to check:
UU, L
UD, R
DU, L
DD, R

Player 1 is of two types: p is known

Consider the following game played between two players. Player 1 is of two types. Nature chooses
between the type of player 1 and player 2 has no information about the type of player 1. Player 2
believes that with probability p he is up against a type A player 1 and with probability 1-p he is up
against a type B player2.

1/2 L R 1/2 L R
T 12,9 3,6 T 0,9 3,6
B 6,0 6,9 B 0,0 6,9
 Type A (2/3) Type B (1/3)

a. Solve for a pure strategy Bayes Nash equilibrium (ia) when p=2/3 (p in known)
Expected Payoffs for Player 2: Because Player 1 is of two types
½ L R

TT 9 6

TB 6 7

BT 3 8

BB 0 9

We need to check:

TT, L
TB, R
BT, R
BB, R
If Player 2 plays L, Type A 1 player will play T and type B player 1 will be indifferent; hence, TT, L
is one PSBN
If Player 2 plays R, Type A player 1 as well as Type B player 1will play B; hence, BB, R is another
PSBN.

b. Solve for a pure strategy Bayes Nash equilibrium (ia) when p=1/3 (p in known)

½ L R

TT 9 6

TB 6 7

BT 3 8

BB 0 9

We need to check:

TT, L
TB, R
BT, R
BB, R
If Player 2 plays L, Type A 1 player will play T and type B player 1 will be indifferent; hence, TT, L
is one PSBN
If Player 2 plays R, Type A player 1 as well as Type B player 1will play B; hence, BB, R is another
PSBN.
 Player 2 is of two types: p is unknown
Consider the following Bayesian Game where Player 2 knows his type but Player 1 does not. Player 1
believes that Player 2 can be type A with probability p or Type B with probability 1-p. Solve for all
pure strategy Bayes Nash equilibrium/ia as a function of p. (p is unknown)

Player 2 is of two types:

1/2 L R 1/2 L R
U 2,2 0,0 U 0,2 4,0
D 0,0 4,4 D 2,0 0,4
Type A (p) Type B (1-p)

Suppose Player 1 chooses U:

Type A Player 2 will choose L
Type B Player 2 will choose L
For U, LL to be a Nash U greater than or equal to D
U: 2p + 0(1-p) = 2p
D: 0(p) + 2(1-p) = 2 – 2p
2p ≥ 2 – 2p
4p ≥ 2
p ≥ 1/2
Therefore, as long as p ≥ 1/2, U, LL is a Bayes Nash.
Now, suppose Player 1 chooses D:
Type A Player 2 will choose R
Type B Player 2 will choose R
For U, LL to be a Nash D greater than or equal to U
D: 4p + 0(1-p)
U: 0p 4(1-p)
4p ≥ 4 – 4p
8p ≥ 4
p ≥ 1/2
Therefore, as long as p ≥ 1/2, B, RR is a Bayes Nash.