🟢

UNIT 5 SEQUENTIAL GAMES

Created @January 16, 2023 10:35 PM

Class GAME THEORY AND STRATEGIC MANNER

Type Study Group

Materials

Reviewed

UNIT 5 SEQUENTIAL GAMES

5.1 SEQUENTIAL GAMES AND EXTENSIVE FORM
Sequential game: Games with a strict order of play where at least one player
has some information about his opponents’ choice when he has to make a
decision

Perfect information: Also known as perfect observability. Players know

everything that has happened prior to making a decision

We represent sequential games with perfect information in its extensive form, which
means:

Players

Actions

Strategies: A complete and detailed list of all possible complete plays of the
game (sequences of actions from the beginning until the end of the game)

The final payoffs associated with each of these paths

A way to capture all these elements is a Game Tree:

Nodes: Situations in which a player has to make a decision

Branches: Feasible actions in each node

UNIT 5 SEQUENTIAL GAMES 1

 Terminal nodes: Final outcomes or payoffs

EXAMPLE 1 - ENTRY DETERRENCE M - E:

A monopolist incumbent firm (M) enjoys monopoly profits of 2 million euros in

a market

A potential competitor (the Entrant, E) makes a decision between entering in

the market (action I) or staying out (action O).

The monopolist has to choose, in case of entry, between accommodating,

sharing the monopoly profits with E (action A), or cutting prices below costs so
that neither firm could make profits (action F, for fighting). In this latter case, both
firms would obtain losses of 1 million each.

🟩 ELEMENTS:

Players: Entrant (E, Player 1) and Monopolist (M, Player 2).

Entrant’s actions: Out (O) and In (I).

Monopolist’s actions: Accommodate (A) and Fight (F).

Strategies: ?

EXAMPLE 2 - ENTRY DETERRENCE T - G

UNIT 5 SEQUENTIAL GAMES 2

 In your neighborhood there is one grocery store and one tailor. At the moment,
the profits of the grocery store owner are around $10000 per month while the
tailor's profits are only $4000 per month.

The tailor asks your advice about his idea to change his shop into a grocery
store. He figures that if the grocer does not respond aggressively to the new
competition, each of them will earn about $6000 per month.

On the other hand, if the grocer does respond aggressively and starts a price
war, then the earnings of each store will be reduced to about $2000 per month.
What is your advice to the tailor?

1. Change the shop into a grocery store.

2. Don’t change the shop.

🟩 ELEMENTS:

Players: Tailor (T, Player 1) and Grocer (G, Player 2).

Tailor’s actions: Out (O) and In (I).

Grocer’s actions: Accommodate (A) and Fight (F).

Strategies: ?

EXAMPLE 3 - CONTRIBUTION TO A FLOWER GARDEN:

UNIT 5 SEQUENTIAL GAMES 3

 Two players live on the same small street. Each has been asked to contribute
with 2 monetary units toward the creation of a flower garden.

The ultimate quality of the garden depends on how many of them contribute.

If both contribute, they get a pleasant garden which yields an individual utility of
4 monetary units to each player.

If only one of them contributes, the garden yields 3 monetary units to each
player.

If no player contributes, there will be no garden (utility zero).

Players move sequentially:

Player 1 has the first move, and chooses whether to contribute.

After observing what player 1 has chosen, player 2 makes her choice.

🟩 ELEMENTS:

Players: Player 1 (1) and Player 2 (2).

Players’ actions: Contribute (C) and Not Contribute (NC).

Strategies: ?

5.2 STRATEGIES

UNIT 5 SEQUENTIAL GAMES 4

 Strategies: complete plans of action contingent on the information available at each
moment of the game. In a sequential game, contingent on all possible combinations
of actions made by players who acted at earlier nodes.

In a perfect information sequential game, a strategy is a function that assigns

an action to each decision node of a player.

If a player has a unique decision node in a sequential game, then actions and
strategies coincide for him.

EXAMPLE 3 - CONTRIBUTION TO A FLOWER GARDEN:

Player 2 has 4 strategies: (NC,C), (C,C), (C,NC) and (NC,NC), where the first action
is his plan if Player 1 chooses C and the second action is his plan if Player 1
chooses NC.

5.3 PERFECT NASH EQUILIBRIUM

EXAMPLE 3 - CONTRIBUTION TO A FLOWER GARDEN:

UNIT 5 SEQUENTIAL GAMES 5

 In sequential games there is usually a multiplicity of Nash
equilibria.
But most of them are not reasonable predictions of how intelligent
players will play the game, because they reflect non-credible
threats or promises or, sometimes, overtly irrational behaviour.

This might happen in a NE because these are actions planned out

of the equilibrium path.

A way to rule out Nash equilibria that represent non-credible strategic moves
(threats, promises...) is to require the principle of sequential rationality to be
satisfied.

UNIT 5 SEQUENTIAL GAMES 6

 The principle of Sequential Rationality (SR) says that all players, when
constructing their strategies in any node, should anticipate future rational behaviour
of their opponents.

A Nash equilibrium which satisfies the principle of SR is called a

Perfect Nash Equilibrium (PNE).

In finite sequential games (with a finite number of turns) the PNE are
computed by BACKWARD INDUCTION (or rollback), that is, solving the game from
the end until the initial node.
Players decide their current moves on the basis of calculations of future
consequences: Look forward and reason backwards.

All finite sequential game with perfect information have a PE and “almost always” is
unique.

EXAMPLE 3 - CONTRIBUTION TO A FLOWER GARDEN:

UNIT 5 SEQUENTIAL GAMES 7

 The Perfect Nash equilibrium (PNE) obtained by backward induction is (NC, (NC,C)),
where NC is the strategy of player 1 and (NC, C) is the strategy of player 2, and with
payoffs (3,1).

Notice that the Street Garden Game is a strategic situation with a

“chicken game” structure and there is first-mover advantage: if played sequentially,
player 1 gets his preferred outcome.

EXAMPLE 1 - ENTRY DETERRENCE M - E:

Notice that the equilibrium (O , F) is

not reasonable as a prediction
because it represents a non-
credible threat: “If E chooses I, then
I will choose F”.

A threat (and a promise) is credible

only if it is in your self-interest (or
you have no other option) to carry it
out when the
circumstances to carry it out come.
Obviously, it is not in your self-
interest to carry it out if you are

UNIT 5 SEQUENTIAL GAMES 8

 threatening with a dominated
action.

This is called the Perfect Nash

Equilibrium of the game.

The reasonable prediction in this game is the equilibrium (I ,A), in which Player 1
(the entrant) anticipates rational behaviour from Player 2 (the monopolist) in
case player 1 chooses to enter into the market.

UNIT 5 SEQUENTIAL GAMES 9

 5.4 STRATEGIC MOVES
Strategic moves are devices to manipulate the rules of the game: a strategic
move as the 1st stage and the altered original game as the 2nd stage.

Three types of strategic moves: commitments, threats and

promises.

The aim of all three is to alter the outcome of the 2nd stage to your own
advantage.

A commitment or unconditional move is a (response) rule in which you move

first and your strategy is fixed (irrevocable).

Intended to gain first-mover advantage.

Threats and Promises occur when you move second: they are response rules.
Different from the best response in the original game, conditional on what the
other side does.

They should be communicated before the other player moves.

Intended to gain second-mover advantage.

All require CREDIBILITY: the other player must believe that you will follow
through. Mere declarations of intentions are NOT enough!

EXAMPLE 3 - CONTRIBUTION TO A FLOWER GARDEN:

UNIT 5 SEQUENTIAL GAMES 10

 Suppose that player 2 publicly announces a contract with a third
player, the delegate (D), before the garden game takes place.

The contract states that the game will be played by player D,

instead of player 2, and that they will share equally the net gains
obtained in the game.

It is common knowledge that player D is selfish.

UNIT 5 SEQUENTIAL GAMES 11

 Notice that a contract with a selfish delegate does not work, even if it
stipulates that the delegate is only paid if he plays NC.

Recall that contracts can be always renegotiated and, after NC is played by

player 1, the contract will be renegotiated by player 2 and the selfish delegate
before the delegate makes his move.

A threat (or a promise) is credible only if it is in your self-interest (or you have no
other option) to carry it out when the circumstances to carry it out come.

Suppose that player 2 publicly announces a contract with a third player, the
delegate (D), before the garden game takes place.

The contract states that the game will be played by player D, instead of player 2,
and that they will share equally the net gains obtained in the game.

It is common knowledge that player D is inequity averse:

UD = xD–2max x 1–xD, 0.
The game tree of the game played between player 1 and the delegate D:

UNIT 5 SEQUENTIAL GAMES 12

 EXAMPLE 4 - ENTRY DETERRENCE M - E VERSION 2:

What can the monopolist do to make his threat credible?

1. Delegate the decision to a CEO who is known to be aggressive.

2. Tie his compensation to market share:

• Pay 10 if market share is above 50%

UNIT 5 SEQUENTIAL GAMES 13

 • Otherwise pay 5

3. Tying your hands: Make accommodate so unattractive that you must fight.

The incumbent monopolist might choose a production technology that has very
high fixed costs.

UNIT 5 SEQUENTIAL GAMES 14

UNIT 5 SEQUENTIAL GAMES 15
 EXAMPLE 5 - SEQUENTIAL INSPECTION:

An employee can shirk (S) at a zero cost or work hard (W) incurring in a cost of
6. Shirking yields zero output for the employer, while working hard yields an
output of 16.

The employer can make an inspection (I) with a cost of 4, that will provide
evidence about the employee’s behaviour. He can also not inspect (NI).

The contract stipulates a wage of 8 to be paid unless there is evidence on

shirking (that is, it is not possible to condition the wage on output).

If the inspection finds shirking, the employee is fired (zero payoff).

Suppose the game is played sequentially: the employer moves first and the
employee after observing his decision moves second.

UNIT 5 SEQUENTIAL GAMES 16

 🟩 ELEMENTS:

Players: Employer (Player 1) and Employee (Player 2).

Employer’s actions/strategies: Inspect (I) and Not Inspect (NI).

Employee’s actions: Shirk (S) and Work hard (W)

Employee’s strategies: (S, S), (W, W), (S, W), (W, S).

PNE: Employer chooses Inspection (I) and the employee follows the
strategy: “If I, then I choose W, if NI, then I choose S ”. The payoffs
are (4,2).

Now, the employer announces a probability of inspection. The

employee chooses his action after observing the announcement.
Finally, there is an inspection or not, according to the realization of the
announced lottery.

The employee will save inspection costs by only inspecting 3⁄4 of the
times, rather than always inspecting.

UNIT 5 SEQUENTIAL GAMES 17

 PROBLEM: Once the employee has worked hard, the employer could decide to
manipulate the lottery on inspecting, because it is costly. Knowing this possible
manipulation, the employee could shirk.

SOLUTION: Making the lottery on the inspection should be public and/or

implemented by a third-independent party.

EXAMPLE 6 - CLEANING THE GARDEN PROMISE:

Bruno asks his younger brother Antonio for some help to clean the
garden. He promises that he will let Antonio play with his Play-Station.

🟩 ELEMENTS:

Players: Antonio (A, Player 1) and Bruno (B, Player 2).

Player 1’s actions: Help (H) and Not help (NH).

Player 2’s actions: Fulfil his promise (F) and do not fulfil (NF).

EXAMPLE 7 - QUALITY PROMISE:

A consumer chooses whether or not to purchase a service from a
firm. If the consumer does not purchase, then both players receive a
payoff of 0. If the consumer decides to purchase, then the firm must
decide whether to produce high or low quality. In the former case,

UNIT 5 SEQUENTIAL GAMES 18

 both players have a payoff of 1. In the latter case, the firm’s payoff is 2 and the
consumer’s payoff is -1.

🟩 ELEMENTS:

Players: Consumer (C, Player 1) and Firm (F, Player 2).

Player 1’s actions: Purchase (P) and Not purchase (NP).

Player 2’s actions: High quality (H) and Low quality (L).

HOW TO MAKE PROMISES CREDIBLE?

A contract works for promises, there is no problem of renegotiation (but it is
almost never feasible because the trustee’s action is not verifiable).

A concern for reputation of not being dishonest (repeated scenario).

A preference for rewarding or trustworthiness of the trustee.

A credible threat of punishment from the investor to the trustee. It is only credible
if the investor has preferences for negative
reciprocity (for example, inequity aversion).

1. Limiting your strategic freedom, in a way that you have no

other option but to follow through the strategic move.

Leaving the outcome beyond your control: automatic fulfilment.

UNIT 5 SEQUENTIAL GAMES 19

 Delegation: mandated negotiating agent with appropriate incentives that should
be different from yours.

Burning your bridges or sinking your ships (eliminating actions).

Cutting off communication.

ELIMINATING ACTIONS:

In non-strategic settings having more options is never worse. Not so much in

strategic environments

You can change your opponent’s actions by removing some of your options.

2. Changing your future payoffs, in a way that to follow

through the strategic move is payoff-maximizing for you.

Reputation: if you play repeatedly, it might be worthwhile to invest in a

reputation of fulfilling always your threats and promises.

Moving in small steps: break the threat or promise into many small pieces.
Example: Paying the constructor of your house.

Rational irrationality: imitating the behaviour of an irrational player that fulfils

threats or promises even it were a dominated action (it makes sense in an
incomplete information scenario).

Teamwork (peer pressure). Become member of a particular club (you are linking
your reputation to the collective club’s reputation).

Contracts, but beware with this two important features of contracts:

Contracts can be renegotiated.

Final payments are contingent on verifiable actions.

🗣 REMEMBER:
• Contracts work differently for threats and for promises.
• With threats: the problem is renegotiation.
• With promises: there is no problem of renegotiation but many times is not
feasible (because the trustee’s action is not verifiable).

5.5 FINITELY REPEATED GAMES

UNIT 5 SEQUENTIAL GAMES 20

 In many cases games are repeated during a finite number of periods,
e.g. 3 periods. A game repeated 3 periods can be seen as a sequential game with 3
stages → We solve it by backward induction.
Repeated games with a finite horizon: there is a last period (a
deadline) which is common knowledge among the players.

Recall that a selfish player, when playing a repeated prisoners’

dilemma with infinite horizon, will only cooperate under the threat of future
punishment included in the punishment strategy of his opponent.

In a finite horizon repeated game, the deadline T will have a very

strong strategic effect!

EXAMPLE 8 - PRISONER’S DILEMMA WITH T=2 AND SELFISH PLAYERS

Solving by backward induction: t=2

In the last period, selfish players will not cooperate. Why? There is no future
where they can punish each other.

In t=2, players choose their dominant action NC whatever the history is.

Solving by backward induction: t=1

In order to obtain cooperation you should threaten with playing something

different that the NE of the stage game in the last period.

But, this is an empty threat if it comes from a selfish player!

UNIT 5 SEQUENTIAL GAMES 21

 In t=1, players choose their dominant action NC.

Formally: each player follows the strategy: “NC in t = 1 and, for t > 1, NC after
any history”.

AND WHAT HAPPENS IF THE GAME IS PLAYED FOR T=3?

Solving by backward induction: t=3

In the last period, selfish players will not cooperate. There is no future where
they can punish
each other. In t=3, players choose their dominant action NC.

Solving by backward induction: t=2

In order to obtain cooperation you should threaten with playing something

different that the NE of
in the last period. Empty threat because they anticipate that they will play NC
in the last period.

In t=2, players choose their dominant action NC.

Solving by backwards induction: t=1

In order to obtain cooperation you should threaten with playing something

different that the NE of
in the next period. Empty threat because they anticipate that they will play
NC in t=2.

In t=1, players choose their dominant action NC.

EXAMPLE 9 - PRISONER’S DILEMMA WITH T=2, SELFISH PLAYERS AND 3

ACTIONS:

UNIT 5 SEQUENTIAL GAMES 22

 IS C IN T=1 IN THE EQUILIBRIUM PATH OF THE REPEATED GAME WITH T=2?

NO!

C is not a NE of the stage game. The only way it could work in t=1 could be with
a strategy such as:
C in t = 1; NC in t = 2 if both players played C in t = 1 and P in t = 2
otherwise

We already know that in t=2, NC will be played.

It is not credible that in t=2 a selfish player will choose P → Threat of punishing
is not sustainable.

The unique PNE of the repeated game is: “NC in t=1 and in t=2, NC after any
history.”

The previous result happens because the stage game (a prisoners’ dilemma)
has a unique (and inefficient) Nash equilibrium.

Every repeated game with finite horizon where the stage game has a unique NE
has a unique PNE outcome (computed by backward induction). This outcome
consists in the repetition in all periods of the NE of the stage game.

UNIT 5 SEQUENTIAL GAMES 23

 If the stage game has a multiplicity of inefficient Nash equilibria (NE), then
the previous result does not hold. That is, there might be a PNE of the finitely
repeated game in which there is cooperation in all but the last period.

Intuition: It is possible to punish a player for deviating in the next-to-last period

by specifying that if he does not deviate the NE he prefers will occur in the last
period, and that deviations lead to the NE he likes less.

EXAMPLE 10 - REPEATING A GAME WITH MULTIPLE NE:

IS C IN T=1 IN THE EQUILIBRIUM PATH OF THE REPEATED GAME WITH T=2?

YES!

C is not a NE of the stage game. The only way it could work in t=1 could be with
a strategy such as:

C in t = 1; play X in t = 2 if both players played C in t = 1 and play Z in t = 2

otherwise

Now the threat is credible because you are threatening with a NE of the stage
game.

Possible deviation in t = 1 to action Z (e.g. by Player 1). The payoff will be (6 +

1) = 7. This is smaller than (5 + 3) = 8, which is your payoff if you do not deviate.

UNIT 5 SEQUENTIAL GAMES 24

UNIT 5 SEQUENTIAL GAMES 25