ECON3014 Topic 1:

Games in strategic form. Nash equilibrium.

Rationalizability
Osborne: Ch 2, 3, 12

A game is a situation where:

a payoff of an invididual (player) depends upon her own action,

and also upon the actions of other agents.

How does a rational individual choose?

My optimal action depends upon what my opponents do,
but their optimal actions may in turn depend upon what I do.

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 Games in normal (or strategic) form

Set of players
N = {1, 2, ..., n}
Each player i has a set of strategies, Si.
Each player chooses a strategy si Si
All players choose their strategies simultaneously and inde-
pendently of each others choices.
This results is a strategy profile:

s = (s1, s2, ..., sn)

Notation: choices of all players but i

si = (s1, s2, .., si1, si+1, .., sn)

The set of all strategy profiles

S = S1 S2 .. Sn

Player is payoff is
ui : S R

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 Example: Prisoners dilemma

Two players.
Each player has two strategies: C(ooperate) and D(efect).
Players are locked into two separate rooms and asked to make a
choice.
Payoffs are

2
c d
1 C 2,2 0,3
D 3,0 1,1

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 Payoffs

What is payoff, ui(s)?

Players need not be concerned only with money:
could be altruistic, could be concerned not to violate a norm, etc.
All of this is captured in the payoff: conditional on opponents
choices, payoffs represent players preference over her strategies.
si could be uncertain, outcome following s could be uncertain
Assume that payoffs are von-Neumann Morgenstern utilities.
Players seek to maximize the expected value of ui(s):

E[ui(si, si)]

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 Back to prisoners dilemma

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c d
1 C 2,2 0,3
D 3,0 1,1

For player 1:

u1(D, c) > u1(C, c)

u1(D, d) > u1(C, d)

D strictly dominates C:
no matter what player 2 plays, D is strictly better than C.
So 1 should play D.
The same is true for 2: she should play d as well.
The game theoretic prediction: (D, d)
Note: This is not socially efficient. (D, d) is Pareto-dominated
by (C, c).

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 Strict dominance

Recall our notation:

si (s1, s2, .., si1, si+1, ..., sn)

Let
Si = j6=iSj
be the set of all such vectors.
A pure strategy si strictly dominates another pure strategy
s0i if si Si:

ui(si, si) > ui(s0i, si)

In this case, s0i is strictly dominated.
If a strategy si strictly dominates every other strategy in Si, then
si is a strictly dominant strategy.
Observation: if a strategy s0i is strictly dominated, it should
never be played by (a rational) player i because there is another
strategy that gives him strictly higher payoff independently of other
players actions.

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 Example

L C R
T 2,5 3,2 0,3
M 5,4 1,1 7,5
B 3,1 0,1 5,0

M strictly dominates B
T and M are not dominated.
We cannot solve this game the same way we solved prisoners
dilemma: We need more assumptions.

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 Common knowledge of rationality

Each player seeks to maximize his expected payoff (in short, is

rational)
We assume that he knows that every other player is also rational,
and knows that every other player knows that every player is
rational and so on.
Rationality is common knowledge.

Is the assumption of common knowledge important?

A puzzle: Two monks with black dots on their forehead live on an
island with no mirrors and no other people. The monks dont speak
to each other and they obey the following rule: if a monk learns that
he has a dot on his forehead, he has to commit suicide by the end of
the day.
A traveller arrives on the island, meets the monks and says: one
of you has a black dot on your forehead. On the second day both
monks commit suicide.
Note: the traveller did not tell the monks something that they did
not know before both of them saw the black dot on each others
forehead.

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 Iterated strict dominance

1) Eliminate all strictly dominated strategies for all players. Left

with reduced game.
2) In the reduced game, eliminate strictly dominated strategies
for all player.
3)Repeat, until no further elimination is possible.

L C R
T 2,5 3,2 0,3
M 5,4 1,1 7,5
B 3,1 0,1 5,0

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 Quality choice game

Firm
H(igh) L(ow)
Consumer B(uy) 2, 2 1, 3
N (o) 0, 0 0, 1

One-sided prisoners dilemma.

For the firm, L strictly dominates H (3 > 2 and 1 > 0).
For the consumer: neither B nor N is strictly dominated.
Since the firm is rational, it will choose L and will not choose H
The consumer knows, that the firm will not choose H
Against L, N is strictly better than B.
Prediction: (N, L)

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 Example

A B C
a 3, 1, 1 3, 2, 1 3, 1, 1
b 0, 2, 1 0, 1, 1 0, 2, 1
c 2, 1, 2 2, 2, 2 2, 1, 2

A B C
a 0, 2, 2 0, 1, 2 0, 2, 2
b 3, 1, 2 3, 2, 2 3, 1, 2
c 2, 2, 1 2, 1, 1 2, 2, 1

No strictly dominated strategies.

Step 1: Player 1:

Suppose player 3 plays T . Then no matter what player 2 is

playing, it is best for player 1 to play a.

Suppose player 3 plays B. Then no matter what player 2 is

playing, it is best for player 1 to play b.

Conclusion: no matter what player 1 believes players 2 and 3 play,

he himself should never play c.
Step 2: Player 3:
If player 3 believes that c will not be played, he should never play
U
Continue until (b, B, D) remain.

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 Best reply

Suppose a player knows what others will play. What should

she play?
Take a strategy profile s. A best reply of a player i to a strategy
profile s is a strategy that maximizes her payoff conditional
on others playing s:

BRi(s) = arg max{ui(x, si)}

xSi

Observation: a strictly dominated strategy can never be a best

reply.

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 Rationalizability

Take
Ri0 = Si

Define the sequence

Rik = {si Rik1 | s jN Rjk1 : si BRi(s)}

A strategy si of player i is rationalizable if

\
si Ri = Rik
k=0

Similar to iterated strict dominance.

Intuition: If a strategy is not a best reply to any strategy the
opponents may play, it will not be played.

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 Nash equilibrium.

A strategy profile s = (s1 , s2 , ..., sn) is a Nash equilib-

rium if for every player i N ,

ui(s1 , s2 , .., si ., sn) ui(s1 , s2 , ., si.., sn)si Si.

or, equivalently, for every player i N

si BRi(s)

Player i assumes that his opponents are playing si, and asks if
it is optimal to play si .
I.e. is there any strategy si which gives a strictly higher payoff
than si , given that the others are playing si?
If the answer is no for every player i, s is a Nash equilibrium.

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 Example

A B C
a 3, 1, 1 3, 2, 1 3, 1, 1
b 0, 2, 1 0, 1, 1 0, 2, 1
c 2, 1, 2 2, 2, 2 2, 1, 2

A B C
a 0, 2, 2 0, 1, 2 0, 2, 2
b 3, 1, 2 3, 2, 2 3, 1, 2
c 2, 2, 1 2, 1, 1 2, 2, 1

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 Example. Existence

2
a b
1 A 1,-1 -1,1
B -1,1 1,-1

No pure strategy NE.

Intuitively, each player best strategy is to confuse the opponent
as much as possible to randomize.

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 Mixed Strategies

p 1-p
a b
q A 1,-1 -1,1
1-q B -1,1 1,-1

Mixed extension of the game: allows players to randomize

between their pure strategies.
Players choose to play according to some probability distribution
over the set of their strategies. Recall that probability distribution
implies:

1. each probability is (weakly) positive

2. sum of probabalities is one.

Key points:
In a mixed strategy equilibrium, a player who randomizes be-
tween two strategies is indifferent between all the strategies that
she asssigns positive probability to.
Player 1s mixed strategy is chosen in order to make player 2
indifferent, and vice versa.

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 Mixed strategies (cont.)

A mixed strategy of player i is mi (Si). Take a pure strategy

(action) s Si: mi(s) is the probability that player i will play s if
he follows mi.
As before, a profile of strategies is

m = (m1, ..., mn) iN (Si)

.
Players randomize independently of each other:
Y
Pr{s | m} = mi(si)
iN

Player is expected payoff is

X Y
E[ui(mi, mi)] = ui(si, si) mj (sj )
sS jN
.

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 Existence of Nash Equilibrium in mixed strategies

Theorem (Nash): Let G be a game with finitely many players,

where each players strategy set is finite. G has a Nash equilibrium,
possibly in mixed strategies.
Let m = (m1, m2, ..., mn) be a Nash equilibrium. The support
of mi is the set of pure strategies s : mi(s) > 0. For every player i :

1. all strategies in the support of mi have the same payoff con-

ditional on mi.

2. any strategy that is not in the support of mi has a (weakly)

lower payoff conditional on mi.

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 Cournot Oligopoly

Two firms, 1 and 2, producing a homogeneous good.

Both firms choose their quantity qi 0 simultaneously.
Total quantity Q = q1 + q2 is placed on market, and gives rise to
market price P (Q).
Firm is profits are i(q1, q2) = qiP (Q) (costs are zero).
Example P (Q) = 90 Q.

1(q1, q2) = q1(90 q1 q2)

1
= 90 2q1 q2.
q1
Suppose firm 1 correctly anticipates q2.
To find optimal quantity, set 1
q1 = 0.
Firm 1s best response function is
90 q2
q1(q2) = .
2
Similarly,
90 q1
q2(q1) = .
2
Setting q2 = q2(q1),

90 ( 90q
2 )
1
q1 =
2
= 30.
Nash equilibrium is q1 = q2 = 30.
Monopoly quantity is 45. Hence firms total profits less than half
monopoly profits.
Socially optimal quantity?
Cournot outputs : Nash equilibrium outputs in a game where
firms choose quantity.

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 Bertrand Oligopoly

Same context, but firms choose prices.

Prices can be continuously varied, i.e. pi is any real number.
If prices are unequal, all consumers go to lower price firm.
If equal, market is shared.
1) There is a Nash equilibrium where p1 = p2 = 0.
2) There is no other Nash equilibrium in pure strategies.
Proof:
1) Check that player 1s best reply contains p1 = 0. Indeed,
player 1s payoff is 1(p1, p2 = 0) = 0 for any p1. The same is true
for player 2.
2) By contradiction assume there is a PSNE (p1 , p2 ) 6= (0, 0).
Cases:

p1 = p2 = p. Player 1s payoff is 1(p1 , p2 ) = Q(p)p/2. Player

1 is better off deviating to p01 = p  if  > 0 is small:

1(p01, p2 ) = Q(p )(p ) > Q(p)p/2,

hence (p1 , p2 ) is not a NE.

p1 > p2 > 0. Player 1s payoff is 0 in this case. He is better off

matching player 2s price and collecting

1(p01 = p2 , p2 ) = Q(p2 )p2 /2 > 0.

p1 > p2 = 0. Player 2s payoff is 0. He is better off matching

player 1s price and collecting

1(p1 , p02 = p1 ) = Q(p1 )p1 /2 > 0.

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 Political Party Competition. Voters

Each voter has a preferred political position, represented by

x [0, 1]
0 extreme left, 1 extreme right
If policy y is adopted, then the voters utility is (x y)2
There is a continuum of voters f (x) is the number of voters
with preferred position x
More accurately, f (x) is the density function of voters.
A proportion of voters whose preferred point is less than x is a
cdf:
Zx
F (x) = f (t)dt
0
Median voter m : F (m) = 0.5
Voters are not strategic, i.e. they vote for a policy that gives them
the highest payoff.

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 Political Party Competition. Parties

Two parties, A and B

Both parties simultaneously choose platforms numbers between
0 and 1.
If a and b are the two platforms, then voter x votes for whichever
platform is closer.
If the two are equidistant, then the voter votes for each with
probability 0.5.
A partys payoff is 1 if it wins the election, 0 if it loses.
If both parties get the same number of votes, payoff is 0.5.

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 Political Party Competition. Equilibrium

Proposition (median voter theorem): The party competition game

has a unique Nash equilibrium where both parties locate at m.
1) (a = m, b = m) is a Nash equilibrium.
2) There is no other equilibrium.
Proof:
1)Payoff for party A is 0.5.
a+m
Suppose that it chooses a < m and gets all voters with x < 2 .
F ( a+m
2 ) < 0.5, so it loses the election.
If it chooses a > m similar thing happens.
2) Cases:

If a < b, the party that does not win for sure can win with
probability 0.5 by mimicking the winner.

If a = b 6= m, then A can do better by choosing m and winning.

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Common knowledge of a game and profit maximization

Cournot duopoly: 2 firms face a demand P = max{0, 90 Q}.

Firm 2 is the same as before: it maximizes its profit.
Firm 1 is overcompetitive: instead of maximizing profit it desires
to be a leader in the market. We will model it as if firm 1 maximizes
the difference between its own and the other firms profit:

u1(q1, q2) = 1(q1, q2) 2(q1, q2)

= (90 q1 q2)(q1 q2)

Benchmark: Two profit-maximizing firms:

q1 = q2 = 30
1(q1, q2) = 2(q1, q2) = 900

If firm 1 is overcompetitive:

90 2q1 = 0

or
90
q1(q2) =
2
as before
90 q1
q2(q1) =
2

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Common knowledge of a game and profit maximization
(cont.)

Nash equilibrium:

q1 = 45
q2 = 22.5
452
1 = = 1012.5
2
 2
45
2 = = 506.25
2
Firm 1 obtains a larger profit compared to the situation when
firm 1 is a profit maximizer. Why?..
If both firms are overcompetitive (zero-sum game):

q1 = q2 = 45
1 = 2 = 0

The profit of both firms drops to 0. Why?..

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