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Mic roe con om ic

-Theory
I THIRD EDITIO N
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:

GEOFFR EY A. JEHLE
Vassar College

PHIL~P J. RENY
-University of Chicago

,Financial Times
-Prentice Hall
is an imprint of
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PEARSON

Harlow, England • London • New York • Boston • San Francisco • Toronto • Sydney • Singapore • ttong Kong
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 /

CHAPTER 7
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--- -~- --- --~ "-- ~-- --- --- --~ --- --- --- --- --- -,
GA ME THEORY
(

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erso n?
~ar how will he bar ain with the sale s
Whe n a cons ume r goes shop pin for a new
~l- s will be
what will be the outc ome ? hat strat egie
If two coun tries nego tiate a trade deal,
on an offsh ore oil tract in a seale -bid
~l_ follo wed by a num ber of oil companies each bidding
au~ -
-hav e;R~ e-
- U situa tions such as these , the,actioru.. any ...ODE} agen L may- tak~ wHl
/2 Becau-:se of this, agents hav.e reasof! to act..s
n;aJegicaJLv(_Game theory
-v/CJ..rn e, ~ ~ quen ces for othe rs ..
strat egic situa tions , or in gam es..r'>nLh
c stud y of how rational agents beha ve in
I J, t:J is
whe
the
re
syste
each
mati
agen t mus t first know the decision of the othe r a_g~nts befo
re know ing wh ich ~
~ n : h c., ~ elf. Thi~ 5_i~ ulari t~s the hallm ark of the
theo ry of gam es, and
decis 10n is best for hims
-er- - ~ ,.,._ • focu s of this chap ter. -
deci ding how ratio nal agen ts behave in such setting§}vill 6e tfie to con-
u _ ti
egi c form games and proc eeds
11 9'v5- ~~ ~ ~~ ~ The chap ter begins with a close look a~t
1

are gam es in whic h the agen ts

&~ ~ form gam es in some detail. The form er
',(\ ~ ~ side r ~s ive
es in whic h Qil!Ytr7s may
uiog l.e, ,sim1 1ltapeous_cbp~. ~her eas the latte r are gam
~ ma,ls.e
make_c.,hoic,,es in sequ ence . • .
. • f\ -·
\ f\ ~
~ ~~ t
T ~
~

~
~
com e
Alon
of a
g the way, we will ~ncounter a variety
am You ~ill see that each method we enco
of meth ods for dete rmin ino 0
the out-
unte r give s rise to a parti cula r
in_ f
iinance
w,e will s~u_d . inclu de thos e base d o d.erf
~C : o...-- 'r ~ ~ solu tion conc e Th~ ~ol~tion conce_ ts ckw ard indu ction oam
1h~n um . . ~1an-Nash e mhb nu .
c.ces.>. . ~ Mk ,., KY ~ <;!:gu Each of these solut 10n conc epts is mor e soph isti-
~ ~~ - . ~ uerie ction , ancl?1guential egmhbnum.in!!~ ro to apply one solu tjgo carbe c lbao ararh er is
v-f'fvU\.- ~~o ,..., ~ ~ cate d than its pred eces sors, and know -
econ omi ~
't&'- .J J~ an impo rtant part of bein g a good applied

1 4Tr e- Ll> -
~ w ~ d0,.; ~
, 0 -..,.. -
-
ThJh (J(U .iJA
~- ~- -, - r - - - ~ - - - -
toJtrr(l'IJ- ~ ~ ~? !C DECISION MAKING _ ic ~nd 1on-strate ic • • ns is that the latte r
e>t q,,/'fY"~.., ~ The esse ntial differen ~ betw~en strate the deci sion s that othe rs migh t
e n 1s0 at10n , without takmg mto acco unt
0• ~ - - £?
th qmec deve lope d1n Chap ter I is a mod el
of n6n:"-
J mak e. For exa~ ple, th~ theoc~ a£ e c~os
c9_9-t'.,&1( ~Jrv-.,_ , ~ 0, 0
~trategic behay10UL Gtve n ,2~1ces and incom
e each consumer acts entice!.)' on his own,
~M Ber tra~
~~. N.. : ,
s. On the othe r hand, the C2u.ruot and
~ ~- , ";Yithout regard for the behav10ur of other the par
4 capt ure strat egic deci sion mak ing on
~r r-,J
m_9d:!_s of duop oly introduced ,in Chapter

l ggg ¥ - --- -.
 306 CHAPTER 7

of the two firms. Each firm understands well that its optimal action depends on the action
taken by the other firm.
To further illustrate the significance of strategic decision making consider the classic
duel between a batter and a pitcher in baseball. To keep things simple, let us assume that
~e pitcher has only two possible pitches ~stball and.Ccurve. Also, suppose it is well
known that this pitcher has the bes~fastball-in the~eague, but his curve is only average.
~ Based on this, it might seem best for the pitcher to always throw his fastball. However,
such a non-strategic decision on the itcher's part fails to take into account the batter's
itcher to thro a t en, bein repared for
~ -
decision. For if ,_.. the batter_ex
it, he will hit it. Consequently, it 'would be wise for the itcher to take into account the
_batters decision about the p.ili;he 's 1tc eci.din~cb_pitch to thro!Y-7"J:°t',
~ To push the analysis a little further, let us assign some utility n ~ to the various
outcomes. For simplicity, we suppose that the ~tuaHon is an~all o-6othin one for both
~ players. Think of it as being the bottom of the nint inning, with a full count, bases oaded,
'two outs, and _the pitcher's team ahead by one run. Assume also that the batter either hits

~
a home run and wins the game) or strikes out (and loses the game). Consequently, there
i;.,_exactly ope pitch reroammg m t e game'."'Flmilly, suppose each player derives utility I
from a win and utility -1 from a loss. We may then represent this situation by the matrix
diagram in Fig. 7 .1.
ln this diagram. the pitcher (P) ~llQ~S..l.he raw.. F (fastball) or C (cpcve)., and the

~
atter (B) chooses the column. The batter hits a home run when he repares for the itch
th_at the pitc er as c 1ose11., and strikes .o.u.t..otbeo,vise,~ e entries in the matrix denote
tb:-:e-p-;l-ay-e=-r_,s·-p-a_y_o~n,_.Gs"a res~lt of their decisions, with the pitcher· s W!}'Off being the first
]:WDber of each entry and th~atter' s the second..:. Thus, the ent 1, -1) in the first row

~
and second column inaicates that if the pitcher throws a fastball and the batter prepare _
a curve, the pitcher's payoff is 1 and the batter's is - I. The other entries are reacMn-ttte--

~
same way.
Although we have so far concentrated on the pitcher's decision, Jbe batter is obvi-
ously i,n a completely symmetric position. Just as the itcher must decide-on=wm: ~ 1 4M
to r-ow ... e atter--[)lust edde on which pitch to prE:,EaFe for;. What can be said a ou
their behaviour in such a setting? ven t ough you might be a6Ie to provide the answer for L,,,,,..,O
yourself already, we will not analyse this game fully just yet. ~· T
However. we can immediately draw a rather important conclusion based solely on
the ideas that each player seeks to maximise his payoff, and that each reasons strategically.

~ Batter

~
F C

r., Pitcher
F
.
-1. 1 1, -1

r~
l_:a
- C - 1 -1 I -
-1, 1

Figure 7.1. The baucr-pi1chcr game.

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 307
GAME THEORY
'S: t' p
dictab le'. Why? Because if the
Here, ~ch..,p~ec . wu.~e have.J n..a.m annac ..thaU s ·uz:'e
sa he alway s throws his fastbali then the
itcher 's behav iour were redictable in that
a home run an win the game. But this
b~tter, Y c oosin g F, would be guaranteed to hit
table as well;.._ he always prepar es for ~
would mean that the ~alte rs 6ehaviour is predic
strateg ically, he will o timall c oose
fa st ball. Conse quent ly, 5ecause the pitcher behaves
• m e..game. But this con-
to throw his curve , thereb st • •
s throw s his fastballi We conclude
tradic ts our origin al supposition that the pitcher alway
s throw a fastb Similarly, it must
that the itcher canno t be correc ti redicted to alway
a curve. Thus, whate ver behaviour
be incorr ect o 1tnlff if1 e pitcher always throws
does event ually arise out of this scenario, it must involv
e a certai n Jack of predictability
also involve
F
same reason s, it must
regard ing the pitch to be thrown. And for precisely the
which pitch to prepar e for.
a lack of predic tabilit y regarding the batter's. choice of
ically, each- taking into
Thus, when rational individuals .make decisi ons strateg
behav e in an 'unpre dictab le' man-
accou nt the decisi on the otlier makes, they somet imes succes sful
is an essent ial aspect of
ner. Any good poker player understands this well - it ~
.non-s trateg ic setting s - w
l>luffing. Note, however, that. there is no such advan tageJn outcom es amon g
one examp le of how
you are alone, there is no one to 'fool'. This is but strateg ic.
icantly frg_m_ those among _n_o~
strate gic decision__rnak~F-s i:nay...d.ilfeL gg_ite signif
decision making, we are ready to
i!ecis ion maker s. Now that we have a taste for strategic
devel op a little theory.

7 .2 STRATEGIC FORM GAMES

duopoly, are but three examp les
~ Th~ er-p itche r duel, as well a~ur .noL an~r trand
e: 0ther examples include
~ ~~ mists wish to an·atys
of the kinds of strateg ic situations econo
0
\Ji .. _
.,\~ ~ ,~in ing betwe en a labour union and a firm,U1'1de wars betwe
en two count ries.~ search -
on. We seek a single framework
t N. ~ 61- and-d evelo pmen t races between companies 7 and so
more. Thus. we
o
Pi ~ - µJ-,O , ~1 capab le of captureleme ing the essential features of each of these setting s and
examp les
,._.G I' u ,- must search for nts that are common among them. What features do these
participants - we shall c~~l them 'playe rs' - e~c h
_ "'(eru ._ n... share ? Well,_~~111\loive&_a-~gmbe-r~- f'1'
• -~ - "D I o£._w_!.!om_,has a►range .,0i-poss16le.. a~uQDs that
,... can be tak~ - we sh~ll call these action s
;}"[~j~ ~ _r dependmg_on his own strat-
f()N >,PJ ,..(.h 6-,,i~tej.iCS.: - and E:,ach of whom derives one payof f or ~th!: -Q§yers. As has b~Em the
9v~ac h_of the _01her
. ~gy choic e as well as the strate ~ch? sen may be quite
f :1~ _ 9fit-' ~16" " . traditi on, we shall
refer to such a s1tuat10n as a game, even thoug h the stakes
definition.
U ~ - seriou s indeed . With this in mind, consider the following
d._k:~ ~ -~~-~ - --

i" ~~ 'ro~" ' ~

17v ~ . --

DEFINITION 7. 1 Strategic Form Game 1

A strate gic form game js a tuple C=
(51, u1)':: 1, where for each playe r i =
1.... , N, S}..is

the set ofstratc gie4 availa ble to playe r[. ar. u,: x J':f: 1
S; ~ JR desaJbes playe r i's payo7f?is
_i strate gic form game is finite if each
;; functi on ol the strategjes chosen by all ayers.
cment s .
p}.3Ycr 's strate cy sel contains linitcfx many

.>f ~vv ,·,~

308 CHAPTER 7

Note that this definition is general enough to cov~r our llatter-pitcher duel. The
strategic form game describing that situation, when the pitcher is designated player 1,
is given by

S1= S2 = {F, C},

ui(F, F) = ui(C, C) = -1,
u1 (F, C) = ui (C, F) = 1. and
ui(s1, si) = -u1(s1, si) for all (s1, si) E S1 x Sz.
\\\)( ~ that two- la er strat • r~ ames with finite str;tegy sets can always be
V'.y;r7 represented in matrix form, with the rows indexing.the-strategies o ye , ns
\ _,.,_\~~.JndexingJ!le_strategies of player 2, and the entries denoting their payoffs.
~\w - -
't<~
7.2.1 DOMINANT STRATEGIES ---7_:};, ~ ~ex--- wt--w:J.l ~~ 'K>--v-~~ f\-
4!f!,ene've1- we attel1)pt to predict the outcome-of-a &"'"", jLJsJJiefr:rnb!e to do sp without ~~
requiring that the players know a _great deal about how their opponents will behave. This
is not always Eossible, but when it i;,- th;;-~tion arrivecfat is particularly convincing~
this section, we consider various J~rms_of :§tratgg~@naAGe, and we look at ways we
can sometimes use these ideas to solve, or narrow down, the sofution to a game.
Let us begin with th tll,'0-p a, ·er strate ic .form• am in Fig. 7. 2. he~, J>la yer 2:s
a ofT-ma imisin strate choice depends on the choice made b r 1 ~
• en at is best Jor 2 to choose ~ , e~t , and if 1...choo·ses_-D downr, theft"i~ iNtfflb.
~r:2.toc-hoose:N{right),. As a result, payer must make his decision strategica y, and he
must consider carefully the decision of player 1 before deciding what to do himself.
What will player .1 do? Look_ closely at the ~a~of~s and you will se~ that IJq & t4s
~-hojce.is aGtually independent of .the c~oi~e:rvade-by prayer 7... Regardless of player
~rcatt jyhffi¢foplft'4!!•F•$- Consequently, player 1• will surely choose U. Having
deduced this, e_layer 2 will then choose L. Thus, the only sensible outcome of this game is
the strategy pair ( U, L), with associated payoff vector (3, O).
The special feature of this game that allows us to 'solve' it - to deduce the outcome
when it is played by rational players - is that player 1 possesses a strategy that is best for
him regardless of the strategy chosen by player 2. Once player l's decision is clear, then
player 2's becomes clear as well. Thus, in two-player games, when one player possesses
such a 'dominant' strategy, tbe outcome is ~~'lghtforward to determine.

L, R \WB-~ ~~
u
-3,0 - 0, -4 ~~
~~,i. D
2,4 -1, 8

Figure 7.2. Strictly dominant strategics. \

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 309
GAME THEORY

on.~_;.:>= 51 x • • • x SN
To make this a bit more formal, we introduce some notati
-1, denote s 'al payer s excep t playe r
denot e the set of joint pure strategies. The symbo l,
i' • So, for examp le, s-1 denotes an eleme nt of 5_ 1, which
itself denote s the set 51 x • • • x ~
following defini tion.
5;-1 x 51+ 1 x • • • x 50he n we have the

~ro N7 .2 Strictly Dominant Strategies

> uJCs1t s 1) for all (s1, s ,) E 5
A strategy, 3·, for playe r i is strictly dominant if u,(s1, s_ 1)
with S;-/= ;;.
y superior t(LJl)./ othef
Jhe presen ce of a strictly dominant strategy one that is strictl
when no strictl y domin ant strategy is available,
strate ies, is rather rare. However, even
game by ruling out strateg ies that
_it may still e poss1 e to simplify the analysis of a
Consi der the example depict ed in
are clearl y unattractive to the player possessing them,:,
y there. To see this, note that
Fig. 7 .3. Neith er player possesses a strictly dominant strateg
player 1 's uniqu e best choice is U when 2 plays L, but
D when 2 plays M; and 2 's uniqu e
ver, each player has a strate gy
best choice is L when l plays U, but R when 1 plays D. Howe
always outperformed by D, in the
that is partic ularly unattractive. Player 1 's strategy C is
n compared to when C is chose n
sense that l's payof f is strictly higher when Dis chose ~
remove Cfrom consid eratio n.
regardless of the strategy chosen by player 2. Thus, we may
y Mis outperformed by R (check
Playe r 1 will never choose it. Similarly, player 2's strateg c;;i
Now that C an_d M have been
this) and it may be removed from consideration as well.
d to that of Fig. 7.2. Thus, as
remov ed, you will notice that the game has been reduce
before, the only sensible outcome is (3, 0). Again, we have
used a dominance idea to help ~
ance of one strategy over one
us solve the game. But this time we focused on the domin
other, rather than over all others.

DEFINITION 7.3 Strictly Domi nated Strategies \

strategies ?,·i, if ui(si, s_;) >
Playe r i's strategy Si strictly dominates another of his
is strictly dominated jp S.
uj(si, s-;) for all s_ 1 E 5_,_ In this case, we also say thats;
strictly domin ated strate gies
As we have noticed, the presence of strictly domin ant or
it compl etely solvable. It is instru ctive
can simpl ify the analysis of a game enoug h to render
of Figs. 7.2 and 7.3.
to-review our solution techniques for the games
\
L M R - \

u 3, 0 0, -5 0, -4

C 1, -1 3, 3 --· -2, 4
. \
.
D 2, 4 4, 1 -1.8 \
Figure 7.3. Strictly dominated strategies.

~
 310 CHAPTER 7

In the game of Fig. 7.2, we noted that U was strictly dominant for player 1. We
were therefore able to eliminate D from consideration. Once done, we were then able to
conclude that player 2 would choose L, or what amounts to the same thing, we were able to
eliminate R. Note that although R ls not strictly dominated in the original game, it is strictly
dominated {by L) in the reduced game in which 1's strategy Dis eliminated. This left the
unique solution (U, L). In the game of Fig. 7.3, we first eliminated C for 1 and M for 2
(each being strictly dominated); then (fo11owing the Fig. 7.2 analysis) eliminated D for 1:
then eliminated R for 2. This again left the unique strategy pair ( U, L). Again, note that Dis
not strictly dominated in the original game, yet it is strictly dominated in the reduced game
in which Chas ·been eliminated. Similarly, Rbecomes strictly dominated only after both C
and D have been eliminated. We now formalise this procedure of iteratively eliminating
strictly dominated strategies. •
Let 5J = S1 for each player i, and for n > 1, let 5'/ denote those strategies of player
i surviving after the nth round of elimination. That is, s1 E 5'/ if s; E s;-1
is.not strictly
dominated in sn- 1 .

~ DEFINITION 7.4 Iteratively Strictly Undominated Strategies

-
A strategy s; for player i is iteratively strictly undominated in S (or survives iterative
elimination of strictly dominated strategies} ifs; E 5'/, for all n > I.

t:
~
So far, we have considered only notions of strict dominance. Related notions of
weak dominance are also available. In particular. consider the following analogues of
Definitions 7.3 and 7.4.

~ION7.5 Weakly Dominated Strategies

~ Player i's strategy s; weakly dominates another of his strategies s;, if u;(s1, s_,) >
uiCs;, s_,) for alls_,~ S-1, with at least one strict inequality. In this case, we also say
~ thats; is weakly dominated in S.
The differen \weak and strict dominance can be seen in th exam le of

[! Fig. 7.4. In this game ...nw$e&@ lay~Bfm& ~~li , 4· However, both

and Rare V:..eakly dominated by U and L, respectively. Thus, eliminating strictly dominated
strategies has no effect here, whereas eliminating weakly dominated strategies isolates
the unique strategy pair (U. L). As in the case of strict dominance, we may also wish to

~ iteratively eliminate weakly dominated strategies.

L R

c! u
D
1, 1

0,0
0.0

0,0

Figure 7.4. Weakly dominated strategies.

\

~
C:
e;
 311
GAME THEORY •

1, let U17 denote those

With this in mind, let HtJ = S1 for each player J, and for n >
strategies of player i surviv ing after the nth round of elimination of weakly domin ated
strategies. That is, s, E U1' if s, E w.1- 1 is not weakly dominated in w,- t =
w.7- I x • • •
I
1-I I
X w.N .

DEFINITION 7.6 Iteratively Weakly·Undominated Strategies

S (or survives iterative
A strategy s, for player i is iteratively weakly undominated in
elimination of weakly dominated strategies} ifs, E ~ for all n >
I.
e weak
It should be clear that the set of strategies remaining after applying iterativ You
e strict domin ance.
domin ance is contained in the set remaining after applying iterativ
are asked to show this in one of the exercises.
domin ance argum ents,
To get a feel for the someti mes surprising power of iterative
in which N > 2 player s try to
consid er the following game called 'Guess the Average'
an integer betwee n 1 and
outgue ss one another. Each player must simultaneously choose
guesse s wins $100, where as the
100. The person closest to one-third the average of the
are ties. Before readin g on, think
others get nothing. The$ I 00 prize is split evenly if there
when there are, say, 20 player s.
for a momen t about how you would play this game
ated strateg ies. Note that choosi ng the
Let us proceed by eliminating weakly domin
rs. This is becaus e one-th ird the averag e
numbe r 33 weakly dominates all higher numbe '
331. Conseq uently, regard less of the others
of the numbe rs must be less than or equal to
than any higher numbe r, and if all other
announ ced numbers, 33 is no worse a choice
33 is strictly better than all
player s happen to choose the numbe r 34, then the choice of
te all numbe rs above 33 from consid eration for
higher numbers. Thus, we may elimina
ent establi shes that all
all players. Therefore, WJ c ( 1, 2, ...
1 argum
, 33}. But a similar
numbe rs above 11 are weakly dominated in W . Thus,
1 WJ c { 1, 2, ... , 11}. Contin uing
only strateg y surviv ing iterative weak
in this manne r establishes that for each player, the
domin ance is choosing ~he numbe r 1.
your mind, you may
_ If you have been keeping the batter-pitcher duel in the back of
is strictly or weakly domin ated.
have noticed that in that game, no strategy for either player
describ ed will reduce the strateg ies
Hence , none of the elimination procedures we have
proced ures are clearly very
under consideration there at all. Although these elimination
the batter- pitche r duel than we
helpfu l in some circumstances, we are no closer to solving
were when we put it aside. It is now time to change that.

-sx'J --,
---r.2.2 NASH EQUILIBRIUM
arket e uilibri um tn which
Accord ing to the theory of deman d and supply, U-le,mtion o
;. he t 1eoretical attract ion of the concep t arises ecause in
demand ~quaJs supply is central
. . . . . )

.
\

I Dependi ng on the number of players, other numbers

may be weakly dominat ed as well. This is explored in the

exercise s.
 312 CHAPTER 7

such a situation, ihe(eSR'l_Q Lend~n..y o.i;.ne~it for an ..one's beha.viour to c;tl ~ These
regularities in behaviour form the asis for making predictions.
With a view towards making predictions, we wish to describe potential regularities in
behaviour that might arise in a strategic setting. At the same time, we wish to incorporate
the idea that th la er>S a{e 'rational..:., both i h sense that the act in their own self-
interest and that they are fully aware of the regularHies in the b~yiauc of qt ers. n t e
strategic setting, just as in the demand-supply setting, regularities in behaviour that can be
'rationally' sustained will be caJled equilibria, In Chapter 4, we have already encountered
the notion of a Nash equilibrium .in the strategic context of Cournot duopoly. This concept
generalises to arbitrary strategic form games. Indeed, Nash equilibrium, introduced in
Nash (1951), is the single most im ortant e uilibrium conce •n of ame theo . ~
nforma11y, a joint strategy s E S constitutes a Nash equiJibriqm as long as each ~
individual, while fu1l aware of the oth ' • • as no ince • his own. N~ ,_
~us, a ash eguilibrium describes behaviWJL.~.an_be rationally sustained. Formally, p.y-1

the conceet is defined Q~ folJQ\\'.S, ~ )V")

[pEFINITION 7.7 - Pure Strategy Nash Equilibrium -

_ Given a strategic form game C =(Si, ui)~ 1, the joint strategy s E Sis a pure strategy
. Nash equilibrium of C if for each player i, ui(s) ~ uj{si, s_i) for all Si E Si.

Note that in each of the games of Figs. 7.2 to 7.4, the strategy pair (U, L) constitutes
• a pure strategy Nash equilibrium. To see this in the game of Fig. 7.2, consider first whether
player 1 can improve his payoff by changing his choice of strategy with player 2 's strategy
fixed. By swHching to D, player 1 's payoff falls from 3 to 2. Consequently, player 1 cannot
improve his payoff. Likewise, player 2 cannot improve his payoff by changing his strategy
wherr player 1 's strategy is fixed at U. Therefore ( U, L) is indeed a Nash equilibrium of
the game in Fig. 7.2. The others can (and should) be similarly checked.
A game may possess more than one Nash equilibrium. For example, in the game of
_Fig. 7.4, (D, R) is also a pure strategy Nash equilibrium because neither player can strictly
improve his payoff by switchi~g strategies when the other player's strategy choice is fixed.
Some games do not.possess any pure strategy Nash equilibria. As you may have guessed,
this is the case for our batter-pitcher duel game in Fig. 7.1, reproduced as Fig. 7.5.
Let us check that there is no pure strategy Nash equilibrium here. There are but four
possibi1ities: (F, F), (F, C), ( C, F), and ( C. C). We will check one, and leave it to you to
check the others. Can (F, F) be a pure strategy Nash equilibrium? Only if neither player
can improve his payoff t5y unilaterally deviating from his part of (F, F). Let us begin with

-F C

F -1, 1 1, -1

--c-- 1,-1 -1.1

Figure 7.5. The batter-pitcher game. \ --·-

\.