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EC941 - Game Theory

Lecture 1

Francesco Squintani
Email: f.squintani@warwick.ac.uk

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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

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3. Bayesian Games
Definition
Information and Bayesian Games
Cournot Duopoly and Public Good Provision
Readings: Sections 9.1 to 9.6

4. Bayesian Game Applications


Juries and Information Aggregation
Auctions with Private Information
Readings: Sections 9.7 to 9.8

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5. Extensive-Form Games
Definition
Subgame Perfection and Backward Induction
Applications
Readings: Chapters 5, 6 and 7

6. Extensive-Form Games with Imperfect Information


Definition
Spence Signalling Game
Crawford and Sobel Cheap Talk
Readings: Chapter 10
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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
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9. Review Session
Solution of Past Exam Questions

Reference: An Introduction to Game Theory


Martin J. Osborne, Oxford University Press, 2003.

Assessment: Final Exam (100% of the grade)

Office Hours: Wednesday 9:00-11:00 Room 1.123

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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.

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What is Game Theory?
Game Theory is the formal study of strategic
interactions.

A strategic interaction involves two or more agents.


They maximize their payoffs and are aware that their
opponents maximize payoffs.

Applications range from economics to politics, to


biology and computer science.

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Games in Strategic Form
A game in strategic form is

a set of players: {1, 2, , I}


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).

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Solution Concepts
A solution concept is a mathematical rule to find the
solution of a game.

It allows the modeler to formulate a prediction on the


play of the interaction she modeled as a game.

Today, we will study 3 solution concepts:


Nash Equilibrium
Dominance
Rationalizability

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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.

Definition The strategy profile s is a Nash equilibrium


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

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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.

Learning Equilibrium Play.


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.

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Dominance
A players strategy strictly dominates another one if it
gives a higher payoff, no matter of what other players do.

Definition Player i s strategy si strictly dominates strategy si


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

Theorem A strictly dominated strategy si is never part of any


Nash equilibrium s.
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A players strategy weakly dominates another strategy if it
is always at least as good, and sometimes better.

Definition Player i s strategy si weakly dominates her


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.

Note There exist games with Nash Equilibria s that include


weakly dominated strategies si for some player i.

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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.
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Rationalizability
Rationalizability is defined via iterated deletion of strictly
dominated strategies.

Consider a finite game G = (I, S, u).

For each player i, and round t = 1, . . . , T, iteratively


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

Xi1 = Si (start with the set of all possible strategies).

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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).

The final index T is such that no strategy in XiT is strictly


dominated in the game where the set of strategies of each
player j is reduced to XjT
(proceed until no strategy is strictly dominated).

The set XiT is the set of rationalizable strategies of player i.


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Rationalizability is justified by common knowledge of rationality.

Each player is rational: She does not play strictly dominated


strategies.

Each player knows that every player is rational: She can


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.

The procedure is iterated until it stops.


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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.

Definition The best response correspondence Bi of player i is:


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

Proposition The strategy profile s is a Nash equilibrium of a


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.
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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.

Players: The two suspects.

Strategies: Each players set of strategy is {Quiet, Fink}.

Preferences: Suspect 1s ordering of the strategy profiles,


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).
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Suspect 2

Quiet Fink
Suspect 1

Quiet 2, 2 0, 3

Fink
3, 0 1, 1
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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.
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Bach or Stravinsky
Two daters would rather be together than separate, but
dater 1 prefers Bach and dater 2 prefers Stravinsky.

Players: The two daters.

Strategies: Each daters strategy set is {Bach, Stravinsky}.

Preferences: Dater 1s ordering of the strategy profiles,


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).
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Dater 2

Dater 1 Bach Stravinsky

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.
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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.
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Matching Pennies
Player 1 wins if the coins are matched.
Player 2 wins if they are not matched.

Players: The two players.

Strategies: Each players set of actions is {Head, Tail}.

Preferences: Player 1s ordering of the strategy profiles,


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).

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Player 2

Player 1 Head Tail

Head -1, 1 1, -1
Tail 1, -1 -1, 1
There is no sure way to win for either of the players.

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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.

Firm is cost of producing qi units is Ci(qi).


Ci is an increasing function.

The firms' total output is Q = q1 + + qn.

The market price is P(Q).


P is the inverse demand function, decreasing if positive.

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Linear Costs and Demand
Firm is revenue is qi P(q1 + + qn).

Firm is profit is revenue minus cost:


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

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

P (Q) = a - Q if a > Q, P(Q) = 0 if a < Q.

pi(q1, , qn) = qi [a (q1 + + qn)] - cqi.

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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.

Best Response functions:


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

To find the Nash equilibria, we solve the system of


best-response functions.

Because this system is linear and symmetric, we


equalize qi* across i = 1,,n:
qi* = bi (qi*) = [a (n-1) qi* c]/2.

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Solving the above equation, we find that the Nash
equilibrium quantity is:
qi* = [a c]/(n+1).

Substituting in the formula for the price, we find that


the Nash equilibrium price is:
pi (qi*) = a Q* = a n[a c]/(n+1)
= [a + nc]/(n+1).

The Nash equilibrium profits are:


pi (qi*) = qi*[a Q*] cqi*
= [a c ]2/(n-1)2.
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q2
With n = 2,
b1(q2) b1(q2) = [a q2 c]/2.
b2(q1) = [a q1 c]/2.

(q1*, q2*) qi* = [a c]/3, i = 1,2.


[a c]/3
b2(q1)

[a c]/3 q1

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Bertrand Competition
Unlike Cournot competition, firms compete in prices.

The demand function is denoted by D,


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.

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Linear Costs and Demand
Ci(qi) = cqi, i=1, , n.

D(p) = a p if a > p, D(p) = 0 if a < p.

Let pi = min {pj, j different from i}.

The profit is:


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.
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Best-Response Correspondence
Suppose that there only two firms, so that pi= pj.
If pj < c, then pi(p) < 0 for pi < pj,

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


pi

pj
c pm pi

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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

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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

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In sum, the best-response correspondence is:
bi(p) = {pi : pi > pj}, if pj < c,

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

bi(p) = f, if c < pj < pm,

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

The Nash equilibrium is pi = c, for all i = 1,,n.

Intuitively, selling at any price pi < c yields negative profit.


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.
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Downsian Electoral Competition
The players are 2 candidates in an election.

A strategy is a real number x, representing a policy on


the left-right political ideology spectrum.

After the candidates choose policies, each citizen votes


for the candidate with the policy she prefers.

The candidate who obtains the most votes wins.


Candidates care only about winning.
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The voters are a continuum with diverse ideologies,
with cumulative distribution F.

For any k, a voter with ideology y is indifferent between


the policies y - k and y + k.

The median m is such that 1/2 of voters has ideologies


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

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

Suppose that x2 < m, the case for x2 > m is symmetric.

If candidate 1 chooses x1 < x2 then she wins the votes


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

Because ( x1 + x2 ) < x2 < m, it follows that


F( ( x1 + x2 ) ) < , so that candidate 1 wins less than
of the votes, and loses the election.

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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.

This is equivalent to ( x1 + x2 ) < m, i.e. x1 < 2m - x2.

So, b1 (x2) = {x1 : x2 < x1 < 2m - x2 } for x2 < m.

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

If x2 = m, then player 1 loses the election unless she


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

By using the best response correspondences the unique


Nash Equilibrium is (m, m). The candidates political
platforms converge to the median policy.

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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.

If instead x1=m, then candidate 2 loses the election for


sure unless she plays x2 = m.
Hence (m, m) is a Nash Equilibrium.

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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.

The price paid by the last bidder is her last bid.

Suppose each bidders valuation of the good is


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.

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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.

To win, the bidder with the highest valuation needs to


bid slightly more than the second highest maximal bid.

If the bidding increment is small, the price the winner


pays equals the second highest maximal bid.

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Second-Price Auction Game
Players: n bidders. Bidder is valuation is vi, we order
v1> > vn > 0, without loss of generality.

Strategies: bidder is maximal bid is bi.

Let bi = max {bj : j different from i}.

Payoffs: ui(b1, ,bn) = vi - bi if bi > bi


0 if bi < bi

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

Bidder 1 wins the object, payoff: v1 b*2 = v1 v2 > 0.


If bidding b1 < v2, she loses the object, the payoff is 0.
If bidding b1 > v2, her payoff is v1 v2 > 0.

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.

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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.

3. (b*1, , b*n) = (v2, v1 , 0, , 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.
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Weakly Dominant Solution
The Nash Equilibrium (b*1, , b*n) = (v1, , vn) is the
unique weakly dominant solution.

bi < bi or bi < bi < vi or


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

bi < vi vi - bi 0 0

bi = vi vi - bi vi - bi 0

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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

In sum, bidding bi = vi yields at least as high a payoff as


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

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Summary of the Lecture

Definition of Games in Strategic Form.

Definition of Solution Concepts


Nash Equilibrium, Dominance and Rationalizability.

Applications
Cournot Oligopoly, Bertrand Duopoly, Downsian
Electoral Competition, Vickrey Second Price Auction.

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Preview Next Lecture

Mixed Strategies.

Nash Equilibrium and Rationalizability.

Correlated Equilibrium.

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