Game Theory Handout I

Dr. Tanmoy Das∗

2022

1 What is Game Theory

Game theory is the study of multi-person decision problems. Such problems arise frequently in
economics. Game Theory is the study of decision making under competition. More specifically,
Game Theory is the study of optimal decision making under competition when one individual’s
decisions affect the outcome of a situation for all other individuals involved.

Definition 1.1. Game theory is a systematic study of strategic interactions among rational
individuals.

1.1 Assumptions
1. Rationality The most important, and maybe one of the most controversial, assumption
of game theory which brings about this discipline is that individuals are rational. We
assume that individuals are rational.

Definition 1.2. An individual is rational if she has well-defined objectives (or prefer-
ences) over the set of possible outcomes and she implements the best available strategy
to pursue them.

Rationality implies that individuals know the strategies available to each individual, have
complete and consistent preferences over possible outcomes, and they are aware of those
preferences. Furthermore, they can determine the best strategy for themselves and flaw-
lessly implement it. Also we can say that, an individual is rational if he/she has well-
defined preferences over the set of possible outcomes and he/she implements flawlessly
the best available strategy to pursue them to achieve the maximum outcome.

2. Common Knowledge A fact“A” is mutual knowledge in a set of agents if each agent

knows “A”, but the knowledge of any agent knowing “A” may not be known to any
other agent in the set of agents. Suppose each student arrives for a class knowing that
the instructor will be late. The information that the instructor will be late is mutual
knowledge, but each student might think that only he knows that the instructor will be
∗ Assistant
Professor, School of Economics, XIM University Bhubaneswar, Odisha, mail to: tan-
moy@xim.edu.in

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 late. Now, if one of the students openly says that “ instructor told me that he (instructor)
will be late ” then each student knows that each student knows that instructor will be
late, then each student knows that each student knows that each student knows that the
instructor will be late, and so on, ad infinitum. The announcement made the mutual
known fact common knowledge among the students.

Definition 1.3. A fact “A” is said to be a common knowledge among players of a game
if all the players know “A”, all the players know that all the players know “A”, all the
players know that all the players know that all players know “A” and so on.

3. No outside communication.

4. Full knowledge of the game: Pay-offs and actions are observable and known by all.

1.2 Classifications of games

Games can be categorized according to several criteria: How many players are there in the
game? Usually there should be more than one player.

• In a simultaneous game, each player has only one move, and all moves are made simul-
taneously.

• In a sequential game, no two players move at the same time, and players may have to
move several times.

• There are games that are neither simultaneous nor sequential. Does the game have ran-
dom moves? Games may contain random events that influence its outcome. They are
called random moves.

• Do players have perfect information? A sequential game has perfect information if

every player, when about to move, knows all previous moves.

• Do players have complete information? This means that all players know the structure
of the game—the order in which the players move, all possible moves in each position,
and the payoffs for all outcomes.

• Real-world games usually do not have complete information. In our games we assume
complete information in most cases, since games of incomplete information are more
difficult to analyze.

• Is the game zero-sum? Zero-sum games have the property that the sum of the payoffs to
the players equals zero. A player can have a positive payoff only if another has a negative
payoff. Poker and chess are examples of zero-sum games. Real-world games are rarely
zero-sum.

• Is communication permitted? Sometimes communication between the players is allowed

before the game starts and between the moves and sometimes it is not.

• Is the game cooperative or non-cooperative? Even if players negotiate, the question is

whether the results of the negotiations can be enforced. If not, a player can always move
differently from what was promised in the negotiation. Then the communication is called
“cheap talk”.

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 • A cooperative game is one where the results of the negotiations can be put into a contract
and be enforced. There must also be a way of distributing the payoff among the members
of the coalition.
We will mainly study -
• Static games of Complete Information (Simultaneous-move games)
– Normal-form games and Nash equilibrium.
– Pure and mixed strategy equilibrium.
– Cournot Model of duopoly.
– Bertrand model of duopoly.
– Hotteling’s electoral competition model.
• Dynamic games of Complete Information (Sequential-move games)
– Complete and perfect information
– Backward Induction method.
– Stackelberg model of duopoly.

+ 2-stage games of Complete but imperfect information

+ Subgame perfection.

– Repeated Games
– two-stage repeated games.

* Extensive-form games.
* Subgame perfect Nash equilibrium(SPNE).

Information
Complete Incomplete
Strategic-form game Bayesian Game
Simultaneous
Moves (Static game) (Static game)
Extensive-form game Extensive-form game
Sequential
(Dynamic game) (Dynamic game)

1.3 Elements of a Game

A game consists of the following elements:
1. Rule of the game: how to play the game.
2. Players: decision makers in the game.
3. Actions: Possible choices made by the players.
4. Strategies: Specified plan of actions for every contingency played by other players.
Specifying which action you would take in any possible contingency that might occur.
5. Pay-offs: Expected reward at the end of the games.
6. Timing: A description of which players take actions when.

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2 Static games of complete Information
Here first the players simultaneously choose actions, then the players receive payoffs that de-
pend on the combination of actions just chosen. Here within the class of such static (simultaneous-
move) games, we will be focusing on the complete information. That is each player’s payoff
function is common knowledge among all the players.

2.1 Normal-form representation

The normal-form representation of a game specifies:

1) The players in the game. Let there are ‘n’ players i.e. i = 1, 2, ...n.

2) The strategies available to each players.

3) The payoff received by each player for each combination of strategies that could be chosen
by the players. We generally write these payoffs in a matrix form, which is called Payoff
Matrix, where in each cell we write the payoffs in a co-ordinate form i.e. (x,y) form and x
- the first entity is the row player’s payoff from his/ her corresponding strategies and y- the
later entity is the payoff is the column player’s payoff from his/ her corresponding strategies.

2.2 Solution procedure

We will follow the dominance method to solve the games. The solution is determined by
attempting to rule out strategies that a rational player would never play.

• Strict dominance: A strategy is said to be strictly dominated if another strategy always

gives improved or better payoffs whatever the other players int he game do.

• Weak dominance: A strategy is said to be weakly dominated if another strategy makes

the player better off in some situations or leaves the player indifferent.

• Iterated strict dominance/ Iterated elimination of strictly dominated strategies: It

assures that strict dominance can be applied to different players in a game. If one player
rules out a particular strategy, because it is strictly dominated by another, then it is as-
sumed that the other players recognize this and they also believe the other player will not
play this dominated strategy.

2.3 Nash Equilibrium (NE)

Nash equilibrium is to argue that if game theory is to provide a unique solution to a game the-
oretic problem then it must be Nash equilibrium. Each player’s predicted strategy must be that
player’s best response to the predicted strategies of the other players. Such a prediction could
be called strategically stable or self-enforcing, because no single player wants to deviate from
his/ her predicted strategy. This is called Nash equilibrium.

Definition 2.1. A Nash equilibrium is a set of strategies, one for each player, such that no
player has incentive to change his or her strategy given what the other players are doing.

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2.4 Examples
2.4.1 Strict Dominance
Consider a hypothetical game, which has the following payoff matrix:
P2
Launch Don’t launch
P1 Launch (40,40) (100,-50)
Don’t launch (-50,100) (-40,-40)
Let’s see how players play-

P2’s decision

P2
Launch Don’t launch
P1 Launch (,40) >(,-50)
Don’t launch (,100) >(,-40)
We can see from the above pay-of matrix that, if P2 chooses “Launch” then P2 will get
either 40 or 100 and if P2 chooses “Don’t launch” then P2 will get either -50 or 40. So at any
circumstances-irrespective of what P1 is choosing P2 will always prefer “Launch” as (40 > −50
and 100 > −40).
As a rational player choosing strategy “Launch” is always preferable to P2 ⇒ “Launch” is
strictly dominating strategy. That is “Don’t launch” is strictly dominated by “Launch”.

P1’s decision

P2
Launch Don’t launch
P1 Launch (40,) (100,)
Don’t launch (-50,) (-40,)
We can see from the above pay-of matrix that, if P1 chooses “Launch” then P1 will get
either 40 or 100 and if P1 chooses “Don’t launch” then P1 will get either -50 or 40. So at any
circumstances-irrespective of what P2 is choosing P1 will always prefer “Launch” as (40 > −50
and 100 > −40).
As a rational player choosing strategy “Launch” is always preferable to P1 ⇒ “Launch” is
strictly dominating strategy. That is “Don’t launch” is strictly dominated by “Launch”.

What is the Nash equilibrium (NE) ?

One way we can see that, being P1 and P2 are rational, they will never play “Don’t launch”
(as it is strictly dominated by “Launch) irrespective of what other players are doing. And there-
fore the Nash equilibrium is (Launch, Launch)=(40,40).

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2.4.2 Weak Dominance
Consider the following game
P2
L R
P1 U (7,2) (5.4)
D (7,2) (2,2)

2.4.3 Iterated Elimination of Strictly Dominated Strategies

Consider the following game
P2
L M R
P1 U (1,0) (1,2) (0,1)
D (0,3) (0,1) (2,0)
Let’s see how players play-

• For P1 neither “U” nor “D” is strictly dominated as: “U” is better than “D” if P2 plays
“L”(1 > 0) but “D” is better than “U” if P2 plays “R” (2 > 0).

• For P2 “R” is strictly dominated by “M” (2 > 1 and 1 > 0) =⇒ P2 as a rational player
will never play “R”.

• P1 knows that P2 is rational then P1 can eliminate “R” from P2’s strategy space. That is,
if P1 knows that P2 is rational then P1 can play the following game:

P2
L M
P1 U (1,0) (1,2)
D (0,3) (0,1)

• In this truncated game, “D” is now strictly dominated by “U” (1 > 0, 1 > 0) for P1.

• As a rational player P1 will never play “D”.

• Thus, if P2 knows that P1 is rational and P2 knows that P1 knows that P2 is rational,
then P2 can eliminate “D” from P1’s strategy space. Then we have the following game

P2
L M
P1 U (1,0) (1,2)

• In this truncated version “L” is strictly dominated by “M”.

• P2 will never play as a rational player =⇒ we have only (U,M), which is the outcome
of the game.

• Therefore the NE is (U,M)=(1,2)

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2.4.4 Prisoner’s Dilemma- A classic game
Two suspects are arrested and charged with a crime. The police department lacks sufficient ev-
idence to convict them, unless at least one confesses. the police hold them in separate cells and
explain the consequences that will follow from the action they could take. If neither confess
then both will be convicted of a minor offense and sentenced to 1 year in jail. If both confess
then both will be sentenced to 6 years in jail. If one confesses and other doesn’t then the con-
fessor will be released immediately but other will go to jail for 9 years.

So, we can write this game in the normal-form game as:

• Players - Prisoner 1 (P1) and Prisoner 2 (P2).

• Strategies available to them - Confess (C) and Not confess (NC).

• Payoffs are given in the following payoff matrix :

P2
C NC
P1 C (-6,-6) (0,-9)
NC (-9,0) (-1,-1)

Solution of the game (by GENERAL METHOD)

P2’s decision

• If P1 chooses “C” then-

– P2 will choose “C” (−6 > −9)

• If P1 chooses “NC” then-

– P2 will choose “C” (0 > −1)

(So, for P2 “NC” is strictly dominated by “C”.[one can verify using strict dominance method])

P1’s decision

• If P2 chooses “C” then-

– P1 will choose “C” (−6 > −9)

• If P2 chooses “NC” then-

– P1 will choose “C” (0 > −1)

(So, for P1 “NC” is strictly dominated by “C”.[one can verify using strict dominance method])

To find the NE, check for which strategies players are mutually agreeing to each other that is
find the Mirror Image. In this example we can see that, when P1 is choosing “C” P2 chooses
“C” and when P2 is choosing “C” P1 chooses “C”. That is players are mutually agreeing for
“C” and “C”. We write the NE as - (C, C)=(-6,-6).

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In terms of mirror image we can see that, P1C → P2C has a mirror image - P2C → P1C and
vice-versa. But, P1NC → P2C has no mirror image (i.e., P2C → P1NC doesn’t exist). Simi-
larly, P2NC → P1C has no mirror image (i.e., P1C → P2NC doesn’t exist).

Therefore, the NE is (Confess, Confess)=(C,C)=(-6,-6).

We can see an interesting fact from the result is that, if both of them would have chosen “Not
Confess”, then they would have ended up in better position (instead of going to jail for 6 years,
they would go to jail for 1 year. which is a Pareto Optimal situation). But, it didn’t happen.
why? (will come later !!).

2.4.5 Battle of Sexes

One couple decides to go on a date, they have two options - one to go to football and the other is
movie. Now male partner (Boy) prefers football and female (Girl) prefers movie. They forgot
their mobiles but as its a date both prefer to go together. If they go to football then the Boy gets
2 (consider it as utility/ satisfaction) and the girl gets 1. If they go to movie then the Boy gets
1 and the Girl gets 2. And if they don’t go together then both get 0. Then what will be their
equilibrium choices.?

We can write this game in the normal-form game, as:

• Players - Boy and Girl.

• Strategies available to them - Football and movie.

• Payoffs are given in the following payoff matrix:

Girl
Football Movie
Boy Football (2,1) (0,0)
Movie (0,0) (1,2)

Solution of the game

Girl’s decision

• If Boy chooses “Football” then-

– Girl will choose “Football”(1 > 0)

• If Boy chooses “Movie” then-

– Girl will choose “Movie”(2 > 0)

‘ Boy’s decision

• If Girl chooses “Football” then-

– Boy will choose “Football”(2 > 0)

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 • If Girl chooses “Movie” then-

– Boy will choose “Movie”(1 > 0)

Using the concept of mutually agreement or mirror image we get two Nash equilibria- (Foot-
ball, Football)=(F,F)=(2,1) and (Movie, Movie)=(M,M)=(1,2). This is a classic example
where we can see that more than one Nash equilibrium exists.

2.4.6 Matching Pennies

Leonardo and Kate are waiting for train in station. They are getting bored. So they decide to
play a game- both of them will turn a penny (from their pocket/ bag) secretly and then they
will reveal their pennies simultaneously. If pennies match (both head/ tail), then Leonardo will
keep both pennies and if pennies don’t match ((one head and other is tail)) then Kate will keep
both coins. So what will be their equilibrium choice(s)?

Let’s write the game in the normal-form game-

• Players - Leonardo and Kate.

• Strategies available to them - Head (H) and Tail (T).

• Now lets make the payoff matrix-

– If both are “Heads”(H,H) then, Leonardo wins 1 penny from Kate i.e. +1 to Leonardo
and -1 to Kate (as Kate is losing 1 penny).
– If both are “Tails”(T,T) then we have same scenario for Leonardo.
– If one is “head” and other is “tail” (H,T) then, Kate wins 1 penny from Leonardo
i.e. +1 to Kate and -1 to Leonardo (as Leonardo losing 1 penny).
– Same scenario will appear to Kate in case of (T,H) option.
– Look, here the pay-off matrix is constructed based on the players gaining or loosing
the number of penny not how many pennies all total they are having.
– So, the payoff matrix is-
Kate
H T
Leonardo H (+1,-1) (-1,+1)
T (-1,+1) (+1,-1)

Solution of the game

• If Leonardo chooses “H” then-

– Kate will choose “T”(+1 > −1)

• If Leonardo chooses “T” then-

– Kate will choose “H”(+1 > −1)

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 • If Kate chooses “H” then-

– Leonardo will choose “H”(+1 > −1)

• If Kate chooses “T” then-

– Leonardo will choose “T”(+1 > −1)

We can see that, there is no situation where they are mutually agreeing to each other also there
DO NOT EXIST any mirror image for any set of strategies i.e. there is no Nash equilibrium. So,
can we say that there is no Nash equilibrium ? - NO!!. Whatever we have seen in sections 2.4.1,
2.4.2, 2.4.3, 2.4.4 and 2.4.5 respective strategies are called pure strategies and those Nash
equilibria are called “Pure-Strategy Nash Equilibrium” as those equilibria can be written in
terms of set of strategies i.e. (C,C), (M,M), (Launch, Launch) etc.. And here comes the concept
of Mixed-Strategy Nash equilibrium. So, in this Matching Pennies game we can not say that
there is no Nash equilibrium; we will say that there is no Pure-strategy Nash equilibrium. But
a game can have both Pure and Mixed strategy equilibria.

2.5 Mixed-Strategy Nash Equilibrium

A mixed-strategy is one in which a player plays his/her available pure strategies with certain
probabilities. If there is no pure strategy equilibrium, then there must be a unique mixed-
strategy equilibrium. We find out the mixed-strategy equilibrium with the help of Best response
function/curve- choices tat maximizes one player’s payoff, given the other player’s choice.

Definition 2.2. Best response is the strategy which produces the most favorable outcome for a
player, taking other player’s strategies are given

Consider the following hypothetical:

P2
L (q) R (1-q)
P1 T (p) (-5,8) (3,-2)
B (1-p) (5,-4) (-3,4)
In this game we can check that there is no pure-strategy Nash equilibrium. So it must have a
mixed strategy Nash equilibrium. What is that? - lets find out.

• P2 believes that P1 will play “T” with the probability ‘p’. Then automatically P1 will
play “B” with probability ‘1-p’ (as the total probability is 1)

• similarly P1 believes that, P2 will play “L” with probability ‘q’ and “R” with probability
‘1-q’.

• Using these assigned probabilities, both the players will calculate their expected payoff
for their respective strategies.

P1’s expected payoff: P1 will consider the probabilities he/she assigned (from his/ her belief)
to P2’s strategies and his/her own payoffs getting from his/her respective strategies to calculate
the expected payoff from his/ her strategies.

• Expected payoff for P1 from playing T is : EP1 (T ) = −5 ∗ q + 3 ∗ (1 − q)

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 • Expected payoff for P1 from playing B is : EP1 (B) = −5 ∗ q + (−3) ∗ (1 − q)

P2’s expected payoff: P2 will also consider the probabilities he/she assigned (from his/ her
belief) to P1’s strategies and his/her own payoffs getting from his/her respective strategies to
calculate the expected payoff from his/ her strategies.

• Expected payoff for P2 from playing L is : EP2 (L) = 8 ∗ p + (−4) ∗ (1 − p)

• Expected payoff for P2 from playing R is : EP2 (R) = (−2) ∗ p + 4 ∗ (1 − p)

Now we can see that, if EP1 (T ) > EP1 (B), then as a rational player P1 will obviously choose
“T” and if EP1 (T ) < EP1 (B), then P1 will choose “B”, which are nothing but their pure strate-
gies. Now to be indifferent between these two strategies (or you can consider that, as they don’t
have any pure strategy equilibrium) EP1 (T ) = EP1 (B) must hold. And EP1 (T ) = EP1 (B)q = 49 .
Using the similar argument and P2’s expected payoffs, we will get p = 83 .

Formulating Best response functions and Curves

• EP1 (T ) > EP1 (B) =⇒

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* q< 8 =⇒ P1 will definitely choose “T” =⇒ p = 1

• EP1 (T ) < EP1 (B) =⇒

3
* q> 8 =⇒ P1 will definitely choose “B” =⇒ 1 − p = 1 =⇒ p = 0

• EP1 (T ) = EP1 (B) =⇒

3
* q= 8 =⇒ P1 is indifferent between “T” and “B” =⇒ p ∈ [0, 1]

Therefore, the Best response function for P1 given P2’s probability ‘q’, BR1 (q) is:

p = 0
 if q > 83
BR1 (q) = p = 1 if q < 38
p ∈ [0, 1] if q = 38



• EP2 (L) > EP2 (R) =⇒

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* p> 9 =⇒ P2 will definitely choose “L” =⇒ q = 1

• EP2 (L) < EP2 (R) =⇒

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* p< 9 =⇒ P2 will definitely choose “R” =⇒ 1 − q = 1 =⇒ q = 0

• EP2 (L) = EP2 (R) =⇒

4
* q= 9 =⇒ P2 is indifferent between “L” and “R” =⇒ q ∈ [0, 1]

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Therefore, the Best response function for P2 given P1’s probability ‘p’, BR2 (p) is:

q = 0
 if p < 94
BR2 (p) = q = 1 if q > 94
q ∈ [0, 1] if p = 49



Let’s draw the best response curves

P1’s Best response curve (BR1 (q))

q

BR1 (q)
3
8

0 1 p

P2’s Best response curve(BR2 (p))

q

BR2 (p)
3
8

0 4 1 p
9

Finding the mixed Strategy equilibrium

If we plot these two best response curves together then the intersection point is the Mixed-
strategy Nash equilibrium. (What we got mathematically earlier)

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 q

1 BR2 (p)

NE=( 49 , 38 )
q∗ = 3
8
BR1 (q)

0 p
p∗ = 4
9
1

So, the Mixed strategy Nash equilibrium is (p∗ , q∗ ) = ( 94 , 38 ). And this particular game has no
pure strategy equilibrium. You can find mixed strategy equilibrium for a game even if it has
pure strategy equilibrium.

NOTE: We have to solve the “Matching Pennies game” in this way. Try to find the mixed
strategy equilibrium for the matching pennies game(see section 2.4.6) and also for the battle of
sexes game (see section 2.4.5).

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