EC2066 MICROECONOMICS

TOPIC 8: GAME THEORY - AN INTRODUCTION

Learning Outcomes

By the end of this chapter, and having completed the Essential reading and activities, you should
be able to:

 explain what a static game is, and compute the Nash equilibria of static games in pure
and mixed strategies
 define what a dominant strategy is, and find dominant strategy equilibria
 explain what a dynamic game is, and compute the sub-game perfect Nash equilibria
 analyse finitely and infinitely repeated games.

Essential Readings

 Morgan, Katz and Rosen, Microeconomics, Chapter 16.

 Perloff, J.M., Microeconomics: theory and applications with calculus, Chapter 14

1. General Introduction
 Game theory is the study of strategic decision-making. A game is a situation of strategic
inter-dependence. That is, the outcomes of one player’s choice (strategy) depend on the
choices of another player acting rationally.

 Strategic inter-dependence is situations where players (decision-makers) take other

players' behaviour into consideration when making their decisions. The payoffs resulting
from any decision are generally dependent on others' actions.

 Rational decision-makers are players assumed to make decisions or choose strategies

which will give them the highest possible expected payoff (or utility).

 In modelling game-theoretic interactions, we assume that each player also knows that
other players are rational and that they know that he knows they are rational and so on.

 Whenever it is possible to model a situation in the form of a game, the model of the
game should specify:

(a) the number of players

(b) the payoffs for all possible combinations of moves by those players

 Game theory is divided into two sections. The first section points to Static Games which
only happen simultaneously (at only one point in time). One example of a static game
that we will encounter is the Cournot Duopoly. The second section is sequential or
Dynamic Games which happen over time or across stages. An example of a sequential
game that we will encounter is the Stackelberg Duopoly.

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 It is important to determine whether the game is static or sequential as given by the

question in the exam.

2. Static Games
 When we analyse game-theoretic interactions, we say we are analysing a game.

 For a start, we usually analyse games with only two players, one player on the horizontal
axis, and the other on the vertical axis.

 We refer to actions as the possible set of choices in which the players can make.

 We refer to strategy as the complete description of the plan of actions of the player.

 Consider the following game between Ann (Player A) and Bob (Player B).

 Ann could go to the ballet or attend a concert. Simultaneously, Bob could also go to the
ballet or attend a concert.

Bob (Player B)
Ballet Concert
Ballet 1, 2 0, 1
Ann (Player A)
Concert 2, 1 1, 0

 The payoffs are written in the following manner (Payoffs for Ann, Payoffs for Bob)

 Hence, if Bob and Ann goes to the Ballet (top left cell), then Ann will receive a payoff of 1
and Bob will receive a payoff of 2. Similarly, if Ann goes to the Ballet and Bob goes to the
concert (top right cell), Ann will receive a payoff of 0 and Bob will receive a payoff of 1.

 If Ann goes to the concert and Bob goes to the Ballet, then Ann receives a payoff of 2
and Bob receives a payoff of 1. If both Ann and Bob go to the concert, then Ann receives
a payoff of 1 and Bob receives a payoff of 0.

 We shall begin analysing what are the optimal choices for Ann and Bob.

 Ann’s set of possible actions are either to go to the ballet or to go to the concert.

 Similarly, Bob’s set of possible actions are to go to the ballet or to go to the concert.

 The set of strategies for Ann are:

 Given that Bob goes to the ballet, Ann’s best response is to go to the concert as her
payoff for going to the concert is 2, which is more than her payoff from going to the ballet
which is only 1.

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 Given that Bob goes to the concert, Ann’s best response is to go to the concert as her
payoff for going to the concert is 1, which is more than her payoff from going to the ballet
which is 0.

 Given that Ann goes to the ballet, Bob’s best response is to go to the ballet as his payoff
for going to the ballet is 2, which is more than his payoff from going to the concert which
is 1.

 Given that Ann goes to the concert, Bob’s best response is to go to the ballet as his
payoff for going to the ballet is 1, which is more than his payoff from going to the concert
which is 0.

What is a Nash equilibrium?

 A Nash equilibrium is a combination of strategies, one for each player, with the property
that no player would unilaterally want to change his strategy given that the other players
play their Nash Equilibrium strategies.

 In short, a Nash equilibrium strategy is the best response to the best strategies the
other players are playing.

2.1 Pure Strategy Nash Equilibrium

 The outcome of this game is such that Ann goes to the concert while Bob goes to the
Ballet. This is a Pure Nash Equilibrium.

 This is a pure strategy Nash Equilibrium as it is not rational for Bob and Ann to deviate
from their actions.

 As Ann goes to the concert, it is not rational for Bob to switch from the Ballet over to
the concert. This is because by doing so, Bob will have a decrease of utility from 1 to 0.
Hence, there is no incentive for Bob to deviate from his strategy of choosing ballet.

 As Bob goes to the ballet, it is not rational for Ann to switch from the concert over to
the ballet. This is because by doing so, Ann will have a decrease of utility from 2 to 1.
Hence, there is no incentive for Ann to deviate from her strategy of choosing concert.

2.2 Strict Dominant Strategies

 Looking at the previous game, we notice that regardless if Bob chooses Ballet or
Concert, Ann will always go to the concert as this gives her higher payoff.

 Looking at the previous game, we notice that regardless if Ann chooses Ballet or
Concert, Bob will always go to the ballet as this gives him higher payoff.

 Hence, we say that Ann has a strict dominant strategy in going to the concert. We say
that Bob has a strict dominant strategy in going to the ballet.

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 Such a Nash Equilibrium as a result of Strict Dominant strategies is dominant strategy

Nash equilibrium.

2.3 Weakly Dominant Strategies

 Now consider a new game:

Bob (Player B)
Ballet Concert
Ballet 1, 2 0, 1
Ann (Player A)
Concert 1, 1 1, 0

 Let us analyse another game to define Weakly dominant strategies.

 Given that Bob goes to the ballet, Ann’s best response could be either going to the Ballet
or going to the concert since both payoffs are 1.

 Given that Bob goes to the concert, Ann’s best response is to go to the concert as her
payoff for going to concert is 1, which is more than her payoff going to the ballet which
is 0.

 Given that Ann goes to the ballet, Bob’s best response is to go to the ballet as his payoff
for going to ballet is 2, which is more than his payoff going to the concert which is 1.

 Given that Ann goes to the concert, Bob’s best response is to go to the ballet as his
payoff for going to ballet is 1, which is more than his payoff going to the concert which is
0.

 Hence, in this case, Ann does not have a strictly dominant strategy in going to the
concert. However, going to the concert is a strategy that is weakly dominant because
going to the concert will never be worse off than going to the ballet.

2.4 Some Observations

 Consider the new game below:

Bob (Player B)
Ballet Concert
Ballet 1, 0 0, 1
Ann (Player A)
Concert 2, 1 1, 0

 Given that Bob goes to the ballet, Ann’s best response is to go to the concert as her
payoff for going to concert is 2, which is more than her payoff going to the ballet which
is 1.

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 Given that Bob goes to the concert, Ann’s best response is to go to the concert as her
payoff for going to concert is 1, which is more than her payoff going to the ballet which
is 0.

 Given that Ann goes to the ballet, Bob’s best response is to go to the concert as his
payoff for going to concert is 1, which is more than his payoff going to the concert which
is 0.

 Given that Ann goes to the concert, Bob’s best response is to go to the ballet as his
payoff for going to ballet is 1, which is more than his payoff going to the concert which is
0.

 We notice that only one player (Ann) has a dominant strategy. Bob does not have a
dominant strategy.

 However, there is still a pure Nash equilibrium of Bob going to Ballet and Ann going to
concert.

 Hence, we only need one player to have a dominant strategy to have a pure Nash
Equilibrium.

 Consider the new game below

Bob (Player B)
Ballet Concert
Ballet 1, 0 0, 1
Ann (Player A)
Concert 1, 1 1, 0

 Given that Bob goes to the ballet, Ann’s best response could be either going to the Ballet
or going to the concert since both payoffs are 1.

 Given that Bob goes to the concert, Ann’s best response is to go to the concert as her
payoff for going to concert is 1, which is more than her payoff going to the ballet which
is 0.

 Given that Ann goes to the ballet, Bob’s best response is to go to the concert as his
payoff for going to concert is 1, which is more than his payoff going to the concert which
is 0.

 Given that Ann goes to the concert, Bob’s best response is to go to the ballet as his
payoff for going to ballet is 1, which is more than his payoff going to the concert which is
0.

 We notice that only one player (Ann) has a weakly dominant strategy in going to the
concert. Bob does not have a dominant strategy.

 However, there is still a pure Nash equilibrium of Bob going to Ballet and Ann going to
concert.

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 Hence, we only need one player to have a weakly dominant strategy to have a pure Nash
Equilibrium.

2.5 Prisoner’s Dilemma

 Consider the new game below.

Bob (Player B)
Ballet Concert
Ballet 7, 7 25, 5
Ann (Player A)
Concert 5, 25 10, 10

 Given that Bob goes to the ballet, Ann’s best response is to go to the ballet as her payoff
for going to ballet is 7, which is more than her payoff going to the concert which is 5.

 Given that Bob goes to the concert, Ann’s best response is to go to the ballet as her
payoff for going to ballet is 25, which is more than her payoff going to the concert which
is 10.

 Given that Ann goes to the ballet, Bob’s best response is to go to the ballet as his payoff
for going to ballet is 7, which is more than his payoff going to the concert which is 5.

 Given that Ann goes to the concert, Bob’s best response is to go to the ballet as his
payoff for going to ballet is 25, which is more than his payoff going to the concert which
is 10.

 The Pure strategy Nash Equilibrium will be both Ann and Bob going to the Ballet.

 This is a Prisoner’s Dilemma. This is because even though there is a Nash equilibrium
of both players going to the ballet, both of them will be much better off going to the
concert together. We will analyse this in Oligopoly theory and this is exactly what
happens in a Cournot duopoly.

 Notice that in the Prisoner’s Dilemma game, each player wants to maximise their
individual payoff and choose the dominant strategy (Ballet, Ballet). In equilibrium, they
receive a jointly worse-off payoff.

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2.6 Iterative Elimination of Strategies

 Consider the game below.

Bob (Player B)
A B C
A 2, 2 4, 2 0, 4
Ann (Player A) B 4, 0 6, 8 2, 2
C 6, 4 4, 0 0, 6

 It is not rational for Ann to choose A. This is because A (2, 4, 0) is dominated by B (4, 6,
2). So we eliminate A for Ann and we will be left with the following game.

Bob (Player B)
A B C
B 4, 0 6, 8 2, 2
Ann (Player A)
C 6, 4 4, 0 0, 6

 It is not rational for Bob to choose A. This is because A (0, 4) is dominated by C (2, 6).
So we eliminate A for Bob and we will be left with the following game.

Bob (Player B)
B C
B 6, 8 2, 2
Ann (Player A)
C 4, 0 0, 6

 It is not rational for Ann to choose C. This is because C (4, 0) is dominated by B (6, 2).
So we eliminate C for Ann and will be left with the following game.

Bob (Player B)
B C
Ann (Player A) B 6, 8 2, 2

 Ann is left with B. It is not rational for Bob to choose C as C (2) is dominated by B (8).
Hence the equilibrium is (B, B).

 We call this method the iterative elimination of dominated strategies.

Activity 9.1

Find all pure strategy Nash Equilibrium

i)
Bob (Player B)
Ballet Concert
Ballet 3, 3 4, 0
Ann (Player A)
Concert 4, 0 6, 5

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ii)

Bob (Player B)
Ballet Concert
Ballet -2, 3 3, 4
Ann (Player A)
Concert 0, 2 1, 3

iii)

Bob (Player B)
Ballet Concert
Ballet 2, 3 5, 2
Ann (Player A)
Concert 7, 4 2, 1

3. Mixed Strategies
 Consider the new game below:

Bob (Player B)
Ballet Concert
Ballet 5, 3 1, 2
Ann (Player A)
Concert 0, 0 3, 5

 Given that Bob goes to the ballet, Ann’s best response is to go to the ballet as her payoff
for going to ballet is 5, which is more than her payoff going to the concert which is 0.

 Given that Bob goes to the concert, Ann’s best response is to go to the concert as her
payoff for going to concert is 3, which is more than her payoff going to the ballet which
is 1.

 Given that Ann goes to the ballet, Bob’s best response is to go to the ballet as his payoff
for going to ballet is 3, which is more than his payoff going to the concert which is 2.

 Given that Ann goes to the concert, Bob’s best response is to go to the concert as his
payoff for going to concert is 5, which is more than his payoff going to the ballet which is
0.

 We notice that both Ann and Bob do not have any dominant strategies. However, there
are two Pure Nash Equilibrium. The first is of both Bob and Ann going to the concert;
the second is both Bob and Ann going to the ballet.

 However, a mixed strategy Nash Equilibrium exists since there is no weakly or strictly
dominant strategy.

 A pure strategy provides a complete definition of how a player will play a game. In
particular, it determines the move a player will make for any situation he or she could
face. A player's strategy set is the set of pure strategies available to that player.

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 A mixed strategy is an assignment of a probability to each pure strategy. This allows for
a player to randomly select a pure strategy. Since probabilities are continuous, there
are infinitely many mixed strategies available to a player.

 In this example, let Ann choose Ballet with probability p and choose Concert with
probability 1 – p; let Bob choose Ballet with probability q and choose Concert with
probability 1 – q. The game is now shown below:

Bob (Player B)
Ballet (q) Concert (1 – q)
Ballet (p) 5, 3 1, 2
Ann (Player A)
Concert (1 – p) 0, 0 3, 5

 E(Utility of Ann) = pq(5) + p(1-q)(1) + (1 – p)q(0) + (1 – p)(1 – q)(3)

 Differentiating EU with respect to p, we obtain:

 5q + (1 – q) – 3(1 – q)

 Setting it equals to 0, we get 7q = 2 and hence q = 2/7. This is the value of q such that
Ann is indifferent between going to the concert and going to the ballet.

 Suppose that Bob chooses q < 2/7, then 5q + (1 – q) – 3(1 – q) < 0. Thus, as p
rises, expected utility will fall. This means that Ann’s best response is to decrease p. The
optimal choice will then be p = 0 and this maximises her expected utility.

 Suppose that Bob chooses q > 2/7, then 5q + (1 – q) – 3(1 – q) > 0. Thus, as p
rises, expected utility will rise. This means that Ann’s best response is to increase p.
The optimal choice will then be p = 1 and this maximises her expected utility.

 Suppose that Bob chooses q = 2/7, then 5q + (1 – q) – 3(1 – q) = 0. Thus, as

we change p, there is no change in Expected Utility. This means that Ann will be
indifferent between going Ballet or Concert at any value particular value of p. This means
that Ann does not have any dominant strategy.

 For Bob, E(Utility of Bob) = pq(3) + p(1-q)(2) + (1 – p)q(0) + (1 – p)(1 – q)(5)

 Differentiating EU with respect to q, we obtain:

3p – 2p – (1 – p) 5

 Setting it equals to 0, we get 6p = 5 and hence p = 5/6. This is the value of p such that
Bob is indifferent between going to the concert and going to the ballet.

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 Suppose that Ann chooses p < 5/6, then 3p – 2p – (1 – p)5 < 0. Thus, as q rises,
expected utility will fall. This means that Bob’s best response is to decrease q. The
optimal choice will then be q = 0 and this maximises his expected utility.

 Suppose that Ann chooses p > 5/6, then 3p – 2p – (1 – p)5 > 0. Thus, as q rises,
expected utility will rise. This means that Bob’s best response is to increase q. The
optimal choice will then be q = 1 and this maximises his expected utility.

 Suppose that Ann chooses p = 5/6, then 3p – 2p – (1 – p)5 = 0. Thus, as we

change q, there is no change in Expected Utility. This means that Bob will be indifferent
between going Ballet or Concert at any value particular value of q. This means that Bob
does not have any dominant strategy.

 Hence the mixed Nash Equilibrium is such that Ann chooses Ballet 5/6 of the time and
Bob chooses Ballet 2/7 of the time.

 We can represent this in a graph. Denoting p as the vertical axis and q as the horizontal
axis. Notice that 0  p, q  1 .

 Two lines are drawn first, they are p = 5/6 and q = 2/7.

P=1

P = 5/6

P=0

q=0 q = 2/7 q=1

 Suppose p > 5/6, then 0. Bob will surely choose Ballet as increasing q
increases his expected utility. This means that Bob will set q =1.

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P=1
P > 5/6
P = 5/6 Bob setting
q=1

P=0

q=0 q = 2/7 q=1

 Suppose p < 5/6, 0, Bob will surely choose Concert as decreasing q

increases his expected utility. This means that Bob will set q = 0.

P=1

P = 5/6

Bob setting
q=0

P < 5/6

P=0

q=0 q = 2/7 q=1

 Suppose q > 2/7, 0, Ann will surely choose Ballet as increasing p increases
her expected utility. This means that Ann will set p = 1.

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Ann setting
P=1
p=1

P = 5/6

q > 2/7

P=0

q=0 q = 2/7 q=1

 Suppose q < 2/7, 0, Ann will surely choose Concert as decreasing p

increases her expected utility. This means that Ann will set p = 0.

P=1

P = 5/6

Ann setting
q < 2/7
p=0

P=0

q=0 q = 2/7 q=1

 Hence, in this case, there are 3 Nash Equilibria. Two of the Nash Equilibria are pure and
the third is a mixed Nash Equilibrium.

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 Notice that the diagram is consistent with our Nash Equilibria analysis earlier.

Activity 9.2

Determine the mixed Nash Equilibrium in the following games.

i)

Bob (Player B)
Ballet (q) Concert (1 – q)
Ballet (p) 3, 2 8, 6
Ann (Player A)
Concert (1 – p) 9, 11 4, 7

ii)

Bob (Player B)
Ballet (q) Concert (1 – q)
Ballet (p) 2, 2 0, 0
Ann (Player A)
Concert (1 – p) 0, 0 2, 2

iii)

Bob (Player B)
Ballet (q) Concert (1 – q)
Ballet (p) 4, 1 1, 4
Ann (Player A)
Concert (1 – p) 1, 4 4, 1

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4. Dynamic Games
 Under static games, we assumed that Ann and Bob make their decisions together at the
same point in time. A Dynamic game is where players take turns to move. For example, Ann
may move first, then Bob will move after Ann.

 Let us start with an example. Suppose that Ann chooses first, and Bob observes Ann’s
choice before taking his action.

 We can represent this in a game tree, which is a graphical representation of the strategic
situation.

 A node indicates a stage in which a decision has to be taken. A branch indicates the actions
that are available at that stage.

 Denoting B if Bob chooses Ballet and C if he chooses Concert, the normal form
representation of this game is shown below. For example, (B if Ann goes Ballet, C if Ann
goes Concert) is denoted by (B, C).

Bob (Player 2)
(B, B) (B, C) (C, B) (C, C)
Ballet 3, 1 3, 1 0, 0 0, 0
Ann (Player 1)
Concert 0, 0 1, 3 0, 0 1, 3

 The dynamic version of this game is shown below.

 In this case, if Ann chooses Ballet, and after Bob observes that Ann chooses Ballet, Bob
can choose Ballet which yields payoff of 3 to Ann and payoff of 1 to Bob. If Bob chooses
Concert after Ann chooses Ballet, then both of them will get 0 payoff.

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 If Ann chooses Concert, and after Bob observes that Ann chooses Concert, Bob can
choose Concert which yields payoff of 1 to Ann and payoff of 3 to Bob. If Bob chooses
ballet after Ann chooses concert, then both of them will get 0 payoff.

4.1 Sub-Game Perfect Nash Equilibrium

 There are 3 sub-games in this case. This is shown below:

Third Sub‐Game

First Sub‐Game Second Sub‐Game

 Sub-game Perfect Nash Equilibrium is a Nash Equilibrium in every sub-game.

 We solve this game by means of backward induction. This means that we start at the
end point, and work backwards.

 Now suppose that Ann has chosen Ballet, Bob will choose Ballet as the payoff will be 1
which is more than 0 if he chooses Concert. This is the equilibrium for this sub-game.

 Now suppose that Ann has chosen Concert, Bob will choose concert as the payoff will
be 3 which is more than 0 if he chooses ballet. This is the equilibrium for this sub-game.

 Hence, the game tree now looks like this:

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 Now we work backwards. Ann knows that if she chooses Ballet, Bob will choose Ballet.
This will give her a payoff of 3. She knows that if she chooses Concert, Bob will choose
Concert, which will give her a payoff of 1. Since the payoff of 3 is more than the payoff
of 1, Ann will choose Ballet. This is the equilibrium for the last sub-game.

 The unique sub-game perfect Nash equilibrium is therefore (Ballet, (Ballet if Ballet,
Concert if concert)).

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4.2 Repeated Games (Infinite)

 Consider the game below:

Bob (Player B)
Fight Collude
Fight 7, 7 25, 5
Ann (Player A)
Collude 5, 25 10, 10

 Notice that this is a Prisoner’s Dilemma. The static Nash equilibrium of this game is
(Fight, Fight).

 Suppose that this game is repeated an infinite amount of times. There will be infinite
number of sub-games. Each sub-game is a Prisoner’s Dilemma as shown above.

 With infinite repetition of the game, it is possible the sub-game perfect Nash Equilibrium
will be that both Bob and Ann will collude following a trigger strategy.

 In a trigger strategy, each player will collude if he/she observe that in the last period the
other player colludes. Otherwise, he/she will fight if he/she observes that in the last
period the other player fights (the other player cheats).

 Consider the discount factor , which measures the level of patience the players have.
The higher its value, the more patient the player is.

 In period t, individuals do not discount their utility since period t represents the current
period.

 In period t + 1, individuals discount their utility by ; in period t + 2, individuals discount

their utility by ; in period t + n, individuals discount their utility by and so on.

 It is rational to collude if expected payoff from Collusion is greater than expected payoff
from Deviation.

 Payoff if both collude is:

10
10 10 10 ⋯ 10 1 ⋯
1
 If one cheats at period 1, he/she fights while the other party is still colluding. The
cheating player earns 25 in period 1 while the cheated earns 5. After period 1, there
will no collusion and each player will fight and earn 7. The expected payoff for the
cheating player is:

7
25 7 7 ⋯ 25 7 ⋯ 25
1
 It will be rational to collude if E(Collusion) > E(Deviation).

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25  10 25 1 7  18 15 and

 implies that both players must be sufficiently patient so that collusion will take
place indefinitely.

4.3 Repeated Games (Finite)

 Consider the game below

Bob (Player B)
Fight Collude
Fight 7,7 25,5
Ann (Player A)
Collude 5,25 10,10

 Suppose that this game is repeated a finite amount of times, say 20 times. We have to
compute the sub-game perfect Nash Equilibrium. We use backward induction again.

 At the 20th time we play this game, the Nash Equilibrium will be (Fight, Fight). This is the
best response that both Ann and Bob can do at the 20th time we play this game.

 Since this is the last game, both players will have incentive to deviate and choose Fight.
This is the key difference from infinitely repeated games as under infinitely repeated
games, there is no last game.

 At the 19th time we play this game, since both Ann and Bob knows that the outcome of
the next game (20th game) will be (Fight, Fight), hence the outcome of the 19th game will
also be (Fight, Fight).

 We repeat this same analysis back to the 1st game.

 As such, we find that all 20 games will have the Nash Equilibrium (Fight, Fight).

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Answers to Activities

Activity 9.1

i) (Concert, Concert)
ii) (Ballet, Concert)
iii) (Concert, Ballet)

Activity 9.2
i) p = ½, q = 2/5

P=1

P = 1/2

P=0

q=0 q = 2/5 q=1

ii) p = ½, q = ½

P=1

P = 1/2

P=0

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iii) p = 1/2 , q = ½

P=1

P = 1/2

P=0

q=0 q =1/2 q=1

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