Game Theory

Nicholson and Snyder Chapter 8

 Strategy and Game Theory
• Game theory is decision making in a strategic setting.
• An agent’s optimal choice may depend on the
choices or actions of others.
• For example, suppose a company is deciding to
choose a price for its product. It might take its rival’s
pricing decision into account. Or a country is deciding
to go to war, it may take the adversary’s decision into
account (will they retaliate? Surrender?)
• Many economic situations can be analysed using game
theory. It is regarded as a more realistic and nuanced
mode of analysis than mere static optimisation which
depends on a set of rigid assumptions.
• However, game theory is a vast and evolving topic
which can get very complicated.
• In this chapter we will only be scratching the surface of
game theory. We may devote three or even four weeks
to it.
• William Spaniel’s youtube channel on game theory
(Game Theory 101) is very informative. I highly
recommend it.
 The Basics
• A game is a model of a strategic situation. A
game has three essential elements.
(1) Players (2) Strategies and (3) Payoffs.
• Some add a fourth element, information, but
it can be subsumed under (2).
• Let us look at each of the three elements
separately.
• Players:
• Each decision maker in a game is a player. They
could be individuals, firms or even entire nations.
• A player has to choose from among a set of
possible actions.
• The number of players is usually fixed throughout
the game.
• We can have two, three up to n-player games.
• Our primary focus would be on two-player
games.
• Strategies:
• Each course of action is a strategy. Strategies could
be complex or simple.
• Let S1 denote the set of strategies open to player 1,
S2 to player 2 and Si to player i. Thus,
s1 ϵ S1 is a particular strategy chosen by player 1
s2 ϵ S2 is a particular strategy chosen by player 2
si ϵ Si is a particular strategy chosen by player i
• A strategy profile is a listing of particular strategies
chosen by each of a group of players.
• Payoffs:
• Payoffs are the final returns to the players at the conclusion
of a game.
• Payoffs can be measured in many ways – levels of utility,
money, risk, prestige, emotion and so on.
• Players are assumed to prefer higher payoffs to lower payoffs.
• In a two player game, u1(s1,s2) represents player 1’s payoffs
given he chooses s1 while the other player chooses s2.
Similarly, u2(s2,s1) represents player 2’s payoffs.
• In an n-player game, the payoff of generic player i is u i(si,s-i),
where si is player i‘s own strategy and
s-i = (s1,…,si-1,si+1,…,sn) of all players other than i.
 The Prisoner’s Dilemma
• The first game we will encounter is a well
known game in game theory called the
prisoner’s dilemma (henceforth, PD).
• P1 and P2 are the two players (prisoners).
• Betray and Silence are the actions available to
them.
• The payoff structure of the game is as follows:
• If P1 betrays and P2 is silent, P1 gets 1 year in prison
while P2 gets 4 years in prison.
• If P2 betrays and P1 is silent, P2 gets 1 year in prison
while P1 gets 4 years in prison.
• If P2 betrays and P1 also betrays, both get 3 years in
prison.
• If both remain silent, they both get 2 years in prison
(due to lack of evidence).
• Let loss of freedom (i.e. years in prison) be represented
by negative numbers, then we can construct the
following Payoff Matrix for the two prisoners.
 P2

Betray Silent
Betray - 3, - 3 - 1, - 4
P1
Silent - 4, - 1 - 2, - 2

The first entry in any cell always

represents the payoff to P1.
• The exact same information can be represented in an
equivalent table.
• If we let four years in prison be equivalent to zero
years of freedom, then three years in prison is
equivalent to 1 year of freedom and so on. We get
the following table:
P2
Betray Silent
P1 Betray 1,1 3, 0
Silent 0, 3 2, 2

• Confirm that it is equivalent to the previous table.

• When information is represented in tables it is
called a “Normal Form” representation.
• There is another way of representing the same
information: (1 , 1)
Betray This way of
representing a
2 game is called an
Betray (3 , 0)
Silent “Extensive Form”
1 (0 , 3)
representation.
Betray The dashed oval
Silent 2 indicates that P2
Silent (2 , 2)
is not aware of
P1’s actions.

Again, the first entry in brackets

always represents the payoff to P1.
• Let us deal with positive payoffs. Now, think about what
the prisoners might do. Neither is aware of the others
actions.
• If both are silent, the payoff is highest for both: (2,2). But
there is no guarantee that the other prisoner will remain
silent if one of them is silent.
• If P1 betrays and P2 is silent, P1 is better-off: (3,0). On the
other hand, if P2 were to betray, P1 is still better-off
betraying: (1,1), because if he had remained silent the
payoff would have been (0,3).
• The same logic applies to P2. Betrayal always guarantees
an extra year of freedom. Betrayal is a Best Response
strategy.
• When we have a payoff matrix, we can
underline best response strategies.
• Start with P1. If P1 betrays, what is P2’s best
response? The best response would be the
one which yields the highest payoff against
P1’s action. Underline it.
P2 When P1 plays Betray, P2 should
play Betray and get a payoff of 1. If
Betray Silent P2 had played Silent instead, he
P1 Betray 1,1 3, 0 would have received a payoff of 0.
Silent 0, 3 2, 2 Therefore, Silent does not represent
a best response if P1 plays Betray.
• If P1 is silent, what is P2’s best response?
Again, the best response would be the one
which yields the highest payoff against P1’s
action. Underline it.
P2 When P1 plays Silent, P2 should play
Betray Silent Betray and get a payoff of 3. If P2
had played Silent instead, he would
P1 Betray 1,1 3, 0
have received a payoff of 2.
Silent 0, 3 2, 2 Therefore, Silent does not represent
a best response if P1 plays Silent.
• Now repeat the process with P2. If P2 betrays,
what is P1’s best response? The best response
would be the one which yields the highest
payoff against P2’s action. Underline it.
P2 When P2 plays Betray, P1 should
Betray Silent play Betray and get a payoff of 1. If
P1 had played Silent instead, he
P1 Betray 1,1 3, 0
would have received a payoff of 0.
Silent 0, 3 2, 2 Therefore, Silent does not represent
a best response if P2 plays Betray.
• If P2 is silent, what is P1’s best response?
Again, the best response would be the one
which yields the highest payoff against P2’s
action. Underline it.
P2 When P2 plays Silent, P1 should play
Betray Silent Betray and get a payoff of 3. If P1
had played Silent instead, he would
P1 Betray 1,1 3, 0
have received a payoff of 2.
Silent 0, 3 2, 2 Therefore, Silent does not represent
a best response if P2 plays Silent.
• Now that we have underlined the best responses
of both players against the other player’s actions
we end up with a payoff matrix as follows.
P2
Betray Silent
P1 Betray 1,1 3, 0
Silent 0, 3 2, 2

• Notice that both the payoffs in the cell

corresponding to (Betray, Betray) are underlined.
The strategy (Betray, Betray) is a best response
strategy (also making it a dominant strategy).
• Best Response: si is a best response for player
i to rival’s strategies s-i , denoted s-i ϵ BRi (s-i) if
ui(si , s-i) ≥ ui(s’i , s-i) for all s’i ϵ Si .

• Dominant Strategy: is a strategy si* for player i

that is a best response to all strategy profiles
of other players. That is si* ϵ BRi (s-i) for all s-i .
• We now introduce a very important equilibrium
concept in economics.
• Nash Equilibrium (NE): A NE is a strategy profile
(s1*, s2*, … , sn*) such that, for each player i = 1, 2,
… , n; si* is a best response to other player’s
equilibrium strategies s-i* i.e. si*ϵ Bri(s-i*).
• In a two-player game, (s1*,s2*) is a NE if s1* and s2*
are mutual best responses against each other.
u1(s1*, s2*) ≥ u1(s1 , s2*) for all s1ϵ S1
u2(s2*, s1*) ≥ u2(s2 , s1*) for all s2 ϵ S2
• There is a slight difference between a NE
strategy and a dominant strategy. A dominant
strategy is a best response to all other
strategies, including NE strategies.
• If all players in a game have a dominant
strategy, we say that the game has a dominant
strategy equilibrium.
• In the PD game we just saw, (Betray, Betray)
was a dominant strategy as well as a NE
strategy.