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1. Introduction

Introduction
• Game theory as a topic in Math:
• How to formulate and solve optimal choice problems when there is strategic
interdependence? Example: The cold war.

• Optimal choice problems  Methodology in Microeconomics:

1. Individual behavior as an instance of decision;
2. There is a good criteria for decision;
3. Equilibrium condition: there is no unilateral incentive for deviation!

• Strategic interdependence
• Elections, oligopoly, lobby, war, corporate finance, regulation, IO,...

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1. What is a game?

• A game is a formal representation of a situation in which a number of

individuals interact in a setting of strategic interdependence
• Each individual’s welfare depends not only on his own actions but also on the
actions of the other individuals.

• The actions that are best for an individual to take may depend on what he
expects the other players to do

Basic elements
• The Players: interactive decision-makers.
• The Rules:
• Who moves when?
• What do they know when they move?
• What can they move?
• The Outcomes: what players care about.
• The Payoffs: representation of players’ preferences over outcomes

• Example: Matching pennies

• Players: Two players 1 and 2
• Rules: each player simultaneously puts a penny down, either heads up or tails up.
• Outcomes: If the two pennies match, player 1 pays 1 dollar to 2; otherwise, player 2 pays
1 dollar to 1.

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Classification
1. Time
• Static games (simultaneous-move) x Dynamic games (sequential move)

2. Information
• Complete information x Incomplete information

3. Other important definitions

• Total conflict (zero-sum games) or some commonality
Special cases: Prisoner´s dilemma, BoS, Matching Pennies, the Stag Hunt
• Perfect or Imperfect Information
• Cooperative or Non-cooperative
• Extensive form representation x Normal form representation

Other Important Definitions

• Rationality
• How good each player is at calculating the strategy that is in his own best
interests and at following this strategy in the actual course of play.
• Complete knowledge of one’s own interests, and flawless calculation of what
actions will best serve those interests.
• Common Knowledge
• Equilibrium
• It is a game-solution concept
• “steady-state”
• Given the available information (exogenous variables) and each player’s
condition (other players’ decisions), there is no incentive for unilateral
deviation (individual player is not willing to change his decision).
• Each player choose the best action depending on the other players´actions. To
do so, he must form a belief about the other players´action.

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2. Extensive-form games
• Captures who moves when, what action each player can take, what
players know when they move, what the outcome is as a function of
the actions taken by the players, and the player’s payoffs from each
possible outcome.
• Example: modified version of matching pennies

Extensive games: definitions

• Decision nodes
• Initial: where the game starts (open circle)
• After the end of each branch is another decision node (solid dot)
• Terminal nodes: end of the game
• At each node (but the terminal), the player called upon to move chooses an
action
• At each stage of the game, one player may have many decision nodes
• Subhistories (or simply history)
• the empty sequence consisting of no actions, representing the start of the
game, and
• All sequences of actions (of course, including the subsequences)
• Terminal history: each possible sequence of actions for the entire
game

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Information set
• Information set: it is a subset of a particular player´s decision nodes
• When play has reached one of the decision nodes in the information set and
it is that player´s turn to move, she does (or does not) know which of these
nodes she is actually at !
• Example: Matching Pennies

Example: Entry game

• An incumbent (player 2) faces the possibility of entry by a challenger
(player 1).
• Actions of each player:
• Player 1: (A (In), B (Out))
• Player 2: (L (Fight), R (Acquiesce))

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Entry game in an extensive form

• Players: 1 and 2
• Terminal histories: {(A,R), (A,L), B}
• Preferences (payoffs)
𝑢 𝐴, 𝑅 = 2, 𝑢 𝐴, 𝐿 = 0, 𝑢 𝐵 = 1
𝑢 𝐴, 𝑅 = 1, 𝑢 𝐴, 𝐿 = 0, 𝑢 𝐵 = 2

Note
• Action set (A): set consisting of all the actions that, under some
circumstances, are available to the player.

• Strategy set (S): complete contingent plan (decision rule) – specifies

how the player will act in every possible distinguishable circumstance
in which she might be called upon to move.
• We are mentioning here what is called PURE STRATEGY: it is a deterministic
choice at each of players’ information set. That is, we are assuming that
players make their choice with certainty!

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Strategies in an extensive form game

• Entry game:

• Player 1: {A, B} and Player 2: {L, R}

Why?

• Modified matching pennies

• Player 1: {H, T}

• Player 2:

𝑠 : Play H if player 1 plays H; play H if player 1 plays T.

𝑠 : Play H if player 1 plays H; play T if player 1 plays T.

𝑠 : Play T if player 1 plays H; play H if player 1 plays T.

𝑠 : Play T if player 1 plays H; play T if player 1 plays T.

3. Normal-form representation of games

• In the normal-form representation of the game

• each player simultaneously chooses a strategy

• the combination of strategies chosen by players determines a payoff for each

player

• Example
• The prisoners' dilemma

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The prisoners' dilemma: the environment

• Two suspects are arrested and charged with a crime

• The police lack sufficient evidence to convict the suspects, unless at

least one confesses

• The suspects are in separate cells

• The police explain the consequences that will follow from the actions
they could take

The prisoners' dilemma: actions and payoffs

• If neither confesses then will be convicted of a minor offense and
sentenced to one month in jail

• If both confess then both will be sentenced to jail for six months

• If one confesses but the other does not, then the confessor will be released
immediately but the other will be sentenced to nine months in jail
• Six for crime
• Three for obstructing justice

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The prisoners' dilemma: matrix representation

• Each player has two strategies: Confess (or fink) or Not confess (or be
mum)

• We implicitly assume that each player does not like to stay in jail

The normal form representation: Players and Strategies

• A finite set of players
• The number of players is n and “player i” is an arbitrary player

• The set of strategies available to player 𝑖 is denoted by 𝑆

• An element 𝑠 in 𝑆 is called a strategy
• The set 𝑆 is called strategy space and may have any structure:
• finite, countable, metric space, vector space

• The collection (𝑠 ) ∈ = (𝑠 , … , 𝑠 ) is called a strategy profile and denoted by s

𝑠 ∈ 𝑆 = 𝑆 × 𝑆 × ⋯× 𝑆
• Given an agent i and a profile s, we denote by (𝑠 , 𝑠 ) the following profile:
(𝑠 , 𝑠 , … , 𝑠 ,𝑠 ,𝑠 ,…,𝑠 )

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The normal form representation: Payoffs

• The payoff of player i is a function

 
𝑢: 𝑆 → [−∞, +∞]
∈
𝑠 → 𝑢 (𝑠)

where 𝑢 (𝑠) is the payoff of player i when he plays strategy 𝑠 and any other
player j plays strategy 𝑠

• We usually adopt the following notation:

𝑢 𝑠 = 𝑢 𝑠 ,𝑠 ,…,𝑠 ,𝑠 ,𝑠 ,…,𝑠 = 𝑢 𝑠 ,𝑠

The normal form representation

• Definition: The normal-form representation of a n-player game
specifies the players’ strategy space 𝑆 , … , 𝑆 and their payoff
functions 𝑢 , … , 𝑢 .

• A game in normal form is a family

𝐺 = (𝑆 ) ∈ , (𝑢 ) ∈

What is the normal form representation for modified matching

pennies?

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4. Questions

• We should now describe how to solve a game-theoretic problem

• Can we anticipate how a game will be played?

• What should we expect to observe in a game played by rational players who

are fully knowledgeable about the structure of the game and each others'
rationality?

2. Static games of complete

information

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1. Simultaneous move
• A normal form game (or strategic form) is usually related to simultaneous
move games.
• As we already know, this does not imply that they act simultaneously
• It suffices that each player chooses his or her action without knowledge of the
others' choices

• For example, in the prisoners' dilemma, the prisoners may reach decisions
at arbitrary times, but it must be in separate cells.
• Notice, however, that we are also able to represent extensive games in
strategic form (later…)

2. Strictly dominated strategies

• Definition:
• Consider a normal form game 𝐺 = (𝑆 ) ∈ , (𝑢 ) ∈
• Let 𝑠 and 𝑠 be two strategies in 𝑆
• Strategy 𝑠 is strictly dominated by strategy 𝑠 if for each possible combination of the other
players' strategies, the player i's payoff from playing 𝑠 is strictly less than the payoff playing
𝑠
• Formally:

∀𝑠 ∈ 𝑆 , 𝑢 𝑠 ,𝑠 < 𝑢 𝑠 ,𝑠

Rational players do not play strictly dominated strategies, regardless of the strategies
that he anticipates his rival will play!

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Strictly dominated strategies: The prisoners’ dilemma

• For a prisoner, playing Not confess is strictly dominated by playing
Confess

• Let’s consider player i

• If player j chooses Confess
• i prefers to play Confess and stay 6 months in jail
• Otherwise, playing Not confess would make him stay 9 months in jail
• If player j chooses Not confess
• I prefers to play Confess and be free
• Otherwise, playing Not confess would make him stay 1 month in jail

Strictly dominated strategies: The prisoners’ dilemma

• A rational player will choose to play Confess

• The outcome reached by the two prisoners is (Confess,Confess)

• This results in a worse payoff for both players than would (Not confess, Not confess)

• This inefficiency is a consequence of the lack of co-ordination

• This happens in many other situations

• the arms race

• the free-rider problem in the provision of public goods

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Iterated Elimination of Strictly Dominated Strategies

• Can we use the idea that “rational players do not play strictly
dominated strategies” to find a solution to other games?
• Consider a game (in normal form) with two players

• Player 1 has two available strategies 𝑆 = {𝑈𝑝, 𝐷𝑜𝑤𝑛}

• Player 2 has three available strategies 𝑆 = {𝐿𝑒𝑓𝑡, 𝑀𝑖𝑑𝑑𝑙𝑒, 𝑅𝑖𝑔ℎ𝑡}

• The payoffs are given by the following matrix

Iterated Elimination of Strictly Dominated Strategies: Notes

1. Proposition: The set of strategy profiles that survive to iterated elimination of

strictly dominated strategies is independent of the order of deletion

2. Each step requires a further assumption about what the players know about
each other's rationality

3. To apply the process for an arbitrary number of steps, we need to assume that
it is common knowledge that players are rational

4. This process often produces a very imprecise prediction about the play of the
game

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Iterated Elimination of Strictly Dominated Strategies:

Limitations
• Consider the following game

• There are no strictly dominated strategies to be eliminated

• The process produces no prediction whatsoever about the play of the game

• Question
• Is there a stronger solution concept than iterated elimination of strictly dominated strategies
but which produces much tighter predictions in a very broad class of games?

3. Nash equilibrium: Motivation

• Suppose that game theory makes a unique prediction about the strategy each player will
choose

• In order for this prediction to be compatible with incentives (or correct) it is necessary
that each player be willing to choose the strategy predicted by the theory

• Thus each player's predicted strategies must be that player's best response to the
predicted strategies of other players

• Such a prediction could be called strategically stable or self-enforcing

• Because no single player wants to deviate from his or her predicted strategy

• A solution of the game satisfying the previous property is called a Nash equilibrium

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Nash equilibrium: Definition

• Consider a normal form game 𝐺 = (𝑆 ) ∈ , (𝑢 ) ∈

• A strategy profile 𝑠 ∗ = (𝑠 ∗ ) ∈ is a Nash Equilibrium of G if for each player i, the strategy

𝑠 ∗ is player i's best response to the strategies specified in 𝑠 ∗ for the other players

• In other words, 𝑠 ∗ = (𝑠 ∗ ) ∈ is a Nash equilibrium if

∀𝑖 ∈ 𝐼, 𝑠 ∗ ∈ 𝑎𝑟𝑔𝑚𝑎𝑥 𝑢 𝑠 , 𝑠 ∗ : 𝑠 ∈ 𝑆

i.e,

∀𝑠 ∈ 𝑆 , 𝑢 (𝑠 , 𝑠 ∗ ) ≤ 𝑢 (𝑠 ∗ , 𝑠 ∗ )

That is, for each player i, 𝑠 ∗ is player i’s best response to the strategies specified for the n-1
other players

Nash equilibrium: Interpretation

• If the theory offers the profile 𝑠 = (𝑠 ) ∈ that is not a Nash

equilibrium then there exists at least one player that will have an
incentive to deviate from the theory's prediction

• If a convention is to develop about how to play a given game then the

strategies prescribed by the convention must be a Nash equilibrium,
else at least one player will not abide the convention

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Nash Equilibrium - Examples

1)

2)

3)

Nash equilibrium: a stronger solution

• Consider a normal form game 𝐺 = (𝑆 ) ∈ , (𝑢 ) ∈
• Proposition: If iterated elimination of strictly dominated strategies eliminates all
but the strategy profile 𝑠 ∗ = (𝑠 ∗ ) ∈ then 𝑠 ∗ is the unique Nash equilibrium of the
game.
• Theorem: If the strategy profile 𝑠 ∗ is a Nash equilibrium then 𝑠 ∗ survives iterated
elimination of strictly dominated strategies
• Question:
• Is there always a unique Nash equilibrium?
• Is there always a Nash equilibrium?

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A classic example: The battle of sexes

• A man (Pat) and a woman (Chris) are trying to decide on an evening's
entertainment

• While at workplaces, Pat and Chris must choose to attend either the
opera or a rock concert

• Both players would rather spend the evening together than apart

A classic example: The battle of sexes

• There are two Nash equilibria: (Opera,Opera) and (Rock,Rock)

• We will see that in some games with multiple Nash equilibria one
equilibrium stands out as the compelling solution: in particular a
convention can be developed

• In the example above, the Nash equilibrium concept loses much of its
appeal as a prediction of play since both equilibria seem equally
compelling: none can be developed as a convention

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Non-existence: Matching pennies

• Consider the following game
• There are two players I = {1,2}

• Each player's strategy space is 𝑆 = {𝐻𝑒𝑎𝑑𝑠, 𝑇𝑎𝑖𝑙𝑠}

• The payoff of the game is as follows:

• Each player has a penny and must choose whether to display it with heads or tails facing
up

• If the two pennies match then player 2 wins player 1's penny

• If the pennies do not match then 1 wins 2's penny

Non-existence: Matching pennies

• There is no Nash equilibrium

• If the players' strategies match then player 1 prefers to switch strategies

• If the players' strategies do not match then player 2 prefers to switch

• This situation occurs in many games

• Poker, battle

• To overcome this difficulty, it has been introduced the notion of mixed

strategy

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4. Mixed strategies
• A mixed strategy is a probability measure (distribution) over the strategies in 𝑆 . A strategy in 𝑆 is
called a pure strategy

• The set of mixed strategies is denoted by Prob(𝑆 ) or ∆(𝑆 )

• A mixed strategy 𝑝 = (𝑝 𝑠 ) ∈ of player i is a vector in ℝ satisfying

∀𝑠 ∈ 𝑆 , 𝑝 = 𝑝 𝑠 ≥ 0 and 𝑝 𝑠 =1
∈

• If the mixed strategy p is such that there exists 𝑠̂ ∈ 𝑆 satisfying

0 𝑖𝑓 𝑠 ≠ 𝑠̂
∀𝑠 ∈ 𝑆 , 𝑝 𝑠 =
1 𝑖𝑓 𝑠 = 𝑠̂

then p is denoted Dirac(𝑠̂ ) and is denoted the pure strategy 𝑠̂

Mixed strategies: expected payoff

• Mixed strategies can be interpreted as agent's uncertainty about which strategy each other
agent will play
• The expected value of agent i's payoff if he plays 𝑠 believing that the other players will play
according to 𝑝 is denoted by
   

𝑢 𝑠 ,𝑝 ≡𝔼 𝑢 𝑠 = 𝑝 (𝑠 ) 𝑢 𝑠 , 𝑠
∈
( )

• The expected value of agent i's payoff if he plays 𝑝 believing that the other players will play
according to 𝑝 is denoted by
 
   
𝑢 𝑝 ≡𝔼 𝑢 = 𝑝 𝑠 𝑢 𝑠 ,𝑠 = 𝑝 𝑠 ×𝑝 𝑠 … × 𝑝 (𝑠 ) 𝑢 𝑠 , 𝑠
∈ ∈

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Nash equilibrium with mixed strategies

• Consider a normal form game 𝐺 = (𝑆 ) ∈ , (𝑢 ) ∈

• Definition: A profile of mixed strategies 𝑝∗ = (𝑝∗ ) ∈ is a Nash

equilibrium of the game G if each player's mixed strategy is a best
response to the other players' mixed strategies, i.e.,

∀𝑖 ∈ 𝐼, 𝑝∗ ∈ 𝑎𝑟𝑔𝑚𝑎𝑥 𝑢 𝑝 , 𝑝∗ : 𝑝 ∈ ∆(𝑆 )

• Note: 𝑝 represents player i's uncertainty about which strategy each

player j will choose

Mixed strategies: Interpretation

• There certainly are cases in which players introduce randomness into their behavior. For
example, players randomly bluff in poker, governments randomly audit taxpayers, and
some stores randomly offer discounts.

• However, a mixed-strategy Nash equilibrium does not rely on any player flipping coins,
rolling dice, or otherwise choosing a strategy at random

• Player j's mixed strategy is interpreted as a common statement of any other player i's
uncertainty about player j's choice of a pure strategy
• Under this interpretation each player chooses a single action rather than a mixed strategy

• A Nash equilibrium (𝑝∗ ) ∈ in mixed strategy is such that any pure strategy in the support of 𝑝∗ is

a best response given that player i’s beliefs about player j's actions is 𝑝∗

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Mixed strategies: Interpretation

• The idea is to endow player j with a small amount of private

information such that, depending on the realization of the private
information, player j slightly prefers one of the relevant pure
strategies

• Since player i does not observe j's private information, i remains

uncertain about j's choice

Mixed strategies: Matching Pennies

• Suppose that player 1 believes that player 2 will play Heads with probability 𝑞 and
Tails with probability 1 − 𝑞
• Given this belief we have

𝑢 𝐻𝑒𝑎𝑑𝑠, 𝑞, 1 − 𝑞 = 1 − 2𝑞 𝑎𝑛𝑑 𝑢 𝑇𝑎𝑖𝑙𝑠, 𝑞, 1 − 𝑞 = 2𝑞 − 1

• Player 1's best response is Heads if 𝑞 < and Tails if 𝑞 >

• Player 1 is indifferent between Heads and Tails if 𝑞 =

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Mixed strategies: Matching Pennies

• Let (𝑟, 1 − 𝑟) denote the mixed strategy in which player 1 plays Heads and Tails,
respectively.
• Player 1’s expected payoff when player 2 plays (𝑞, 1 − 𝑞):

𝑟𝑞 −1 + 𝑟 1 − 𝑞 1+ 1−𝑟 𝑞 1+ 1−𝑟 1−𝑞 −1

= 2𝑞 − 1 + 𝑟(2 − 4𝑞)
• As we’ve seen before, Player 1’s best response (𝑟 ∗ 𝑞 ) is:

𝑟 ∗ 𝑞 ∈ 𝑎𝑟𝑔𝑚𝑎𝑥 2𝑞 − 1 + 𝑟(2 − 4𝑞)

1
𝑟 = 1, 𝑖𝑓 𝑞 <
2
1
𝑟∗ 𝑞 = 𝑟 = 1, 𝑖𝑓 𝑞 >
2
1
∀𝑟 ∈ [0,1], 𝑖𝑓 𝑞 =
2

Mixed strategies: Matching Pennies

• Let (𝑞, 1 − 𝑞) denote the mixed strategy in which player 2 plays Heads and Tails,
respectively.
• Player 2’s expected payoff when player 1 plays (𝑟, 1 − 𝑟):

𝑟𝑞 1 + 𝑟 1 − 𝑞 (−1) + 1 − 𝑟 𝑞 (−1) + 1 − 𝑟 1 − 𝑞 1
= 𝑞 4𝑟 − 2 − (𝑟 + 1)
• Player 2’s best response (𝑞 ∗ 𝑟 ) is:

𝑞 ∗ 𝑟 ∈ 𝑎𝑟𝑔𝑚𝑎𝑥 𝑞 4𝑟 − 2 − (𝑟 + 1)
1
𝑞 = 0, 𝑖𝑓 𝑟 <
2
1
𝑞∗ 𝑟 = 𝑞 = 1, 𝑖𝑓 𝑟 >
2
1
∀𝑞 ∈ [0,1], 𝑖𝑓 𝑟 =
2

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Mixed strategies: Matching Pennies - Equilibrium

Mixed strategies: The battle of sexes

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