Chapter 6

Game Theory

2006 Thomson Learning/South-Western

Basic Concepts

All games have three basic elements:

Players
Strategies
Payoffs

Players can make binding agreements in

cooperative games, but can not in
noncooperative games, which are studied
in this chapter.

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.

Strategies

A strategy is a course of action available

to a player.
Strategies may be simple or complex.
In noncooperative games each player is
uncertain about what the other will do
since players can not reach agreements
among themselves.

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.

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.

Nash Equilibrium

The most widely used approach to

defining equilibrium in games is that
proposed by Cournot and generalized in
the 1950s by John Nash.
A Nash equilibrium is a set of strategies,
one for each player, that are each best
responses against one another.

Nash Equilibrium

In a two-player games, a Nash

equilibrium is a pair of strategies (a*,b*)
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.

The Prisoners Dilemma

The Prisoners 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.

The Prisoners Dilemma

10

The DA separates the suspects and tells

each, If you confess and your companion
doesnt, 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.

The Prisoners Dilemma

The normal form (i.e. matrix) of the game

is shown in Table 6-1.

11

The confess strategy dominates for both

players so it is a Nash equilibria.
However, an agreement to remain silent (not
to confess) would reduce their prison terms
by one year each.
This agreement would appear to be the
rational solution.

TABLE 6-1: The Prisoners Dilemma

B
A

Confess
Silent

12

Confess

Silent

-3, -3

-1, -10

-10, -1

-2, -2

The Prisoners Dilemma:

Extensive Form

13

The representation of the game as a tree

is referred to as the extensive form.
Action proceeds from top to bottom.

FIGURE 6-1: The Prisoners Dilemma:

Extensive Form

Confess

.
Confess

-3, -3

14

Silent

B
Silent

-10, -1

Confess

Silent

-1, -10

-2, -2

TABLE 6-2: Solving for Nash Equilibrium in

Prisoners Dilemma Using the Underlining
Method
Step 1

B
Confess
Silent

15

Confess

Silent

-3, -3

-1, -10

-10, -1

-2, -2

TABLE 6-2: Solving for Nash Equilibrium in

Prisoners Dilemma Using the Underlining
Method
Step 2

B
Confess
Silent

16

Confess

Silent

-3, -3

-1, -10

-10, -1

-2, -2

TABLE 6-2: Solving for Nash Equilibrium in

Prisoners Dilemma Using the Underlining
Method
Step 3

B
Confess
Silent

17

Confess

Silent

-3, -3

-1, -10

-10, -1

-2, -2

TABLE 6-2: Solving for Nash Equilibrium in

Prisoners Dilemma Using the Underlining
Method
Step 4

B
Confess
Silent

18

Confess

Silent

-3, -3

-1, -10

-10, -1

-2, -2

TABLE 6-2: Solving for Nash Equilibrium in

Prisoners Dilemma Using the Underlining
Method
Step 5

B
Confess
Silent

19

Confess

Silent

-3, -3

-1, -10

-10, -1

-2, -2

Dominant Strategies

20

A dominant strategy refers to the best

response to any strategy chosen by the
other player.
When a player has a dominant strategy
in a game, there is good reason to
predict that this is how the player will
play the game.

Mixed Strategies

21

A mixed strategy refers to when the

player randomly selects from several
possible actions.
By contrast, the strategies in which a
player chooses one action or another
with certainty are called pure strategies.

TABLE 6-3: Matching Pennies

Game in Normal Form
B
A

Heads
Tails

22

Heads

Tails

1, -1

-1, 1

-1, 1

1, -1

FIGURE 6-2: Matching Pennies Game

in Extensive Form

Heads

23

Tails

Heads

Tails

Heads

1, -1

-1, 1

-1, 1

B
Tails

1, -1

TABLE 6-4: Solving for Pure-Strategy Nash

Equilibrium in Matching Pennies Game
B
A

Heads
Tails

24

Heads

Tails

1 , -1

-1, 1

-1, 1

1 , -1

TABLE 6-5: Battle of the Sexes in

Normal Form
B (Husband)
A (Wife)

25

Ballet
Boxing

Ballet
2, 1
0, 0

Boxing
0, 0
1, 2

FIGURE 6-3: Battle of the Sexes

Game in Extensive Form

A (Wife)
Ballet

.
Ballet

2, 1

26

Boxing

B (Husband)

B (Husband)
Boxing

0, 0

Ballet

Boxing

0, 0

1, 2

TABLE 6-6: Solving for Pure-Strategy

Nash Equilibria in Battle of the Sexes
B (Husband)
A (Wife)

27

Ballet
Boxing

Ballet
2, 1
0, 0

Boxing
0, 0
1, 2

Best-Response Function

28

The function which gives the payoffmaximizing choice for one player in each
of a continuum of actions of the other
player is referred to as the best-response
function.

TABLE 6-7: Computing the Wifes Best

Response to the Husbands Mixed Strategy
B (Husband)
Ballet

A (Wife)

29

Boxing

Ballet h
Box 1
2, 1
Box 3
0, 0

Boxing 1-h
Box2
0, 0
Box 4
1, 2

(h)(2) + (1 h)(0)
= 2h
(h)(0) + (1 h)(1)
=1-h

FIGURE 6-4: Best-Response Functions

Allowing Mixed Strategies in the Battle
of the Sexes

h
1

Husbands bestresponse
function

Wifes bestresponse
function

1/3

.
30

Pure-strategy
Nash equilibrium
(both play Boxing)

2/3

Pure-strategy
Nash equilibrium
(both play Ballet)

Mixed-strategy
Nash equilibrium

The Problem of Multiple Equilibria

31

A rule that selects the highest total payoff

would not distinguish between two purestrategy equilibria.
To select between these, one might follow
T. Schellings suggestion and look for a
focal pointa logical outcome on which
to coordinate, based on information
outside the game.

TABLE 6-8: Husbands

Contingent Strategies
Contingent Strategy

32

Strategy written equivalently in conditional format

Always go to Ballet

Ballet / Ballet, Ballet / Boxing

Follow his wife

Ballet / Ballet, Boxing / Boxing

Do the opposite

Boxing / Ballet, Ballet / Boxing

Always go to Boxing

Boxing / Ballet, Boxing / Boxing

TABLE 6-9: Sequential Version of the

Battle of the Sexes in Normal Form

B (Husband)
A (Wife)

33

Ballet
Boxing

Ballet / Ballet
Ballet / Boxing
2, 1
0, 0

Ballet / Ballet
Boxing / Boxing
2, 1
1, 2

Boxing / Ballet
Ballet / Boxing
0, 0
0, 0

Boxing / Ballet
Boxing / Boxing
0, 0
1, 2

FIGURE 6-5: Sequential Version of the

Battle of the Sexes in Extensive Form

A (Wife)
Ballet

.
Ballet

2, 1

34

Boxing

B (Husband)
Boxing

0, 0

B (Husband)

Ballet

Boxing

0, 0

1, 2

TABLE 6-10: Solving for Nash Equilibria

in the Sequential Version of the Battle
of the Sexes
B (Husband)
Ballet

A (Wife)

Ballet / Ballet
Ballet / Boxing
Nash
equilibrium 1
2, 1

Boxing / Ballet
Ballet / Boxing
0, 0

Boxing
0, 0

35

Ballet / Ballet
Boxing / Boxing
Nash
equilibrium 2
2, 1
1, 2

0, 0

Boxing / Ballet
Boxing / Boxing
0, 0
Nash
equilibrium 3
1, 2

Subgame-Perfect Equilibrium

36

Game theory offers a formal way of

selecting the reasonable Nash equilibria in
sequential games using the concept of
subgame-perfect equilibrium.
A proper subgame consists of the part of
the game tree including an initial decision
not connected to another in an oval and
everything branching out below it.

FIGURE 6-6: Proper Subgames in the

Battle of the Sexes

Simultaneous
Version

A (Wife)
Ballet

.
Ballet

2, 1

37

Boxing

B (Husband)
Boxing

0, 0

Ballet

B (Husband)
Boxing

0, 0

1, 2

FIGURE 6-6 (cont.): Proper

Subgames in the Battle of the Sexes

Sequential
Version

A (Wife)
Ballet

.
Ballet

2, 1

38

Boxing

B (Husband)
Boxing

0, 0

B (Husband)

Ballet

Boxing

0, 0

1, 2

Backward Induction

39

A shortcut to finding the subgameperfect equlibrium directly is to use

backward induction.
Backward induction solves for the
equilibrium by working backwards from
the end of the game to the beginning.

FIGURE 6-7: Backward Induction in

the Sequential Battle of the Sexes

A (Wife)
Ballet

.
Ballet

2, 1

40

Boxing

B (Husband)
Boxing

0, 0

(Next Slide)

B (Husband)

Ballet

Boxing

0, 0

1, 2

FIGURE 6-7: Backward Induction in

the Sequential Battle of the Sexes

A (Wife)
Ballet

Boxing

B (Husband)
plays Ballet
2, 1

41

B (Husband)
plays Boxing
1, 2

Indefinite Time Horizon

Use the following version of the

Prisoners Dilemma:
The game is played in the first period for
certain, but for how many more periods after
that the game is played is uncertain.
Let r be the probability the game is repeated
for another period.
(1 r) is the probability the repitions stop for
good.

42

Indefinite Time Horizon

43

In equilibrium, both players play Silent

and each earns 2 each period the
game is played, implying a players
expected payoff over the course of the
game is
(-2)(1 + r + r2 + r3 + . . .)
6.1

Indefinite Time Horizon

If

a player cheats and plays Confess, the

cheater earns 1 in that period, but then
both play Confess every period and from
then on, each earning 3 for each
period, for a total expected payoff of
-1 + (-3)(r + r2 + r3 + . . .) 6.2

44

Indefinite Time Horizon

For

cooperation to be a subgame-perfect
equilibrium, (6.1) must exceed (6.2).
Adding 2 to both expressions, and then
adding 3(r + r2 + r3 + . . .) to both
expressions, (6.1) exceeds (6.2) if
r + r2 + r3 + . . . > 1
6.3

45

Continuous Actions

Equations for the Tragedy of Commons:

120 s A s B
s A (120 s A s B )
120 2 s A sB
sB
s A 60
2
sA
sB 60
2

46

6.4
6.5
6.6
6.7
6.8

FIGURE 6-8: Best-Response Functions

in the Tragedy of the Commons
SB
120

As best-response
function

60
40

Nash equilibrium
Bs best-response
function
40

47

60

120

SA

Continuous Actions

48

Equations for the Tragedy of Commons

After Equilibria are Shifted:
132 s A sB

6.9

sB
s A 66
2

6.10

FIGURE 6-9: Shift in Equilibrium

When As Benefit Increases
SB

As best-response
function shifts out

Nash equilibrium
shifts

40
36

Bs best-response
function
SA

40 48

49