Game Theory

Game Theory
What is game theory?

• Game theory is the formal study of conflict and
cooperation.
• Game theoretic concepts apply whenever the actions of

several agents are interdependent.
• These agents may be individuals, groups, firms, or any

combination of these.
• The concepts of game theory provide a language to

formulate, structure, analyze, and understand strategic
scenarios.
Definitions of games
• The object of study in game theory is the game, which
is a formal model of an interactive situation.
• It typically involves several players; a game with only

one player is usually called a decision problem.
• The formal definition lays out the players, their

preferences, their information, the strategic actions
available to them, and how these influence the
outcome.
What is Game Theory?
“Game Theory attempts to
mathematically capture behaviour in
games where an individual’s success
in making choices depends on the
choices of others.”
Examples of where to use game theory
• A shop owner deciding the price of biscuits
• Deciding whether to help someone
• Auctions
• Voting systems
• Animal behaviour and evolution

Basic Concepts
• Any situation in which individuals must make
strategic choices and in which the final
outcome will depend on what each person
chooses to do can be viewed as a game.
• Game theory models seek to portray complex

strategic situations in a highly simplified
setting.
6
Basic Concepts
• All games have three basic elements:
– Players
– Strategies
– Payoffs
• Players can make binding agreements in

cooperative games, but cannot in non-
cooperative games, which are studied in this
chapter.
7
Players
• A player is a decision maker and can be anything
from individuals to entire nations.
• Players have the ability to choose among a set of

possible actions.
• Games are often characterized by the fixed number

of players.
• Generally, the specific identity of a play is not

important to the game. 8
Strategies
• A strategy is a course of action available to a
player.
• Strategies may be simple or complex.
• In non-cooperative games each player is

uncertain about what the other will do since
players can not reach agreements among
themselves.
9
Payoffs
• Payoffs are the final returns to the players at the
conclusion of the game.
• Payoffs are usually measure in utility although

sometimes measure monetarily.
• In general, players are able to rank the payoffs

from most preferred to least preferred.
• Players seek the highest payoff available.
10
Equilibrium Concepts
• In the theory of markets an equilibrium occurred
when all parties to the market had no incentive
to change his or her behavior.
• When strategies are chosen, an equilibrium

would also provide no incentives for the players
to alter their behavior further.
• The most frequently used equilibrium concept is

a Nash equilibrium.
11
Rules and Actions
• The rules of the game determine the timing of
players’ moves and the actions players can
make at each move.
• An action is a move that a player makes at a

specified stage of a game.
Simultaneous-move game
• A simultaneous-move game (also known as a
normal-form game) requires three elements.
First, a set of players.
• Second, each player must have a set of

strategies.
• Once each player chooses a strategy from

their strategy set, we have a strategy profile.
Example
• For example, suppose there are two
players, 1 and 2, and 1 can choose
between Up or Down (so 1's strategy
set is {U;D}).
• Player 2 can choose between Left or

Right (so 2's strategy set is {L;R}).
• If player1 chooses Up and 2 chooses

Left, we have the strategy profile
{U;L}.
• There are altogether 4 such strategy

profiles: the one just mentioned, plus
{D; L}, {U;R} and {D;R}
Example
• A payoff function for any player is
defined over the set of strategy
profiles.
• For each strategy profile, each

player gets a payoff.
• Suppose 𝑆𝑖 denotes the set of

strategies of player 𝑖.
• S1 = {U;D}and S2 = {L;R}.
• Let 𝑠𝑖 denote a strategy of 𝑖 (that

is, 𝑠𝑖 is in the set 𝑆𝑖 ).
Example
• If there are 𝑛 players, a strategy
profile is (𝑠1 , 𝑠2 , … . . 𝑠𝑛 ).
• For any such strategy profile, there

is a payoff for each player.
• Let ui (𝑠1 , 𝑠2 , … . . 𝑠𝑛 ) . denote the

payoff of player 𝑖.
• For example u1({U;L}) = u1({D;R}) =

1 and u1({D; L}) = u1({U;R}) = 2.
• Furthermore, suppose u2({U;L}) =

u2({D;R}) = 2, u2({D; L}) = 3 and
u2({U;R}) = 1.
• This can be written in a
convenient matrix form (known
as the normal form) as follows.
• The first number in each cell is

the payoff of player 1 and the
second number is the payoff of
player 2.
• Note that player 1 chooses rows

and player 2 chooses columns.
• It is sometimes useful to write
the strategy
profile 𝑠1 , 𝑠2 , … . . 𝑠𝑛 as
(𝑠𝑖 , 𝑠−𝑖 ).
• Where 𝑠−𝑖 is the profile of

strategies of all players other
than player 𝑖.
Dominant and dominated strategies
• Suppose a player has a strategy that gives a higher payoff compared to other
strategies irrespective of the strategy choices of others.
• Such a strategy is called a dominant strategy.
• If a player has a dominant strategy, his problem is simple: he should clearly play
that strategy.
• If each player has a dominant strategy, the equilibrium of the game is obvious:
each player plays his own dominant strategy.
An Overview of Game Theory
Assumptions:
• All players are interested in maximizing their payoffs.
• All players have common knowledge about the rules of the

game
• Each player’s payoff depends on actions taken by all Players
• Complete information (payoff function is common knowledge

among all players) is different from perfect information (player
knows full history of game up to the point he is about to move)
Game Trees: Decision Trees for
Strategic Situations
• The main difference between a game tree and

a decision tree is that several different players
make moves in a game tree, but only one
player makes moves in a decision tree.
Example
• The situation of Air Lion and
Beta Airlines.
• Assume that each firm has only

two possible output levels:
“high” and “low”.
• Air Lion’s decision is depicted in

Figure.
• A little square called a decision

node is used to represent a
point at which a decision has to
be made.
Example
• Because there are two
players.
• Have to provide a label

that indicates whose
decision node it is.
• If it were simply a decision

tree for Air Lion,
• We would put payoffs at

the end of each of the two
branches.
Example of Game Tree
• Beta has the same
possible actions, “high”
and “low”, as Air Lion.
• Before choosing its

output level, Beta gets
to see what choice Air
Lion has made.
• As a result, Beta has

two different decision
nodes in Figure
• The payoffs for each possible
outcome (combination of
actions) are represented at the
end of each final branch.
• The first number in each pair is

Air Lion’s payoff for that
outcome; the second is Beta’s.
• For example, if Air Lion’s

output is “high” and Beta’s
output is “low”, then
• Air Lion earns a profit of a

6,000 and Beta earns a 1,000.
• The actions that the two
firms can be seen but not
their Strategies.
• A strategy specifies what

action the firm will take
at each of its decision
nodes.
• A strategy specifies what

action the firm will take
at each of its decision
nodes.
• Air Lion chooses its
output level first and has
only one decision node.
• For Air Lion, the strategy

is simply: produce “high”
or produce “low”.
• Beta’s strategy is more

complicated than Air
Lion’s.
• Beta has two decision
nodes in the game tree.
• Beta gets to see what

choice Air Lion has made
before making its own
choice.
• Beta chooses a decision

rule that specifies what
action it will take
conditional on what Air
Lion has done;
• One possible strategy
for Beta is the
following:
• If Air Lion produces

“high”, then I will
produce “low”, and
• If Air Lion produces

“low”, then I will
produce “high”
Dominant Strategy Equilibrium
• Consider Beta’s strategy
first.
• Suppose that Air Lion has

chosen “low”.
• Then Beta would earn

€6,000 by choosing “high”
and € 3,000 by choosing
“low”.
• Thus, conditional on Air

Lion’s choosing “low”,
Beta’s payoff is maximized
by choosing “high”.
Dominant Strategy Equilibrium
• If Air Lion had chosen “high”, then
• Beta would choose “high” for a

payoff of € 4,000 rather than
“low” for a payoff of € 1,000.
• Hence, no matter what Air Lion’s

strategy is, one best strategic
response for Beta is to produce
“high” no matter what Air Lion
does.
Beta
Air Lion Low High
Low 3,000, 3,000 1,000, 6,000
High 6,000, 1,000 4,000, 4,000
• A strategy that works at least as well as any other
one, no matter what the other player does, is
known as a dominant strategy.
• There is no reason for players to use anything

other than their dominant strategy, if they have
one.
• Hence, in equilibrium, we would expect Beta to

choose the strategy produce “high” no matter
what Air Lion does.
What about Air Lion’s strategy?
• If Air Lion chooses “low”, its payoff is
€ 3,000 if Beta responds by
producing “low”, or € 1,000 if Beta
responds by producing “high”.
• If Air Lion chooses “high”, then its

payoff is either € 6,000 or € 4,000,
depending on how Beta responds.
• Air Lion does better by choosing

“high”, no matter how Beta
responds.
• Hence, produce “high” is a dominant

strategy for Air Lion.
• This is what we would expect Air

Lion to do in equilibrium.
• When each player has a dominant strategy, the
only reasonable equilibrium outcome is for each
player to use its dominant strategy.
• The set of dominant strategies and the resulting

outcome are known as a dominant strategy
equilibrium.
• Dominant strategy equilibrium An outcome in a

game in which each player follows a dominant
strategy.
Nash condition and credibility condition.
• Nash condition requires that no firm be able to gain by
unilaterally changing what it is doing
• Each firm must play a best response to what the other firm
is doing.
• Each player’s equilibrium strategy must be a best response

to the equilibrium strategy chosen by the other player.
• Since a dominant strategy is a best response to anything, a

dominant strategy equilibrium clearly satisfies the Nash
condition.
 Credibility condition:
• It requires that each time a firm is called upon to make

a move, it is in the firm’s self-interest to carry out the
action called for by its strategy.
• This property is clearly satisfied by Air Lion’s strategy.
• Since there is only one part to Air Lion’s strategy, the

Nash condition alone guarantees that Air Lion would
want to carry out that strategy.
• The credibility condition is more complicated for
Beta, because its strategy has two parts that must
be checked.
• First, the credibility condition is satisfied by Beta’s

decision to produce “high” in response to a high
output level by Air Lion.
• This is the action the firm actually takes in

equilibrium, it too is taken care of by the Nash
condition.
• The real issue is whether
Beta’s threatened
response of high output to
low output by Air Lion is
credible.
• If Air Lion chose “low”,

then Beta would earn
€6,000 by producing
“high” and only € 3,000 by
producing “low”.
• It is no coincidence that
Beta’s strategy is credible.
• Since Beta is playing
a dominant strategy,
we know that no
matter what Air Lion
does,
• Beta’s equilibrium
strategy does at
least as well as any
other.
• In summary, the dominant strategy
equilibrium that we found satisfies both the
Nash condition and the credibility condition.
The Prisoner’s Dilemma
• The Prisoner’s Dilemma is a game in which
the optimal outcome for the players is
unstable.
• The name comes from the following situation.

– Two people are arrested for a crime.
– The district attorney has little evidence but is
anxious to extract a confession.
41
– The DA separates the suspects and tells each, “If you
confess and your companion doesn’t, I can promise
you a six-month sentence, whereas your companion
will get ten years.
– If you both confess, you will each get a three year

sentence.”
– Each suspect knows that if neither confess, they will

be tried for a lesser crime and will receive two-year
sentences.
42
B
Confess Not confess
A: 3 years A: 6 months
Confess
B: 3 years B: 10 years
A A: 10 years A: 2 years
Not confess
B: 6 months B: 2 years
43
• The normal form of the game is shown in Next
table
– The confess strategy dominates for both players so
it is a Nash equilibria.
– However, an agreement not to confess would

reduce their prison terms by one year each.
– This agreement would appear to be the rational

solution.
44
• The “rational” solution is not stable, however,
since each player has an incentive to cheat.
• Hence the dilemma:
– Outcomes that appear to be optimal are not
stable and cheating will usually prevail.
45
Nash Equilibrium
• A Nash equilibrium is a pair of strategies (a*,b*)
in a two-player game such that a* is an optimal
strategy for A against b* and b* is an optimal
strategy for B against A*.
– Players can not benefit from knowing the equilibrium

strategy of their opponents.
• Not every game has a Nash equilibrium, and

some games may have several.
46
An Illustrative Advertising Game
• Two firms (A and B) must decide how much to
spend on advertising.
• Each firm may adopt either a higher (H)

budget or a low (L) budget.
• The game is shown in extensive (tree) form in

Figure
47
• A makes the first
7,5
move by choosing
either H or L at the
L first decision “node.”
B
H 5,4
• Next, B chooses
L either H or L, but the
large oval
A surrounding B’s two
L 6,4
B decision nodes
H indicates that B does
H 6,3 not know what
choice A made.
48
• The numbers at the end of
each branch, measured in
7,5 thousand or millions of
dollars, are the payoffs.
L
B
– For example, if A chooses H
and B chooses L, profits will
H 5,4 be 6 for firm A and 4 for firm
L B.
A
• The game in normal (tabular)
L 6,4 form is shown in Table where
B A’s strategies are the rows
H
and B’s strategies are the
H 6,3 columns.
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Table: The Advertising Game in Normal
Form
B’s Strategies
L H
L 7, 5 5, 4
A’s Strategies H 6, 4 6, 3
7,5
L
B
H 5,4
L
A L 6,4
B
H
H 6,3 50
Dominant Strategies and Nash
Equilibria
• A dominant strategy is optimal regardless of the strategy adopted by an opponent.
– As shown in Table or Figure , the dominant strategy for B is L since this yields a larger
payoff regardless of A’s choice.
• If A chooses H, B’s choice of L yields 5, one better than if the choice of H was made.
• If A chooses L, B’s choice of L yields 4 which is also one better than the choice of H.
B’s Strategies
L H
L 7, 5 5, 4
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Equilibria
• A will recognize that B has a dominant strategy and choose the strategy
which will yield the highest payoff, given B’s choice of L.
– A will also choose L since the payoff of 7 is one better than the payoff from
choosing H.
• The strategy choice will be (A: L, B: L) with payoffs of 7 to A and 5 to B.
B’s Strategies
L H
L 7, 5 5, 4
52
Equilibria
• Since A knows B will play L, A’s best play is also L.
• If B knows A will play L, B’s best play is also L.
• Thus, the (A: L, B: L) strategy is a Nash equilibrium:

it meets the symmetry required of the Nash
criterion.
• No other strategy is a Nash equilibrium. 53

Iterated Dominated Strategy
• Even if a player does not have a dominant strategy, he might have one
or more dominated strategies.
• A dominated strategy for 𝑖 is a strategy of 𝑖 (say) 𝑠𝑖 that yields a lower

payoff compared to another strategy (say 𝑠𝑖′ ) irrespective of what
others are playing.
• In other words, the payoff of 𝑖 from playing 𝑠𝑖 is always (i.e. under all
possible choices of other players) lower than the payoff from playing
𝑠𝑖′ .
• Since 𝑠𝑖 is a dominated strategy, 𝑖 would never play this strategy. Thus

we can eliminate dominated strategies.
• Indeed, we can eliminate such strategies not just once, but in an

iterative fashion
• If in some game, all strategies except one for
each player can be eliminated by iteratively
eliminating dominated strategies, the game is
said to be dominance solvable.
A game without dominant strategies
• Consider the game below:
• There are no strictly dominant strategies, but there is a strictly dominated

strategy.
• Playing U is strictly dominated by D for Player 1.
• We can conclude that Player 1 will never play U, and so our game reduces to the
matrix.
• But Player 2 should know that Player 1 will never play U, and
• If Player 1 never plays U then some of Player 2’s strategies are strictly
dominated!
• Namely, playing L are both strictly dominated by playing C and R as long as

Player 1 never plays U.
• So we can eliminate those strategies for Player 2, yielding the matrix in

• Finally, Player 1 should anticipate that Player
2 (anticipating that Player 1 will never play U)
will never play L or R, and so
• Player 1 should conclude that M is strictly

dominated by D.
Player 2
Player 1 L C R
M 0,3 1,5 4,4
D 2,4 3,6 3,0
• Player 2 will play C no matter what player 1 plays.
• Eliminate R and then last player 1 will play D if player 2

plays C.
• So finally the outcome would be 3,6
Player 2 Player 2
Player 1 C R
Player 1 C
M 1,5 4,4
D 3,6
D 3,6 3,0
Example
Player 2
Player 1
• R is strictly dominated by C
Now M is strictly dominated by U

• Now compare L and C for Player 2 L is
dominated by C. Now D for Player 1 and C for
player 2 is the outcome. (4,2)
Example of IEDS
Conclusion
I. For player 1, Bottom is
dominated by Top. Eliminate
Bottom.
II. In the remaining game, for

player 2, Right is dominated by
Middle. Eliminate Right.
III. In the remaining game, for

player 1, Top is dominated by
Middle. Eliminate Top.
IV. In the remaining game, for

player 2, Middle is dominated
by Left. Eliminate Middle.
• This gives us (Middle, Left) as the

unique equilibrium.
Nash equilibrium
• However, for many games the above criteria of dominance
do not allow us to find an equilibrium.
• Players might not have dominant strategies; moreover none

of the strategies of any player might be dominated.
• The following game provides an example.

• The problem with dominance criteria is that they apply only
to some games.
• For games that do not have dominant or dominated

strategies, the idea of deriving an equilibrium using
dominance arguments does not work.
• If we cannot derive an equilibrium by using dominant

strategies or by (iteratively) eliminating dominated
strategies.
• How do we proceed?
Pure and mixed strategies
• The Prisoners' Dilemma game, each player has the strategies C and D.
• However, this is not a full description of strategies.
• A player could also do the following: play C with probability 𝑝 and play D
with probability (1 − 𝑝), where 𝑝 is some number between 0 and 1.
• Such a strategy is called a `mixed' strategy; while a strategy that just

chooses one action (C or D) is called a `pure' strategy.
• All games have at least one Nash equilibrium (in either pure or mixed strategies).
• This is why Nash equilibrium is the central solution concept in game theory.
• A strategy profile (𝑠1∗ , 𝑠2∗ , … . . , 𝑠𝑛∗ ) is a Nash equilibrium (in pure strategies) if it is a
mutual best response.
• In other words, for every player 𝑖, the strategy 𝑠𝑖∗ is a best response to 𝑠−𝑖
∗
. (as
explained above, this is the strategy profile of players other than 𝑖).
• In other words, if (𝑠1∗ , 𝑠2∗ , … . . , 𝑠𝑛∗ ) is a Nash equilibrium, it must satisfy the
∗
property that given the strategy profile 𝑠−𝑖 of other players.
• Player 𝑖 cannot improve his payoff by replacing 𝑠𝑖∗ with any other strategy.
• To find out the Nash equilibrium of the game,
we must look for the mutual best responses.
• Player 1's best response is as follows:

• Player 1's best response is as follows:
• Player 2's best response:
Note from these that the only mutual

best response is (B1;B2). This is the
only Nash equilibrium in this game.
• Nash equilibrium is not necessarily unique.
• Consider the following game.
• There are multiple pure strategy Nash equilibria.

Both (A,A) and (B,B) are Nash equilibria.
Dominance criteria and Nash
equilibrium
• While a dominant strategy equilibrium is also a Nash equilibrium,
Nash equilibrium does not require dominance.
• The greater scope of Nash equilibrium comes at a cost: it places

greater rationality requirements on players.
• To play (B1;B2), player 1 must correctly anticipate that player 2 is

going to play B2.
• Such a requirement is even more problematic when there are

multiple Nash equilibria.
• On the other hand, if players have dominant strategies, they do not

need to think at all about what others are doing.
• This is why a dominant strategy equilibrium (or one
achieved through iterative elimination of dominated
strategies) is more convincing than a Nash equilibrium.
• However, as noted before, many games do not have

dominant or dominated strategies, and are therefore
not dominance solvable.
• We need a solution concept that applies generally to all

games, and Nash equilibrium is such a concept.
Example 1: Tennis (Mixed Strategy)
• Notice that this game has no pure strategy Nash equilibrium. However, as you will
see below, the game does have a Nash equilibrium in mixed strategies.
• Let p be the probability that Serena chooses DL (down the line), so 1‐p is the
probability that she chooses CC (Cross court).
• Let q be the probability that Venus positions herself for DL, so 1‐q is the
probability that she positions herself for CC.
• To find mixed strategies, we compute the mix and q-mix options.

Row Player’s Optimal Choice of p
• Serena solves for the value of p that equates Venus’s payoff from positioning herself for DL or CC:
50p+10(1‐p) = 20p+80(1‐p), or
50p+10‐10p = 20p+80‐80p, or
40p+10 = 80‐60p, or
100p = 70, so
p = 70/100 = .70.
• If Serena plays DL with probability p=.70 and CC with probability 1‐p=.30, then Venus’s success rate
from
• DL=50(.70)+10(.30)=38%=Venus’s success rate from

• CC=20(.70)+80(.30)=38%.
• Since this is a constant sum game, Serena’s success rate is 100%‐

• Venus’s success rate = 100‐38=62%.
Row Player’s Optimal Choice of p
• Chose p so as to equalize the payoff your opponent
receives from playing either pure strategy.
• This requires understanding how your opponent’s

payoff varies with your choice of p.
• Graphically, in the Tennis example:

Column Player’s Optimal Choice of q
• Venus solves for the value of q that equates Serena’s payoff from playing DL or CC:
50q+80(1‐q) = 90q+20(1‐q), or
50q+80‐80q = 90q+20‐20q, or
80‐30q = 70q+20, or
60 = 100q, so
q = 60/100 = .60.
• If Venus positions herself for DL with probability q=.60 and CC with probability 1‐q=.40,
then Serena’s success rate from
• DL=50(.60)+80(.40)=62%=Serena’s success rate from CC=90(.60)+20(.40)=62%.
• Since this is a constant sum game, Venus’s success rate is 100%‐Serena’s success rate =
100‐62=38%.
Column Player’s Optimal Choice of q
• Choose q so as to equalize the payoff your
opponent receives from playing either pure
strategy.
• This requires understanding how you opponent’s
payoff varies with your choice of q.
• Graphically, in our example:
• A strictly mixed strategy Nash equilibrium in a 2
player, 2 choice (2x2) game is a p > 0 and a q > 0
such that p is a best response by the row player to
column player’s choices, and q is a best response by
the column player to the row player’s choices.
• In our example, p=.70, q=.60. The row player’s

payoff (Serena) was 62 and the column player’s
payoff (Venus) was 38. (Serena wins 62%, Venus
38%).
• Pure strategies can now be understood as a
special case of mixed strategies, where p is
chosen from the set {0, 1} and q is chosen
from the set {0, 1}.
• For example, if p=0 and q=1, then row player

always plays CC and column player always
plays DL.
Keeping the Opponent Indifferent
• Why is this a useful objective for determining the mixing
probability?
• In constant sum games, such as the tennis example, making your

opponent indifferent in expected payoff terms is equivalent to minimizing
your opponents’ ability to recognize and exploit systematic patterns of
behavior in your own choice.
• In constant sum games, keeping your opponent indifferent is equivalent to

keeping yourself indifferent.
• The same objective works for finding mixed strategy equilibria in

non‐constant sum games as well, where players interests are not totally
opposed to one another.
• Necessarily suggests that the game is played repeatedly.

Best Response Functions
• Another way to depict each player’s choice of the mixing
probability. (Recall p=Pr(DL) by Serena, q=Pr(DL) by Venus).
• Shows strategic best response of q=f(p) and p=g(q).
• p, q =0 is always play CC, p, q =1 is always play DL.

Construction of Best Response Functions
• Use the graphs of the optimal choices of q=f(p) and p=g(q):
Combining the Best Response Functions
Reveals the Mixed Strategy Nash Equilibrium
• Combined Best Response Functions

• Nash equilibria are mutual best responses
Mixed strategies (Subject Guide)
• Consider the following game.
• Notice that this game has no pure strategy Nash equilibrium.
• However, as you will see below, the game does have a Nash
equilibrium in mixed strategies.
• A Nash equilibrium can then be defined in the
usual way: a profile of mixed strategies that
constitute a mutual best response.
• A mutual best response in mixed strategies

has an essential property that makes it easy to
find mixed strategy Nash equilibria.
• We have an equilibrium in which both players
play strictly mixed strategies:
 Player 1 plays A1 with probability p and B1 with

probability (1- p) where 0 < p < 1,
• and
 Player 2 plays A2 with probability q and B2 with

probability (1- q) where 0 < q < 1.
• In this case, whenever player 1 plays A1, she gets
an expected payoff of:
• 𝜋1 (𝐴1 ) = 3𝑞 + 2(1 − 𝑞):
• Whenever player 1 plays B1, she gets an expected

payoff of:
• 𝜋1 (𝐵1 ) = 2𝑞 + 3(1 − 𝑞):

• Suppose 𝜋1 𝐴1 > 𝜋1 (𝐵1 ).
• Then clearly player 1 should simply play A1, rather than

any strictly mixed strategy, to maximise her payoff.
• In other words, player 1's best response in this case

would be to choose p = 1, rather than a strictly mixed
strategy p < 1.
• But then we do not have a mixed strategy Nash

equilibrium.
• Similarly, if 𝜋1 𝐴1 < 𝜋1 𝐵1 ,player 1's best
response would be to choose p = 0 (i.e. just to
play B1), and again we cannot have a mixed
strategy Nash equilibrium.
• So if player 1 is going to play a mixed strategy in equilibrium it must be that she is
indifferent between the two strategies.
• How does such indifference come about?
• This is down to player 2's strategy choice.
• Player 2's choice of q must be such that player 1 is indifferent between playing A1 or B1.
• In other words, in equilibrium q must be such that 1(A1) = 1(B1), i.e. we have:
3𝑞 + 2(1 − 𝑞) = 2𝑞 + 3(1 − 𝑞)
which implies q = 1/2.
• But if player 2 is going to choose q = 1/2 it must be that he is indifferent between A2 and
B2 (otherwise player 2 would not want to mix, but would play a pure strategy).
• How can such indifference come about?

• Player 1 must choose p in such a way so as to
make player 2 indifferent between A2 and B2.
• In other words, player 1's choice of p is such

that 𝜋2 𝐴2 = 𝜋2 i.e. we have:
1 = 3p
which implies p = 1/3.
• Therefore, the mixed strategy Nash
equilibrium is as follows.
Player 1 plays A1 with probability 1/3 and B1

with probability 2/3,
While player 2 plays A2 with probability 1/2

and B2 with probability 1/2
• Write down the best response function of
each player.
• Player 1's best response function is given by:

• Player 2's best response function is given by:
• Figure 4.1 below shows these best response functions and shows the equilibrium
point (where the two best response functions intersect).
• The best-response functions. They cross only at E, which is the mixed strategy
Nash equilibrium.
• There are no pure strategy Nash equilibria in this case.

• The essential property of a mixed strategy Nash
equilibrium in a two-player game is that each
player's chosen probability distribution must make
the other player indifferent between the strategies
he is randomising over.
• In a 𝑘-player game, the joint distribution implied by

the choices of each player in every combination of
𝑘 − 1 players must be such that the 𝑘𝑡ℎ player
receives the same expected payoff from each of the
strategies he plays with positive probability.
• Once we include mixed strategies in the set of
strategies, we have the following existence
theorem, proved by John Nash in 1951.
• Nash proved the existence theorem for his

equilibrium concept using a mathematical result
called a `fixed-point theorem'.
Mixed Strategy Nash Equilibrium
• A mixed strategy is one in which a player plays his available pure
strategies with certain probabilities.
• Mixed strategies are best understood in the context of repeated games,

where each player’s aim is to keep the other player(s) guessing, for
example: Rock, Scissors Paper.
• If each player in an n‐player game has a finite number of pure strategies,

then there exists at least one equilibrium in (possibly) mixed strategies.
(Nash proved this).
• If there are no pure strategy equilibria, there must be a unique mixed

strategy equilibrium.
• However, it is possible for pure strategy and mixed strategy Nash

equilibria to coexist, as in the Chicken game.
Backwards induction
• The concept of backwards induction
corresponds to the assumption that it is
common knowledge that each player will act
rationally at each node where he moves —
even if his rationality would imply that such a
node will not be reached.
Finite horizon perfect information
game
• Consider any node that comes just before
terminal nodes, that is, after each move
stemming from this node, the game ends.
• If the player who moves at this node acts

rationally, he will choose the best move for
himself.
• Hence, we select one of the moves that give this

player the highest payoff.
• Assigning the payoff vector associated with
this move to the node at hand,
• Delete all the moves stemming from this node

so that we have a shorter game.
• Where our node is a terminal node. Repeat

this procedure until we reach the origin.
Example
• Consider the following well-known game, called
as the centipedes game.
• This game illustrates the situation where it is

mutually beneficial for all players to stay in a
relation.
• While a player would like to exit the relation, if

she knows that the other player will exit in the
next day.
• Player 1 moves,
choosing between
going across (α) or
down (δ).
• If he goes across, he
would get 2; if he goes
down, he will get 3.
• He will go down.
• Therefore, we reduce
the game as follows:
• In the second day, player

2 moves, choosing
between going across (a)
or down (d).
• If she goes across, she

will get 3;
• If she goes down, she

will get 4.
• Hence, we reckon that

she will go down.
• Therefore, we
reduce the game
further.
• Now, player 1 gets

0 if he goes across
(A), and gets 1 if
he goes down (D).
• Therefore, he goes
down.
Matching Pennies (Perfect
Information)
• If player 1
chooses Head,
player 2 will
Head; and if 1
chooses Tail,
player 2 will
prefer Tail, too.
• Hence, the game

is reduced to
• In that case, Player 1 will be indifferent
between Head and Tail.
• Choosing any of these two option or any

randomization between these two acts will
give us an equilibrium with backwards
induction.
Example (Perfect information:
backward induction)
• Subgame perfect Nash
equilibria can be derived
simply by solving
backwards, i.e. by using
backward induction.
• Equilibrium derived using

backward induction fits
with the definition of
SPNE given above.
• The game has a subgame

starting at the node after
Firm E plays In.
backward induction)
• In the subgame after
E plays In,
• There is only one

player (Firm I), and
the Nash equilibrium
in this subgame is
simply the optimal
action of Firm I,
which in this case is
to choose A.
backward induction)
• Therefore the Nash
equilibrium in the subgame is
A.
• It follows that any Nash

equilibrium of the whole game
that involves playing A in the
subgame is a subgame perfect
Nash equilibrium.
• Here, the only Nash

equilibrium of the whole game
that satises this property is (In,
A).
• Therefore, this is the only

SPNE.
Example 2
• Consider the game in
which player 1 chooses
between L,R and player 2
moves second and
chooses between l,r.
• In this game there are

two strict subgames, one
starting after each action
of player 1.
• In the left subgame,

player 2's optimal choice
is l, and in the right
subgame player 2's
optimal choice is r.
Example 2
• Player 1 would compare 3 from R
and 0 from L, and choose R.
• The choices obtained by

backward induction are shown in
Figure.
• It follows that the SPNE is (R; lr).
• Note that it is not sucfficient to

write (R,l) - the equilibrium
specification is meaningless
unless you specify the full
strategy for player 2.
Imperfect information: information
sets
• Since player 2 does
not know what player
1 has chosen, at the
time of taking an
action player 2 does
not know whether he
is at the left node or
at the right node.
• Information set is
represented as in
Figure by connecting
the two nodes by a
dotted line
Imperfect information: information
sets
• Player 2 knows he is at the
information set (after player
1 moves),
• But does not know where

he is in the information set
(i.e. he does not know what
player 1 has chosen).
• Since player 2 takes an

action without knowing
what player 1 has done, the
game is the same as a
simultaneous-move game.
• Nash equilibrium is simply

(a2; b1).
Subgame perfection under imperfect
information
• Backward induction need not work under
imperfect information.
• This is why the concept of a subgame perfect

Nash equilibrium is more general compared to
backward induction.
• If we always had perfect information, we could

simply define backward induction equilibria.
• Consider the
imperfect information
game introduced.
• This game does not

have any strict
subgames, so the only
subgame is the whole
game.
• Therefore, any Nash

equilibrium of the
whole game is trivially
subgame perfect.
• The pure strategy
Nash equilibrium in
this game is (a2;
b1).
• This is also the

subgame perfect
Nash equilibrium.
• Consider the game in
Figure.
• Initially player 1
decides whether to
come in (and play
some game with
player 2) or stay out
(in which case player
2 plays no role).
• If the choice is to come in,
player 1 decides between A
and B.
• Player 2 decides between C

and D.
• When player 2 makes his

decision, he knows that
player 1 has decided to come
in (if not then player 2 would
not have been asked to play),
but without knowing what
player 1 has chosen between
A and B.
• In other words, the
situation is just as if once
player 1 comes in, player 1
and player 2 play a
simultaneous-move game.
• Identify the pure strategy

Nash equilibria.
• Player 1 has 4 strategies:

Out A, Out B, In A and In B,
while player 2 has 2
strategies: C and D.
• We might think strategies
like Out A do not make
sense,
• But in game theory we try

to model the thought
process of players, and
even if player 1 stays out,
• She would do so only after

thinking about what she
would have done had she
entered.
• Strategies reflect such
thinking (it is as if
player 1 is saying `I
have decided to finally
stay out, but had I
come in I would have
chosen A').
• Writing normal form of
the game.
• The pure strategy Nash

equilibria are (Out A;C),
(Out B;C) and (In A;D).
Pure strategy subgame perfect Nash
equilibria.
• Backward induction does

not work here:
• We cannot fold back given
the information set of
player 2.
• However, subgame
perfection still works.
equilibria.
• Note that apart from the

whole game, there is just
one strict subgame, which
starts at the node after
player 1 chooses In.
• The normal form of the

subgame is given below.
equilibria.
• The subgame has two pure
strategy Nash equilibria: (B;C)
and (A;D).
• If (B;C) is played in the

subgame, player 1 compares
1 (from Out) with 0 (from In
followed by (B;C)) and
decides to stay out.
• Therefore, a SPNE of the

whole game is (OutB;C).
equilibria.
• Since the set of SPNE is a subset
of the set of Nash equilibria, and
• Since (B;C) and (A;D) are the

Nash equilibria in the subgame.
• It must be that any Nash

equilibria of the whole game
that involves playing either (B;C)
and (A;D) in the subgame are
subgame perfect.
equilibria.
• (Out A;C) is Nash but not

subgame perfect, while the
other two are subgame perfect.
Sub-Game-Perfect Nash Equilibrium
• Backward induction is a powerful solution concept with
some intuitive appeal.
• Unfortunately, it can be applied only to perfect information

games with a finite horizon.
• Its intuition, however, can be extended beyond these

games through sub-Game perfection.
• We will illustrate how one can check whether a strategy

profile is a sub-game perfect equilibrium.
Definition SPNE
• A Nash equilibrium is said to be subgame perfect if an only if it is a Nash
equilibrium in every subgame of the game.
• An extensive-form game can contain a part that could be considered a

smaller game in itself;
• Such a smaller game that is embedded in a larger game is called a sub-

game.
• A main property of backward induction is that, when restricted to a

subgame of the game, the equilibrium computed using backward
induction remains an equilibrium (computed again via backward
induction) of the subgame.
• Subgame perfection generalizes this notion to general dynamic games:

• A Nash equilibrium is said to be subgame perfect if an
only if it is a Nash equilibrium in every subgame of the
game.
• A subgame must be a well-defined game when it is

considered separately. That is,
 It must contain an initial node, and

 All the moves and information sets from that node on
must remain in the subgame.
Example
• Consider, for instance, the centipede game in Figure 11.1, where the
equilibrium is drawn in thick lines. This game has three subgames.
One of them is:
• Here is another subgame:
• The third subgame is the game itself.
• Note that, in each subgame, the equilibrium computed via

backward induction remains to be an equilibrium of the subgame.
• Any subgame other than the entire game itself is called proper.
Matching penny game
• This game has three subgames:
One after Player 1 chooses Head, one after

Player 1 chooses Tail, and the game itself.
Again, the equilibrium computed through

backward induction is a Nash equilibrium at
each subgame.
Matching penny game
• We cannot apply backward induction in this
game because it is not a perfect information
game.
• One can compute the subgame perfect

equilibrium, however.
An imperfect-information game
• This game has two sub
games:
• One starts after Player

1 plays E; the second
one is the game itself.
• First compute a Nash equilibrium of the sub
game, then fixing the equilibrium actions as
they are (in this sub game), and
• And then take the equilibrium payoffs in this

sub game as the payoffs for entering the sub
game, compute a Nash equilibrium in the
remaining game.
• The sub game has only
one Nash equilibrium,
as T dominates B, and R
dominates L.
• In the unique Nash

equilibrium, Player 1
plays T and Player 2
plays R, yielding the
payoff vector (3,2), as
illustrated in Figure.
• Given this, the • Player 1 chooses E
game reduces to in this reduced
game.
Sub game-perfect Nash equilibrium
• Therefore, the sub
game-perfect
equilibrium is as in
Figure.
• First, Player 1 chooses

E and then they play
(T,R) simultaneously.
Sequential-move or extensive-form
games
• Games depicted in such a way
are also known as extensive-
form games.
• Consider the following

extensive-form game.
• Each player has two actions:
• Player 1's actions are a1 and

a2 and player 2's actions are
b1 and b2.
Sequential-move or extensive-form
games
• Player 1 moves before player 2.
• Player 2 can observe player 1's action and,

therefore, can vary his action depending
on the action of player 1.
• For each profile of actions by player 1 and

player 2 there are payoffs at the end.
• As usual, the first number is the payoff of

the first mover (in this case player 1) and
• The second number is the payoff of the

second mover (here player 2).
• It has decision nodes and branches from

decision nodes to successor nodes.
Actions and strategies
• A strategy in an extensive form game
is a complete plan of actions.
• Strategy for player i must specify an

action at every node at which i can
possibly move.
• Each player has 2 actions.
• For player 1, the set of actions and

the set of strategies is the same.
• Player 1 can simply decide between

a1 and a2.
• Therefore, the strategy set of player 1

is simply {a1,a2}.
• Now player 2 can
choose 2 possible
actions at the left node
(after player 1 plays a1)
and
• 2 possible actions at
the right node (after
a2).
• So there are 2 X 2 = 4 possible
strategies for player 2. These
are:
1. If player 1 plays a1, play b1 and if

player 1 plays a2, play b1.



• So the strategy set of player 2 is
• {(b1b1); (b1b2); (b2b1); (b2b2)}.
• Suppose instead of 2 actions,

player 2 could choose between
b1, b2 and b3 at each node.
• In that case, player 2 would

have 3 x 3 = 9 strategies.
• Suppose player 1 had 3
strategies a1, a2 and a3,
and after each of these,
player 2 could choose
between b1 and b2.
• Then player 2 would have

2 x 2 x 2 = 8 strategies.
Finding Nash equilibria using the
normal form
Player 2
Player 1 b1 b2
a1 3,1 1,0
a2 4,1 0,1
• To find Nash equilibria in an extensive-

form game, the most convenient
method is to transform it into its
normal form.
• Therefore, we have a 2-by-4 matrix of

payoffs as follows:
Finding Nash equilibria using the
normal form
Player 2
Player 1 b1 b2
a1 3,1 1,0
a2 4,1 0,1
• Once normal form is wrote, it is easy to

find Nash equilibrium.
Pure strategy Nash equilibria of the
extensive-form game
• (a2; b1b1) no player can do better by deviating. Therefore, (a2; b1b1) is a Nash equilibrium.
• (a1; b1b2). This is indeed a Nash equilibrium. It is not enough to write (a1; b1).
• Unless we know what player 2 would have played in the node that was not reached.
• (a1; b1b1) is not Nash equilibrium. As there is possibility of deviation.
• (a2; b2b1) is also a Nash equilibrium.
• These are the three pure strategy Nash equilibria of the game.
Repeated Prisoners’ Dilemma
• In a one-shot game, rational players
simply play their dominant
strategies. So (D;D) is the only
possible equilibrium.
• Suppose the game is repeated.
• Can we say something about the

behaviour of players in such
`supergames' that differs from the
behaviour in the one-shot game?
• Consider the case of a finite number of
repetitions. Say the game is played twice.
Would anything change?
• The answer is no.
• In the second round, players simply face a

one-shot game and they would definitely
play their dominant strategies.
• Given that (D;D) will be played in the next

period, playing anything other than D today
makes no sense.
• Therefore, in each period players would play

(D;D).
• If the game is played a 100 times, in
the last period (D;D) will be played.
• This implies that (D;D) will be

played in the 99th period, and so
on.
• Actual behaviour in laboratory

settings differs from this.
• Faced with a large finite number of

repetitions, players do cooperate
for a while at least.
Infinitely repeated Prisoners' Dilemma
game.
• Payoffs: discounted present value
• First, we need to have an appropriate notion of payoffs in the

infinitely repeated game.
• Each player plays an action (in this case either C or D) in each period.
• So in each period, the players end up playing one of the four possible
action profiles (C;C), (C;D), (D;C) or (D;D). Let at denote the action
profile played in period t.
• Then in period 𝑡, player 𝑖 receives the payoff 𝑢𝑖 (𝑎𝑡 ). The payoff of

player 𝑖 in the repeated game is simply the discounted present value
of the stream of payoffs.
• Let 𝛿 denote the common discount factor across players, where 0 < 𝛿 < 1.
• If today's date is 0, and a player receives x in period 𝑡, the present value

of that payoff is 𝛿 𝑡 𝑥.
• The discount factor can reflect players' time preference.
• This can also arise from a simple rate of interest calculation, in which
𝛿 case can be interpreted as 1/(1 + 𝑟), where r is the rate of interest.
• Higher values of indicate that players are more patient (i.e. value future
payoffs more).
• If 𝛿 is very low, the situation is almost like a one-shot game, since players
only value today's payoff, and place very little value on any future payoff.
• Given such discounting, the payoff of player i in
the repeated game is:
Cooperation through trigger
strategies
• The history at t is the action profile played in
every period from period 0 𝑡𝑜 𝑡 ≥ 1.
• A strategy of a player consists of an initial

action, and after that, an action after every
history.
Trigger strategy
• Start by playing C (that is, cooperate at the
very first period, when there is no history yet).
• In period 𝑡 ≥ 1:
 If (C;C) was played last period, play C

 If anything else was played last period, play D.
• Note that cooperation (playing (C;C)) would work only
until someone deviates to D.
• After the very first deviation, each player switches to D.
• Since anything other than (C;C) implies playing (D;D)

next period, once a switch to (D;D) has been made,
there is no way back: the players must play (D;D)
forever afterwards.
• This is called as trigger strategy.

Trigger strategy
• Start by playing (C;C).
• In period t:
 If (C;C) is played in t - 1, play (C;C)
 Otherwise play (D;D).
• Suppose a player deviates in period t.
• We only need to consider what happens from t onwards.
• The payoff starting at period 𝑡 is given by:

• If the player did not deviate in period t, the
payoff from 𝑡 onwards would be:
• For deviation to be suboptimal, we need:
• which implies:
• Thus if the players are patient enough,
cooperation can be sustained in equilibrium.
• In other words, playing (C,C) always can be the

outcome of an equilibrium if the discount
factor 𝛿 is at least 1/2.
Folk theorem
• The above game showed that cooperative
payoff (2; 2) can be sustained in equilibrium.
• However, this is not the only possible

equilibrium outcome.
• Indeed, many different payoffs can be

sustained in equilibrium.
• For example, note that always playing (D;D) is an equilibrium no
matter what the value of 𝛿 is.
• Each player simply adopts the strategy `play D initially, and at

any period 𝑡 ≥ 1, play D irrespective of history'.
• Note that both players adopting this strategy is a mutual best

response. Therefore, we can sustain (1; 1) in equilibrium.
• In fact, by using suitable strategies, we can sustain many more -

in fact infinitely more - payoffs as equilibrium outcomes.
• For the Prisoners' Dilemma game, we will describe the set of

sustainable payoffs below.
• The result about the large set of payoffs that can be sustained as
equilibrium outcomes is known as the `folk theorem'.
• Folk theorem is adapted to the repeated Prisoners' Dilemma
game.
• We have to compare payoffs in the repeated game to payoffs in

the one-shot game that is being repeated.
• The easiest way to do that is to normalise the repeated game

payoff by multiplying by 1 − 𝛿.
• Then if a player gets 2 every period, the repeated game payoff is

2
1−𝛿∗ = 2.
1−𝛿
• This normalisation implies that the set of normalised repeated

game payoffs now coincide with the set of payoffs in the
underlying one-shot game.
• We have to look at the set of payoffs of the one-shot game and ask which of
these are sustainable as the normalised payoff in some equilibrium of the
repeated game.
• Whenever we mention a repeated game payoff, we always refer to

normalised payoffs.
• In this game, a player can always get at least 1 by simply playing D.
• It follows that a player must get at least 1 as a (normalised) repeated game

payoff.
• It follows that a player must get at least 1 as a (normalised) repeated game

payoff.
• Consider any pair of payoffs (𝜋1 ; 𝜋2 ) such that
𝜋𝑖 > 1 for 𝑖 = 1,2.
• Any such payoff can be supported as an

equilibrium payoff for high enough .
• For the Prisoners' Dilemma game we can also

sustain the payoff (1,1) as an equilibrium
outcome irrespective of the value of 𝛿.
• The set of payoffs that can be supported as equilibrium
payoffs in our example is shown as the shaded part in
Figure.
• The set of payoffs that can be supported as equilibrium

payoffs under an infinitely-repeated game.
Example
(a) Find conditions on the discount factor under
which cooperation can be sustained in the
repeated game in which the above game is
repeated infinitely.
Example
• First, note that player 2 has no incentive to deviate from (C;C).
• To ensure that player 1 does not deviate, consider the

following strategy profile. Play (C;C) initially.
• At any period t > 0, if (C;C) has been played in the last period,
play (C;C). Otherwise, switch to (D;D).
• Under this strategy profile, player 1 will not deviate if:
4
• which implies 𝛿 ≥
5
(b) Under what conditions is there an
equilibrium in the infinitely-repeated game in
which players alternate between (C,C) and (D,D),
starting with (C,C) in the first period?
Solution Subject Guide

Problems
• Consider the simultaneous-move game below with two players, 1 and 2.
Consider the following strategy combinations:
 Strategy Combination 1: Player 1 plays 𝑎2 ; player 2 plays b1 with

probability 1/4 and 𝑏2 with probability 3/4.
 Strategy Combination 2: Player 1 plays 𝑎2 ; player 2 plays b1 with

probability 3/4 and 𝑏2 with probability 1/4.
 Show that strategy combination 1 is a Nash equilibrium of the game,

while strategy combination 2 is not a Nash equilibrium of the game.
Solution
1 3
• 𝑎1 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑙𝑖𝑡𝑦𝑜𝑓 𝑏1 𝑎𝑠 & 𝑏2 𝑎𝑠
4 4
1 3 6
3∗ +1 = = 1.5
4 4 4
1 3
4 4
1 3 8
2∗ +2∗ = =2
4 4 4
2 is better than 1.5 so strategy combination 1 is in Nash equilibrium as

playing 𝑎2 𝑖𝑠 𝑏𝑒𝑡𝑡𝑒𝑟 𝑡ℎ𝑎𝑛 𝑎1
Solution
3 1
4 4
3 1 10
3∗ +1∗ = = 2.5
4 4 4
1 3
4 4
3 1 8
2∗ +2∗ = =2
4 4 4
2.5 is better than 2 so strategy combination 2 is not in Nash equilibrium as

playing 𝑎1 𝑖𝑠 𝑏𝑒𝑡𝑡𝑒𝑟 𝑡ℎ𝑎𝑛 𝑎2
Conclude
• To summarise, if 1 plays 𝑎2 , 2 is indifferent across pure
strategies, so any mixture by 2 is a best response.
• However, we also need 1 to be playing a best response.
• For this to happen, the mixed strategy of 2 must be

such that 𝑎2 is a best response by 1 – i.e. 1 does not
want to switch to 𝑎1 .
• This is satisfied by strategy combination 1, but not by 2.

Problems 1st
• Consider the following simultaneous-move
game with two players, 1 and 2.
• Show that each player playing each pure

strategy with equal probability is a mixed-
strategy Nash equilibrium of the game.
2nd
• Consider the following extensive-form game with two players. Initially, player 1
can either play ‘𝑷𝟏 ’ to keep the game going, or play ‘𝑺𝟏 ’ to end the game.
• If player 1 chooses ‘𝑷𝟏 ’, Player 2 then chooses between ‘𝑷𝟐 ’ and ‘𝑺𝟐 ’.
• Finally, if 2 chooses 𝑷𝟐 , player 1 can choose between 𝑷𝟑 and 𝑺𝟑 .
• The payoffs are written as (Payoff to 1, Payoff to 2). Identify any subgame
perfect Nash equilibrium.
3rd
• Two firms face the following strategic pricing
problem.
• Each firm can set a high price H or a low price
L.
The payoffs are as follows:
• Suppose this pricing game between the firms is repeated
infinitely.
• Firms discount the future, so that, for each firm, a payoff of 𝒙

received 𝒕 periods from today is worth 𝜹𝒕 𝒙 today, where 𝟎 < 𝜹 <
𝟏.
• Show that it is possible to sustain cooperation (which in this case

involves each firm setting the high price H every period) in the
infinitely repeated game for high enough values of d.
• Your answer must specify the strategies that the firms should
follow in the repeated game to sustain cooperation.

Game Theory

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Game Theory

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Game Theory

What is game theory?

• Game theoretic concepts apply whenever the actions of

• These agents may be individuals, groups, firms, or any

• The concepts of game theory provide a language to

• It typically involves several players; a game with only

• The formal definition lays out the players, their

• A shop owner deciding the price of biscuits

• Deciding whether to help someone

• Animal behaviour and evolution

• Game theory models seek to portray complex

• Players can make binding agreements in

• Players have the ability to choose among a set of

• Games are often characterized by the fixed number

• Generally, the specific identity of a play is not

• Strategies may be simple or complex.

• In non-cooperative games each player is

• Payoffs are usually measure in utility although

• In general, players are able to rank the payoffs

• Players seek the highest payoff available.

• When strategies are chosen, an equilibrium

• The most frequently used equilibrium concept is

• An action is a move that a player makes at a

• Second, each player must have a set of

• Once each player chooses a strategy from

• Player 2 can choose between Left or

• If player1 chooses Up and 2 chooses

• There are altogether 4 such strategy

• For each strategy profile, each

• Suppose 𝑆𝑖 denotes the set of

• Let 𝑠𝑖 denote a strategy of 𝑖 (that

• For any such strategy profile, there

• Let ui (𝑠1 , 𝑠2 , … . . 𝑠𝑛 ) . denote the

• For example u1({U;L}) = u1({D;R}) =

• Furthermore, suppose u2({U;L}) =

• The first number in each cell is

• Note that player 1 chooses rows

• Where 𝑠−𝑖 is the profile of

• Such a strategy is called a dominant strategy.

• All players are interested in maximizing their payoffs.

• All players have common knowledge about the rules of the

• Each player’s payoff depends on actions taken by all Players

• Complete information (payoff function is common knowledge

• The main difference between a game tree and

• Assume that each firm has only

• Air Lion’s decision is depicted in

• A little square called a decision

• Have to provide a label

• If it were simply a decision

• We would put payoffs at

• Before choosing its

• As a result, Beta has

• The first number in each pair is

• For example, if Air Lion’s

• Air Lion earns a profit of a

• A strategy specifies what

• A strategy specifies what

• For Air Lion, the strategy

• Beta’s strategy is more

• Beta gets to see what

• Beta chooses a decision

• If Air Lion produces

• If Air Lion produces