Normal Form Games and Nash Equilibrium: ECON2112: Week 1

Normal form games and Nash equilibrium
ECON2112: Week 1
DJ Thornton
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Table of contents
1. Introduction
2. Normal Form Games
3. Nash Equilibrium
4. Mixed Strategies
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Introduction
Game Theory (Informally)
• Game theory studies strategic, multi-person decision problems.
• A strategic situation (game) is a situation in which two or more individuals

(players) interact and each player’s action has some e↵ect on the outcome.
• Game theory provides a way for us to solve games.
• A solution is a set of recommendations about how to play the game, such that no
player would have an incentive not to follow this recommendation.
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Example: The Prisoners’ dilemma
Description of the game taken from Wikipedia:

“Two members of a criminal gang are arrested and imprisoned. Each prisoner
is in solitary confinement with no means of speaking to or exchanging messages
with the other. The police admit they don’t have enough evidence to convict
the pair on the principal charge. They plan to sentence both to a year in prison
on a lesser charge. Simultaneously, the police o↵er each prisoner a Faustian
bargain. If he testifies against his partner, he will go free while the partner will
get nine years in prison on the main charge. Oh, yes, there is a catch ... If
both prisoners testify against each other, both will be sentenced to six years
in jail.”
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Prisoner 2
Not Confess Confess
Not Confess 1, 1 9, 0
Prisoner 1
Confess 0, 9 6, 6
• The Prisoners’ dilemma is a multi-person decision problem: the outcome is jointly

determined by Prisoner 1 and Prisoner 2.
• What should be the solution to this game?
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Normal Form Games
Normal form games: General case
What do we need to have a multi-person decision problem or strategic situation?
(What constitutes a game?)
• We need players, say n players.
• Each player has to make a decision or strategy, therefore, for each player we need
a strategy set.
• We need to know players’ preferences over possible outcomes. Therefore, for each
player and each strategy profile (a strategy for each player) we need to specify the
payo↵ to that player if that strategy profile is played.
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Normal form games: Formal definition
Definition 1 (Normal Form game)

An n-player normal form game G = (S1 , . . . , Sn ; u1 , . . . , un ) consists of
• for each player i = 1, . . . , n, a set of strategies Si ; and
• for each player i = 1, . . . , n a utility function ui that, for each strategy profile
(s1 , . . . , sn ) 2 S1 ⇥ · · · ⇥ Sn specifies a real number ui (s1 , . . . , sn ) 2 R.
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Example: Prisoners’ Dilemma
• There are two players, therefore, n = 2.
• A strategy set for each player
• S1 = {Not Confess, Confess}
• S2 = {Not Confess, Confess}
• a utility function for each player
u1 (Not Confess, Not Confess) = 1 u2 (Not Confess, Not Confess) = 1

u1 (Not Confess, Confess) = 9 u2 (Not Confess, Confess) = 0
u1 (Confess, Not Confess) = 0 u2 (Confess, Not Confess) = 9
u1 (Confess, Confess) = 6 u2 (Confess, Confess) = 6 8
Of course, all this information can be summarised using the following normal form
(sometimes called matrix form) representation.
Not Confess Confess

Confess 0, 9 6, 6
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Example: Battle of the sexes
Description of the game taken from Wikipedia:

“Imagine a couple that agreed to meet this evening, but cannot recall if they
will be attending the opera or a football match (and the fact that they forgot is
common knowledge). The husband would most of all like to go to the football
game. The wife would like to go to the opera. Both would prefer to go to
the same place rather than di↵erent ones. If they cannot communicate, where
should they go?”
• There are two players, therefore n = 2. Let player 1 be the wife and player 2 be
the husband.
• A strategy set for each player. S1 = {O, F } and S2 = {O, F }

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• a utility function for each player

u1 (O, O) = 2 u2 (O, O) = 1
u1 (O, F ) = 0 u2 (O, F ) = 0
u1 (F , O) = 0 u2 (F , O) = 0
u1 (F , F ) = 1 u2 (F , F ) = 2
• Again we can represent this in the matrix form
O F
O 2, 1 0, 0
F 0, 0 1, 2
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Game Theory: Assumptions
• Players have common knowledge about the structure of the game.
• Players choose their strategies independently.
• If players can communicate at no cost, then the messages they send are part of
their strategies and the game specifies what messages can be sent (not in this
course). Second part of the course deals with “costly” signaling/communication.
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Nash Equilibrium
Nash equilibrium
• The aim of Game Theory is to provide at least one solution for every game.
• A solution is understood as as set of recommendations, one for each player.
• The solution has to be stable: no player has any reason to stray from the
recommendation (that is, they can’t achieve a strictly higher payo↵ by straying).
Definition 2 (Nash equilibrium)

A Nash equilibrium is a strategy profile such that no player has an incentive to
unilaterally deviate from their strategy.
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Nash equilibrium. Formal definition
Notation: Denote by S the set of strategy profiles S1 ⇥ · · · ⇥ Sn .
Consider an n-player normal form game G = (S1 , . . . , Sn ; u1 , . . . , un ).
Definition 3 (Nash equilibrium (formal))

The strategy profile s ⇤ = (s1⇤ , . . . , sn⇤ ) 2 S is a (pure strategy) Nash equilibrium of G
if for each i = 1, . . . , n
ui (s1⇤ , . . . , si⇤ 1 , si⇤ , si+1

⇤
, . . . , sn⇤ ) ui (s1⇤ , . . . , si⇤ 1 , si , si+1
⇤
, . . . , sn⇤ )
for every si 2 Si .
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Nash equilibrium. A characterisation
Notation: We write
S i = S1 ⇥ · · · ⇥ Si 1 ⇥ Si+1 ⇥ · · · ⇥ Sn ,
and
s i = (s1 , . . . , si 1 , si+1 , . . . , sn ) 2 S i.
So, S i is the set of all strategy profiles for players other than i. For example, in a two
player game,
S 1 = S2 , S 2 = S1 .
E.g. in the Prisoner’s dilemma, S 1 =S 2 = S1 = S2 = {Not Confess, Confess}.
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Definition 4 (Best response)

The set of player i’s best responses to s i = (s1 , . . . , si 1 , si+1 , . . . , sn ) 2S i is the
set of player i’s strategies that solve:
0
max ui (s1 , . . . , si 1 , si , si+1 , . . . , sn ).
si0 2Si
Furthermore, we denote by BRi (s i ) the set of player i’s best responses against s i .
Sometimes you might also see the compact notation (si , s i ) ⌘ (s1 , s2 , . . . , sn ) so that
si0 is a best response to s i if and only if
si0 2 arg max ui (si0 , s i ).
si0 2Si
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Theorem 1 (NE i↵ BR)

The strategy profile (s1⇤ , . . . , sn⇤ ) is a Nash equilibrium if and only if for every
i = 1, . . . , n we have si⇤ 2 BRi (s ⇤ i ).
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Nash equilibrium
Consider an n-player normal form game G = (S1 , . . . , Sn ; u1 , . . . , un ).
If the strategy profile s = (s1 , . . . , sn ) is not a Nash equilibrium then there is a player i
and a strategy si0 2 Si such that:
ui (si , s i ) < ui (si0 , s i ).
That is, if s is not a Nash equilibrium at least one player has an incentive to deviate
from s.
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Nash Equilibrium: Examples
Example: Prisoners’ dilemma.

Not Confess Confess
Confess 0, 9 6, 6
BR1 (Not Confess) = {Confess} BR2 (Not Confess) = {Confess}

BR1 (Confess) = {Confess} BR2 (Confess) = {Confess}
• Therefore, NE = {(Confess, Confess)}.
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O F
O 2, 1 0, 0
F 0, 0 1, 2
BR1 (O) = {O} BR2 (O) = {O}

BR1 (F ) = {F } BR2 (F ) = {F }
• NE = {(O, O), (F , F )}
• Note: There’s actually another NE here, but it involves something called mixed
strategies (next week’s topic).
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Example: Another 2x2 game

L R
T 1, 1 0, 0
B 0, 0 0, 0
BR1 (L) = {T } BR2 (T ) = {L}

BR1 (R) = {T , B} BR2 (B) = {L, R}
• NE = {(T , L), (B, R)}
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Example: A 4x3 game

L C R
TT 0, 3 8, 8 8, 9
T 1, 8 7, 9 6, 4
M 2, 2 6, 1 9, 1
B 1, 8 7, 9 9, 7
BR2 (TT ) = {R}

BR1 (L) = {M}
BR2 (T ) = {C }
BR1 (C ) = {TT }
BR2 (M) = {L}
BR1 (R) = {M, B}
BR2 (B) = {C }
• NE = {(M, L)}.
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Example: A 3-player game (2x2x2)
L R L R
T 1, 1, 1 0, 0, 0 T 1, 1, 3 0, 0, 0
B 0, 0, 0 1, 1, 1 B 2, 0, 0 0, 1, 0
W E
BR1 (L, W ) = {T } BR2 (T , W ) = {L} BR3 (T , L) = {E }

BR1 (L, E ) = {B} BR2 (T , E ) = {L} BR3 (T , R) = {W , E }
BR1 (R, W ) = {B} BR2 (B, W ) = {R} BR3 (B, L) = {W , E }
BR1 (R, E ) = {T , B} BR2 (B, E ) = {R} BR3 (B, R) = {W }
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• NE = {(B, R, W )}
Matching Pennies
Example: Matching Pennies
A game is played between two players, player 1 and player 2. Each player has
a penny and must secretly turn the penny to heads or tails. The players then
reveal their choices simultaneously. If the pennies match (both heads or both
tails) player 1 keeps both pennies, so wins one from player 2 (+1 for player 1,
-1 for player 2). If the pennies do not match (one heads and one tails) player 2
keeps both pennies, so receives one from Player 1 (-1 for player 1, +1 for
player 2).
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Matching Pennies
Example: Matching Pennies

H T
H 1, 1 1, 1
T 1, 1 1, 1
BR1 (H) = {H} BR2 (H) = {T }

BR1 (T ) = {T } BR2 (T ) = {H}
• NE = ?
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Mixed Strategies
Mixed Strategies
H T
H 1, 1 1, 1
T 1, 1 1, 1
• Suppose players were allowed to randomise between H and T .
• That is, suppose that player 1 is allowed to play H with probability 0  x  1 and
T with probability 1 x.
• In turn, suppose that player 2 is allowed to play H with probability 0  y  1 and

T with probability 1 y .
• These will be called mixed strategies.
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Mixed Strategies
H T
H 1, 1 1, 1
T 1, 1 1, 1
• Really, we are extending the strategy sets from S1 = {H, T }, to

S1 = {xH + (1 x)T | x 2 [0, 1]}
and from S2 = {H, T }, to
S2 = {yH + (1 y )T | y 2 [0, 1]}.
• Also note that x and y are just arbitrary variable names, that is, S1 = S2 .
• Are there values 0  x  1 and 0  y  1 that constitute a Nash equilibrium?

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Matching Pennies: Mixed Strategies
Suppose that player 2 plays H with probability 0  y  1 and T with probability 1 y.

Example: Expected payo↵s for player 1
y 1 y
H T
H 1, 1 1, 1
T 1, 1 1, 1
u1 (H, y ) = y (1 y)
u1 (T , y ) = y + (1 y ).
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We now want to compute BR1 (y ): player 1’s best response to player 2 playing H with
probability y and T with probability (1-y).
Example: Comparing expected payo↵s for player 1
u1 (H, y ) = y (1 y)
u1 (T , y ) = y + (1 y ).
That is, player 1 prefers H to T if and only if
y (1 y) > y + (1 y ),
1
y>
2
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1
• Player 1 prefers H to T if and only if y > 2
• If x represents the probability that player 1 plays H, we have that:

Example: Best response function for player 1
8
> 1
<x = 1
> if y> 2
BR1 (y ) 0  x  1 if 1
y=
>
>
2
: 1
x =0 if y< 2.
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Mixed Strategies
Example: Plotting player 1’s best response function

y
H 1
BR1 (y )
1
2
T x
1 1
2
T H
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Mixed Strategies
We can also calculate BR2 :

Example: Expected payo↵s for player 2
H T
x H 1, 1 1, 1
(1 x) T 1, 1 1, 1
u2 (H, x) = x + (1 x)
u2 (T , x) = x (1 x).
1
We find that player 2 strictly prefers H to T if x < 2 32
Mixed Strategies
1
• Player 2 strictly prefers H to T if x < 2
• Remember: y represents the probability that player 2 plays H

Example: Best response function for player 2
8
> 1
<y = 1
> if x< 2
BR2 (x) 0  y  1 if 1
x=
>
>
2
: 1
y =0 if x> 2
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Mixed Strategies
Example: Plotting player 2’s best response function

y
BR2 (x)
H 1
BR1 (y )
1
2
T x
1 1
2
T H
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Mixed Strategies
Recall Theorem 1,
Theorem 1 (NE i↵ BR)
The strategy profile (s1⇤ , . . . , sn⇤ ) is a Nash equilibrium if and only if for every
i = 1, . . . , n we have si⇤ 2 BRi (s ⇤ i ).
Example: Mixed strategy Nash equilibrium

• The Nash equilibrium is the point where BR1 (y ) and BR2 (x) intersect.
1 1
• This happens when x = 2 and y = 2
• Given y = 12 , player 1 obtains an expected payo↵ equal to zero and does not have
an incentive to deviate.
• Given x = 12 , player 2 obtains an expected payo↵ equal to zero and does not have
an incentive to deviate.
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Mixed Strategies and Dominated Strategies
ECON2112: Week 2
DJ Thornton
Mixed Strategies
Mixed Strategies
Recall our definition of a game:

Definition 1 (Normal Form game)
An n-player normal form game G = (S1 , S2 , . . . , Sn ; u1 , u2 , . . . , un ) consists of
• for each player i = 1, 2, . . . , n, a set of pure strategies Si ; and
• for each player i = 1, 2, . . . , n a utility function ui that, for each pure strategy
profile (s1 , s2 , . . . , sn ) 2 S1 ⇥ S2 · · · ⇥ Sn specifies a real number
ui (s1 , . . . , sn ) 2 R.
(informally) A pure strategy is a “definite” choice.
A mixed strategy is a probability distribution over the possible “definite” choices.
1
Mixed strategies
Example 2
If player 1 has two strategies, e.g., S1 = {T , B}, examples of mixed strategies are:
1 1
T + B,
2 2
1 2
T + B,
3 3
↵T + (1 ↵)B for any 0  ↵  1
Definition 3 (Mixed Strategy)

A mixed strategy for player i is a probability distribution pi over i’s set of pure
strategies Si .
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Mixed strategies
Example 4
If player 1 has two strategies, e.g., S1 = {T , B}, we could also write the mixed
strategy
p1 = ↵T + (1 ↵)B
by just writing out the coefficients
p1 = (↵, 1 ↵),
so long as we have imposed some order on the strategies. This has the advantage of
instantly resembling a coordinate in the Cartesian plane.
This notation tends to generalise more naturally when we have more strategies, but
for the purposes of this course we will stick to the former notation. Be aware of this
subtle di↵erence if you consult other textbooks.
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Utility of a mixed strategy
We have only defined utility functions for pure strategies.
Consider a two player game with strategy sets S1 = {T , B}, and S2 = {L, R}. What is
player 2’s utility if player 1 plays the mixed strategy p1 = 13 T + 23 B?
We define u2 (p1 , L) as the expected utility under the strategy p1 , that is,
1 2
u2 (p1 , L) = u2 ( 13 T + 23 B, L) = u2 (T , L) + u2 (B, L).
3 3
What about if player 2 plays the mixed strategy p2 = 12 L + 12 R? Then the expected
utility of (p1 , p2 ) is
1 1 1 1 2 1 2 1
u2 (p1 , p2 ) = · u2 (T , L) + · u2 (B, L) + · u2 (B, L) + · u2 (B, R).
3 2 3 2 3 2 3 2
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The notation for the utility of a mixed strategy in an n-player game is a bit heavy. We
present the two-player case below and note that the more general case is similar.
Let’s write S1 = {s11 , s12 } and S2 = {s21 , s22 } for player 1 and player 2’s pure
strategies, and write p1 = (p11 , p12 ) and p2 = (p21 , p22 ) for an arbitrary mixed strategy
by player 1 and player 2. Note that the probability that player 1 plays s11 and player 2
plays s21 is p11 ⇥ p21 . So
u1 (p1 , p2 ) = p11 p21 u1 (s11 , s21 ) + p12 p21 u1 (s12 , s21 ) + p11 p22 u1 (s11 , s22 ) + p12 p22 u1 (s12 , s22 )
u2 (p1 , p2 ) = p11 p21 u2 (s11 , s21 ) + p12 p21 u2 (s12 , s21 ) + p11 p22 u2 (s11 , s22 ) + p12 p22 u2 (s12 , s22 ).
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The notation for the utility of a mixed strategy in an n-player game is a bit heavy. We
present the two-player case below and note that the more general case is similar.
Let’s write S1 = {s11 , s12 } and S2 = {s21 , s22 } for player 1 and player 2’s pure
strategies, and write p1 = (p11 , p12 ) and p2 = (p21 , p22 ) for an arbitrary mixed strategy
by player 1 and player 2. Note that the probability that player 1 plays s11 and player 2
plays s21 is p11 ⇥ p21 . So
2 X
X 2
u1 (p1 , p2 ) = p1i p2j u1 (s1i , s2j )
i=1 j=1
2 X
X 2
u2 (p1 , p2 ) = p1i p2j u2 (s1i , s2j )
i=1 j=1
5
Nash equilibrium with mixed strategies
Definition 5 (Nash Equilibrium)

The mixed strategy profile p ⇤ = (p1⇤ , p2⇤ , . . . , pn⇤ ) is a Nash equilibrium of G if for
each i = 1, . . . , n
ui (p1⇤ , . . . , pi⇤ 1 , pi⇤ , pi+1

⇤
, . . . , pn⇤ ) ui (p1⇤ , . . . , pi⇤ 1 , pi , pi+1
⇤
, . . . , pn⇤ )
for every other mixed strategy pi available to player i.
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Nash equilibrium with mixed strategies

The mixed strategy profile p ⇤ = (p1⇤ , p2⇤ , . . . , pn⇤ ) is a Nash equilibrium of G if for
each i = 1, . . . , n
ui (pi⇤ , p ⇤ i ) ui (pi , p ⇤ i )
for every other mixed strategy pi available to player i.
Note:
Each of the pi⇤ ’s in the mixed strategy profile p ⇤ are themselves distributions over
player i’s strategies (i = 1, . . . , n). So pi⇤ might look something like 12 T + 12 B (for
example).
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Mixed Strategies
Consider an n-player normal form game G = (S1 , . . . , Sn ; u1 , . . . , un ) where n is a finite

number and Si is finite for every i = 1, . . . , n.
Theorem 1 (Nash, 1950)
The game G has at least one Nash equilibrium, possibly in mixed strategies.
Proof.
Unfortunately well beyond the scope of this course... but for those interested, it
follows from a famous result about fixed points.
Note:
Every pure strategy si can be expressed as a mixed strategy that gives probability one
to si and probability zero to every other strategy.
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Mixed Strategies and Nash equilibrium
Suppose that p ⇤ = (p1⇤ , . . . , pn⇤ ) is a Nash Equilibrium of some game G .

• No player can unilaterally deviate from p ⇤ and obtain a higher payo↵. Moreover,
it is enough to check the following:
p ⇤ is a Nash equilibrium if for every player i = 1, . . . , n:
ui (pi⇤ , p ⇤ i ) ui (si , p ⇤ i )
for every si 2 Si (intuition?).

• If players other than i play according to p i then player i is indi↵erent between
any two pure strategies used with strictly positive probability by pi⇤ .
8
Mixed Strategies
Example 6
H T
H 1, 1 1, 1
T 1, 1 1, 1
Under the Nash equilibrium ( 12 H + 12 T , 12 H + 12 T ) player 1 is indi↵erent between H

and T and player 2 is indi↵erent between H and T .
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Nash equilibrium: Equivalent definition
Consider an n-player normal form game G = {S1 , S2 , . . . , Sn ; u1 , . . . , un } and a mixed

strategy profile p = (p1 , p2 , . . . , pn ).
Definition 7
The set of player i’s best responses against p i 2 P i is the set of player i’s
strategies that solve:
max
0
ui (pi0 , p i ).
pi
Furthermore, we denote by BRi (p i ) the set of player i’s best responses against p i .
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Nash equilibrium: Equivalent definition
Definition 8
The strategy profile (p1⇤ , p2⇤ , . . . , pn⇤ ) is a Nash equilibrium if for every i = 1, . . . , n we
have pi⇤ 2 BRi (p ⇤ i ).
11
Mixed Strategies
Example 9 (Battle of the sexes)

L R
T 2, 1 0, 0
B 0, 0 1, 2
• The game has two Nash equilibria in pure strategies (T , L) and (B, R).
• What about Nash equilibria in mixed strategies?
12
Mixed Strategies
Example 10 (Battle of the sexes)

L R
T 2, 1 0, 0
B 0, 0 1, 2
• Let x be the probability that player 1 plays T .
• Let y be the probability that player 2 plays L.
8 8
> 1 > 2
<x = 1
> if y> 3 <y = 1
> if x> 3
BR1 (y ) 0  x  1 if 1 BR2 (x) 0  y  1 if 2
y= x=
>
>
3 >
>
3
: 1 : 2
x =0 if y< 3. y =0 if x< 3.
• The NE are: (T , L), (B, R) and ( 23 T + 13 B, 13 L + 23 R)

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Dominated Strategies and Admissibility
Dominated Strategies: Motivation
• Under what conditions can we say that a strategy is unequivocally better than
another?
• Certainly this should be the case if a strategy always gives a larger payo↵ than a
second strategy no matter what the other players do.
14
Dominant Strategies
Example 11 (Prisoners’ Dilemma)

Not Confess Confess
Confess 0, 9 6, 6
BR1 (Not Confess) = {Confess} BR2 (Not Confess) = {Confess}

BR1 (Confess) = {Confess} BR2 (Confess) = {Confess}
• For any player, whatever the other player does, Confess pays more than Not
Confess.
• We say that the strategy Not Confess is strictly dominated by Confess, or that
the strategy Confess strictly dominates the strategy Not Confess. 15
Normal Form Games
Definition 12 (Strictly Dominated Strategy)

Given a game G , the (mixed) strategy pi is strictly dominated by the (mixed)
strategy pi0 6= pi if for every pure strategy profile of the opponents s i we have:
ui (pi , s i ) < ui (pi0 , s i ).
• If a player has a strictly dominated strategy, it will never be used in a Nash

equilibrium.
16
Equilibrium in Dominant Strategies: Example
Example 13 (3x3 game)

L C R
T 1, 1 0, 2 5, 1
M 2, 0 1, 1 6, 0
B 0, 3 0, 6 5, 5
• T and B are strictly dominated by M.

• L and R are strictly dominated by C .
• (M, C ) is the unique Nash equilibrium.
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Strictly Dominated Strategies: Properties
• If a strategy is strictly dominated, it will never be used in a Nash equilibrium and,

moreover:
Theorem 2
Let G be an n-player normal form game such that player i has a strictly dominated
strategy in G . Let G 0 be the n-player normal form game that is obtained from G by
removing such a strictly dominated pure strategy. Then G and G 0 have the same set
of Nash equilibria.
18
Example 14
3 player game
L C R L C R
T 1, 1, 1 0, 0, 1 1, 2, 1 T 1, 1, 0 1, 3, 0 2, 1, 0
B 0, 1, 1 2, 0, 1 0, 0, 1 B 1, 1, 0 2, 0, 0 2, 3, 0
X Y
19
Example 14
3 player game
R
T 1, 2, 1
(T , R, X ) is the unique Nash equilibrium of the original game.
The process is called iterated deletion of strictly dominated strategies.
19
Example 15 (3 player game)

L C R L C R
T 2, 1, 1 0, 0, 1 0, 0, 1 T 1, 1, 0 1, 3, 0 2, 1, 0
B 0, 0, 1 1, 1, 1 1, 2, 1 B 1, 1, 0 2, 0, 0 2, 3, 0
X Y
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Example 15 (3 player game)

L R
T 2, 1, 1 0, 0, 1
B 0, 0, 1 1, 2, 1
X
We have reduced the original game to the Battle of the Sexes between players 1 and 2.
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Weakly Dominated Strategies: Motivation
Example 16 (Rational players will never play strictly dominated strategies)

L R
T 1, 1 1, 0
B 0, 1 0, 0
• If player 2 plays L player 1 is better o↵ playing T .

• If player 2 plays R player 1 is better o↵ playing T .
• Therefore, player 1 will never play B. (And player 2 will never play R.)
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Weakly Dominated strategies.
What happens in the following situation?

L R
T 1, 1 0, 0
B 0, 0 0, 0
• If player 2 plays L player 1 is better o↵ playing T .

• If player 2 plays R player 1 is indi↵erent between T and B.
• That is, for player 1, strategy T always does at least as good as strategy B and
sometimes does strictly better.
22
Definition 17 (Weakly Dominated Strategy (informal))

The strategy pi is weakly dominated by pi0 if, whatever the other players play, pi0 is
always at least as good as pi and sometimes strictly better.
Definition 18 (Weakly Dominated Strategies)

Given a game G we say that strategy pi is weakly dominated by strategy pi0 if for
every pure strategy profile of the opponents s i 2 S i
ui (pi , s i )  ui (pi0 , s i )
and there exists at least one pure strategy profile s 0 i such that
ui (pi , s 0 i ) < ui (pi0 , s 0 i ).
23
Weakly and Strictly Dominated Strategies: Comparison
Definition 12 (Strictly Dominated Strategy)

Given a game G we say that the strategy pi is strictly dominated by the strategy
pi0 6= pi if for every s i
ui (pi , s i ) < ui (pi0 , s i ).
Definition 16 (Weakly Dominated Strategies)

Given a game G we say that strategy pi is weakly dominated by pi0 if for every s i
ui (pi , s i )  ui (pi0 , s i ),
and there exists at least one s 0 i such that
ui (pi , s 0 i ) < ui (pi0 , s 0 i ).
24
What happens in the following situation?

L R
T 1, 1 0, 0
B 0, 0 0, 0
• Strategy T is always at least as good as strategy B, and sometimes (when player

2 plays L) is strictly better.
• We may be interested in equilibria where neither strictly nor weakly dominated
strategies are played. A Nash equilibrium satisfying this property is called
admissible.
• (T , L) is the unique admissible Nash equilibrium.
• Nonetheless, note that (B, R) is a Nash equilibrium.
25
Dominated Strategies: Summary
To summarise
• Players will never use strictly dominated strategies in a Nash equilibrium.
• Therefore, if the objective is to compute Nash equilibria, it is safe to apply
iterated deletion of strictly dominated strategies.
• As we have seen, there are Nash equilibria where players play weakly dominated
strategies.
• Therefore, if the objective is to compute Nash equilibria, it is not safe to apply
iterated deletion of weakly dominated strategies.
26
Applications
Normal form games
Definition 1 (Finite Normal Form Game)

An n-player finite normal form game G = (S1 , S2 , . . . , Sn ; u1 , u2 , . . . , un ) consists of
• for each player i = 1, . . . , n a set of pure strategies Si , and
• for each player i = 1, . . . , n a utility function ui defined on the set of pure strategy
profiles.
• So far the strategy set Si has always been finite.
• However, we can also work with Si infinite.
• The definitions of Nash equilibrium, strictly and weakly dominated strategies do

not change.
27
Applications
Cournot model of duopoly.

Cournot model of duopoly: Assumptions.
• There are two firms, 1 and 2 competing in a duopolistic market.
• These firms produce an identical good.
• Firms choose the quantities that they are going to produce.
• The market clearing price when Q = q1 + q2 is the total amount in the market is:
8
<a Q if Q < a (where a > 0)
p=
:0 if Q a.
• Producing q1 units of the good costs cq1 dollars to firm 1.
• Producing q2 units of the good costs cq2 dollars to firm 2. We assume c < a.
28
Cournot model of duopoly: The game.
• Players: Firms 1 and 2.
• Strategy set of firm 1: any number larger or equal to zero. That is, S1 = [0, 1).
• Strategy set of firm 2: any number larger or equal to zero. That is, S2 = [0, 1).
• For each strategy profile (q1 , q2 ) we need to specify payo↵s to player (firm) 1 and
player (firm) 2.
(
(a q1 q2 )q1 cq1 if q1 + q2 < a
• ⇡1 (q1 , q2 ) = pq1 cq1 =
cq1 if q1 + q2 a.
(
(a q1 q2 )q2 cq2 if q1 + q2 < a
• ⇡2 (q1 , q2 ) = pq2 cq2 =
cq2 if q1 + q2 a.
29
Doupoly and Cournot competition: Solution.
Definition 19 (Nash equilibrium for two firms in competition)

A strategy profile (q1⇤ , q2⇤ ) is a Nash equilibrium if
⇡1 (q1⇤ , q2⇤ ) ⇡1 (q1 , q2⇤ ) for every q1 2 [0, 1)

⇡2 (q1⇤ , q2⇤ ) ⇡2 (q1⇤ , q2 ) for every q2 2 [0, 1)
• Fix the production of firm 2 to q2 . What is the best strategy that firm 1 can take?
• Choose q1 that satisfies:
max ⇡1 (q1 , q2 ) = max (a q1 q2 )q1 cq1 = max (a c q2 )q1 q12 .

q1 q1 q1
30
Duopoly and Cournot competition: Solution.
• Assuming q2 < a c, the optimal q1 is:

1
BR1 (q2 ) = (a c q2 ).
2
• Similarly for firm 2:

1
BR2 (q1 ) = (a c q1 ).
2
• Thus the profile (q1⇤ , q2⇤ ) is a Nash equilibrium if it solves
2q1⇤ =(a c q2⇤ ),

2q2⇤ =(a c q1⇤ ).
31
Duopoly and Cournot competition: Solution.
• Solving simultaneously, we find that

a c
q1⇤ = q2⇤ = .
3
• Recall that we assumed qi < a c (i = 1, 2) in order to derive this equilibrium.

We must check that this is the case. Remember that c < a (one of our initial
assumptions in the model) which implies that a c > 0 and hence
a c
a c > 0 =) > 0 =) qi⇤ > 0,
3
as assumed.
32
We can also apply iterated deletion of dominated strategies.
• S1 = [0, 1); S2 = [0, 1).
a c
• The monopoly quantity 2 strictly dominates any larger quantity.
• S11 = [0, a 2 c ]; S21 = [0, a 2 c ].
a c
• Given this, 4 dominates any lower quantity.
• S12 = [ a 4 c , a 2 c ]; S22 = [ a 4 c , a 2 c ].
3(a c)
• Given this, 8 dominates any larger quantity.
33
• S13 = [ a 4 c , 3(a8 c) ]; S23 = [ a 4 c , 3(a8 c) ].

5(a c)
• Given this, 16 dominates any lower quantity.
• S14 = [ 5(a16 c) , 3(a8 c) ]; S24 = [ 5(a16 c) , 3(a8 c) ].
• ···
• S11 = { a 3 c }; S21 = { a 3 c }.
34
Applications
Bertrand model of duopoly.

Bertrand model of duopoly: Assumptions.
• Two firms 1 and 2 that produce exactly the same good.
• The demand is going to absorb Q units of the good, no matter at what price.
• Each firm i has to choose a price out of the interval [0, 1).
• Buyers will always buy from the firm with the lowest price.
Q
• If both firms set the same price, each firm will sell 2 units.
• For each firm, producing 1 unit of the good costs c dollars.
35
Bertrand model of duopoly: The game.
• Two players.
• Strategy sets S1 = S2 = [0, 1).
• Payo↵s for firm 1 (for firm 2 are analogous):

8
>
>(p1 c)Q if p1 < p2
<
⇡1 (p1 , p2 ) = 1
(p1 c)Q if p1 = p2
>
>
2
:
0 if p1 > p2
36
Bertrand model of duopoly: The solution.
• Nash equilibrium: Prices (p1⇤ , p2⇤ ) such that
⇡1 (p1⇤ , p2⇤ ) ⇡1 (p1 , p2⇤ ) for every p1 2 [0, 1)

⇡2 (p1⇤ , p2⇤ ) ⇡2 (p1⇤ , p2 ) for every p2 2 [0, 1]
• The unique Nash equilibrium is p1⇤ = p2⇤ = c.
• However, note that choosing a price equal to c is a weakly dominated strategy!
37
Applications
The Problem of the commons.

The Problem of the commons: Assumptions.
• There are n farmers in a village.
• Each farmer has to decide how many goats gi (i = 1, . . . , n) to own.
• Goats will have to share the same limited space, hence, the benefit of having a
goat will decrease on the total number of goats.
• We will assume that the benefit of having a goat when the total number of goats
P
is equal to A G 2 (where A is a positive constant and G = ni=1 gi ).
• The cost of buying and caring for a goat is c.
• We assume A > c.
• For simplicity, we will assume that goats are perfectly divisible. 38

The Problem of the commons: The game.
• Number of players: n.
• Strategy sets: For each farmer (player) the interval [0, 1).
• Given a strategy profile (g1 , . . . , gn ) the payo↵ to farmer i is:
⇡i (g1 , . . . , gn ) = gi (A (g1 + · · · + gn )2 ) cgi .
39
The Problem of the commons: Solution.
• Take the first order condition of gi (A (g1 + · · · + gn )2 ) cgi .
• A (g1 + · · · + gn )2 2(g1 + · · · + gn )gi c = 0.
• Aggregate over every farmer:
• nA n(g1 + · · · + gn )2 2(g1 + · · · + gn )2 nc = 0, that is:
• n(A c) = (2 + n)(g1 + · · · + gn )2 .
• From where we can obtain a value for the total number of goats in a Nash
equilibrium:
 1
⇤ n 2
G = g1 + · · · + gn = (A c)
2+n
40
The Problem of the commons: Social Optimum.
• What is the socially optimal number of goats?
• From a utilitarian standpoint: whatever number G maximizes:

G (A G 2) cG
• Taking the first order condition:

A G2 2G 2 c=0
• From where we can obtain a value for the socially optimal number of goats:
 1
⇤⇤ 1 2
G = (A c)
3
• Exercise: Check that G ⇤⇤ < G ⇤ whenever n > 1. Why is this? 41

Applications
Hotelling model of political competition

Political competition (Hotelling): Assumptions
• Consider an election with two parties, 1 and 2.
• Each party has to announce its political ideology.
• Based on these announcements the voters will cast their vote.
• The party with most votes wins the election. In case of a tie, a fair coin is tossed
to determine the winner.
• Each voter will cast her vote for the political party that is closest to her political
ideology.
42
Political competition (Hotelling): Assumptions
• To be concrete, suppose that the space of political ideologies is the interval

[0, 1] ⇢ R.
• Parties hence have to choose ideologies I1 , I2 in [0, 1]
• Suppose that each “point” in [0, 1] is inhabited by a voter who has that ideology.
E.g. there is a voter with ideology ⇡/4.
0.5 ⇡/4
0 1
Socialist Alternative UNSW Conservatives
43
Hotelling model of Political competition: The game.
• Players: parties, 1 and 2.
• Strategies: S1 = S2 = [0, 1].
• Payo↵s:
• Let I1 < I2 . Party 1 gets a share of the votes equal to 12 (I1 + I2 ).
• If 12 (I1 + I2 ) > 1
2
then Party 1 gets a payo↵ equal to 1 and Party 2 gets a payo↵ equal
to 0.
• If 12 (I1 + I2 ) = 1
2
then both parties get a payo↵ equal to 12 .
• If I1 = I2 then both parties will get a payo↵ equal to 12 .
44
Hotelling model of Political competition: The solution.
I1 I2
0.3 0.5 0.8

0 1
45
I1 I2
1
(I
2 1
+ I2 )
0.3 0.5 0.8
0 1
45
I1 I2
1
(I
2 1
+ I2 )
0.3 0.5 0.8
0 1
• In the above example, party 1 wins (though party 2 is not playing a best
response!).
• Nash equilibrium: Ideologies I1⇤ and I2⇤ such that no party can unilaterally increase
their chances of winning the election.
• The unique Nash equilibrium is I1 = I2 = 12 .
45
Applications
Bertrand model of duopoly (version 2)

Bertrand model of duopoly (v. 2): Assumptions.
• Consider a duopoly with di↵erentiated products. Producing one unit of either

good costs c to the firm.
• Firms choose prices p1 and p2 . There is a “sustitutability” parameter b < 2, s.t.
• If firms choose prices p1 and p2 , consumers demand

q1 (p1 , p2 ) = a p1 + bp2
from firm 1.
• If firms choose prices p1 and p2 , consumers demand

q2 (p1 , p2 ) = a p2 + bp1
from firm 2.
46
Bertrand model of duopoly (v 2): The game.
Therefore, the game is given by:
• Set of players, firms 1 and 2,
• Each firm has to choose a price in the interval [0, 1),
• Firm i tries to maximize profits given by ⇡i (pi , p i ) = (pi c)qi ,
47
Bertrand model of duopoly (v 2): Solution.
• Take as given p2 and compute BR1 (p2 ).
• Given p2 firm one chooses a price p1 so that

max ⇡1 (p1 , p2 ) = max (p1 c)q1 = max (p1 c)(a p1 + bp2 )
p1 p1 p1
• BR1 (p2 ) = 12 (a + bp2 + c).
• And since everything is symmetric, BR2 (p1 ) = 12 (a + bp1 + c).
• The profile (p1⇤ , p2⇤ ) is a Nash equilibrium if it solves:

1
p1⇤ = (a + bp2⇤ + c)
2
1
p2 = (a + bp1⇤ + c).
⇤
2 48
Extensive form games: backward induction, perfect and
imperfect information
ECON2112: Week 3
DJ Thornton
Introduction
• In a normal form game, players take decisions simultaneously.
• In an extensive form game, players take decisions sequentially.
• A game of perfect information is an extensive form game where players can

always observe and remember other players’ past actions.
• Examples: Chess, checkers, tic tac toe . . .
1
Games of Perfect Information
Perfect Information
Representation and some terminology

1
L R
2
a b 1, 3
2, 1 0, 0
• The open circle is the initial node.
• The black circles and the open circle are called decision nodes.
• L, R , a and b are called actions.
• 1 and 2 are the names of the players.
• We specify a payoff vector in each final node.
2
Perfect Information
What is a strategy?
1
L R
2 2
a b c d
2, 1 0, 0 4, 0 1, 3
• L, R , a, b, c , d are called actions.
• What is player 1’s set of pure strategies?
• What is player 2’s set of pure strategies?
3
Pure, mixed and behavioral strategies
In an extensive form game there are three different concepts of strategies:

Pure strategies
In a extensive form game, a player’s pure strategy is a plan of action for the
entire game, that tells the player what action to take at every juncture of the
game where she has to move.
Mixed strategies
In an extensive form game, a player’s mixed strategy is a probability distribution
on the set of that player’s pure strategies.
Behavioral strategies
A player’s behavioral strategy at a decision node where the player has to move
is a probability distribution over the actions available at that decision node.
4
Pure strategies
Example 1
1
L R
2 2
a b c d
2, 1 0, 0 4, 0 1, 3
• Recall: L, R , a, b, c , d are the actions.
• Player 1’s set of pure strategies: S1 = {L, R }
• Player 2’s set of pure strategies: S2 = {ac , ad , bc , bd }
5
Pure strategies
Example 2
1
L R
2 2
a b c d
1
2, 1 0, 0 A B 1, 3
4, 0 1, 4
• Player 1’s set of pure strategies: S1 = {LA, LB , RA, RB }
• Player 2’s set of pure strategies: S2 = {ac , ad , bc , bd }.
6
Pure strategies
Example 3 (A perfect information game with moves of Nature)

1
L R
2 N
1 1
a b 2 2
2
2, 1 0, 0 c d 0, 3
4, 0 2, 3
• We can introduce moves of Nature.
• Player 1 set of pure strategies: S1 = {L, R }.
• Player 2 set of pure strategies: S2 = {ac , ad , bc , bd }.
7
Example 4
1
L R
2 2
a b c d
2, 1 0, 0 4, 0 1, 3
• Set of behavioral strategy profiles: the set of profiles that look like this
(xL + (1 − x )R , ya + (1 − y )b, zc + (1 − z )d )
where 0 ≤ x ≤ 1, 0 ≤ y ≤ 1, 0 ≤ z ≤ 1.
8
Example 5
1
L R
2 2
a b c d
1
2, 1 0, 0 A B 1, 3
4, 0 1, 4
(xL + (1 − x )R , ya + (1 − y )b, zc + (1 − z )d , wA + (1 − w )B )
where 0 ≤ x ≤ 1, 0 ≤ y ≤ 1, 0 ≤ z ≤ 1, 0 ≤ w ≤ 1.
9
Example 6 (A perfect information game with moves of Nature)

1
L R
2 N
1 1
a b 2 2
2
2, 1 0, 0 c d 0, 3
4, 0 2, 3
(xL + (1 − x )R , ya + (1 − y )b, zc + (1 − z )d )
where 0 ≤ x ≤ 1, 0 ≤ y ≤ 1, 0 ≤ z ≤ 1.
10
Normal Form Representation
Back to pure strategies: Normal Form Representation
• Once we know what the set of pure strategies is for each player, we can write
down the normal form representation of a an extensive form game.
Example 7
1
L R
2
a b 1, 3
a b
2, 1 0, 0 L 2, 1 0, 0
R 1, 3 1, 3
11
Normal Form Representation
Example 8
1
L R
2 2
a b c d
2, 1 0, 0 4, 0 1, 3
ac ad bc bd
L 2, 1 2, 1 0, 0 0, 0
R 4, 0 1, 3 4, 0 1, 3
12
Normal form Representation
Example 9
1
L R
2 2
a b c d
1
2, 1 0, 0 A B 1, 3
4, 0 1, 4
ac ad bc bd
LA 2, 1 2, 1 0, 0 0, 0
LB 2, 1 2, 1 0, 0 0, 0
RA 4, 0 1, 3 4, 0 1, 3
RB 1, 4 1, 3 1, 4 1, 3 13
Normal form Representation
Example 10
1
L R
2 N
1 1
a b 2 2
2
2, 1 0, 0 c d 0, 3
4, 0 2, 3
ac ad bc bd
L 2, 1 2, 1 0, 0 0, 0
R 2, 32 1, 3 2, 32 1, 3
14
Nash Equilibrium
Nash Equilibrium of an extensive form game

The Nash equilibrium of a perfect information game (or, more generally, of an
extensive form game) is the Nash equilibrium of its Normal form representation.
15
Nash Equilibrium
Typically, there are unreasonable Nash equilibria in a perfect information game:

Example 12 (A non credible threat)
1
L R
a b
2
L 2, 1 0, 0
a b 1, 3
R 1, 3 1, 3
2, 1 0, 0
• The game has two Nash equilibria in pure strategies (L, a) and (R , b).
• Under (R , b), player 2 is threating player 1 with playing b if he plays L.
• But, is this a credible threat?
16
Nash Equilibrium
Example 13 (A non credible threat)
1
L R
a b
2
L 2, 1 0, 0
a b 1, 3
R 1, 3 1, 3
2, 1 0, 0
• Suppose that player 2 finds himself in a situation where he has to choose

between a and b.
• In such a case, he would choose a.
• Player 1 should foresee this, and play L instead of R .
• Moreover, note that b is a weakly dominated strategy for player 2. 17
Backwards Induction: Rollback Equilibrium
Backwards Induction
• The main idea on the last example can be generalized:

Definition 14 (Backwards Induction)
Players should optimise and make their actions in a way consistent with
deductions about other players’ rational behavior in the future.
• The implementation of the Backwards Induction to games of perfect

information involves a computational method.
18
Backwards Induction. Computation
Backwards Induction. Computation in perfect information games

• First find optimising behavior at the the last decision nodes in the game.
• Then substitute those decision nodes by the expected payoff induced by
such optimising behavior.
• Repeat the same procedure in the resulting perfect information game.
• Note that the result of this procedure is a behavioral strategy.
19
Example 15
1
L R
2 2
a b c d
1
2, 1 0, 0 A B 1,3
4, 0 1, 4
• The optimal behavior as prescribed by backwards induction is A,
20
Example 15
1
L R
2 2
a b c d
2, 1 0, 0 4,0 1,3
• The optimal behavior as prescribed by backwards induction is A, a,
20
Example 15
1
L R
2
2,1 c d
4,0 1,3
• The optimal behavior as prescribed by backwards induction is A, a,
20
Example 15
1
L R
2
2,1 c d
4,0 1,3
• The optimal behavior as prescribed by backwards induction is A, a, d
20
Example 15
1
L R
2,1 1,3
• The optimal behavior as prescribed by backwards induction is A, a, d and L.
20
Example 15
1
L R
2,1 1,3
• The optimal behavior as prescribed by backwards induction is A, a, d and L.

• This corresponds to the behavioral strategy profile (A, a, d , L).
• Such a behavioral strategy profile is equivalent to the pure strategy profile
20
(LA, ad ).
Example 16
1
L R
2 N
1 1
a b 2 2
2
2, 1 0, 0 c d 0, 3
4, 0 2, 3
• Moves that conform with Backwards Induction: d ,
21
Example 16
1
L R
2 N
1 1
a b 2 2
2, 1 0, 0 2, 3 0, 3
• Moves that conform with Backwards Induction: d ,
21
Example 16
1
L R
N
1 1
2, 1 2 2
2, 3 0, 3
• Moves that conform with Backwards Induction: d , a, L.
21
Example 16
1
L R
2, 1 1, 3
• Moves that conform with Backwards Induction: d , a, L.

• This produces the behavioral strategy profile: (L, a, d ) .
• Which is equivalent to the pure strategy profile: (L, ad ).
21
Behavioral Strategies
Theorem 1 (Kuhn, 1957)

In any extensive form game with perfect recall, every probability distributions
on ending nodes induced by a mixed strategy profile can also be induced by
some behavioral strategy profile.
• The consequence is that, although mixed strategies are more general, there
is no loss of generality in working only with behavioral strategies.
22
Perfect vs. imperfect information
• In a normal form game, players take decisions simultaneously.
• In an extensive form game, players take decisions sequentially.
• A perfect information game is an extensive form game where players always

know all their opponents past moves.
• However, in general, a player might not know all the history of moves when it
is his turn to move.
23
Example 17 (A game with perfect information)
1
L R
2 2
a b c d
2, 1 0, 0 1, 3 1, 3
• Whenever player 2 has to move, she knows whether player 1 chose L or R .
24
Example 18 (A game without perfect information)
1
L R
2
a b a b
2, 1 0, 0 1, 3 1, 3
• When player 2 has to move, she does not knows whether player 1 chose L or
R.
• The dotted line is called an information set.
25
Definitions and Terminology
Extensive form game definition
Definition
The extensive form representation of a game specifies:
1. the players in the game,
2. when each player has the move,
3. if relevant, Nature’s moves and the corresponding probabilities attached to
each move of Nature,
4. what each player can do at each of her opportunities to move,
5. what each player knows at each of her opportunities to move,
6. the payoff received by each player for each combination of moves that could
be chosen by the players.
26
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• The game starts at the initial node (the open circle) and continues along the
branches according to Nature’s and the players’ moves.
• N represents Nature. 27
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• Black circles and the open circle are decision nodes.
27
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• Dotted lines represent information sets.
• Each information set is labelled by the player who moves at that information
set. 28
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• An information set contains the decision nodes that the player who moves at
that information set cannot differentiate between.
• Information sets can be singletons (i.e. consist of just one element). 28

N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• When player 1 has to move he does not know what has been Nature’s move.
(But he knows the probabilities.)
29
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• When player 2 has to move, he does not know whether player 1 chose L or R .
(But he knows the outcome of Nature’s move)
29
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• In his singleton information set, Player 3 knows Nature’s move, that player 1
chose R and that player 2 chose a.
29
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• At every information set the extensive form specifies the set of actions
available to the player that moves.
30
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• Note that decision nodes contained in the same information have the same
set of actions available.
• At every ending node there is an assignment of payoffs to players. 30

N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• There is a unique history of actions from the initial node to each decision
node.
31
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• Likewise, there is a unique history of actions from the initial node to each
ending node.
31
Extensive form games and subgame-perfect equilibrium
ECON2112: Week 4
DJ Thornton
Information Sets
Information Sets
• Information sets tell us when players are moving.
• An information set contains all the information that a player possesses when
he has to move.
• When a player moves at some information set, this player cannot distinguish
between decision nodes (in other words, the histories leading to the decision
nodes) contained in that information set.
• Every decision node inside the same information set must have the same set
of choices available.
1
Perfect Recall
Perfect Recall
We only consider extensive form games with perfect recall. Perfect recall means
that whenever a player has to move, he remembers all his previous moves and
whatever he knew before.
Extensive form that does not satisfy perfect recall:
1
L R
2 2
a b c d
1
e f e f
2
Subgames
Subgames
A subgame is a part of an extensive form game that could be considered as a
separate game. In particular:
• If the subgame contains a decision node x then it also contains the whole
information set that x belongs to.
• If the subgame contains a decision node x then it also contains every choice,
decision node, and final node that comes after x .
Example 1
Every extensive form is also a subgame of itself.
Definition 2 (Proper subgame)

A proper subgame is a subgame that is different from the entire game that
contains it. 3
Information Sets, Perfect Recall and Subgames
Example 3
1
L R
1 1
A B C D
2 2
a b a b c d c d
2, 1 − 2, 0 − 2, 0 − 1, 4 4, 1 0, 0 0, 0 1, 4
• This game has three subgames.
4
Information Sets, Perfect Recall and Subgames
Example 4 (A game without proper subgames)

1
L R
2
A B
1 A B
a b a b
4,1 1,4 1,2 0,2 3,1 2,2
• This extensive form game has only one subgame, which is the entire game.
• Therefore, this game has no proper subgames.
5
Strategies
Strategies
• We can distinguish the following types of strategies

Definition 5 (Pure Strategy)
In an extensive form game, a pure strategy is a plan of action for the entire
game, that tells the player which particular choice to take at every possible
information set.
Definition 6 (Mixed Strategy)
A mixed strategy is a probability distribution over the set of pure strategies.
Definition 7 (Behavioral Strategies)

In an extensive form game, a player’s behavioral strategy specifies at every
information set where he has to move a probability distribution over the
choices that follow. A behavioral strategy profile specifies at every information
set a probability distribution over the choices that follow. 6
Pure and mixed strategies
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0
• Player 1 set of pure strategies: S1 = {L, R }.
• Player 2 set of pure strategies: S2 = {a, b}.

7
• Player 3 set of pure strategies: S3 = {ec , ed , fc , fd }.
N
1 2
3 3
1
L R
2 L R
a b a b
3 3
2,1,2 3,1,0 e f c d c d c d
2,3,1 1,0,8 1,2,3 3,4,1 5,3,4 3,6,1 2,4,1 1,2,0

• The set of behavioral strategy profiles is made of all elements of the form:
(xL + (1 − x )R , ya + (1 − y )b, ze + (1 − z )f , wc + (1 − w )d )
where 0 ≤ x ≤ 1, 0 ≤ y ≤ 1, 0 ≤ z ≤ 1, and 0 ≤ w ≤ 1.
8
Nash equilibrium
Nash Equilibrium

The Nash equilibrium of an extensive form game is the Nash equilibrium of its
normal form representation.
Therefore, we need to:
1. Compute the normal form representation.
2. Compute the set of Nash equilibria of that normal form.
9
Nash Equilibrium in Extensive Form Games
Example 9 (Two equivalent representations)
1
T B
2
L R L R
L R
3, 1 0, 0 0, 0 1, 3 T 3, 1 0, 0
B 0, 0 1, 3
• This game has 3 Nash equilibria, (T , L), (B , R ), and ( 34 T + 41 B , 14 L + 43 R )
10
Nash Equilibrium in Extensive Form Games
Example 10
1
Out In
1
2,5 T B
2
L R L R L R
OutT 2, 5 2, 5
3, 1 0, 0 0, 0 1, 3 OutB 2, 5 2, 5
InT 3, 1 0, 0
InB 0, 0 1, 3
• However, when the extensive-form game has subgames, there is another
(stricter) equilibrium concept that we can use.
11
Backwards Induction
Backwards Induction
Backwards Induction
Players should make their choices in a way consistent with deductions about
other players’ rational behavior in the future.
• How can we apply the principle of backwards induction in extensive form

games?
12
Backwards Induction
Backwards Induction

games?
• To respond to that, we have to make precise what “rational behavior in the

future” means.
12
Backwards Induction
Backwards Induction

games?
• To respond to that, we have to make precise what “rational behavior in the

future” means.
• One possibility is to require a Nash equilibrium in every subgame.
12
Subgame Perfect Equilibrium
Definition 11 (Subgame Perfect Equilibrium)

A strategy profile is a Subgame Perfect Equilibrium of an extensive form game if
it induces a Nash equilibrium in every subgame.

• In games of perfect information, it is the same as backwards induction.
13


• It is computed by first resolving the last subgames in the game.
13


• Then we substitute the subgames by the expected payoff induced by the
Nash equilibria of the subgame.
13


• Then we substitute the subgames by the expected payoff induced by the
Nash equilibria of the subgame.
• And we keep resolving last subgames in the same way until we solve the
entire game
13
Example 12
1
Out In
1
2,5 T B
2
L R L R
3, 1 0, 0 0, 0 1, 3
• The last subgame has three Nash equilibria, (T , L), (B , R ) and
T + 41 B , 14 L + 43 R .
!3 "
4
14
Example 12
1
Out In
2,5 3, 1

T + 41 B , 14 L + 43 R .
!3 "
4
• If players play (T , L) in the subgame, we obtain the SPE (In, T , L).

14
Example 13
1
Out In
1
2,5 T B
2
L R L R
3, 1 0, 0 0, 0 1, 3
T + 41 B , 14 L + 43 R .
!3 "
4
15
Example 13
1
Out In
2,5 1, 3

T + 41 B , 14 L + 43 R .
!3 "
4
• If players play (B , R ) in the subgame, we obtain the SPE (Out , B , R ).

15
Example 14
1
Out In
1
2,5 T B
2
L R L R
3, 1 0, 0 0, 0 1, 3
T + 41 B , 14 L + 43 R .
!3 "
4
16
Example 14
1
Out In
2,5 3 3
,
4 4

T + 41 B , 14 L + 43 R .
!3 "
4
• If players play 34 T + 41 B , 14 L + 43 R in the subgame, we obtain the SPE

! "
Out , 34 T + 41 B , 14 L + 43 R .
! "
16
Example 15
1
L R
1 1
A B C D
2 2
a b a b c d c d
1, 1 − 2, 0 − 2, 0 − 1, 3 3, 1 0, 0 0, 0 1, 3
17
Example 15
1
L R
1 1
A B C D
2 2
a b a b c d c d
1, 1 − 2, 0 − 2, 0 − 1, 3 3, 1 0, 0 0, 0 1, 3
• The subgame in the left has three Nash equilibria
17
Example 15
1
L R
1 1
A B C D
2 2
a b a b c d c d
1, 1 − 2, 0 − 2, 0 − 1, 3 3, 1 0, 0 0, 0 1, 3

• The subgame in the right has three Nash equilibria
17
Example 15
1
L R
1 1
A B C D
2 2
a b a b c d c d
1, 1 − 2, 0 − 2, 0 − 1, 3 3, 1 0, 0 0, 0 1, 3

• The subgame in the right has three Nash equilibria
• Therefore, there are at least nine subgame perfect equilibria. 17
SPE in perfect information games
Example 16
1
L R
2 2
a b c d
1
2, 1 0, 0 A B 1, 3
4, 0 1, 4
• This game has 4 subgames.

• The last subgames are trivial 1-player games.
18
Example 16
1
L R
2 2
a b c d
2, 1 0, 0 4, 0 1, 3

18
Example 16
1
L R
2
2, 1 c d
4, 0 1, 3

18
Example 16
1
L R
2, 1 1, 3

• We keep solving the game in the same fashion. 18
Example 16
1
L R
2, 1 1, 3

• We keep solving the game in the same fashion. 18
Subgame Perfect Equilibrium. Properties.

• Every subgame perfect equilibrium is a Nash equilibrium.
• Not every Nash equilibrium is subgame perfect.
• However, subgame perfection has no bite if the extensive form game does
not have proper subgames.
19
Applications
Applications
Stackelberg competition
Stackelberg model of duopoly competition.

• Two firms, 1 and 2, choose quantities.
20

• The unit cost of production for both firms is constant and equal to c
20

• The inverse demand function is
P = P (Q ) = a − Q
20

• The inverse demand function is
P = P (Q ) = a − Q
• As opposed to Cournot Competition where quantities are set simultaneously,

firm 1 chooses quantity first, then firm 2 observes the quantity chosen by
firm 1 and then chooses how much to produce.
20
Stackelberg competition
• It is a sequential move game.
• We have to compute the subgame perfect equilibrium of the game.
• We start analysing the last subgames.
21
Last stages
• Suppose firm 1 chose q1 = q¯1 .
22
Last stages
• Firm 2 observes this and maximizes:
π2 (q̄1 , q2 ) = (a − (q̄1 + q2 ))q2 − cq2 .
22
Last stages
π2 (q̄1 , q2 ) = (a − (q̄1 + q2 ))q2 − cq2 .
• Therefore, upon observing q̄1 , firm 2 will choose:
a − q̄1 − c
q2∗ (q̄1 ) = .
2
22
Last stages
π2 (q̄1 , q2 ) = (a − (q̄1 + q2 ))q2 − cq2 .
• Therefore, upon observing q̄1 , firm 2 will choose:
a − q̄1 − c
q2∗ (q̄1 ) = .
2
• Note that a strategy for firm 2 is a function q2∗ : [0, ∞) → [0, ∞) such that, given
a quantity produced by firm 1, q1 , tells how much to produce, q2∗ (q1 ).
22
First stage
• Firm 1 knows that if he produces q1 firm 2 will produce according to q2∗ (q1 ).
23
First stage
• Firm 1 will choose q1 to maximize
π1 (q1 ) = (a − (q1 + q2∗ (q1 )))q1 − cq1 .
i.e.
# # $$
a − q1 − c
π1 (q1 ) = a − q1 + q1 − cq1 .
2
23
First stage
• Firm 1 will choose q1 to maximize
π1 (q1 ) = (a − (q1 + q2∗ (q1 )))q1 − cq1 .
i.e.
# # $$
a − q1 − c
π1 (q1 ) = a − q1 + q1 − cq1 .
2
• Firm 1 will choose:

dπ1 (q1 ) a−c
= 0 −→ q1∗ = .
dq1 2
23
Notice the conceptual difference:

• Subgame perfect equilibrium strategies:
a−c
q1∗ =
2
∗ a − q1 − c
q2 ( q1 ) = .
2
• Subgame perfect equilibrium outcome:

a−c
q1∗ =
2
a−c
q2∗ (q1∗ ) =
4
24
Applications
Bargaining
Bargaining
A model of bargaining
Players 1 and 2 are bargaining over a dollar. They alternate making offers. In the
first stage, player 1 offers a split (s1 , 1 − s1 ) of the dollar to player 2. Player 2 can
either accept, in which case the game would end, or reject in which case the
game would continue to the second stage. In the second stage, player 2 offers a
split (s2 , 1 − s2 ) of the dollar to player 1. Player 2 can either accept, in which case
the game would end, or reject in which case the game would continue to the
third stage. In the third stage a settlement (s, 1 − s) is given exogenously and
the game ends. Players are impatient and have a discount factor equal to δ < 1.
25
Bargaining
t=3: payoffs are (s, 1 − s)
26
Bargaining
t=2: player 1 accepts any split (s2 , 1 − s2 ) such that s2 ≥ δs.
26
Bargaining
0.1 If player 2 offers s2 = δs, player 1 accepts and payoffs are (δs, 1 − δs).
26
Bargaining
0.2 If player 2 offers s2 < δs, player 1 rejects and payoffs are (δs, δ(1 − s)).
26
Bargaining
0.2 If player 2 offers s2 < δs, player 1 rejects and payoffs are (δs, δ(1 − s)).
0.3 Therefore, player 2 proposes a split (δs, 1 − δs).
26
Bargaining
t=1: player 2 accepts any split (s1 , 1 − s1 ) such that 1 − s1 ≥ δ(1 − δs).
27
Bargaining
0.1 If player 1 offers 1 − s1 = δ(1 − δs), player 2 accepts and payoffs are
(1 − δ(1 − δs), δ(1 − δs)).
27
Bargaining
(1 − δ(1 − δs), δ(1 − δs)).
0.2 If player 1 offers 1 − s1 < δ(1 − δs), player 2 rejects and payoffs are
(δ2 s, δ(1 − δs)).
27
Bargaining
(1 − δ(1 − δs), δ(1 − δs)).
(δ2 s, δ(1 − δs)).
0.3 Therefore, player 1 proposes a split (1 − δ(1 − δs), δ(1 − δs))
27
Bargaining
(1 − δ(1 − δs), δ(1 − δs)).
(δ2 s, δ(1 − δs)).
0.3 Therefore, player 1 proposes a split (1 − δ(1 − δs), δ(1 − δs))
In the subgame perfect equilibrium, payoffs are (1 − δ(1 − δs), δ(1 − δs)).
27
Repeated Games
ECON2112: Week 5
DJ Thornton
1
Table of contents
1. Introduction
2. Finitely Repeated Prisoner’s Dilemma
3. Infinitely Repeated Prisoner’s Dilemma
2
Introduction
Prisoner’s Dilemma
The unique equilibrium in the Prisoner’s Dilemma is (B, R).
L R
T 10, 10 0, 11
B 11, 0 3, 3
3
Prisoner’s Dilemma
The unique equilibrium in the Prisoner’s Dilemma is (B, R).
L R
T 10, 10 0, 11
B 11, 0 3, 3
We want to investigate whether repetition can lead to cooperation.
3
Twice Repeated Prisoner’s Dilemma
Consider the following twice-repeated game.
4
L R
1. Players play T 10, 10 0, 11
B 11, 0 3, 3
4
L R
B 11, 0 3, 3
2. Players observe which action combination has been played.
4
L R
B 11, 0 3, 3
2. Players observe which action combination has been played.
L R
B 11, 0 3, 3
4
What is the subgame perfect equilibrium of the twice repeated Prisoner’s Dilemma?
5
• Go to the second stage.
• It does not matter what was played in the first stage, we have a subgame that
resembles the prisoners dilemma.
• Prisoners dilemma:
L R
T 10, 10 0, 11
B 11, 0 3, 3
5
• If in the first stage (T , L) was played, the subgame is
L R
T 20, 20 10, 21
B 21, 10 13, 13
• And the Nash equilibrium of the subgame is (B, R).

5
• If in the first stage (T , R) was played, the subgame is
L R
T 10, 21 0, 22
B 11, 11 3, 14

5
• If in the first stage (B, L) was played, the subgame is
L R
T 21, 10 11, 11
B 22, 0 14, 3

5
• If in the first stage (B, R) was played, the subgame is
L R
T 13, 13 3, 14
B 14, 3 6, 6

5
• Go now to the first stage and solve the game obtaining by replacing each subgame
with its corresponding equilibrium payo↵
L R
T 13, 13 3, 14
B 14, 3 6, 6
6
L R
T 13, 13 3, 14
B 14, 3 6, 6
• The unique Nash equilibrium is (B, R).
6
L R
T 13, 13 3, 14
B 14, 3 6, 6
• Therefore, in the twice repeated Prisoner’s Dilemma players play (B, R) twice.
6
L R
T 13, 13 3, 14
B 14, 3 6, 6
• Therefore, in the twice repeated Prisoner’s Dilemma players play (B, R) twice.
• We cannot obtain cooperation.
6
Finitely Repeated Prisoner’s
Dilemma
Finitely Repeated Prisoner’s Dilemma: T repetitions
• Let T be a finite integer.
7

• If the Prisoner’s Dilemma is played T times then (B, R) is played in every stage:
7

• Go to the T th stage: Whatever has been played does not matter. The Nash
equilibrium of the subgame is (B, R).
7

• Go to the (T 1)th stage: Whatever has been played does not matter, and in the
next stage players will always play (B, R). The Nash equilibrium of the subgame is
(B, R).
7

(B, R).
• [. . .]
7

(B, R).
• [. . .]
• Go to the first stage. Players will play (B, R).
7

(B, R).
• [. . .]
• Go to the first stage. Players will play (B, R).
• We cannot hope for cooperation if the Prisoner’s Dilemma is played a finite

number of times. 7
Repeated Games
• No matter how often this game is repeated (as long as this is a finite number of
times).
• There is only one equilibrium: Play the one-shot equilibrium at every stage.
8
Repeated Games
times).
• Reason: The last stage becomes of predominant importance.
8
Repeated Games
times).
• The players know that they will always play the one-shot equilibrium in the last
stage.
8
Repeated Games
times).
stage.
• The second to the last round will be treated as a single game where they play the
one-shot equilibrium.
• etc. . .
8
Repeated Games
times).
stage.
• The second to the last round will be treated as a single game where they play the
one-shot equilibrium.
• etc. . .
• The game unravels completely to the beginning.

8
Infinitely Repeated Prisoner’s
Dilemma
Infinitely Repeated Prisoner’s Dilemma
• In most actual situations one cannot exclude the possibility of meeting the
opponents once more.
9
• Hence, a model in which the exact number of repetitions is known in advance is

unrealistic.
9
• Hence, a model in which the exact number of repetitions is known in advance is

unrealistic.
• Infinitely repeated games o↵er a better approximation to model long term

competition.
9
What is a player’s total payo↵ in an infinitely repeated game?
10
• Suppose that players play (B, R) in every stage.
10
• That means that each player gets payo↵ 3 in every stage.
10
• But there are infinitely many stages.
10
10
• We will solve this by discounting the future. Let 2 [0, 1) be the discount factor.
10
• A payo↵ equal to 3 in the second stage is equivalent to a payo↵ equal to 3 in the

first stage.
10
• A payo↵ equal to 3 in the second stage is equivalent to a payo↵ equal to 3 in the

first stage.
• A payo↵ equal to 3 in the third stage is equivalent to a payo↵ equal to 3 2 in the

first stage. 10
Aside: Sum of a Geometric Series
Geometric Series
The sum of a geometric series is computed as follows:
2 3 t
M =1+ + + + ... + + ...
11
Geometric Series
2 3 t
M =1+ + + + ... + + ...
2 3 t
= 1 + (1 + + + + ... + + . . .)
11
Geometric Series
2 3 t
M =1+ + + + ... + + ...
2 3 t
= 1 + (1 + + + + ... + + . . .)
=1+ M
11
Geometric Series
2 3 t
M =1+ + + + ... + + ...
2 3 t
= 1 + (1 + + + + ... + + . . .)
=1+ M
1
=) M = .
1
11
Geometric Series
2 3 t
M =1+ + + + ... + + ...
2 3 t
= 1 + (1 + + + + ... + + . . .)
=1+ M
Note the above derivation is only valid when | | < 1.
11

Players play infinitely many times:
L R
T 10, 10 0, 11
B 11, 0 3, 3
• Note that there does not exist a last stage.
• Can we support cooperation ((T , L) in every stage) as a Subgame Perfect

Equilibrium?
12

Players play infinitely many times:
L R
T 10, 10 0, 11
B 11, 0 3, 3
• Note that there does not exist a last stage.
• Can we support cooperation ((T , L) in every stage) as a Subgame Perfect

Equilibrium?
• For that we need to specify what would happen if a player deviates, i.e. does not
cooperate in some stage.
12
L R
Players play infinitely many times: T 10, 10 0, 11
B 11, 0 3, 3
10
• If players cooperate in every stage, the total payo↵ for each of them is 1 .
13
L R
B 11, 0 3, 3
10
• We want to deter deviations from playing (T , L) in every stage.
13
L R
B 11, 0 3, 3
10
• We want to deter deviations from playing (T , L) in every stage.
• A deviation starts a subgame. We have to propose a Nash equilibrium (actually, a

sugbame perfect equilibrium) for this subgame that renders the deviation
unprofitable.
13
L R
B 11, 0 3, 3
• Consider the following strategy profile: Play (T , L) for ever unless a player
deviates, if a player deviates play (B, R) for ever.
14
L R
B 11, 0 3, 3
10
• If nobody deviates payo↵s are 1 for each player.
14
L R
B 11, 0 3, 3
10
• If player 1 deviates plays B in the first stage he obtains

3
11 + .
1
14
L R
B 11, 0 3, 3
10
• If player 1 deviates plays B in the first stage he obtains

3
11 + .
1
• Therefore, player 1 will not deviate in the first stage if:
10 3
11 + . 14
1 1
10 3
11 +
1 1
15
10 3
11 +
1 1
()
1
8
15
10 3
11 +
1 1
()
1
8
• i.e. a player will not deviate if he is sufficiently patient.
15
10 3
11 +
1 1
()
1
8
• (The discount factor is normally considered to be very close to 1.)
15
10 3
11 +
1 1
()
1
8
• (The discount factor is normally considered to be very close to 1.)
1
• If the discount factor is strictly larger than 8 we do not need to punish the
deviator for ever.
15
L R
B 11, 0 3, 3
Note:
• If a player does not want to deviate in the first stage, then he does not want to
deviate in any stage.
16
L R
B 11, 0 3, 3
Note:
• In the described equilibrium we do not observe deviations nor punishments.
• This is because punishments are design so that no player deviates.
16
L R
B 11, 0 3, 3
Note:
• In the described equilibrium we do not observe deviations nor punishments.
• This is because punishments are design so that no player deviates.
• Cooperation and then punishment if somebody deviates is one equilibrium. Note
that players playing (B, R) for ever is also a subgame perfect equilibrium.
• (In general, in any finitely of infinitely repeated game playing the one shot game
equilibrium in every stage is always a SPE.) 16
Finitely repeated (modified) Prisoner’s Dilemma
• It has been argued that the Prisoner’s Dilemma gives a distorted image of
repeated games.
17
repeated games.
• Two important reasons
17
repeated games.
• It has a unique Nash equilibrium.
17
repeated games.
• The unique Nash equilibrium payo↵ coincides with the payo↵ that both players
would obtain if they want to punish each other.
17
repeated games.
• The unique Nash equilibrium payo↵ coincides with the payo↵ that both players
would obtain if they want to punish each other.
• In other words. The only way of punishing your opponent is to play the unique
one-shot Nash equilibrium.
17
Repeated Games
Consider the following modification of the Prisoner’s Dilemma
L R RR
T 10, 10 0, 11 2, 0
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0
• We have added strategies BB and RR.
• T and L are still strictly dominated strategies.
• The modified game has now 3 Nash equilibria, (R, B), (BB, RR), and
( 14 B + 34 BB, 14 R + 34 RR).
• For the purposes of the example let us focus in the two pure Nash equilibria. 18
Can we sustain cooperation, (T , L), in the first stage in a SPE?
L R RR
T 10, 10 0, 11 2, 0
Players play twice
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0
Can we sustain cooperation?

• In the second stage players must play a Nash equilibrium of the modified Prisoners
Dilemma.
19
L R RR
T 10, 10 0, 11 2, 0
Players play twice
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0

Dilemma.
• Consider the following strategy profile: Play (T , L) in the first stage, play (B, R)
in the second stage if no player deviated in the first stage, and play (BB, RR) in
the second stage if some player deviated in the first stage.
19
L R RR
T 10, 10 0, 11 2, 0
Players play twice
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0

Dilemma.
• Payo↵ under this strategy profile if nobody deviates: 10 + 3
• Payo↵ to a player if he deviates in the first stage: 11 + 0 19
L R RR
T 10, 10 0, 11 2, 0
Players play twice
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0

Dilemma.
• Payo↵ under this strategy profile if nobody deviates: 10 + 3
• Payo↵ to a player if he deviates in the first stage: 11 + 0 19
L R RR
T 10, 10 0, 11 2, 0
Players play twice
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0

Dilemma.
• The described strategy profile is a SPE.
19
Can we sustain cooperation, (T , L), in the first T 1 stages?
L R RR
T 10, 10 0, 11 2, 0
Players play T times
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0

• In the last stage players must play a Nash equilibrium of the modified Prisoners
Dilemma.
• Consider the following strategy profile: Play (T , L) in the first T 1 stages, play
(BB, RR) for at least one period after a deviation, play (B, R) in the T th stage if
no player deviated in the T 1th stage.
20
L R RR
T 10, 10 0, 11 2, 0
Players play T times
B 11, 0 3, 3 1, 0
BB 0, 2 0, 1 0, 0

• In the last stage players must play a Nash equilibrium of the modified Prisoners
Dilemma.
• Consider the following strategy profile: Play (T , L) in the first T 1 stages, play
(BB, RR) for at least one period after a deviation, play (B, R) in the T th stage if
no player deviated in the T 1th stage.
• The described strategy profile is a SPE.
20
Repeated Games
Folk Theorem (very informal, Friedman 1971)

Under mild conditions on the one-stage game, players can (rationally) sustain high
long-run payo↵s in the repeated game by means of a “gentlemen’s agreements”.
21
Repeated Games (Additional Examples)
ECON2112: Week 5
DJ Thornton
1
Table of contents
1. Repeated Bertrand Competition
2. Repeated Cournot Competition
3. Environmental Agreements
4. International Trade
2
Repeated Bertrand Competition
• Two firms, 1 and 2 name prices simultaneously
• For a given pi and pj (j 6= i), demand for firm i’s product is:
8
>
< a pi , pi < pj
>
Q = a 2pi , pi = pj
>
>
:
0, pi > pj
• Marginal costs are c < a for both firms
a+c
• Monopoly price is pm = 2
• Consider the infinitely repeated game based on this stage game

3
• Can the monopoly price be sustained in a subgame perfect equilibrium?
• In other words, can repeated competition lead to collusion?
• Yes, if punishment and rewards are appropriately designed and if players are
patient.
4
Grim Trigger Strategy
• Consider any time t. There are two possible histories.
1. A player deviated from the cooperative strategy (p1 , p2 ) = (pm , pm ) at some time
prior to t.
2. No player has deviated from the cooperative strategy.
• If player 2 observes that player 1 has deviated from the cooperative strategy,
player 2 plays p2 = c in all future periods. A mutual best-response from player 1’s
is to also play p1 = c in all future periods.
• If neither player has deviated, both players continue to play pm . We need to check
this is a mutual best response.
5
• Suppose player 2 plays the trigger strategy and that no player has deviated up
until time t. If player 1 plays p1 = pm ✏ at time t, (for ✏ arbitrarily small), their
profit is
(a c)2
+ 0 + 0 + ...
4
• Alternatively, playing p1 = pm will yield a lifetime payo↵ of

(a c)2 (a c)2 2 (a c)2
+ + + ...
8 8 8
• So player 1 plays pm if and only if

(a c)2 (a c)2 1
() .
8(1 ) 4 2
6
1
• If 2, then the grim trigger strategy is a Nash equilibrium.
• In fact, it is a subgame perfect Nash equilibrium. The two types of subgames are:
1. Outcomes of earlier stages have been (pm , pm ), or
2. At least one earlier stage di↵ered from (pm , pm ).
• In case 1., continuing to play the grim trigger strategy is a NE in the subgame. In
case 2., playing (c, c) in all future stages is a NE in the subgame.
• Thus the grim trigger strategy is subgame perfect.
7
Repeated Cournot Competition
Repeated Cournot Competition (Exercise)
• Section 2.3.C (Gibbons): Collusion between Cournot Duopolists
• Firm 1 chooses q1 and Firm 2 chooses q2 (simultaneously)
• Inverse demand: P = a Q where Q = q1 + q2 .
a c
• Monopoly quantity is qm = 2 .
• Consider the infinitely repeated game based on this stage game– can the
monopoly quantity be sustained in a SPE?
8
Environmental Agreements
• Two countries, 1 and 2.
• Emission Ei 2 {10, 20}
20 10
(Ei +Ej )2
• Net benefit 40Ei 2 20 0, 0 350, 50
10 50, 350 200, 200
• Resembles a Prisoner’s dilemma.
• Ei = 20 is a dominant strategy.
• (E1 , E2 ) = (20, 20) is the unique NE in a one-shot game.
3
• (E1 , E2 ) = (10, 10) can be sustained if 7.
9
International Trade
Setting up the game
• Two countries 1 and 2
• Two firms: A (in country 1) and B (in country 2).
• Demand in country i 2 {1, 2} is Pi = 18 Qi .
• Constant marginal costs: cA = cB = c = 6.
• Ti : tari↵ imposed by government of country i (on imports)
• Simplifying assumption: Ti 2 {0, 20} – either free trade (Ti = 0) or prohibitive

tari↵ (Ti = 20).
10
Setting up the game
• There are four players– two governments and two firms.
• Write FT (Free trade) and PT (Prohibitive Tari↵) for the strategy of each
government.
• Write (qi1 , qi2 ) 2 [0, 1)2 for the strategy of firm i 2 {A, B}.
• Payo↵s exhibit tradeo↵: profits for firms vs. welfare for government.
Think of this as a dynamic game:
• In stage 1, government set tari↵s.
• In stage 2, firms engage in quantity competition.

11
Subgame perfect equilibrium
Consider the second stage. Three things could have happened in the first stage:
• Both countries adopt FT =) Cournot duopoly in each market
• Both countries adopt PT =) Monopoly in each market
• 1 adopts FT , 2 adopts PT (or vice versa) =) duopoly in 1, monopoly in 2
Now we work out the stage 2 equilibrium for all possible outcomes in stage 1.
12
Suppose both countries adopt FT .
• Country 1
• Equilibrium quantities are qA1 = qB1 = 4, profits are ⇡A1 = ⇡B1 = 16.
Q12
• Aggregate output: Q1 = 4 + 4 = 8, consumer surplus is CS1 = 2 = 32.
• Country 2 is identical.
FT PT
Profits are: ⇡A = ⇡A1 + ⇡A2 = 32 and ⇡B = ⇡B1 + ⇡B2 = 32. FT 64, 64 ,
PT , ,
Welfare is W1 = CS1 + ⇡A = 64, and W2 = CS2 + ⇡B = 64.
13
Suppose both countries adopt PT .
• Country 1
• Equilibrium quantities are qA1 = 6, qB1 = 0, profits are ⇡A1 = 36, ⇡B1 = 0.
Q12
• Country 2 is identical but replace 1 with 2 and B with A.

FT PT
PT , 54, 54
14
Suppose Country 1 adopts FT and 2 adopts PT .
• Country 1
Q12
• Country 2
Q22
Profits are: ⇡A = ⇡A1 + ⇡A2 = 16 and ⇡B = ⇡B1 + ⇡B2 = 52.
Welfare is W1 = CS1 + ⇡A = 48, and W2 = CS2 + ⇡B = 70. 15

FT PT
Prisoner’s dilemma strikes again! FT 64, 64 48, 70
PT 70, 48 54, 54
• Stage 1 is a game between two governments.
• SPE outcome is for both firms to choose PT in stage 1, and each firm to sell
monopoly quantity in its own market.
Now suppose countries play the two-stage game infinitely many times. Can they come
to a (tacit) free-trade agreement?
Check that there is an SPE in which countries play a trigger strategy and check that
3
(FT , FT ) can be sustained for 8.
16
Repeated Games (Additional Examples)
ECON2112: Week 5
DJ Thornton
1
Table of contents
1. Repeated Bertrand Competition
2. Repeated Cournot Competition
3. Environmental Agreements
4. International Trade
2
• Two firms, 1 and 2 name prices simultaneously
• For a given pi and pj (j 6= i), demand for firm i’s product is:
8
>
< a pi , pi < pj
>
Q = a 2pi , pi = pj
>
>
:
0, pi > pj
a+c
• Monopoly price is pm = 2
• Consider the infinitely repeated game based on this stage game

3
• Can the monopoly price be sustained in a subgame perfect equilibrium?
• In other words, can repeated competition lead to collusion?
• Yes, if punishment and rewards are appropriately designed and if players are
patient.
4
• Consider any time t. There are two possible histories.
1. A player deviated from the cooperative strategy (p1 , p2 ) = (pm , pm ) at some time
prior to t.
2. No player has deviated from the cooperative strategy.
• If player 2 observes that player 1 has deviated from the cooperative strategy,
player 2 plays p2 = c in all future periods. A mutual best-response from player 1’s
is to also play p1 = c in all future periods.
• If neither player has deviated, both players continue to play pm . We need to check
this is a mutual best response.
5
• Suppose player 2 plays the trigger strategy and that no player has deviated up
until time t. If player 1 plays p1 = pm ✏ at time t, (for ✏ arbitrarily small), their
profit is
(a c)2
+ 0 + 0 + ...
4
• Alternatively, playing p1 = pm will yield a lifetime payo↵ of

(a c)2 (a c)2 2 (a c)2
+ + + ...
8 8 8
• So player 1 plays pm if and only if

(a c)2 (a c)2 1
() .
8(1 ) 4 2
6
1
• If 2, then the grim trigger strategy is a Nash equilibrium.
• In fact, it is a subgame perfect Nash equilibrium. The two types of subgames are:
1. Outcomes of earlier stages have been (pm , pm ), or
2. At least one earlier stage di↵ered from (pm , pm ).
• In case 1., continuing to play the grim trigger strategy is a NE in the subgame. In
case 2., playing (c, c) in all future stages is a NE in the subgame.
• Thus the grim trigger strategy is subgame perfect.
7
Repeated Cournot Competition
Repeated Cournot Competition (Exercise)
• Section 2.3.C (Gibbons): Collusion between Cournot Duopolists
• Firm 1 chooses q1 and Firm 2 chooses q2 (simultaneously)
• Inverse demand: P = a Q where Q = q1 + q2 .
a c
• Monopoly quantity is qm = 2 .
• Consider the infinitely repeated game based on this stage game– can the
monopoly quantity be sustained in a SPE?
8
• Two countries, 1 and 2.
• Emission Ei 2 {10, 20}
20 10
(Ei +Ej )2
• Net benefit 40Ei 2 20 0, 0 350, 50
10 50, 350 200, 200
• Resembles a Prisoner’s dilemma.
• Ei = 20 is a dominant strategy.
• (E1 , E2 ) = (20, 20) is the unique NE in a one-shot game.
3
• (E1 , E2 ) = (10, 10) can be sustained if 7.
9
International Trade
Setting up the game
• Two countries 1 and 2
• Two firms: A (in country 1) and B (in country 2).
• Demand in country i 2 {1, 2} is Pi = 18 Qi .
• Constant marginal costs: cA = cB = c = 6.
• Ti : tari↵ imposed by government of country i (on imports)
• Simplifying assumption: Ti 2 {0, 20} – either free trade (Ti = 0) or prohibitive

tari↵ (Ti = 20).
10
Setting up the game
• There are four players– two governments and two firms.
• Write FT (Free trade) and PT (Prohibitive Tari↵) for the strategy of each
government.
• Write (qi1 , qi2 ) 2 [0, 1)2 for the strategy of firm i 2 {A, B}.
• Payo↵s exhibit tradeo↵: profits for firms vs. welfare for government.
Think of this as a dynamic game:
• In stage 1, government set tari↵s.
• In stage 2, firms engage in quantity competition.

11
Consider the second stage. Three things could have happened in the first stage:
• Both countries adopt FT =) Cournot duopoly in each market
• Both countries adopt PT =) Monopoly in each market
• 1 adopts FT , 2 adopts PT (or vice versa) =) duopoly in 1, monopoly in 2
Now we work out the stage 2 equilibrium for all possible outcomes in stage 1.
12
Suppose both countries adopt FT .
• Country 1
Q12
• Country 2 is identical.
FT PT
PT , ,
13
Suppose both countries adopt PT .
• Country 1
Q12
• Country 2 is identical but replace 1 with 2 and B with A.

FT PT
PT , 54, 54
14
Suppose Country 1 adopts FT and 2 adopts PT .
• Country 1
Q12
• Country 2
Q22
Profits are: ⇡A = ⇡A1 + ⇡A2 = 16 and ⇡B = ⇡B1 + ⇡B2 = 52.
Welfare is W1 = CS1 + ⇡A = 48, and W2 = CS2 + ⇡B = 70. 15

FT PT
Prisoner’s dilemma strikes again! FT 64, 64 48, 70
PT 70, 48 54, 54
• Stage 1 is a game between two governments.
• SPE outcome is for both firms to choose PT in stage 1, and each firm to sell
monopoly quantity in its own market.
Now suppose countries play the two-stage game infinitely many times. Can they come
to a (tacit) free-trade agreement?
Check that there is an SPE in which countries play a trigger strategy and check that
3
(FT , FT ) can be sustained for 8.
16
Games of Incomplete Information (Bayesian Games)
ECON2112: Week 7
DJ Thornton
1
Table of contents
1. Introduction to incomplete information
2. Static games of incomplete information
3. Let’s go for a drink! (version 1)
4. Let’s go for a drink! (version 2)
2
Incomplete Information
• Games of incomplete information:
• Static:
I don’t know who you really are—though I have some idea.
• Dynamic:
I don’t know who you really are—though I have some idea and I see what you did.
3
Introduction to incomplete
information
A robbery
• A robber with a gun asks for your wallet

Y
g ng
R R
s n s n
(0, 1) (2, 4) (0, 1) (4, 2)
4
A robbery
• A robber with a gun asks for your wallet

Y
g ng
R R
s n s n
(0, 1) (2, 4) (0, 1) (4, 2)
• Unique SPNE: (ng , n, n)

4
A robbery
• What if the robber does not mind killing you?

Y
g ng
R R
s n s n
(0, 3) (2, 4) (0, 3) (4, 2)
5
A robbery
• What if the robber does not mind killing you?

Y
g ng
R R
s n s n
(0, 3) (2, 4) (0, 3) (4, 2)
• Unique SPNE: (g , n, s)
5
A robbery
• Do you know what robbers really care about?

N
p 1 p
g ng g ng
R R R R
s n s n s n s n
(0, 3) (2, 4) (0, 3) (4, 2) (0, 1) (2, 4) (0, 1) (4, 2)
6
From imperfect to incomplete information
• We represented robbery as a game of imperfect information
• We can think of it in an alternative way:
• There are two types of robber: good and bad—t 2 {g , b}
• Robber’s type is her private information
• The prior probability of t = b, p, is common knowledge—Pr (b) = p 2 (0, 1)
7
From imperfect to incomplete information
• We represented robbery as a game of imperfect information
• We can think of it in an alternative way:
• There are two types of robber: good and bad—t 2 {g , b}
• Robber’s type is her private information
• The prior probability of t = b, p, is common knowledge—Pr (b) = p 2 (0, 1)
• This is a game of incomplete information—we will learn to deal with them as

Bayesian games
7
A matter of language
• Sometimes it is not-so-intuitive to talk of types when we talk of private

information
• E.g. your grade is either 85 or 35. The lecturer knows it (it is her private
information), but it’s not really her type
• A change of language may convince the skeptics:
• There are two states: good and bad—✓ 2 {g , b}
• The state is Robber’s private information
• The prior probability of ✓ = b, p, is common knowledge—Pr (✓) = p 2 (0, 1)
8
Static games of incomplete
information
Static games of incomplete information
• We begin with static games; normal form representation will be our focus for now
• What do we need?
• Players
• Actions (or choices) they can take
• Types for each player, representing all possible di↵erent information they can
privately know and that a↵ects payo↵s (this way includes “states”)
• Payo↵s that depend both on actions and types (potentially on the type of other
players)
• A prior probability distribution over types

9
Prior and beliefs (technical note)
• In general, we will need to specify beliefs that players have
• A belief is a probability distribution over all the nodes in an information set
• In static games, this complication arises only if my type tells me something about
the other player’s type:
If good lecturers have good students, then if I am a good lecturer I must believe...
10
Prior and beliefs (technical note)
• Call the prior distribution p (e.g., p (1) = Pr (t = 1) and so on)
• By Bayes’ rule the belief pi (t i | ti ) that player i of type ti has about i’s type is
given by
p (t i , ti )
pi (t i | ti ) =
p (ti )
Pr (ti | t i ) p (t i )
=P
z2T i Pr (ti | z) p (z)
• But if types are independent, pi (t i | ti ) = p (t i ), so beliefs = prior
11
Static games of incomplete info: some examples
• The Prisoner’s Dilemma, with two possible types for one or both players
• Each prisoner can be of type “snitch” or “no snitch”: t 2 {s, n}
• If ti = s, payo↵ are as normal. If ti = n, payo↵s are such that the prisoner prefers to
deny if the other is denying
• Each player’s type is their private information
• Prior distribution over types is common knowledge
12
• Battle of Sexes, with two possible types for one or both players
• Player 1: same as in complete info Battle of Sexes
• Player 2: two di↵erent types:
• One type wants to meet player 1
• The other type wants to avoid player 1
• Player 2’s type is her private information
• Prior distribution over types is common knowlege
13
• Bertrand competition, with two possible types for one or both players
• Each firm can be of type “low cost” or “high cost”: t 2 {l, h}
• If ti = l, firm i’s marginal cost is cl . If ti = h, firm i’s marginal cost is ch > cl
• One’s type is private info, prior distribution over types is common knowledge
14
• Cournot competition, with two possible states of the world, ✓ 2 {h, l}
• If ✓ = h, market demand is Q = ah P.
• If ✓ = l, market demand is Q = al P, where ah > al
• Firm 1 knows the state
• Firm 2 only knows a prior probability distribution over the states
15
Let’s go for a drink! (version 1)
• First, I need 2 players
• Then I need types: each player is either fun (type 1) or boring (type 0)—private
info!
1
• Pr (1) = Pr (0) = 2
• Each can choose in or out (or mix however between them)
• If both choose in, they get payo↵ equal to the other player’s type
• Drinking alone is bad and gives 0
• Doing whatever else you were planning to do gives you 13 .

16
A normal form representation
Definition 1 (Bayesian Normal Form)

A normal form representation of an n-player game of incomplete information is
• an action space A ⌘ A1 ⇥ · · · ⇥ An
• type space T ⌘ T1 ⇥ · · · ⇥ Tn
• payo↵ functions u ⌘ u1 , . . . un defined over A ⇥ T . That is, ui (a | t) ,
a 2 A, t 2 T
• beliefs p ⌘ p1 , . . . , pn
We denote the game by G = (A, T , p, u).
17
• Action space is A = A1 ⇥ A2 = {in, out} ⇥ {in, out}, so an element a 2 A is

something like (out, out)
• Type space T = T1 ⇥ T2 = {0, 1} ⇥ {0, 1}, so an element t 2 T is something like

(0, 1)
• Payo↵ function is something like (clearly not practical)

8
>
> 1 if ai = aj = in and tj = 1;
>
>
>
<0 if a
i = aj = in and tj = 0
ui (a | t) =
>
> 0 if ai = in and aj = out;
>
>
>
:1
3 if ai = out
18
Better!
in out
in t2 ,t1 0, 13
1 1 1
out 3, 0 3, 3
19
Strategies
Definition 2 (Strategies for Bayesian Games)

In the static Bayesian game G = (A, T , p, u), a strategy for player i is a function
si (ti ) which, for each type ti 2 Ti , specifies the action from the feasible set Ai that
type ti would choose if drawn by Nature.
• That is, we reduce the extensive form and define di↵erent strategies for each
di↵erent player-type
• Said otherwise, each type is treated as a di↵erent player
20
Bayesian Nash Equilibrium
• Recall each player-type ti has beliefs p (t i | ti ) about other players types
• A rational player-type chooses her strategies to maximize her expected payo↵,

where:
• The expectation is taken with respect to the set of types of all other players
• And each profile of types is “weighted” by pi (t i | ti )
E [ui (ai , s i (t i ) | t) | ti ] ⌘
X
ui (s1 (t1 ) , . . . , si 1 (ti 1 ) , ai , si+1 (ti+1 ) , sn (tn ) | t) pi (t i | ti )
t i 2T i
21
Bayesian Nash Equilibrium
Definition 3 (Bayesian Nash Equilibrium)

In the static Bayesian game G = (A, T , p, u), the strategy profile s ⇤ = (s1⇤ , . . . , sn⇤ ) is
a (pure-strategy) Bayesian Nash equilibrium if for each player i and each of i’s types
ti 2 T i
si⇤ (ti ) 2 arg max E [ui (ai , s i (t i ) | t) | ti ]
ai 2Ai
• That is, each player-type is maximizing the expected payo↵ conditional on her
own type.
• In a BNE, no player wants to change their strategy, even if the change involves
only one action by one type.
22
Let’s go for a drink (version 1)
• Is si (0) = si (1) = in for all i = 1, 2 a (pure strategy) Bayesian Nash equilibrium?
in out
in t2 ,t1 0, 13
1 1 1
out 3, 0 3, 3
• And what about other symmetric strategy profiles? (symmetric means: all players
do the same—only allowed/interesting when the game is symmetric: if we invert
the names of the players, the game remains the same)
23
Prove/disprove the statement
• There exists a symmetric Bayesian Nash equilibrium in which all players play out
in out
in t2 ,t1 0, 13
1 1 1
out 3, 0 3, 3
24
• There exists a symmetric Bayesian Nash equilibrium in which fun players play in
and boring players play out
in out
in t2 ,t1 0, 13
1 1 1
out 3, 0 3, 3
25
• There exists a symmetric Bayesian Nash equilibrium in which fun players play out
and boring players play in
in out
in t2 ,t1 0, 13
1 1 1
out 3, 0 3, 3
26
27
info!!!
1
• Pr (1) = Pr (0) = 2
27
info!!!
1
• Pr (1) = Pr (0) = 2
27
info!!!
1
• Pr (1) = Pr (0) = 2
• If both choose in, they get payo↵ equal to the product of their types
• Drinking alone is bad and gives 0
• Doing whatever else you were planning to do gives you 13 .

27
• Action space is A = A1 ⇥ A2 = {in, out} ⇥ {in, out}, so an element a 2 A is

something like (out, out)
• Type space T = T1 ⇥ T2 = {0, 1} ⇥ {0, 1}, so an element t 2 T is something like

(0, 1)
• Payo↵ function is something like

8
>
> 1 if ai = aj = in and ti = tj = 1;
>
>
>
<0 if a = a = in and {t = 0 or t = 0}
i j i j
ui (a | t) =
>
> 0 if ai = in and aj = out;
>
>
>
:1
3 if ai = out
28
Better!
in out
in t1 t2 ,t2 t1 0, 13
1 1 1
out 3, 0 3, 3
29
Let’s go for a drink (version 2)
• Is si (0) = si (1) = in for all i = 1, 2 a (pure strategy) Bayesian Nash equilibrium?
in out
in t1 t2 ,t2 t1 0, 13
1 1 1
out 3, 0 3, 3
• And what about other symmetric strategy profiles?
30
• There exists a symmetric Bayesian Nash equilibrium in which all players play out
in out
in t1 t2 ,t2 t1 0, 13
1 1 1
out 3, 0 3, 3
31
• There exists a symmetric Bayesian Nash equilibrium in which fun players play in
and boring players play out
in out
in t1 t2 ,t2 t1 0, 13
1 1 1
out 3, 0 3, 3
32
• There exists a symmetric Bayesian Nash equilibrium in which fun players play out
and boring players play in
in out
in t1 t2 ,t2 t1 0, 13
1 1 1
out 3, 0 3, 3
33
Applications of Bayesian Nash Equilibrium
ECON2112: Week 8
DJ Thornton
1
Table of contents
1. Application: Auctions
2. Application: Another interpretation of mixed strategies
2
Application: Auctions
An auction
• First-price, sealed-bid auction
• Two bidders, i = 1, 2
• i’s valuation is vi
• vi ⇠ U [0, 1] (i.i.d. draws)
• Tie-breaking rule is fair coin
3
An auction
• Actions: bi 2 R+ ⌘ [0, 1)
• Types Ti = [0, 1]
• Beliefs: pi (vi | vj ) = p (vi ), i 6= j
• Payo↵s 8
>
< vi b i ,
> if bi > bj ;
ui (bi , bj | vi ) = (vi bi ) /2, if bi = bj ;
>
>
:
0, otherwise.
4
Strategies
• Recall that a pure strategy for player i in a static Bayesian game is a function that
for each possible type gives an action
• In our case we can write bi (vi ), i.e. the bid that player i would choose if type i is
drawn
5
(Bayesian Nash) Equilibrium
• Each player-type must maximize her expected payo↵

1
max (vi bi ) Pr (bi > bj (vj )) + (vi bi ) Pr (bi = bj (vj ))
bi 2
6
• Each player-type must maximize her expected payo↵

1
max (vi bi ) Pr (bi > bj (vj )) + (vi bi ) Pr (bi = bj (vj ))
bi 2
• Let us focus on symmetric equilibria where players use linear strategies
• I.e. bi (vi ) = ↵ + vi , where ↵, 2 R are two parameters we have to find
6
1
max (vi bi ) Pr (bi > ↵ + vj ) + (vi bi ) Pr (bi = ↵ + vj )
bi 2
7
1
max (vi bi ) Pr (bi > ↵ + vj ) + (vi bi ) Pr (bi = ↵ + vj )
bi 2
• Since vj is uniformly distributed on [0, 1], the probability that it is exactly equal to
any number is 0:
max (vi bi ) Pr (bi > ↵ + vj )
bi
7

bi
8

bi
✓ ◆
bi ↵ bi ↵
• Notice that Pr (bi > ↵ + vj ) = Pr vj < =
8

bi
✓ ◆
bi ↵ bi ↵
bi ↵
max (vi bi )
bi
8

bi
✓ ◆
bi ↵ bi ↵
bi ↵
max (vi bi )
bi
2 vi + ↵
F.O.C. bi =
8
vi ↵
• We get bi (vi ) = 2 + 2
• How do we find ↵?
• Notice that no bidder should ever bid more than her valuation: bi (vi )  vi
• Indeed, in a symmetric equilibrium there is always a chance of winning, hence any

bid bi > vi gives negative expected payo↵
↵
• In particular bi (0) =  0 (together with bi 2 R+ ) ) ↵ = 0
2
9
vi ↵
• We get bi (vi ) = 2 + 2
• How do we find ↵?
• Notice that no bidder should ever bid more than her valuation: bi (vi )  vi
• Indeed, in a symmetric equilibrium there is always a chance of winning, hence any

bid bi > vi gives negative expected payo↵
↵
• In particular bi (0) =  0 (together with bi 2 R+ ) ) ↵ = 0
2
There is a symmetric (Bayesian Nash) equilibrium where bidders bid
half their valuation
• Appendix 3.2B in your textbook shows that this is the unique symmetric
equilibrium with strictly increasing, di↵erentiable strategies. 9
Conclusions
• Why do bidders bid half their valuation in the first-price auction?
• Consider a di↵erent (probably more familiar) auction format: the English

(ascending) auction
• Bidding starts from some (low) value
• Bidders call out progressively higher bids
• The last bidder to call out a bid wins, and pays his bid
• If the increment by which you can outbid the last person is infinitesmally small,
who wins? What fraction of their valuation do they end up paying?
10
Conclusions
• As long as you can call out a higher bid and stay under/at your valuation, you
would do it (bidding exactly your valuation, you are indi↵erent)
• Each bidder drops out when bidding reaches their valuation, so the winner is the one
with the highest valuation, and will pay the second highest valuation
11
Conclusions
• What about the case of two bidders with vi ⇠ U (0, 1) competing via first-price
auction?
• Each bidder bids as if he has the highest valuation in the room (if he’s wrong, it
won’t matter anyway)
• Each bidder bids the expected second highest valuation in the room,
conditional on his being the highest
vi
• When there are two bidders, that is 2 . If there are 3 bidders, it is 23 vi . If there are n
bidders, it is n n 1 vi
• This is a general result in auction theory known as the revenue equivalence theorem
12
Application: Another interpretation
of mixed strategies
Mixed strategies revisited
• recall the Battle of the Sexes
Pat
Opera Fight
Opera 2, 1 0, 0
Chris
Fight 0, 0 1, 2
• Nash Equilibria: (Opera, Opera), (Fight, Fight), and

2 1 1 2
3 Opera + 3 Fight, 3 Opera + 3 Fight
13
• A player’s mixed strategy might represent that player literally randomising
• A player’s mixed strategy might represent her opponent’s uncertainty about her
choice of a pure strategy
14
• A player’s mixed strategy might represent that player literally randomising
• A player’s mixed strategy might represent her opponent’s uncertainty about her
choice of a pure strategy
• Formally, let Chris’s payo↵ if both go to the Opera be 2 + tc
• Similarly, Pat’s payo↵ if both go to the Fight is 2 + tp
14
Pat
Opera Fight
Opera 2 + tc , 1 0, 0
Chris
Fight 0, 0 1, 2 + tp
• tc and tp are uniformly distributed over [0, x] and we will look at x ! 0 (hence, a
slight perturbation of the payo↵s, not a big one)
15
Threshold strategies
• Let us focus on (pure) strategies of the following type:
• Chris plays Opera if tc is greater than a threshold c
• Pat plays Fight if tp is greater than a threshold p
• Notice that this implies that each play favourite option with probability (x c) /x
and (x p) /x
• we want to show that in equilibrium they both converge to 2 /3 as x ! 0.
• That is, as incomplete information vanishes, the BNE in which each player-type takes
a single action for sure converges to a NE in which each player plays a mixed strategy
16
Expected payo↵s
• Chris’s expected payo↵s from playing Opera and Fight are

p ⇣ p⌘ p
(2 + tc ) + 1 · 0 = (2 + tc )
x x x
p ⇣ p ⌘ p
·0+ 1 ·1=1
x x x
17
Expected payo↵s
• Chris’s expected payo↵s from playing Opera and Fight are

p ⇣ p⌘ p
(2 + tc ) + 1 · 0 = (2 + tc )
x x x
p ⇣ p ⌘ p
·0+ 1 ·1=1
x x x
• Playing Opera is optimal if and only if

x
tc 3=c
p
17
Expected payo↵s
• Repeating the exercise for Pat gives

x
p= 3
c
18
Expected payo↵s

x
p= 3
c
• This implies p = c and

p 2 + 3p x =0
18
Expected payo↵s

x
p= 3
c
• This implies p = c and

p 2 + 3p x =0
p
p 3+ 9 + 4x
Pr (most pref. option) = 1 =1
x 2x
• Taking the limx!0 gives 2 /3 (you have to use de l’Hôpital).
18
Dynamic Games of Incomplete Information
ECON2112: Week 9
DJ Thornton
1
Table of contents
1. Introduction and a new solution concept
2. Solving full vs. empty wallet
2
Introduction and a new solution
concept
Bayesian Nash equilibrium
• Static games of imperfect info can be described by normal form representation of

a game of incomplete info
• Solution concept for a game of incomplete info: Bayesian Nash equilibrium
• For arguments very similar to Nash equilibrium, a Bayesian Nash equilibrium

always exists for finite games
• How far did this take us?
3
Plan of the Lecture
• Dynamic games of incomplete information might
• Have (Bayesian Nash) equilibria which are not sensible
• Have no proper subgame
4
Plan of the Lecture
• Dynamic games of incomplete information might
• Have (Bayesian Nash) equilibria which are not sensible
• Have no proper subgame
• Define a new equilibrium concept
• Strategies are optimal given beliefs
• Beliefs are derived using Bayes’ rule and strategies
4
Throw away the wallet
Y g (1, 3)
tf tw
n s n s
(2, 2) (0, 1) (1, 2) (0, 0)
5
Throw away the wallet
n s
g 1, 3 1, 3
tf 2, 2 0, 1
tw 1, 2 0, 0
• NE = SPE = {(tf , n) , (g , s)}
• (g , s) is not sensible, since the threat to play s is not credible
• There are several ways to eliminate this equilibrium, we focus on one way which
will help us introduce a new equilibrium concept
6
Beliefs
Y g (1, 3)
tf tw
n s n s
(2, 2) (0, 1) (1, 2) (0, 0)
• Suppose R’s info set is reached—even if it was not on the equilibrium path,
shouldn’t she “believe” something about the relative probability of the two nodes?
7
Beliefs
• A belief is a probability distribution over the nodes in an information set
• For each node x, a number µ (x) 0

P
• Summing over the entire info set: µ (x) = 1
8
Beliefs
Y g (1, 3)
tf tw
n s n s
(2, 2) (0, 1) (1, 2) (0, 0)
• Choose some beliefs for player R, what should she do?
9
Perfect Bayesian Equilibrium (PBE)
• A PBE is
• A strategy profile and
• a system of beliefs (a belief for each node in each info set)
• that satisfy a list of requirements (R1, R2, R3b).
10
PBE requirements
Requirements 1 and 2
Requirement 1 [R1] At any information set, the player with the move must have a
belief about which node in the information set has been reached.
Requirement 2 [R2] Given their beliefs, the players’ strategies must be sequentially
rational: at each information set the strategy of the player with the move
from that node onward must be optimal given the players’ beliefs at that
information set and the other players’ strategies from that node onward.
11
Sequential rationality
Y g (1, 3)
tf tw
n s n s
(2, 2) (0, 1) (1, 2) (0, 0)
• Strategies (g , s) cannot be played in any PBE:
• For any belief that R can hold, n is the only sequentially rational strategy
12
Sequential rationality
Y g (1, 3)
tf tw
n s n s
(2, 2) (0, 1) (1, 2) (0, 0)
• (tf , n) is played in the unique PBE:
• For any belief that R can hold, n is the only sequentially rational strategy
• tf is the unique sequentially rational strategy for Y given R will play n

13
Full vs. empty wallet
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
14
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
• R’s best choice depends on her beliefs
• What are reasonable beliefs for R?

14
Requirement 3
Requirement 3 [R3] At information sets on the equilibrium path, beliefs are

determined by Bayes’ rule and players’ equilibrium strategies.
An information set is on the equilibrium path if and only if it is reached

with positive probability if the game is played according to the equilibrium
strategies.
15
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
• Y always plays ng ) R must believe...
16
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
• Y plays ng i↵ wallet is full ) R must believe...
16
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
• Y plays ng i↵ wallet is full ) R must believe...
• Y plays ng i↵ wallet is empty ) R must believe...

16
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
• Y always plays ng with probabilities F if wallet is full and E if wallet is empty

) R must believe...
17
And o↵ the path? (Requirement 4)
Requirement 4 [R4] At information sets o↵ the equilibrium path, beliefs are

determined by Bayes’ rule and players’ equilibrium strategies where
possible
• See pp. 180 and 181 in textbook for a clear example; meaning of “where
possible” might depend on circumstances
• You can think at [R3] and [R4] as
[R3b] At any information set, beliefs are determined by Bayes’ rule and players’
equilibrium strategies where possible
18
Solving full vs. empty wallet
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
19
1. Y ’s seq. rationality
2. R’s seq. rationality
3. consistency
There is no “correct” order, it depends on what you want to show
20
Some notation
• E: probability of ng if E
• F: probability of ng if F
• R: probability of s
• Pr (F | ng ): R’s belief that F is true at R’s information set (reached only if ng

has been played)
Definition 1 (Perfect Bayesian Equilibrium)

A PBE of Full vs. empty wallet is a strategy profile E, F, R and beliefs
Pr (F | ng ) satisfying requirements R1-3b.
21
Pooling and separating equilibria
Definition 2 (Pooling and Separating)

A PBE E, F, R ; Pr (F | ng ) is pooling if E = F; it is separating if E 6= F.
22
There is a separating equilibrium in which you give the wallet if and only
if it is empty.
23
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
24
if it is empty.
1. Y ’s seq. rationality ! it would depend on R’s strategies
2. R’s seq. rationality ! it would depend on her beliefs
3. consistency ! depends on Y ’s strategies, so we can do this
25
if it is empty.
1. Y ’s seq. rationality !
2. R’s seq. rationality !
3. Consistency ! Pr (F | ng ) = 1 is the only consistent belief
26
if it is empty.
2. R’s seq. rationality !the only seq. rational strategy is to shoot
3. consistency ! Pr (F | ng ) = 1 is the only consistent belief
27
if it is empty.
1. Y ’s seq. rationality ! both types of Y prefer to give the wallet (contradiction!!!)
2. R’s seq. rationality ! the only seq. rational strategy is to shoot
28
if it is empty.
1. Y ’s seq. rationality ! both types of Y prefer to give the wallet (contradiction!!!)
2. R’s seq. rationality ! the only seq. rational strategy is to shoot
Answer: the statement is wrong
28
There is a pooling equilibrium in which you always give the wallet
3. Consistency !
29
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
30
1. Y ’s seq. rationality ! give is seq. rational if R shoots
2
2. R’s seq. rationality ! shoot is seq. rational if Pr (F | ng ) 5
3. Consistency ! Any belief Pr (F | ng ) 2 [0, 1] is consistent
31
1. Y ’s seq. rationality ! give is seq. rational if R shoots
2
2. R’s seq. rationality ! shoot is seq. rational if Pr (F | ng ) 5
3. Consistency ! Any belief Pr (F | ng ) 2 [0, 1] is consistent
Answer: yes, for example, you always give, the robber shoots if you do not
give; if you do not give, the robber believes the wallet is full with probability
.7.
31
There is a pooling equilibrium in which you never give the wallet
3. Consistency !
32
1 p p
(1, 0) g Y Y g (1, 10)
ng ng
n s n s
(1, 2) (0, 0) (10, 2) (0, 5)
33
There is a pooling equilibrium in which you never give the wallet
1. Y ’s seq. rationality ! not give is seq. rational if R does not shoot
2
2. R’s seq. rationality ! not shoot is seq. rational if p  5
3. Consistency ! Pr (F | ng ) = p is unique consistent belief
Answer: yes, but only if p  2/5. In this equilibrium, you never give, the
robber never shoots; if you do not give, the robber believes the wallet is full
with probability p.
34
Is there any separating equilibrium?
Is there a separating equilibrium?
35
1. If a separating equilibrium exists, then E < F
35
Proof: Otherwise, E > F 0. Fix a strategy R for the robber. If E > 0 is

seq. rational, then
R · 0 + (1 R) · 1 1
|{z} ) R =0
| {z }
exp. payo↵ of ng |E exp. payo↵ of g |E
and F = 1 is the unique seq. rational strategy if the wallet is full

(contradiction!!!)
35
2. If a separating equilibrium exists, then E > 0 (i.e. when the wallet is empty, you
do not give it to the robber with positive probability)
36
2. If a separating equilibrium exists, then E > 0 (i.e. when the wallet is empty, you
do not give it to the robber with positive probability)
Proof: Suppose E = 0 and F> 0. By consistency:

Fp
Pr (F | ng ) = =1
F p + E (1 p)
but then R shoots. If R shoots, then E = F = 0 is the unique seq.
rational strategy for Y (contradiction!)
36
2. If a separating equilibrium exists, then E >0
3. If a separating equilibrium exists, then R = 0 and F =1
37
3. If a separating equilibrium exists, then R = 0 and F =1
Proof: Suppose R > 0, then you will give the wallet if it is empty:
R · 0 + (1 R) · 1 < 1
|{z}
| {z }
exp. payo↵ of ng |E exp. payo↵ of g |E
contradicting E > 0.
37
3. If a separating equilibrium exists, then R = 0 and F = 1.
Put it all together: E > 0, F = 1, R = 0.
38
• E > 0, F = 1, R =0
• consistency:
Fp p
Pr (F | ng ) = =
Fp + E (1 p) p + E (1 p)
39
• E > 0, F = 1, R =0
• consistency:
Fp p
Pr (F | ng ) = =
Fp + E (1 p) p + E (1 p)
• R’s sequential rationality

p 2
Pr (F | ng ) = 
p + E (1 p) 5
3 p
E
21 p
but E < F  1, so we need p < 2/5. 39
• E > 0, F = 1, R =0
• consistency:
Fp p
Pr (F | ng ) = =
Fp + E (1 p) p + E (1 p)
• R’s sequential rationality

p 2
Pr (F | ng ) = 
p + E (1 p) 5
3 p
E
21 p
but E < F  1, so we need p < 2/5. 39
Answer: yes, but only if p < 2/5. In equilibrium,

 ◆
3 p
E 2 ,1
21 p
F =1
R =0
p
Pr (F | ng ) =
p+ E (1 p)
(so if p < 2/5, there is a continuum of separating equilibria).
40

Normal Form Games and Nash Equilibrium: ECON2112: Week 1

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Normal form games and Nash equilibrium

2. Normal Form Games

• Game theory studies strategic, multi-person decision problems.

• A strategic situation (game) is a situation in which two or more individuals

• Game theory provides a way for us to solve games.

Description of the game taken from Wikipedia:

• The Prisoners’ dilemma is a multi-person decision problem: the outcome is jointly

• What should be the solution to this game?

What do we need to have a multi-person decision problem or strategic situation?

(What constitutes a game?)

• We need players, say n players.

Definition 1 (Normal Form game)

• There are two players, therefore, n = 2.

• A strategy set for each player

• S1 = {Not Confess, Confess}

• S2 = {Not Confess, Confess}

• a utility function for each player

u1 (Not Confess, Not Confess) = 1 u2 (Not Confess, Not Confess) = 1

Not Confess Confess

Description of the game taken from Wikipedia:

• A strategy set for each player. S1 = {O, F } and S2 = {O, F }

• a utility function for each player

• Again we can represent this in the matrix form

• Players have common knowledge about the structure of the game.

• Players choose their strategies independently.

• A solution is understood as as set of recommendations, one for each player.

Definition 2 (Nash equilibrium)

Notation: Denote by S the set of strategy profiles S1 ⇥ · · · ⇥ Sn .

Consider an n-player normal form game G = (S1 , . . . , Sn ; u1 , . . . , un ).

Definition 3 (Nash equilibrium (formal))

ui (s1⇤ , . . . , si⇤ 1 , si⇤ , si+1

E.g. in the Prisoner’s dilemma, S 1 =S 2 = S1 = S2 = {Not Confess, Confess}.

Definition 4 (Best response)

Theorem 1 (NE i↵ BR)

Consider an n-player normal form game G = (S1 , . . . , Sn ; u1 , . . . , un ).

ui (si , s i ) < ui (si0 , s i ).

Example: Prisoners’ dilemma.

BR1 (Not Confess) = {Confess} BR2 (Not Confess) = {Confess}

• Therefore, NE = {(Confess, Confess)}.

Example: Battle of the sexes

BR1 (O) = {O} BR2 (O) = {O}

Example: Another 2x2 game

BR1 (L) = {T } BR2 (T ) = {L}

• NE = {(T , L), (B, R)}

Example: A 4x3 game

BR2 (TT ) = {R}

Example: A 3-player game (2x2x2)

BR1 (L, W ) = {T } BR2 (T , W ) = {L} BR3 (T , L) = {E }

Example: Matching Pennies

Example: Matching Pennies

BR1 (H) = {H} BR2 (H) = {T }

• Suppose players were allowed to randomise between H and T .

• In turn, suppose that player 2 is allowed to play H with probability 0  y  1 and

• These will be called mixed strategies.

• Really, we are extending the strategy sets from S1 = {H, T }, to

• Are there values 0  x  1 and 0  y  1 that constitute a Nash equilibrium?

Suppose that player 2 plays H with probability 0  y  1 and T with probability 1 y.

That is, player 1 prefers H to T if and only if

• If x represents the probability that player 1 plays H, we have that:

Example: Plotting player 1’s best response function

We can also calculate BR2 :

• Remember: y represents the probability that player 2 plays H

Example: Plotting player 2’s best response function