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You are on page 1of 54

Lecture 1

Francesco Squintani

Email: f.squintani@warwick.ac.uk

1

Syllabus

1. Games in Strategic Form

Definition and Solution Concepts

Applications

Readings: Chapter 2, 3, 12

2. Mixed Strategies

Nash Equilibrium and Rationalizability

Correlated Equilibrium

Readings: Chapter 4

2

3. Bayesian Games

Definition

Information and Bayesian Games

Cournot Duopoly and Public Good Provision

Readings: Sections 9.1 to 9.6

Juries and Information Aggregation

Auctions with Private Information

Readings: Sections 9.7 to 9.8

3

5. Extensive-Form Games

Definition

Subgame Perfection and Backward Induction

Applications

Readings: Chapters 5, 6 and 7

Definition

Spence Signalling Game

Crawford and Sobel Cheap Talk

Readings: Chapter 10

4

7. Repeated Games

Infinitely Repeated Games

Nash and Subgame-Perfect Equilibrium

Finitely Repeated Games

Readings: Chapter 14 and 15

8. Bargaining

Ultimatum Game and Hold Up Problem

Rubinstein Alternating Offer Bargaining

Nash Axiomatic Bargaining

Readings: Section 6.2 and Chapter 16

5

9. Review Session

Solution of Past Exam Questions

Martin J. Osborne, Oxford University Press, 2003.

6

Structure of the Lecture

Definition of Games in Strategic Form.

Solution Concepts

Nash Equilibrium, Dominance and Rationalizability.

Applications

Cournot Oligopoly, Bertrand Duopoly, Downsian

Electoral Competition, Vickrey Second Price Auction.

7

What is Game Theory?

Game Theory is the formal study of strategic

interactions.

They maximize their payoffs and are aware that their

opponents maximize payoffs.

biology and computer science.

8

Games in Strategic Form

A game in strategic form is

for each player i, a set Si of strategies si

for each player i, preferences over the set of strategy

profiles S={(s1 , , sI )}, represented by u : S RI

(a strategy profile includes one strategy for each player).

9

Solution Concepts

A solution concept is a mathematical rule to find the

solution of a game.

play of the interaction she modeled as a game.

Nash Equilibrium

Dominance

Rationalizability

10

Nash Equilibrium

A (pure-strategy) Nash equilibrium is a strategy profile

s with the property that no player i can do better by

choosing a strategy different from si, given that every

other player j adheres to sj.

if, for every player i, ui(s) ui(si, si) for every strategy si

of player i.

11

There are two main justifications for Nash Equilibrium:

Self-Enforcing Contract.

The players meet and agree before playing on the

course of actions s. The contract s is self-enforcing if

no player has reasons to deviate if the others do not.

The play s is in equilibrium if no player i would

deviate, were she to learn the opponents play s-i,

because of communication, observation, or repetition.

12

Dominance

A players strategy strictly dominates another one if it

gives a higher payoff, no matter of what other players do.

if ui (si , si) > ui (si , si) for every profile si of opponents

strategies.

Nash equilibrium s.

13

A players strategy weakly dominates another strategy if it

is always at least as good, and sometimes better.

strategy si if

ui (si , si) ui(si , si) for every profile si of opponents

strategies

ui(si , si) > ui(si , si) for some profile si of opponents

strategies.

weakly dominated strategies si for some player i.

14

Player 2

Player 1 C D

A 1, 1 0, 0

B 0, 0 0, 0

There are two Nash Equilibria: (A,C) and (B,D).

The Nash Equilibrium (B,D) is weakly dominated.

15

Rationalizability

Rationalizability is defined via iterated deletion of strictly

dominated strategies.

define the set Xit of strategies of player i as follows.

16

For each t = 0, . . . , T 1, Xit+1 is a subset of Xit such

that every strategy of player i in Xit that is not in Xit+1 is

strictly dominated in the game where the set of strategy

of each player j is reduced to Xjt

(in each round, delete all strictly dominated strategies).

dominated in the game where the set of strategies of each

player j is reduced to XjT

(proceed until no strategy is strictly dominated).

17

Rationalizability is justified by common knowledge of rationality.

strategies.

reduce the game by deleting all players strictly dominated

strategies from her model of the interaction (the game).

Each player knows that every player knows that every player

is rational: She deletes all strictly dominated strategies in the

reduced game.

18

Best Response Correspondences

The best response correspondence Bi of player i assigns

to each profile s-i of opponents strategies, the set of

player i s strategies that maximizes her payoff.

Bi (si) = {si in Si : ui(si, si) ui(si, si) for all si in Si}.

game G=(I, S, u) if and only if every players strategy is a best

response to the other players strategies: si belongs to Bi(si ) for

every player i.

19

Prisoners Dilemma

Two prisoners are separately interviewed. By accusing the

other suspect, ones prison term is reduced. But if they

both stayed quiet, they would not be incarcerated.

from best to worst is (F, Q), (Q, Q), (F, F), (Q, F).

Suspect 2s ordering is (Q, F), (Q, Q), (F, F), (F, Q).

20

Suspect 2

Quiet Fink

Suspect 1

Quiet 2, 2 0, 3

Fink

3, 0 1, 1

21

Solutions of Prisoners Dilemma

Quiet Fink

Quiet 2, 2 0, 3

Fink 3, 0 1, 1

Fink is the best response of each player, regardless of what

the other player does. Fink is the strictly dominant and

rationalizable strategy. (Fink, Fink) is the Nash Equilibrium.

22

Bach or Stravinsky

Two daters would rather be together than separate, but

dater 1 prefers Bach and dater 2 prefers Stravinsky.

from best to worst is (B, B), (S, S), (B, S) = (S, B).

Dater 2s ordering is (S, S), (B, B), (S, B) = (B, S).

23

Dater 2

Bach 2, 1 0, 0

Stravinsky 0, 0 1, 2

If they can coordinate, either the two daters go to Bachs

concert or to Stravinskys concert.

24

Solutions of Bach or Stravinsky

Bach Stravinsky

Bach

2, 1 0, 0

Stravinsky 0, 0 1, 2

For each player, B is the best response to B, and S is the best

response to S. There are two Nash Equilibria, (B, B) and (S, S).

All strategies are rationalizable, and none is dominated.

25

Matching Pennies

Player 1 wins if the coins are matched.

Player 2 wins if they are not matched.

from best to worst, is (H, T) = (T, H), (H, H) = (T, T).

Player 2s ordering is (H, H) = (T, T), (H, T) = (T, H).

26

Player 2

Head -1, 1 1, -1

Tail 1, -1 -1, 1

There is no sure way to win for either of the players.

27

Solutions of Matching Pennies

Head Tail

Head

-1, 1 1, -1

Tail

1, -1 -1, 1

For player 1, H is the best response to T and viceversa, for

player 2, H is the best response to H and T is the best

response to T. All strategies are rationalizable and none is

dominated. There are no Nash Equilibria. 28

Cournot Oligopoly

A good is produced by n firms.

Ci is an increasing function.

P is the inverse demand function, decreasing if positive.

29

Linear Costs and Demand

Firm is revenue is qi P(q1 + + qn).

pi(q1 + + qn) = qi P(q1 + + qn) - Ci (qi).

30

To find the Best Response Functions, differentiate pi

with respect to qi, set it equal to zero, and obtain:

dpi (q1, , qn)/dqi = a qi (q1 + + qn) c = 0.

bi (qi) = [a (q1 + + qi-1 + qi+1 ++ q n) c]/2.

best-response functions.

equalize qi* across i = 1,,n:

qi* = bi (qi*) = [a (n-1) qi* c]/2.

31

Solving the above equation, we find that the Nash

equilibrium quantity is:

qi* = [a c]/(n+1).

the Nash equilibrium price is:

pi (qi*) = a Q* = a n[a c]/(n+1)

= [a + nc]/(n+1).

pi (qi*) = qi*[a Q*] cqi*

= [a c ]2/(n-1)2.

32

q2

With n = 2,

b1(q2) b1(q2) = [a q2 c]/2.

b2(q1) = [a q1 c]/2.

[a c]/3

b2(q1)

[a c]/3 q1

33

Bertrand Competition

Unlike Cournot competition, firms compete in prices.

if the good is available at the price p, then the total

amount demanded is D(p).

The firm setting the lowest price sells to all the market.

34

Linear Costs and Demand

Ci(qi) = cqi, i=1, , n.

pi(p1, , pn) = (pi c)(a - pi) if pi < pi,

pi(p) = (pi c)(a - pi)/|{k : pk = pi}| if pi = pi,

pi(p) = 0 if pi > pi.

35

Best-Response Correspondence

Suppose that there only two firms, so that pi= pj.

If pj < c, then pi(p) < 0 for pi < pj,

pi

pj

c pm pi

36

If pj = c, then pi(p) < 0 for pi < pj,

pi(p) = 0 for pi > pj : bi(p) = {pi : pi > pj}.

If pj > pm, then bi(p) = {pm}.

pi pi

pj

c pm pi c pm pj pi

37

If c < pj < pm then pi(p) increases in pj, but

discontinuously drops at pi = pj. So, bi(p) = f.

The best response correspondence is empty.

pi

c pj pi

38

In sum, the best-response correspondence is:

bi(p) = {pi : pi > pj}, if pj < c,

If the lowest industry price were pj > c, then firm i sells to

the whole industry at any price pi with c < pi < pj.

In equilibrium, pi = c, for all i.

39

Downsian Electoral Competition

The players are 2 candidates in an election.

the left-right political ideology spectrum.

for the candidate with the policy she prefers.

Candidates care only about winning.

40

The voters are a continuum with diverse ideologies,

with cumulative distribution F.

the policies y - k and y + k.

y > m, and 1/2 has ideologies y < m. So, F (m) = 1/2.

41

Best Response Functions

Fix the policy x2 of candidate 2 and consider 1s choice.

of citizens with ideology y < ( x1 + x2 ).

F( ( x1 + x2 ) ) < , so that candidate 1 wins less than

of the votes, and loses the election.

42

If x1 > x2, then candidate 1 wins the votes of citizens

with ideology y > ( x1 + x2 ).

She wins more or less than of the votes if and only if

1 F( ( x1 + x2 )) > .

In this case, she wins the election.

43

For x2 > m, b1 (x2) = {x1 : 2m - x2 < x1 < x2}.

plays x1 = m. So b1 (m) = {m}.

Nash Equilibrium is (m, m). The candidates political

platforms converge to the median policy.

44

Intuitively, consider any pair of platforms (x1, x2) other

than (m, m). One candidate can win the election by

deviating and locating e closer to m than x2.

Hence (x1, x2) is not a Nash Equilibrium.

sure unless she plays x2 = m.

Hence (m, m) is a Nash Equilibrium.

45

Vickrey Second-Price Auctions

In an English auction, n bidders submit increasing

bids for a good, until only one is left, who wins the

auction.

independent of the other bidders values.

For example, Vickreys model applies when the good is

a work of art, but not when it is a oil field.

46

The English auction is equivalent to a sealed-bid

auction, in which each bidder decides, before bidding

begins, the most she is willing to bid.

bid slightly more than the second highest maximal bid.

pays equals the second highest maximal bid.

47

Second-Price Auction Game

Players: n bidders. Bidder is valuation is vi, we order

v1> > vn > 0, without loss of generality.

0 if bi < bi

48

Nash Equilibria

1. (b*1, , b*n) = (v1, , vn).

If bidding b1 < v2, she loses the object, the payoff is 0.

If bidding b1 > v2, her payoff is v1 v2 > 0.

If bidding bi > v1, the payoff is vi b1 = vi v1 < 0.

If bidding bi < v1, she loses the object, the payoff is 0.

49

2. (b*1, , b*n) = (v1, 0, , 0)

Bidder 1 wins the object, her payoff is v1.

The payoff of bidders i = 2, , n is 0.

If bidding bi > v1, the payoff is vi b1 = vi v1 < 0.

If bidding bi < v1, she loses the object, the payoff is 0.

Bidder 2 wins the object, payoff v2 b1 = v2 v2 = 0.

To win, bidder i = 1, 3, , n must bid bi > b2 = v1,

so the payoff is vi b1 < vi v1 < 0.

Any of these bidders payoff is at least as good if

losing the good.

50

Weakly Dominant Solution

The Nash Equilibrium (b*1, , b*n) = (v1, , vn) is the

unique weakly dominant solution.

bi = bi & i wins bi=bi & i loses bi > vi

bi < vi vi - bi 0 0

bi = vi vi - bi vi - bi 0

51

vi < bi < bi or bi > bi or

bi < vi bi =bi & i wins bi =bi & i loses

bi = vi vi - bi 0 0

bi > vi vi - bi vi bi (< 0) 0

bidding bi > vi or bi < vi for any opponents bids.

52

Summary of the Lecture

Nash Equilibrium, Dominance and Rationalizability.

Applications

Cournot Oligopoly, Bertrand Duopoly, Downsian

Electoral Competition, Vickrey Second Price Auction.

53

Preview Next Lecture

Mixed Strategies.

Correlated Equilibrium.

54

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