AN INTRODUCTION TO

GAME THEORY
Oxbridge Economics; Mo Tanweer
Mohammed.Tanweer@cantab.net
Game Theory
 What is Game Theory?
 Game theory is a branch of applied mathematics that is
often used in the context of economics.
 It studies strategic interactions between agents. In strategic
games, agents choose strategies which will maximize their
return, given the strategies the other agents choose.
 The essential feature is that it provides a formal modelling
approach to social situations in which decision makers
interact with other agents.
 Behavioural economics introduces psychology into the mix
too
Schelling (2005)
Nobel Prize
 Game Theoretic ideas
 What is a “game”? Zero-sum vs Non-zero sum

Skills vs Chance
Sequential vs Simultaneous
Strategic vs Independent
Rational vs Irrational
First-mover advantage vs
Second-mover advantage
Shopping Mall story Pyrrhic victory

Cheating
Dominant vs Dominated Brinkmanship
strategies
Repeated vs One-shot games
Tipping Points
Pure vs Mixed strategies
Focal Points
Flat Tire story Backward Induction Rollback Analysis

Nash Equilibirum Punishment strategies

 Backward Induction (Rollback analysis)

Extensive form
Game Tree 0,2
d
Branches B
Start at the final node
Nodes N and work out the
k
A optimal response
2,1 there…
S
Use Backward
1,0
Induction

What is the Nash

 Backward-induction applications Equilibrium?
 E.g. Apple; your career
 Backward Induction Use Backward
Induction

What is the Nash

equilibrium?

0,1
2,3 4,5
N N N
A A A
1,0
s s s
S B S B S B

n n n
3,6 3,2 2,2
 Backward Induction
1,1,1 What is the Nash
t equilibrium?
B
2,3,2
N n N
A
A

S u 3,3,3
S 0,0,2
C
1,2,4
d N
A

S
0,2,0
Airbus-Boeing example
 Consider the rivalry between Airbus and Boeing to develop a new
commercial jet aircraft.
 Suppose Boeing is ahead in the development process, and Airbus is
considering whether to enter the competition.
 If Airbus stays out, it earns zero profit while Boeing enjoys a monopoly
and earns a profits of $1 billion.

 If Airbus decides to enter and develop the rival airplane, then Boeing
has to decide whether to accommodate Airbus peacefully, or to wage a
price war.
 In the event of peaceful competition, each firm will make a profit of
$0.3 billion. If there is a price war, each will lose $0.1 billion because
the prices of airplanes will fall so low that neither firm will be able to
recoup its development costs.
 Draw the tree (extensive form) of this game.
 Find the rollback equilibrium using backward induction.
Number Between 1 and 10
 The following game is a finite, sequential game:
 Two players, A and B, take turns choosing a number between 1 and 10
(inclusive).
 A goes first.
 The cumulative total of all the numbers chosen is calculated as the game
progresses.
 The winner is the player whose choice of number takes the total to 100
or more.

 Play the game.

 Does this game have First Mover Advantage or Second-Mover

Advantage?
 HINT: Use backward induction to prove it
Number Between 1 and 10 - solution
 To win the game, you want to say the number that takes you to 100
or above:
 So the only way I can do that is if my opponent gives me a number that
is 90 or above
 So to make sure HE gives ME 90 or above, I need to give him 89
 He obviously knows this as this game contains FULL INFORMATION, and
so is trying to give ME 89 at the same time (so that I can give him 90 or
abvoe and he can win the game)
 To avoid him giving me 89, I need to give him 78 – that way there is no
way he can give me 89, and ensures I can give him the 89 instead
 Using backward-induction (rollback analysis); we work towards the
solution
 10089786756453423121

 The person who picks 1 i.e. the FIRST MOVER can ALWAYS
guarantee a win
Centipede Game How do the results change when you move
to a finite game?

 The following game is a simultaneous game:

 Assuming Extensive form game - in which two players take turns choosing
either to accept some money, or pass it to the other player who has the
option of accepting or rejecting it back to the original player.
 E.g. I have £1, I can accept it, or pass it back to you when it becomes
£1.50;
 You can accept it or reject it back to me where it becomes £2.00;
 I can accept it or reject it back to you where it becomes £2.50 etc etc.

£1,£0 £0,£1.50 £2.00,£0 £0,£2.50

Backward-induction
 We have shown very simply, that any game that is:
 Sequential

 Finite

 Rationality

 Can be solved using backward-induction

 This has stark implications for the game of CHESS

 In theory, Chess can be solved

 The problem is that no computer is powerful enough to

calculate the solution
 Chess: Game Tree
B W
 
   So just TWO moves into
  Chess, and you already
  have 400 possible
  outcomes
 
 
 
  The problem is that no computer is
W 
powerful enough to calculate the

 
 solution

 It is estimated that there are
 

 10^120 total number of possible

 moves in Chess.

 The estimated number of atoms in
 
  the universe are 10^80. A
  supercomputer would take
  3x10^103 years to check out all

 these moves (FYI: the Sun is

predicted to die by then).
 Pay-off matrix
Prisoners’ Dilemma Normal form

Silent Betray

Silent 6mths,6mths 10 years,0 years

A
Betray 0 years,10 years 5 years, 5 years

REMEMBER: The first number always goes to the player

on the LEFT, and the second number always goes to the
player on the TOP. (e.g. 0,10 means A gets 0 years and B
gets 10 years)
Rock-Paper-Scissors
 The following game is a simultaneous game:
 Assuming you know this game, construct a normal form (table) payoff
matrix for this game. What is the Nash equilibrium?

 Rock beats Scissors.

 Paper beats Rock.

 Scissors beats Paper.

 Play the game.

No Nash-
 HINT: This is a zero-sum.
equilibrium
Game of Chicken
 Refers to a game of “brinkmanship”
 Traditional game of chicken refers to two cars driving to
each other
 The principle of the game is that while each player prefers
not to yield to the other, the outcome where neither player
yields is the worst possible one for both players.
 This yields a situation where each player, in attempting to
secure his best outcome, risks the worst.
 Chicken Normal form Pay-off matrix

Dean

Swerve (Chicken) Straight (Tough)

Swerve
0, 0 -1, 1
(Chicken)
James
Straight
1, -1 -2, -2
(Tough)

A different pure strategy equilibrium is preferred by each player

 Nuclear arms race
 Real-world
example of brinkmanship is in the game between
North Korea and the USA and the nuclear weapons issue

N. Korea

Not build Build

Not Build 4, 4 1, 3
U.
S.
Build 3, 1 2, 2

Rationality?
“Trembling Hand”
 Refers to a game of “brinkmanship”
 Trembling hand perfect equilibrium is a refinement of Nash
Equilibrium
 A trembling hand perfect equilibrium is an equilibrium that takes
the possibility of off-the-equilibrium play into account by
assuming that the players, through a "slip of the hand" or tremble,
may choose unintended strategies
 So a player may have a dominant strategy, but may play a
different strategy “with a tremble of the hand”
 Allows for “irrational” play
 The game represented in the following normal form matrix has
two pure strategy Nash equilibria, namely <Up, Left> and
<Down, Right>. However, only <U,L> is trembling-hand perfect.
Nash vs Bayesian Equilibria
 Applies to games of incomplete information
 Use probabilistic analysis
 Update their beliefs as per Bayes’ Rule as the game
progresses
 A perfect Bayesian equilibrium is a strategy profile and
a belief system such that the strategies are sequentially
rational given the belief system and the belief system is
consistent, wherever possible, given the strategy profile.
Hotelling’s Model

Suppose that two ice-cream sellers, George and Henry, are trying to decide where
to locate along a stretch of beach. Suppose further that there are 100 customers
located at even intervals along this beach, and that a customer will buy only from
the closest vendor. What is the Nash equilibrium?

Applications to
the real world?
Guess 2/3 of the Average

Choose a number between 0 and 100.

A prize of 20 sweets will be split equally between all students whose number is
closest to 2/3 of the average (mean) of the numbers chosen.

What do you choose?

Write down your answer.

What is the Nash equilibrium?

Game Theory – Keynes - Investments
 Split the Sweets game
I offer you and your partner 5 sweets to split.

The first person offers a split to the second. FMA vs SMA

The second person has to accept the split.

Play the game

Repeated game
I offer you and your partner 10 sweets to split. vs One-shot
game?
The first person offers a split to the second.

The second person can accept OR reject the split, in which case both people get
nothing.

Play the game

P.D - Simultaneous-sequential game
 The following game is a simultaneous game:

6 months,6 months
Silent
B

Silent
Betray
A
10 years, 0 years
Betray 0 years,10 years
What’s the Nash? Silent
Does it change
B
when we move from
simultaneous to
sequential? Why? Betray
5 years,5 years
 Simultaneous-sequential game: Chicken
What’s the Nash in each of these
cases? Is there First mover or
second mover advantage?
0, 0 0, 0
Swerve Swerve
Dean James

Swerve Straight Swerve Straight

James Dean
-1, 1 -1, 1
Straight 1, -1 Straight 1, -1
Swerve Swerve
Dean James

Straight Straight
-2, -2 -2, -2
 FMA vs SMA
What is the Nash
1,1 equilibrium?
Ads
Clinton Obama can look
forward to Clinton’s
In optimal responses
Obama No Ads 4,2 and make a first
move that is to his
own advantage
Out 3,3
Ads
Clinton
FMA – ‘set the
stage’ right

No Ads SMA – ‘ability to

Running a race / Cut 2,4 react optimally’
the cake / Google /
3G / XBOX
 Pizza Pies
 Consider a small college town with a population of dedicated pizza eaters but able to accommodate only two
pizza shops, Mo’s Pizza Pies and Francesca’s Delicious Pizzas.
 Each seller has to choose a price for its pizza.
 To keep things simple we will assume that only 3 prices are available (H, M, L).
 If a high price is set, the sellers can achieve a profit margin of $12 per pie.
 The med price = $10 per pie.
 The low only $5 per pie.

 Each store has a loyal captive consumer base who will buy 3,000 pizzas every week, no matter what price is
charged in either store.
 There is also a floating demand of 4,000 pies a week.
 The people who buy these pizzas are price-conscious and will go to the store with the lowest price. If both stores
charges the same price, they will be split equally between the stores.

 If Francesca goes M and Mo goes H:

 Francesca has her 3000 + 4000 (at $10) = $70,000
 Mo only has his 3000 (at $12) = $36,000.

 Payoff matrix overleaf

 Pizza Pies
Mo’s Pizza Pies

High Med. Low

High 60, 60 36, 70 36, 35

Francesca’s Med. 70, 36 50, 50 30, 35

Deep Dish
Low 35, 36 35, 30 25, 25
Check for a Dominant Strategy (for Check for DominATED strategy
either player) (for either player)

Find the Nash equilibrium. Remember: A dominated strategy is NEVER

played. So you can eliminate it.
 Battle of the Sexes
The Battle of the Sexes is a two-player coordination game used in game theory. Imagine a couple. The husband
would most of all like to go to the football game. The wife would like to go to the opera. Both would prefer to go to
the same place rather than different ones. If they cannot communicate, where should they go?

Male

Opera Football

Opera 3, 2 0, 0
Female
Football 0, 0 2, 3

Find the Nash

equilibrium (hint: But players prefer
may be more than different equilibrium
1!) 
Find all the Nash equilibria
Column What is the Nash equilibrium?

Left Right
Check for dominant… or
dominated strategies…

Up 1, -1 4, -4
Row
Down 2, -2 3, -3
 Find all the Nash equilibria
Column

Left Middle Right

Check for
dominant… or
dominated
Up 5, -5 3, -3 2, -2 strategies…

Row Straight 6, -6 4, -4 3, -3

Down 1, -1 6, -6 0, 0
Find all the Nash equilibria
Column

Left Right
Check for dominant… or
dominated strategies…

Up 2, 4 1, 0
Row
Down 6, 5 4, 2
 Find all the Nash equilibria
Column

Left Centre Right

Check for
dominant… or
dominated
Up 1, 2 2, 1 1, 0 strategies…

Row Straight 0, 5 1, 2 7, 4

Down -1, 1 3, 0 5, 2
Find all the Nash equilibria
Column

Left Centre Right

Check for
dominant… or
dominated
Up 4, 3 2, 7 0, 4 strategies…

Row
Down 5, 5 5, -1 -4, -2
 Letters game
Two players, Jack and Jill are put in separate rooms. Then each is told the rules of
the game.

Each is to pick one of six letters, G, K, L, Q, R, or W.

If the two happen to choose the same letter, both get prizes as follows:

Letter: G K L Q R W
Jack’s prize: 3 2 6 3 4 5
Jill’s prize: 6 5 4 3 2 1

If they choose different letters, they get 0.

Everyone knows these payoffs.

Draw the table for this game. What are the Nash equilibria? Are any of them focal
points? Now play this game in pairs (one of you Jack, one of
you Jill, and see what happens.
Find all the Nash equilibria
Column

Left Right
Check for dominant… or
dominated strategies…

Up 1, 1 0, 1
Row
Down 1, 0 1, 1
Find all the Nash equilibria
Column

Left Right

Up 1, 1 0, 0
Row
Down 0, 0 0, 0
 Battle of the Bismarck Sea (1943)
 Famous actual naval engagement in 1943, during WWII.
 The game in question – the battle of the Bismarck named for the body of water in the southwestern Pacific Ocean near Bismark
Achipelago and Papua-New Guinea.
 In 1943, a Japanese admiral was ordered to transport troops and lead a supply convoy to New Guinea. The Japanese had a choice
between a rainy northern route and a sunnier southern route.
 The U.S air forces knew that the convoy would sail and wanted to send bombers after it, but they did not know which route the
Japanese would take.
 The Americans had to send reconnaissance aircraft to scout for the Japanese, but they had only enough planes to explore one route at
a time.
 The sailing time was 3 days.
 If the Japanese convoy was on the route that the Americans explored first, the US could send its bombers straightaway; if not, a day
of bombing was lost by the Americans.
 In addition, the poor weather on the northern route made it likely that visibility would be too limited for bombing on one day in 3.
 Thus the Americans could anticipate two days of active bombing if they explored the Northern route but discovered that the Japanese
had gone South.
 If the Americans explored the Southern route first and found the Japanese there, they could get in 3 days of bombing; but if they
found that the Japanese had gone north, they would get only 1 single day of bombing completed.
 Because the Japanese had to choose their route without knowing which direction the Americans would search first, and because the
Americans had to choose the direction of their initial reconnaissance without knowing which way the Japanese had gone, this was a
SIMULTANEOUS game.
 Hence payoff matrix overleaf.
 Battle of the Bismarck Sea (1943)

Japanese Navy

North South

U. North 2, -2 2, -2
S.
A.
F. South 1, -1 3, -3

Check for dominant strategy Check for dominant strategy

Find the Nash
for the U.S.A for the Japanese
equilibrium.
 The Pirate Game
The pirate game is a simple mathematical game. It illustrates how, if assumptions
conforming to a homo economicus model of human behaviour hold, outcomes may be
surprising. It is a multi-player version of the ultimatum game.
The Game
•There are five rational pirates, A, B, C, D and E. They find 100 gold coins. They must
decide how to distribute them.
•The Pirates have a strict order of seniority: A is superior to B, who is superior to C, who is
superior to D, who is superior to E.
•The Pirate world's rules of distribution are thus: that the most senior pirate should
propose a distribution of coins. The pirates should then vote on whether to accept this
distribution; the proposer is able to vote, and has the casting vote in the event of a tie. If
the proposed allocation is approved by vote, it happens. If not, the proposer is thrown
overboard from the pirate ship and dies, and the next most senior pirate makes a new
proposal to begin the system again.
•Pirates base their decisions on three factors. First of all, each pirate wants to survive.
Secondly, each pirate wants to maximize the amount of gold coins he receives. Thirdly,
each pirate would prefer to throw another overboard, if all other results would otherwise
be equal
 The Pirate Game – The Result
The Result
•It might be expected intuitively that Pirate A will have to allocate little if any to himself for fear
of being voted off so that there are fewer pirates to share between. However, this is as far from
the theoretical result as is possible.
•This is apparent if we work backwards: if all except D and E have been thrown overboard, D
proposes 100 for himself and 0 for E. He has the casting vote, and so this is the allocation.
•If there are three left (C, D and E) C knows that D will offer E 0 in the next round; therefore, C
has to offer E 1 coin in this round to make E vote with him, and get his allocation through.
Therefore, when only three are left the allocation is C:99, D:0, E:1.
•If B, C, D and E remain, B knows this when he makes his decision. To avoid being thrown
overboard, he can simply offer 1 to D. Because he has the casting vote, the support only by D is
sufficient. Thus he proposes B:99, C:0, D:1, E:0. One might consider proposing B:99, C:0, D:0,
E:1, as E knows he won't get more, if any, if he throws B overboard. But, as each pirate is eager
to throw each other overboard, E would prefer to kill B, to get the same amount of gold from C.
•Assuming A knows all these things, he can count on C and E's support for the following
allocation, which is the final solution:
•A: 98 coins; B: 0 coins; C: 1 coin; D: 0 coins; E: 1 coin
•Also, A:98, B:0, C:0, D:1, E:1 or other variants are not good enough, as D would rather throw A
overboard to get the same amount of gold from B.
Game Theory – Keynes - Investments

 Investment game:
 You can choose to invest in a stock market or not invest

 If you invest, it costs you $100

 If you choose not to invest it costs $0
 If you invest, you will get a return (net profit) of $50 IF at least 90% of
your peers invest
 If less than 90% of people do not invest, you will lose your $100 (a -100
return)
 Let us play the game and see what happens
Applications to
the real world?
Split the £ game
I offer you and your partner £10 to split.

You write down what share you want of it WITHOUT TELLING THE OTHER PERSON.

The aim, as always, is to maximise your OWN share.

You then reveal your answers.

If the shares equal less than £10, that is the split.

If the sum of the shares are more or equal to £10, you both get nothing (I get my
£10 back).
Play the game
AN INTRODUCTION TO
GAME THEORY
Oxbridge Economics; Mo Tanweer
Mohammed.Tanweer@cantab.net