Game Theory Concepts

I. Definition of a game
Elements of a game: The players are the individuals who make decisions. Each player's goal is to maximize his utility by choice of actions. Nature is a non-player who takes random actions at specified points in the game with specified probabilities. An action is the choice a player can make. Information is modelled using the concept of information set. We may think of it as a player's knowledge, at a particular time, of the values of different variables. A strategy is a rule that tells a player which action to take at each instant of the game given his information set. The payoff is either the utility that a player gets once all players and nature have picked their strategy, or the expected utility that a player receives as a function of the strategies chosen by himself and other players. The outcome of the game of the game is a set of interesting elements that the one picks from the values of actions, payoffs and other variables after the game is played out. An equilibrium is a strategy combination consisting of a best strategy for each player of the game.

II. Information concepts

Information is common knowledge if it is known to all players, each player knows that all of them know it, each of them knows that all of them know that all of them know it, and so on and so forth... Information is perfect if each information set is a singleton. Under perfect information each players knows exactly where he is in the game tree. No moves are simultaneous, and all players observe Nature's moves. Any game of incomplete or asymmetric information is also a game of imperfect information. Information is certain if Nature does not move after any player moves. Without simultaneous moves, a game of certain information is also a game of perfect information. Note that certainty does not prevent Nature from moving first.

Information is symmetric if no player has information different from other players when he moves or at the end node. Note that a game of symmetric information can have unobservable moves by Nature or simultaneous moves. The main point is that under symmetric information no player has an informational advantage. Information is complete if Nature does not move first or her initial move is observed by every player. Incomplete information means that Nature moves first and is unobserved by at least one of the players. In such a case, information is also imperfect.

III. Static Game of Complete Information: Nash Equilibrium

In a static game of complete information the players' choose their actions simultaneously and their payoff functions are common knowledge. Notice that these games necessarily have imperfect information due to simultaneous moves. Consider a game of n players. Let s = ( s1 ,..., sn ) be a set of strategies. Let si denote player is strategy, s-i denotes the strategies of all remaining players. Finally let i ( si , si ) denote player is payoff under strategy s. The strategy si* is a dominant strategy if it is player is best response to any strategies that the other players may pick: i ( si* , si ) i ( si , si ) si , si . A dominant strategy equilibrium is a strategy combination consisting of each player's dominant strategy. Illustration: the prisoner's dilemma Player i's best response or best reply to the strategy s-i is strategy si* such that i ( si* , si ) i ( si , si ) si . The strategy s* is a Nash equilibrium if no player has incentive to deviate from his strategy given that the other players do not deviate. Formally: * ) ( , * ) s i . i, i ( si* , s i i si s i

IV. Dynamic Games of Complete Information

A subgame in an extensive form game (a) begins at a decision node o that is a singleton information set (but not necessarily the game's first decision node) (b) includes all the decision and terminal nodes following o in the game tree and c) does not cut any information sets. The last point is very important.

Definition (Selten 1965): A Nash equilibrium is subgame perfect if the players' strategies constitute a Nash equilibrium in every subgame. The concept of subgame perfection is used to eliminate Nash equilibria that rely on non-credible threats or promises. To find a subgame perfect Nash equilibrium one must solve the game by backwards induction. Consider that there are only 2 players. Player 1 selects an action a1 before player 2. In equilibrium, player 1 perfectly anticipates player 2's best reply. In other words, player 2 solves max a2 2 ( a 2 , a1 ).

The solution of this gives player 2's best reply function (and thus equilibrium strategy) as a function of a1 : s2 ( a1 ) . Player 1 then solves: max a1 1 ( a1 , s2 ( a1 )).

V. Static Games of Incomplete Information: Bayesian Nash Equilibrium.

In a game of incomplete information at least one player does not know another player's payoff function. In such games, nature often chooses at the start of the game what we call a player's type. This then defines its strategy set, information partition and payoff function. A player's type defines his strategy set, information partition and payoff function Nature chooses for him at the start of a game of incomplete information. A state of the world is a move by Nature. Besides their types, players hold beliefs on other players' types. Let pi (t i / ti ) be player is belief, that is the probability that he assigns to other players having types t-i given that he, himself has type ti. It is important to understand that in a Bayesian game the strategy spaces are no longer given in the normal form representation of the game (box form). Instead, a strategy is a function of the type. A strategy for player i is the function si (ti ) , where for each type ti , si (ti ) specifies the actions that type ti would choose. In a separating strategy each type chooses a different action. In a pooling strategy, all types choose the same action.

In a Static Bayesian game the strategies si* (ti ) for i = 1,,n form a Bayesian Nash Equilibrium if for each player i and for each i's types ti , si* (ti ) solves
* max p i (t i / ti ) i ( ai , ti , s (t i )) i ai ti

The solution of this maximisation gives a function si(ti). A Bayesian Nash equilibrium is very close to the Nash equilibrium in that all players strategy is a best response when maximizing their expected utility. The expectation is taken with respect to other players' types.

VI. Dynamic Games of Incomplete Information: Perfect Bayesian Equilibrium

Those are more complex but also interesting games. The equilibrium concept in this case getting rid off non-credible threat is complex but intuitive. First let me give a definition: For a given equilibrium an information set is -on the equilibrium path if it will be reached with positive probability when the game is played according to the equilibrium strategies. -off the equilibrium path if it is certain not to be reached when the game is played according to the equilibrium strategies. In equilibrium 4 requirements must be satisfied: Requirement 1: At each information set, the player with the move must have a belief about which node in the information set has been reach by the play of the game. For a non-singleton information set, a belief is a probability distribution over the nodes in the information set; for a singleton information set, the player's belief puts a probability one on the single decision node. Requirement 2: Given their beliefs, the players' strategies must be sequentially rational. That is, at each information set, the action taken by the player with the move (and the player's subsequent strategy) must be optimal given the player's belief at that information set and the other players' subsequent strategies. Requirement 3: At information sets on the equilibrium path, beliefs are determined by Bayes' rule and the players' equilibrium strategies Requirement 4: At informations sets off the equilibrium path, beliefs are determined by Bayes rule and the players equilibrium strategies where possible. A perfect Bayesian equilibrium consists of strategies and beliefs satisfying requirement 1 through 4.