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Chapter A: Economic Tools

1 Preliminaries
The concepts of set and function are extensively used in what follows. Here is the place to recall
their meaning and to fix some notation.
Roughly speaking, a set is completely determined by its members provided there is no ambigu-
ity on how those members are selected or specified. It is frequently useful to define sets by means
of sets, and in particular to form subsets from a given set. To illustrate, let A denote the set of all
men and women. Consider the property '.x/ having the meaning x is currently employed. The
set of all men and women who are currently employed is defined by B D fx 2 A W '.x/g. The set
B is also a subset of A. In defining B we specified its members as being all those x 2 A satisfying
property '.x/. For notation, the number of elements of a set A is denoted by jAj.
Given two sets X and Y , a function f W X ! Y associates to each x 2 X a single element
of Y , which is called the image of x under f and denoted by f .x/. The set of all functions with
domain X and codomain Y is represented by Y X . When X and Y are finite sets, the set Y X
contains exactly jY jjXj elements. A correspondence is a special case of a function that assumes
values in a set whose elements are subsets of another set. More concretely, given two sets X and
Y , a correspondence F W X  Y assigns to each element x 2 X a subset F .x/  Y . It is merely
a function F W X ! 2Y , where 2Y stands for the set of all subsets of Y (i.e., A 2 2Y , A  Y ).
Example 1 (Function). Consider X D fx1 ; x2 g, Y D fy1 ; y2 ; y3 g, and the function f W X ! Y ,
as defined by the rule
(
y1 ; if x D x1
f .x/ D
y3 ; if x D x2 :

Because f is completely specified by f .x1 / and f .x2 /, a more concise notation is to express f
as the vector .f .x1 /; f .x2 // D .y1 ; y3 /. Under the convention f D .f .x1 /; f .x2 //, the set of all
functions of the kind f W X ! Y is

Y X D f.y1 ; y1 /; .y1 ; y2 /; .y1 ; y3 /; .y2 ; y1 /; .y2 ; y2 /; .y2 ; y3 /; .y3 ; y1 /; .y3 ; y2 /; .y3 ; y3 /g;

and contains jY X j D jY jjXj D 32 D 9 elements. 

Example 2 (Correspondence). Consider X D fx1 ; x2 ; x3 g, Y D fy1 ; y2 g, and the correspon-

dence F W X  Y as given by
fy g; if x D x1
1
F .x/ D fy1 ; y2 g; if x D x2
fy2 g; if x D x3 : 

Example 3 (Best-reply as a correspondence). Consider the normal form game with two players,
two strategies for each, and payoffs as described by the matrix in figure 1. In this particular case
both players are always indifferent between any two strategies since their payoffs are the same.
Their best-reply against the strategies played by the opponent defines a correspondence instead of a

1
function. For concreteness, the set of strategies of player 1 is S1 D fU; Dg, and the set of strategies
of player 2 is S2 D fL; Rg. The best-reply correspondence of player 1 is b1 W S2  S1 mapping
each s2 2 S2 to strategies in S1 that maximize the payoff of player 1 given the choice s2 of player
2. Therefore, b1 .L/ D b1 .R/ D fU; Dg. By a similar argument, the best-reply correspondence of
player 2 is b2 W S1  S2 as given by b2 .U / D b2 .D/ D fL; Rg. The triviality of this example
rests on the assumption about the payoff matrix. More in general, best-reply correspondences are
responsive to changes in the choice of each players opponent. 

Player 2
L R

U 1; 1 1; 1
Player 1
D 1; 1 1; 1

Figure 1: Example 3.

2 Game Theory
For the purposes of these notes, the word game refers to any multiperson decision problem and
is associated with a situation of strategic interaction among different agents (consumers, firms,
organizations, etc.). A game is fully described by its rules, information structure, and players with
their respective payoffs. There are two ways of formalizing the concept of game. One is to define
its normal form (also referred to as the strategic form), which is a concise description of a game and
encompasses the list of players, the sets of all strategies available to each player, and the payoffs
associated with each profile of strategies. While this is an adequate description of a simultaneous-
move game, it does not reveal much of the structure of sequential (or dynamic) games. In order
to capture the more complicated protocols that guide the play of a sequential game we use the
extensive form representation. The extensive form of a game is a complete description of the order
of play, the information and choices that are available to each player when they move during the
game, and the final payoffs.
This section is intended as an overview of static and sequential games. It is not comprehensive
by any means. We emphasize the mechanics of describing the game and finding a plausible predic-
tion of its outcome. In doing so we restrict attention to games of complete information (roughly,
the class of games where there is no uncertainty among the players about the structure of the game),
to the Nash equilibrium solution concept (and its subgame perfect refinement in sequential games),
and most of time to pure strategies.1
1
See http://www.econ.canterbury.ac.nz/personal_pages/paul_walker/gt/hist.htm for a chronological overview of
major developments in the field.

2
2.1 Static games of complete information
In a static or simultaneous game players independently choose their actions once and for all. These
choices lead to an outcome of the game and the payoffs. One interpretation is that each player
simultaneously takes a single action not knowing or seeing what anyone else is choosing. Then,
conditional on the play of the game, the payoffs are distributed to the players. In a static game
of complete information the whole structure (including rules, possible actions, and preferences of
each player over the outcomes) of the game is common knowledge among the players. Such
a static game can be completely described by three components that comprise the normal form
representation of the game: players, strategies, and payoffs. More formally,

N D ff1; : : : ; ng; fS1 ; : : : ; Sn g; fu1 ; : : : ; un gg; (1)

is the normal form of the game, where f1; : : : ; ng represents the set of players, Si stands for the
set of strategies (understood here as all available actions) of player i , and ui W S1 


 Sn ! R
is the utility function of player i . The utility ui represents the way player i ranks a strategy
profile .s1 ; : : : ; sn / in S1 


 Sn , and to some extent captures the players
Q preferences over
the final outcomes of the game. For notation: S D S1 


 Sn , S i D j i Sj , and s i D
.s1 ; : : : ; si 1 ; siC1 ; : : : ; sn / is a typical element of S i .
An alternative definition of a normal form representation emphasizes a consequentialist inter-
pretation of each players preferences. Players evaluate the different outcomes of the game, and
(apparently) do not necessarily bother about the actions that lead to any specific outcome. In order
to formalize this consequentialist view, we can take as given the set O of all possible outcomes,
and a function o W S ! O associating an outcome of the game to each strategy profile. Player i
now has preferences over the elements of O. Assume they are representable by a utility function
vi W O ! R. Enlarge the definition of a game in normal form to include the new objects, and re-
place the utility function ui by vi . Because we can always redefine the relevant utility with domain
S by ui D vi o, we will follow the more concise definition expressed in (1).

ui
S R
o
vi
O

It is common to describe the normal form of a game in a matrix format whenever possible.
For example, with n D 2 (two players) and jS1 j D jS2 j D 2 (two strategies for each player, e.g.,
S1 D fa; bg and S2 D fc; d g), the normal form game is usually depicted as in figure 2.

Example 4 (Coordination game). Two players agree to meet at a certain place (out of two pos-
sible locations), but cannot communicate to say where they are going. If they meet, their payoff
is 1. Otherwise, their payoff is 0. The set of players is f1; 2g. If we label the two meeting places
as A and B, the sets of strategies become S1 D S2 D fA; Bg. Payoffs can be described by
u1 .s1 ; s2 / D u2 .s1 ; s2 / D 1 if s1 D s2 , and u1 .s1 ; s2 / D u2 .s1 ; s2 / D 0 if s1 s2 . See figure
3. 

3
 Player 2
c d

a u1 .a; c/; u2 .a; c/ u1 .a; d /; u2 .a; d /

Player 1
b u1 .b; c/; u2 .b; c/ u1 .b; d /; u2 .b; d /

Figure 2: 2  2 game.

Example 5 (Prisoners dilemma). In this game there are two players who can decide to cooperate
(C ) or not (NC ). The set of players is f1; 2g, and the sets of strategies are S1 D S2 D fC; NC g.
By cooperating both achieve a payoff of 2: u1 .C; C / D u2 .C; C / D 2. If player 1 cooperates
but player 2 does not, then player 2 gets a payoff of 3, while player 1 gets 0: u1 .C; NC / D 0,
and u2 .C; NC / D 3. Symmetrically, u1 .NC; C / D 3, and u1 .NC; C / D 0. When no one
cooperates: u1 .NC; NC / D u2 .NC; NC / D 1. Observe that both players have a higher payoff
when they both cooperate (if they both do not, their payoff is 1 < 2), but each one has an incentive
to unilaterally deviate from this strategy (the payoff of a unilateral deviation is 3 > 2). See figure
4. 

Player 2 Player 2
A B C NC

A 1; 1 0; 0 C 2; 2 0; 3
Player 1 Player 1
B 0; 0 1; 1 NC 3; 0 1; 1

Figure 3: Coordination game. Figure 4: Prisoners dilemma.

Example 6 (Zero-sum game). A particular case of a zero-sum game is the matching pennies
game (figure 5). Here two players simultaneously select the side of a coin (heads or tails). If both
agree on their selection (that is, the sides match), player 1 wins. Otherwise, player 2 wins. In terms
of notation, the set of players is f1; 2g, and the sets of strategies are S1 D S2 D fH; T g. Payoffs
are given by u1 .H; H / D u1 .T; T / D 1, and u2 .H; T / D u2 .T; H / D 1, with the understanding
that u1 .s/ C u2 .s/ D 0 for all s 2 S. 

Example 7 (Cournot duopoly). Two firms simultaneously choose quantities. Given the market
demand and the cost structure of the firms, their profits (payoffs) can be specified. The normal
form game can be described by the set of players f1; 2g, the sets of strategies S1 D S2 D RC
(i.e., si  0 is the production of firm i ), and the payoffs, or profits, ui .s/ given the production
profile s. For notation we also use qi to represent the level of production of firm i , and i .q1 ; q2 /
to represent its total profit given the production of both firms. 

4
 Player 2
H T

H 1; 1 1; 1
Player 1
T 1; 1 1; 1

Figure 5: Matching pennies.

Example 8 (The problem of the commons). There are n farmers who graze their cows on a com-
mon field. The i -th farmer owns ki cows, which are perfectly divisible. The total costs associated
with a farmers livestockP are c.ki / D cki , where c  0. They are the same for each farmer
i . When there are K D niD1 ki cows grazing on the common field, the average revenue that a
farmer gets with one cow is v.K/. Given the limited resources, there exists a maximum number K
of cows that can graze on the field: v.K/ > 0 for K < K, and v.K/ D 0 when K  K. It is also
assumed that v 0 < 0 and v 00 < 0 in the range of K where v.K/ > 0. Finally, each farmer chooses
simultaneously how many cows to own. The normal form representation is described by the set of
players f1; : : : ; ng, theP
set of strategies

Si D RC , and the payoff function ui W S ! R as expressed
n
by ui .si ; s i / D si v j D1 sj csi . 

We make the prediction that the strategies that are more likely to be played are part of a Nash
equilibrium (NE) of the normal form game N . Loosely speaking a strategy profile is a NE when
unilateral deviations are not profitable. For any player i , if no one else deviates from the strategy
prescribed by the equilibrium profile, player i will not deviate either because there are no incentives
in terms of payoffs to play a different strategy. This idea is made precise next.

Definition 9 (Nash equilibrium). The strategy profile s  2 S is a NE of the normal form game
N when for each player i : ui .s  /  ui .si ; s  i / for all si 2 Si .

There are two alternative and equivalent definitions of a NE. One is helpful for computational
purposes, and requires defining how each player optimally reacts to the strategies played by the
other players.

Definition 10 (Best-reply correspondence). The best-reply correspondence of player i is a multi-

valued function bi W S i  Si such that: si0 2 bi .s i / if, and only if, si0 2 Si and ui .si0 ; s i / 
ui .si ; s i / for all si 2 Si . In a more concise notation, bi .s i / D arg maxsi 2Si ui .si ; s i /.

A best-reply correspondence specifies the best strategies that a player can choose against any
possible combination of strategies of the other players. In a NE no player has an incentive to
unilaterally deviate from the prescribed strategy. An intuitive expression of this idea in terms of
best-reply correspondences is that each player is using an optimal strategy given what is prescribed
to the other players. A NE of the normal form game N is therefore a strategy profile s  2 S
satisfying si 2 bi .s  i / for all i D 1; : : : ; n. To illustrate the use of this definition, assume that
each bi is a function and Si  R in a way that si D bi .s i / defines an equation with n unknowns.

5
In order to find one NE, it suffices to obtain a solution to the following system of n equations with
n unknowns:
s1 D b1 .s2 ; s3 ; : : : ; sn/
s2 D b2 .s1 ; s3 ; : : : ; sn/
::
:
sn D bn .s1 ; s2 ; : : : ; sn 1 /:
The second alternative definition of a NE emphasizes the (correct) conjectures each player
entertains about the other players when following the prescribed strategy. Denote the conjecture
of player i about the strategies of the other players by s Ei 2 S i . A NE is a strategy profile
s  2 S satisfying two properties. First, given the conjecture s Ei , player i plays a best response:
si 2 bi .siE /. Second, the conjecture of each player is correct in equilibrium, that is, s Ei D s  i for
all i D 1; : : : ; n.
Example 4 (continued). Using the best-reply correspondences (see figure 6), b1 .A/ D b2 .A/ D
fAg and b1 .B/ D b2 .B/ D fBg, so that .A; A/ and .B; B/ are NE of the game. Note that .A; B/
and .B; A/ are not, as b1 .B/ D B A and b1 .A/ D A B. 
Example 5 (continued). The strategy profile .NC; NC / is the only NE of the game. It is a NE
because ui .NC; NC / D 1 > 0 D ui .C; NC / for i D 1; 2. No other profile is NE: ui .NC; C / D
3 > 2 D ui .C; C /, i D 1; 2, thus ruling out .C; C /, and u1 .NC; NC / D 1 > 0 D u1 .C; NC /, so
that .C; NC / cannot be NE (by symmetry, .NC; C / cannot be NE either). See figure 7. 

s2 s2
b1 .
/ b1 .
/
b2 .
/ b2 .
/

B NC

NE NE

A C

NE

A B s1 C NC s1

Figure 6: Equilibria in example 4. Figure 7: Equilibrium in example 5.

Example 6 (continued). There is no NE (in pure strategies) here. Checking the best-reply cor-
respondences: b1 .H / D H and b2 .H / D T (ruling out .H; H /), b1 .T / D T and b2 .T / D H
(ruling out .T; T /), b1 .T / D H and b2 .H / D T (ruling out .H; H /), b2 .H / D T and b1 .T / D T
(ruling out .H; T /), and b2 .T / D H and b1 .H / D H (ruling out .T; H /). See figure 8. 

6
 p
Example 8 (continued). Suppose that v.K/ D K S K when K  K, S and v.K/ D 0 for K >
q P
S
K. Assume for simplicity that c D 0. The payoff of player is ui .si ; s i / D si KS si
j i sj
Pn
when j D1 sj  K. S Computing the best response of player i , we maximize ui .si ; s i / in si
P
S
assuming that j i sj < K:
s
S
X si si S
X
K si sj q D0) DK si sj ; (2)
2 KS si
P 2
j i j i sj j i

P

and thus bi .s i / D 23 K S j i sj . In equilibrium, (2) implies that every player satisfies the
same FOC. Hence si D k for all i , where k solves k D bi .k; : : : ; k/. Thefore, the NE is s  2 S
S
2K
with si D 2nC1 for all i . (For the case where n D 2, see figure 9.) Note that the total number of
S
cows grazing in the common field in equilibrium is nk D 2K1 , which tends to K S from below as
2C n
n ! 1. 

s2
s2
b1 .
/
b2 .
/
S
K
T
b1 .s2 / NE
2KS
3

b2 .s1 /

0 2KS S
K s1
H T s1 3

Figure 8: Best responses in example 6. Figure 9: Equilibrium in example 8, n D 2.

(Addendum) Equilibrium and efficiency in example 8. In a general setting with n players, payoffs
are given by the expression
n
X 
ui .si ; s i / D v sj si csi ;
j D1

where v W RC ! RC assigns to the total number of cows grazing in the field, K, the average

7
productivity v.K/ of a farmer. The function v satisfies
x
v.K/ > 0 for all K 2 0; K/;
x
v.K/ D 0 for all K  K;
v.0/ > c  0;
v 0 .K/ < 0; v 00 .K/ < 0 x
for all K 2 0; K/:

Recall that Kx is that maximum number of cows that can be grazed on the pasture, and thus the
average productivity is positive if the field is not overcrowded, greater than the marginal cost for
small K, and a decreasing and concave function of the total number of cows up to K. x

v.K/

v.0/

0 Kx KD
Pn
j D1 sj

Figure 10: Average production, example 8.

In order to find a NE of the game in example 8 it suffices to solve a system of n equations and
n unknowns, provided the solution is well-behaved. In fact, if s  D .s1 ; : : : ; sn/ is a solution to
the system of equations
@ui
.s/ D 0; i D 1; : : : ; n
@si
Pn
with j D1 sj < Kx and si > 0 for all i D 1; : : : ; n, then s  is a NE of the game and it is symmetric
(i.e, si D sj for all i; j ). This assertion can be verified as follows. Symmetry of the solution is a
consequence of
X n  X n 
@ui  0   
.s / D v sj si C v sj cD0
@si j D1 j D1
 
Pn 
c v j D1 sj
) si D   ;
Pn 
v0 j D1 sj

8
which does not depend on i . Each si is a best-response
P against s  i , as the function ui .si ; s  i / is
 x
strictly concave in the range of si where si C j i sj < K:
 X   X 
@2 ui  00  0
2
.si ; s i / D v si C sj si C 2v si C sj < 0:
@si
j i j i

 is zero andthus ui .si ;s i / D csi  0 <
Moreover, outside of that range the averageproductivity
Pn Pn
ui .s  /. The last inequality follows from v 
j D1 sj c D v0  
j D1 sj si > 0. Therefore,

si is a best response against s  i , and s  must be a NE of the game.

.K/

0 K  K  Kx K

Figure 11: Overgrazing in example 8.

In the NE of game computed above the total number of cows that graze in the field is not
optimal from a social viewpoint. In fact, the total number of cows that maximize the sum of the
payoffs
Xn X n 
v sj si csi D v.K/K cK;
iD1 j D1
Pn
where K D x as the solution K  to the
iD1 si , can be obtained from the FOC (assuming K < K)
equation
v 0 .K/K C v.K/ c D 0:
Pn
Define K  D 
iD1 si , the total number of cows in the NE of the game. Then,
K
v 0 .K  / C v.K  / c D 0 .i D 1; : : : ; n/
n
) v 0 .K  /K  C v.K  / cD .n 1/.v.K  / c/ < 0:
Because of the right-hand side of the previous equations is the derivative of the concave function
.K/ D v.K/K cK, we have K  > K  and .K  / < .K  / (see figure 11). In other words,
 
when all players choose Kn instead of Kn , each farmers profit increases.

9
2.2 Sequential games of complete information
A sequential game unfolds over time, and we capture this special feature by means of a game
tree. The set of players remains nearly unchanged, except that we now allow one additional
player in the game who behaves in a predetermined way and and call it Nature. The payoff
functions stand essentially as they were in the static game, but they now map more explicitly the
final outcome of the game to a numerical value. All these changes are described in the context of
a game that ends after a finite number of moves with the help of its extensive form representation,
which will be denoted by E .
A finite game in extensive form E starts at an initial node, called origin or root, from which
emanate various branches (or edges) leading to further nodes, called the immediate successors of
the origin, and so on. A finite game has a finite number of nodes, which fall into two classes. One
corresponds to those nodes that have no successors. Nodes with no successors are called terminal
nodes. The other is the class of decision nodes, which are nodes that are not terminal. In order to
represent the order of the moves during the game, partition the decision nodes to indicate which
player controls each node. Moreover, for each player i , partition the nodes that are controlled by
i into information sets. If a node belonging to a given information set of player i is reached in a
particular play of the game, player i cannot tell which of the nodes belonging to that information set
has been reached. Associate the set of branches proceeding from an information set with choices
for the player that moves at that information set. Each node in a given information set has the same
number of immediate successors, and the branches leading to them are associated with the same
set of choices or actions. Finally, restrict the game tree so that for each node there exists a unique
path from the origin to it. Therefore, identify the set of outcomes with the set of terminal nodes,
and attach a vector of payoffs to each terminal node.
This informal description of an extensive form game is formalized next. For completeness we
include Nature as a player in the definitions below.

Definition 11 (Extensive form game). The extensive form representation of a game is a list E D
fI; X; ; x0 ; Z; ; fHi W i 2 I g; fAi .
/ W i 2 I g; ; fvi W i 2 I gg, whose elements are defined and
interpreted as follows.
1. I D f0; 1; : : : ; ng is the set of players, where i D 0 is Nature.
2. X is the (finite) set of nodes representing the positions in the game, and  is a transitive and
asymmetric binary relation on X with the interpretation of a precedence relation: x  x 0
when the node x precedes x 0 . There exists a unique node x0 2 X preceding each element
of X n fx0 g. Each node other than x0 has an immediate predecessor, which is assumed to be
unique.
3. Z  X is the set of terminal nodes: Z D fz 2 X W x 2 X such that z  xg.
4.  W X n Z ! I is a function specifying which player gets to move at each decision node.
5. Hi is a partition of the set of decision nodes controlled by i , Xi D fx 2 X n Z W .x/ D i g.
That is, Hi S is a collection of nonempty subsets h of Xi satisfying h \ h0 D ; for all h h0
in Hi , and h2Hi h D Xi .2 Refer to each h 2 Hi as an information set of player i : the
interpretation is that player i moves at x 2 h only knowing that he or she is moving at some
node in h.
2
S
For terminology, we refer to E as a game of perfect information when jhj D 1 for all h 2 i 2I Hi , i.e., when
every information set is a singleton. Otherwise (i.e., when there exist i and h 2 Hi with jhj > 1) we say that E has
imperfect information.

10
 6. Ai .x/ are the actions available to player i D .x/, who controls the decision node x. In
order to preclude the actions available from revealing any additional information, we require
that Ai .x/ D Ai .x 0 / whenever fx; x 0 g  h. To simplify notation, we denote by Ai .h/ the
common set of actions available at the nodes belonging to h.
7.  is a function assigning probabilities
P to actions available at information sets where Nature
moves: .h; a/  0 and a2A0 .h; a/ D 1 for h 2 H0 , where A0 is the set of actions
available at nodes belonging to the information set h.
8. vi W Z ! R is the payoff function of player i . It assigns a real number to each terminal
node, and thus to each possible outcome of the game.

A (pure) strategy for player i in E is a complete contingent plan telling the player what to do
in each circumstance. In other words, a strategy si of player i associates S a feasible deterministic
choice to each of i s information sets. It is a function si W Hi ! h2Hi Ai .h/ satisfying the
restriction si .h/ 2 Ai .h/ for all h 2 Hi . Denote by Si the set of all strategies of player i , and
by the S the set of all strategy profiles .s1 ; : : : ; sn/ 2 S1 


 Sn . A strategy profile s 2 S
induces a unique path from the initial node x0 to a terminal node. We define for each player i a
payoff function on the set of all strategies: ui .s/ D vi .z/, where z 2 Z is the terminal node that
s induces. Because we can always describe the normal form representation of an extensive form
game E , we can also find the NE of a game in extensive form by computing the NE of its normal
form representation.

Remark 12. The extensive form game E can also be represented in a normal form N D
fI; fSi W i 2 I g; fui W i 2 I gg, where Si and ui are defined as above. In fact, each extensive
form game has exactly one formal form. But many different extensive form games may give rise
to the same normal form. To illustrate, consider the normal form game N1 depicted in figure 12.
The extensive form games El , l D 1; 2; 3; 4, displayed in figure 13, have the same normal form
N1 . 

Player 2
L R

l 0; 0 1; 1
Player 1
r 1; 1 1; 1

Figure 12: N1 .

Example 13 (Trust game). Player 1 needs to hire a plumber for a one-day job. The only plumber
in town is player 2, who is promptly available. Player 1 first chooses whether to hire (action a) or
not (action b) player 2. If hired, player 2 decides whether to do a decent job (action c) or to defect
(action d ), doing a subpar job. The game tree and the payoff vectors are depicted in figure 14. The
set of players is I D f1; 2g. The set of nodes is X D fx0 ; x1 ; z1 ; z2 ; z3 g, with the terminal nodes
being the elements of Z D fz1 ; z2 ; z3 g. The precedence relation  is completely described by the

11
 1 2
1 2
E E

l r L R

2 1

L R L R l r l r

               
0 1 1 1 0 1 1 1
0 1 1 1 0 1 1 1
1 2
3 4
E E

l r L R
2 1
   
1 1
L R 1 l r 1

       
0 1 0 1
0 1 0 1

Figure 13: Games with the same normal form N1 .

comparisons

x0  z1 ; x0  x1 ; x1  z2 ; and x1  z3 :3 (3)

Specifying the player who controls each decision node, we define the function  W X n Z ! I ,
where .x0 / D 1 and .x1 / D 2. The information sets of player 1 are the elements of H1 D ffx0 gg.
That is, the only information set of player 1 is h D fx0 g. For player 2, H2 D ffx1 gg. The only
action set of player 1 is A1 .x0 / D fa; bg. For player 2, A2 .x1 / D fc; d g. The payoff function
of player 1 is v1 W Z ! R, where v1 .z1 / D 1, v1 .z2 / D 1, and v1 .z3 / D 2. Similarly, the
payoff function of player 2 is v2 W Z ! R, where v2 .z1 / D 0, v2 .z2 / D 1, and v2 .z3 / D 2. The
sets of strategies are S1 D fa; bg and S2 D fc; d g. See figure 16 for the payoff functions ui on
S D S1  S2 . 

Example 14 (Sequential coordination). The original coordination game in example 4 can be

written in extensive form by assuming that player 1 moves first and player 2 moves next but does
not observe which location, A or B, was chosen. This is shown in figure 18. Consider the same
situation except that now player 2 moves after (perfectly) observing the choice of player 1 (see
figure 15). The set of players is I D f1; 2g. The set of nodes is X D fx0 ; x1 ; x2 ; z1 ; z2 ; z3 ; z4 g,
and the terminal ones are collected in the set Z D fz1 ; z2 ; z3 ; z4 g. The precedence relation  is
described by

x0  x1 ; x0  x2 ; x1  z1 ; x1  z2 ; x2  z3 ; and x2  z4 :
3
Because of transitivity of the precedence relation, the missing comparisons (viz., x0  z2 and x0  z3 ) are
implied by the last three comparisons in (3).

12
 1 1
x0 x0

a b A B
2 2 2
z1  x1 x1 x2
1
0 c d A B A B
z2  z3  z1  z2  z3  z4 
1 2 1 0 0 1
1 2 1 0 0 1

Figure 14: Example 13. Figure 15: Example 14.

Player 2 Player 2
c d .A; A/ .A; B/ .B; A/ .B; B/

a 1; 0 1; 0 A 1; 1 1; 1 0; 0 0; 0
Player 1 Player 1
b 1; 1 2; 2 B 0; 0 1; 1 0; 0 1; 1

Figure 16: Normal form of example 13. Figure 17: Normal form of example 14.

The function  W X n Z ! I satisfies .x0 / D 1 and .x1 / D .x2 / D 2. The collections of

information sets: H1 D ffx0 gg, and H2 D ffx1 g; fx2 gg. The action sets are A1 .x0 / D A2 .x1 / D
A2 .x2 / D fA; Bg. The payoffs as functions of the final nodes are easily inferred from figure 15.
The set of strategies of player 1 is S1 D fA; Bg. Define the information sets h2 D fx1 g and h02 D
fx2 g. A strategy for player 2 is a function s2 W fh2 ; h02 g ! fA; Bg, that is, s2 D .s2 .h2 /; s2 .h02 //.
Therefore, S2 D f.A; A/; .A; B/; .B; A/; .B; B/g. The payoff functions ui on S D S1  S2 are
shown in figure 17. 

1
x0

A B
x1 2 x2

A B A B
z1  z2  z3  z4 
1 0 0 1
1 0 0 1

Figure 18: Extensive form representation of a version of example 4.

Example 15 (Market game MWG). The players are firms. Player 1 decides whether or not to
enter the market. If player 1 chooses to enter, then it has to decide whether or not to fight the

13
 1
x0

l r
1
 z1 x1 Player 2
0
2 F A F A
x2 2 x3
F 3; 1 1; 2
Player 1
F A F A
A 2; 1 3; 1
z2  z3  z4  z5 
3 1 2 3
1 2 1 1

Figure 19: Example 15. Figure 20: Example 15 after entry.

incumbent firm (player 2). Not observing what player 1 has chosen after entering the market,
player 2 has to decide whether or not to fight the entrant. The game tree is displayed in figure 19.
Note that after player 1 enters the market, both players play an extensive form game whose normal
is depicted in figure 20. Describing the players and sets of nodes:

I D f1; 2g; X D fx0 ; x1 ; x2 ; x3 ; z1 ; z2 ; z3 ; z4 g; and Z D fz1 ; z2 ; z3 ; z4 g:

The precedence relation on X can be inferred from

x0  x1 ; x0  z1 ; x1  x2 ; x1  x3 ; x2  z2 ;
x2  z3 ; x2  z3 ; x3 z4 and x3  z5 :

The function that assigns decision nodes to players:  W X n Z ! I , where .x0 / D .x1 / D 1
and .x3 / D .x4 / D 2. The information sets are the elements of H1 D ffx0 g; fx1 gg for player 1
and H2 D ffx2 ; x3 gg for player 2. The action sets of player 1 are A1 .x0 / D fl; rg and A1 .x1 / D
fF; Ag. The action sets of player 2 are A2 .x2 / and A2 .x3 /, both equal to fF; Ag, which represents
the actions available at the information set h2 D fx2 ; x3 g 2 H2 . The payoffs associated with each
outcome of the game are easily describe by inspecting the game tree in figure 19. The strategies
available to player 1 are the functions s1 W H1 ! A1 .x0 / [ A1 .x1 / satisfying s1 .h1 / 2 A1 .x0 /
and s1 .h01 / 2 A1 .x1 /, where we define h1 D fx0 g and h01 D fx1 g. Under the convention that
s1 D .s1 .h1 /; s1 .h01 //, the set of strategies of player 1 is S1 D f.l; F /; .l; A/; .r; F /; .r; A/g. For
player 2, who has a single information set, we have S2 D fF; Ag (there are only two functions
of the form s2 W H2 ! fF; Ag). The payoffs functions ui on S are displayed in the normal form
representation of the game in figure 21. 

Example 16 (MWG). Consider the following variation of example 15. If player 1 decides to
enter the market, then depending on the choice of player 2 both firms fight and get a low payoff or
both firms arrange a suitable division of the market and obtain a higher payoff. The game tree is

14
 Player 2 1
x0
F A
l r
.l; F / 0; 2 0; 2 2
z1  x1
0
.l; A/ 0; 2 0; 2 L R
2
Player 1
.r; F / 3; 1 1; 2 z2  z3 
3 2
.r; A/ 2; 1 3; 1 1 1
RR

Figure 21: Normal form of example 15. Figure 22: Example 16.

displayed in figure 22. The elements of the extensive form game are

I D f1; 2g; X Dfx0 ; x1 ; z1 ; z2 g; Z D fz1 ; z2 g;

x0  z1 ; x0 x1 ; x1  z1 ; x1  z3 ;
 W X n Z ! I; with .x0 / D 1 and .x1 / D 2;
H1 D ffx0 gg; H2 D ffx1 gg; A1 .x0 / D fl; rg; A2 .x1 / D fL; Rg:

Payoffs and strategies are easily inferred from the game tree and the normal form representation in
figures 22 and 25. 

Example 17 (MWG). Another variation of example 15. Player 1 decides to stay out of the market
by playing l, or to enter and automatically commit to a strategy (F or A). When player 1 enters
the market player 2 cannot tell which strategy player 1 has committed to. The game tree is shown
in figure 23. The elements of the extensive form game are

I D f1; 2g; X Dfx0 ; x1 ; x2 ; z1 ; : : : ; z5 g; Z D fz1 ; : : : ; z5 g;

x0  z1 ; x0 x1  z2 ; z3 ; x0  x1  z4 ; z5 ;
 W X n Z ! I; with .x0 / D 1 and .x1 / D 2;
H1 D ffx0 gg; H2 D ffx1 ; x2 gg; A1 .x0 / D fl; F; Ag; A2 .fx1 ; x2 g/ D fF; Ag:

Player 1 has a single information set h1 D fx0 g, and therefore the concept of strategy requires
that a action at h1 be specified: S1 D fl; F; Ag. Likewise, player 2 has a single information set
h2 D fx1 ; x2 g. All strategies available to player consist in selecting a single action to be played at
h2 : S2 D fF; Ag. See figure 24 for the normal form of this game. 

Example 18 (Centipede game). Two players can either equally split a payoff of 6 utils after four
rounds or they can decide to quit the game with a lower payoff earlier. Players 1 is the first to
move, and can either terminate the game, in which case both players quit with a payoff of 1 util, or
leave the decision to player 2 in the next round. Player 2 then faces the same choice, except for a

15
 1
x0
Player 2

l F A F A

l 0; 2 0; 2
 z1 x1 2 x2
0
Player 1 F 3; 1 1; 2
2
F A F A
A 2; 1 3; 1
z2  z3  z4  z5 
3 1 2 3
1 2 1 1

Figure 23: Example 17. Figure 24: Normal form of example 17.

difference in the payoff of terminating the game. This iteration can be repeated if player 2 chooses
to continue. The game is depicted in figure 26. Except for the payoff functions, the elements of
the extensive form game are

I D f1; 2g; X Dfx0 ; x1 ; x2 ; x3 ; z1 ; : : : ; z5 g; Z D fz1 ; : : : ; z5 g;

x0  x1  x2  x3 z5 ; x0  z1 ; x1  z2 ; x2  z3 ; x3  z4 ;
 W X n Z ! I; with .x0 / D .x2 / D 1 and .x1 / D .x3 / D 2;
H1 D ffx0 g; fx2 gg; H2 D ffx1 g; fx3 gg; A1 .x0 / D A1 .x2 / D A2 .x1 / D A2 .x3 / D fT; P g:

Payoff functions and strategies can be inferred from the game tree and the normal form represen-
tation in figure 27. 

Player 2
1 P 2 P 1 P 2
L R  z5
x0 x1 x2 x3 3
l 0; 2 0; 2 T T T T 3
Player 1
 z1  z2  z3  z4
r 3; 1 2; 1 1 0 2 1
1 3 2 4

Figure 25: Normal form of example 16 Figure 26: Example 18.

Every sequential game can be represented in normal form. The NE solution concept for this
type of games is thus well defined. But it may predict certain outcomes that are not intuitive, as
in example 16. The game in this example has two NE: .l; L/ and .r; R/. The equilibrium strategy
profile .r; R/ requires player 2 to choose R and accommodate the entry of player 1. The equilib-
rium strategy profile .l; L/ is not easy to explain: player 2 chooses an action that is not optimal
in the event that player 1 enters the market. Since this event does not occur in equilibrium, the
non-credible threat of player 2 is compatible with the impossibility of finding profitable unilateral
deviations. In terms of expectations, this unappealing feature of NE is in part derived from the fact

16
 Player 2
.T; T / .T; P / .P; T / .P; P /

.T; T / 1; 1 1; 1 1; 1 1; 1

.T; P / 1; 1 1; 1 1; 1 1; 1
Player 1
.P; T / 0; 3 0; 3 2; 2 2; 2

.P; P / 0; 3 0; 3 1; 4 3; 3

Figure 27: Example 18.

that NE imposes consistent beliefs (in the sense of players expecting optimal choices from their
opponents) on the equilibrium path, but places no constraints on the beliefs about choices off the
equilibrium path. In example 16, player 1 chooses l because of the expectation that player 2 plays
L at a node that is never reached in equilibrium. This expectation is not consistent with an optimal
decision on the part of player 2 had the game actually reached that node. At the same time, the
notion of NE does not require player 2 to select an optimal decision at the information set fx1 g:
independently of what player 2 chooses in the decision node x1 , his or her payoff will be equal to
2. In order to refine the NE solution concept so as to rule out equilibria such as .l; L/, we introduce
the notion of subgame perfect Nash equilibrium (SPNE), which requires players to choose optimal
actions at every decision node in the game.
To define the SPNE of the extensive form game E we need to give an unambiguous meaning
to the requirement that players make optimal decisions at each decision node. This is essentially
done by defining the concept of a subgame of E , and then requiring that equilibrium strategy
profiles be compatible with optimal choices (in the sense of being part of a NE) in each subgame.
Loosely speaking, a subgame E0 of E is an extensive form game obtained from E by pruning
its tree in a suitable manner and preserving information sets and payoffs. An example of subgame
is the original game E itself. If E is a game of perfect information, any subgame of E can
found by picking a decision node and including in the subgame all its successors. More generally,
we impose two kinds of restrictions to define a subgame E0 of E .
A. E0 begins at a decision node x 2 X such that
 the subgame begins at a node that belongs to an information set of the original game
containing a single node (x 2 h 2 Hi ) h D fxg) and
 includes all of its successors ( if x 0 2 X and x  x 0 , then x 0 belongs to the set of nodes
of E0 ).
B. If x 0 is a decision node of E0 and x 00 2 h 2 Hi in the original game with x 0 2 h, then x 00 is
also a decision node of E0 .
Important cases where the conditions above fail are illustrated in figures 28 to 31. In figure 28,
the purported subgame does not have an admissible game tree because there is not a unique initial
node. In contrast, in figure 29 the subgame begins at a single information set, but it contains
more than one node. The game tree defining the alleged subgame in figure 30 is not admissible
because it does not contain every successor of the initial node of the subgame: there is one terminal

17
 E0 E0

Figure 28: Not a subgame (initial nodes). Figure 29: Not a subgame (info set).

E0 E0

Figure 30: Not a subgame (successor). Figure 31: Not a subgame (info set).

node that succeeds the initial node of the subgame and is not contained in the set of nodes of the
subgame. Finally, figure 31 shows an example where one information set is destroyed in the sense
there is one node in the information that belongs to the subgame and another that does not. This
operation is not allowed in the construction of a subgame.
The definition of a SPNE requires one additional piece of notation. Let E .h/ denote the
subgame of E that begins at the decision node belonging to h, where h in an information set of
some player in the game with a single element. Note that E .fx0 g/ D E when x0 is the initial
node of E .

Definition 19 (SPNE). A SPNE of E is a strategy profile s  2 S that induces a NE in each

subgame E .h/ of E .

Example 13 (continued). By inspecting the normal form of this game, we identify a single NE
s  D fa; d g. There are two subgames: the game itself and the proper subgame E1 (see figure 32).
The last subgame is a single-player game where player 2 selects the NE d . Therefore, s  induces
NE in E .fx1 g/ D E1 and is also SPNE. 

Example 14 (continued). There are four NE strategy profiles in the sequential coordination game:

s  D .A; .A; A//; .A; .A; B//; .B; .A; B//; and .B; .B; B//:

18
 E E
1 1
x0 x0
1 2
a b 1
E E A B E
2 2 2
z1  x1 x1 x2
1
0 c d A B A B
z2  z3  z1  z2   z3  z4
1 2 1 0 0 1
1 2 1 0 0 1

Figure 32: Example 13, subgames. Figure 33: Example 14, subgames.

E
1
x0

r 1
l E
1
 z1 x1 2
0
2 F A F A
x2 2 x3
F 3; 1 0; 2
1
F A F A
A 2; 1 3; 1
z2  z3  z4  z5 
3 1 2 3
1 2 1 1

Figure 34: Example 15, subgames. Figure 35: Example 15, N1 .

This extensive form game has two proper subgames: E1 D E .fx1 g/ and E2 D E .fx2 g/. In
each proper subgame only player 2 is called to move, and the NE in E1 requires that action A
be played and the NE in E2 demands the choice of action B. There are only two NE of the
whole game E compatible with these choices, .A; .A; B// and .B; .A; B//, and they are both
SPNE. 

Example 15 (continued). There are three NE in the market game: s  D ..l; F /; F /; ..l; A/; F /;
and ..r; A/; A/: This game has only one proper subgame E1 D E .fx1 g/, whose normal N1 is
depicted in figure 35. The only NE of this subgame is .A; A/: player 1 selects A and player 2
chooses A. The only NE of the whole that induces this profile of actions in the subgame E1 is
..r; A/; A/, which is in fact the only SPNE of E . 

Example 16 (continued). This game has two NE: s  D .l; L/ and .r; R/. The only proper sub-
game is the one starting at node x1 . In the subgame E .fx1 g/ the NE is for player 2 to choose R.
Therefore, the only strategy profile of the whole that is compatible with such an outcome at the
last subgame is .r; R/ (the only SPNE). 

19
 1 P 2 P 1 P 2
 z5
x0 x1 x2 x3 3
T T T T 3

 z1  z2  z3  z4

1 0 2 1
1 3 2 4
1 2 3
E E E E

Figure 36: Example 18, subgames.

2 2
.T; T / .T; P / .P; T / .P; P / T P

T 0; 3 0; 3 2; 2 2; 2 T 2; 2 2; 2
1 1
P 0; 3 0; 3 1; 4 3; 3 P 1; 4 3; 3

Figure 37: Example 18, N1 . Figure 38: Example 18, N2 .

Example 17 (continued). This game has two NE: s  D .l; F / and .A; A/. There is no proper
subgame in this game. Each NE is also SPNE. 

Example 18 (continued). There are four NE in the centipede game:

s  D ..T; T /; .T; T //; ..T; T /; .T; P //; ..T; P /; .T; T //; and ..T; P /; .T; P //:

There are three proper subgames, as shown in figure 36: E1 ; E2 , and E3 . The strategic repre-
sentation N1 of E1 has two NE: .s1 .fx2 g/; s2 / D .T; .T; T // and .T; .T; P //. The only NE of
the whole game compatible with these NE of E1 are ..T; T /; .T; T // and ..T; T /; .T; P //. The
subgame E2 , with normal form N2 , has one NE .s1 .fx2 g/; s2 .fx3 g// D .T; T /. The only NE of
the whole game compatible with this equilibrium is ..T; T /; .T; T //. Finally, note that the only NE
of the subgame E3 has player 2 choosing T . The only NE of E compatible with this NE and the
ones from E1 and E2 is ..T; T /; .T; T //, which is the only SPNE of E . The same equilibrium
strategy profile can be found using backward induction. 

2.3 Mixed strategies

Extend the previous setting in order to account for mixed strategies. Starting with a normal form
game ff1; : : : ; ng; fS1 ; : : : ; Sn g; fu1 ; : : : ; un gg where the sets Si are finite, define .Si / as the set
of all probability measures on Si . A typical element of .Si / is denote by i and assigns to each
pure strategy si 2 Si a number i .si / 2 P 0; 1, which is interpreted as the probability that player
i plays the pure strategy si and satisfies si 2Si i .si / D 1. In other words, a P mixed strategy can
be viewed as a function i W Si ! R such that i .si /  0 for all si 2 Si and si 2Si i .si / D 1.
The original payoff function ui with domain S D S1  S2 


 Sn can be extended to the set

20
of mixed strategy profiles D .S1 /  .S2 / 


 .Sn / by defining ui ./ as the expected
utility of player i given , namely
X
ui ./ D E .ui / D 1 .s1 /2 .s2 / : : : n .sn / ui .s/: (4)

s2S
Pr.s2S is played/

The normal form game is N D ff1; : : : ; ng; f.S1 /; : : : ; .Sn /g; fu1 ; : : : ; un gg, where the payoff
functions ui W ! R are now defined as above. The concept of NE can be extended to this
setting: it is a (mixed) strategy profile   2 such that, for all i : ui .i ;  i /  ui .i ;  i / for all
i 2 .Si /.

i .T /

.Si /

0 1 i .H /

Figure 39: Set of mixed strategies.

To illustrate, consider the matching pennies game (example 6). The set of all mixed strategies
of player i , as shown in figure 39, is

.Si / D fi 2 R2 W i D .i .H /; i .T //  0; i .H / C i .T / D 1g:

To compute the expected payoff of each player given  2 .S1 /  .S2 /, first calculate the
probability of each pure strategy profile s 2 S1  S2 :

s D .H; H / W Pr.s/ D 1 .H /2 .H /

s D .H; T / W Pr.s/ D 1 .H /2 .T / D 1 .H /.1 2 .H //
s D .T; H / W Pr.s/ D 1 .T /2 .H / D .1 1 .H //2 .H /
s D .T; T / W Pr.s/ D 1 .T /2 .T / D .1 1 .H //.1 2 .H //:

21
Recalling equation (4), compute the expected payoffs:

i D1 E .u1 / D 1 .H /2 .H /u1 .H; H / C 1 .H /.1 2 .H //u1 .H; T /

C .1 1 .H //2 .H /u1 .T; H / C .1 1 .H //.1 2 .H //u1 .T; T /
D1 22 .H / C 2.22 .H / 1/ 1 .H /

1 1

i D2 E .u2 / D E .u1 /
D 1 C 22 .H / 2.22 .H / 1/1 .H /
D 21 .H / 1 C 2.1 21 .H // 2 .H /:

2 2

ui .i ;  i /
i < 0; i > 0
i

i D i D 0

0 1 i .H /

i > 0; i < 0
i

Figure 40: Expected payoff: i C i i .H /.

To find the best response of player 1, we maximize u1 .1 ; 2 / in 1 . Because u1 .1 ; 2 / is linear
in 1 , the optimal choice of 1 .H / depends on the sign of the coefficient 1 D 2.22 .H / 1/:
1
2 .H / < 2
) 1 < 0 W the optimal strategy is 1 .H / D 0
1
2 .H / > 2
) 1 > 0 W the optimal strategy is 1 .H / D 1
1
2 .H / D 2
) 1 D 0 W any 1 .H / 2 0; 1 is optimal:

By a similar argument, the optimal choice of 2 .H / depends on 2 D 2.1 21 .H //:

1
1 .H / > 2
) 2 < 0 W the optimal strategy is 2 .H / D 0
1
1 .H / < 2
) 2 > 0 W the optimal strategy is 2 .H / D 1
1
1 .H / D 2
) 2 D 0 W any 2 .H / 2 0; 1 is optimal:

22
 2 .H /
b1
b2

NE Player 2
1
S C

S 5; 2 3; 1
1
2 Player 1
C 6; 3 4; 4

0 1 1 1 .H /
2

Figure 41: Best-reply correspondences. Figure 42: Simultaneous-move game.

The best-reply correspondences are completely characterized in terms of the probability of playing
H , and are depicted in figure 41. The only NE of the game N is the strategy profile   2
satisfying i .H / D i .T / D 21 , i D 1; 2.
Allowing mixed strategies in the matching pennies game helps illustrate a general feature of NE
in mixed strategies: each pure strategy that player 1 plays with positive probability in equilibrium
(in the example, H and T ) is a best response in pure strategy against the mixed strategy 2 of
player 2 and gives the same expected payoff: u1 .H; 2 / D 21 1 C 12 . 1/ D 0 D 21 . 1/ C 21 1 D
u1 .T; 2 /, where (with abuse of notation) H stands for the mixed strategy 1 D .1; 0/ and T is
used in the place of the mixed strategy 1 D .0; 1/. A similar observation applies to player 2:
u2 .1 ; H / D 12 . 1/ C 12 1 D 0 D 21 1 C 12 . 1/ D u2 .1 ; T /. Therefore, guessing a NE in mixed
strategy where both players play H and T with positive probability suggests a method for finding
the solution by means of two equations:
2 .H / .1 2 .H // D 2 .H / C .1 2 .H // ) 2 .H / D 1
2

1 .H / C .1 1 .H // D 1 .H / .1 1 .H // ) 1 .H / D 12 :

We present two last examples of equilibria in mixed strategies.
Example 20 (Simultaneous-move game). Consider the static game whose payoff matrix is shown
in figure 42. By allowing mixed strategies its normal form is expressed as
N D ff1; 2g; f.S1 /; .S2 /g; fu1 ; u2 gg;
where
.Si / D f.i .S/; i .C // W i .S/; i .C /  0; i .S/ C i .C / D 1g;
and the payoff function ui W .S1 /  .S2 / ! R maps each profile of mixed strategies  2
.S1 /  .S2 / to its expected payoff
X
ui ./ D E .ui / D Pr.s/ui .s/:
s2S

23
A NE of the game is a (mixed) strategy profile   such that

u1 .1 ; 2 /  u1 .1 ; 2 / for all 1 2 .S1 /; and

u2 .1 ; 2 /  u2 .1 ; 2 / for all 2 2 .S2 /:

Now compute the expected payoff of each player in order to find the equilibrium of the game.

Player 1 E .u1 / D Pr.S; S/u1 .S; S/ C Pr.S; C /u1 .S; C / C Pr.C; S/u1 .C; S/

C Pr.C; C /u1 .C; C /

D 1 .S/2 .S/  5 C 1 .S/2 .C /  3 C 1 .C /2 .S/  6 C 1 .C /2 .C /  4
D 1 .S/ C 4 C 22 .S/

Player 2 E .u2 / D Pr.S; S/u2 .S; S/ C Pr.S; C /u2 .S; C / C Pr.C; S/u2 .C; S/

C Pr.C; C /u2 .C; C /

D 1 .S/2 .S/  2 C 1 .S/2 .C /  1 C 1 .C /2 .S/  3 C 1 .C /2 .C /  4
D .21 .S/ 1/2 .S/ C 4 31 .S/:

The best-responses in terms of 1 .S/ and 2 .S/ are as follows. For player 1,

b1 .2 .S// D arg max . 1 .S/ C 4 C 22 .S// ) 1 .S/ D b1 .2 .S// D 0:
1 .S /20;1

For the other player, we maximize E .u2 / D .21 .S/ 1/2 .S/ C 4 31 .S/ in 2 .S/ 2 0; 1

1;
and obtain

if 1 .S/ > 21
b2 .1 .S// D 0; 1 ; if 1 .S/ D 12
0; if 1 .S/ < 12 :

Therefore, the unique NE of the game is   D .1 2 / with 1 .S/ D 2 .S/ D 0 and 1 .C / D
2 .C / D 1. See figure 43.


Example 21 (Sequential game). In the sequential version of the game in example 20 player 1
moves first and takes the action S or C . After observing the initial choice of player 1, player
2 selects S or C (see figure 44). In order to describe the strategies available to the players, we
list their information sets. Player 1 moves at the initial node, which is the only element of the
information set h1 . In this case H1 D fh1 g. Player 2 moves at the only node belonging to the
information set h2 following the choice of S by player 1, and at the information set h02 when player
1 chooses C at the beginning of the game. Therefore, H2 D fh2 ; h02 g. Pure strategies for players 1
and 2 are, respectively, functions of the type

s1 W H1 ! fS; C g and s2 W H2 ! fS; C g:

24
 2 .S/
b1
b2

NE

0 1 1 1 .S/
2

Figure 43: Best-reply correspondences.

Listing all pure strategies available to the players (as a convention s2 D .s2 .h2 /; s2 .h02 /):

S1 D fS; C g and S2 D f.S; S/; .S; C /; .C; S/; .C; C /g:

Allowing for mixed strategies in the game, we write its normal form as

N D ff1; 2g; f.S1 /; .S2 /g; fu1 ; u2 gg;

where

.S1 / D f.1 .S/; 1 .C // W 1 .S/; 1 .C /  0; 1 .S/ C 1 .C / D 1g; and

X
.S2 / D .2 .SS/; 2 .SC /; 2 .CS/; 2 .C C // W 2 .s2 /  0; 2 .s2 / D 1 :
s2 2S2

The restriction of the expected payoff functions to pure strategies is shown in figure 45. To find the
equilibrium strategy profile we compute the expected payoffs of the players. When computing the
expected payoffs, we make a simplification and consider 2 .CS/ D 0. This assumption is justified
because the pure strategy .C; S/ of player 2 is strictly dominated by the pure strategy .S; C /, and
therefore in any NE strategy profile   we have 2 .CS/ D 0.

25
 1
h1

S C 2
h2 h02
2 2 .S; S/ .S; C / .C; S/ .C; C /

S C S C S 5; 2 5; 2 3; 1 3; 1
1
        C 6; 3 4; 4 6; 3 4; 4
5 3 6 4
2 1 3 4

Figure 44: Sequential game. Figure 45: Payoff matrix (pure strategies).

Player 1 E .u1 / D Pr.S; SS/u1 .S; SS/ C Pr.S; SC /u1 .S; SC /

C Pr.S; CS/u1 .S; CS/ C Pr.S; C C /u1 .S; C C /

C Pr.C; SS/u1 .C; SS/ C Pr.C; SC /u1 .C; SC /
C Pr.C; CS/u1 .C; CS/ C Pr.C; C C /u1 .C; C C /
D 1 .S/2 .SS/ C 2 .SC /  5 C 1 .S/2 .C C /  3 C 1 .C /2 .SS/  6
C 1 .C /2 .SC / C 2 .C C /  4
D .22 .SC / 1/1 .S/ C 4 C 22 .SS/

Given the expected payoff E .u1 /, the optimal response of player 1 to the opponents strategy can
be summarized as follows:

1
2 .SC / > 2
) 1 .S/ D 1
1
2 .SC / < 2
) 1 .S/ D 0
1
2 .SC / D 2
) any 1 .S/ 2 0; 1 is optimal:

26
Player 2 E .u2 / D Pr.S; SS/u2 .S; SS/ C Pr.S; SC /u2 .S; SC /

C Pr.S; CS/u2 .S; CS/ C Pr.S; C C /u2 .S; C C /

C Pr.C; SS/u2 .C; SS/ C Pr.C; SC /u2 .C; SC /
C Pr.C; CS/u2 .C; CS/ C Pr.C; C C /u2 .C; C C /
D 1 .S/2 .SS/ C 2 .SC /  2 C 1 .S/2 .C C /  1 C 1 .C /2 .SS/  3
C 1 .C /2 .SC / C 2 .C C /  4
D .21 .S/ 1/2 .SS/ C 1 .S/2 .SC / C 4 31 .S/:
In view of the functional form of E .u2 /, the best response of player 2 can be summarized as
follows:

0 < 1 .S/ < 1 ) 2 .SC / D 1

1 .S/ D 0 ) any division 2 .SC / C 2 .C C / D 1 is optimal
1 .S/ D 1 ) any division 2 .SS/ C 2 .SC / D 1 is optimal:
If   is a NE, then either   .S/ D 1 or 1 .S/ < 1. Listing the NE in mixed strategies we look
at one case at a time. First, using the best response of player 1, those NE with 1 .S/ D 1 satisfy
2 .SC /  12 . They are thus described by the pairs .1 ; 2 / satisfying
1
1 .S/ D 1; 2 .SS/ C 2 .SC / D 1; and 1 .SC /  :
2
Two examples: player 1 uses the pure strategy S and player 2 either plays the pure strategy SC or
mixes SC and SS with equal probabilities. Finally, the equilibria where 1 .S/ < 1 have player
2 choosing the pure strategy SC with certainty if 1 .S/ > 0, but in this case we must have (by
the best-response of player 1) 1 .S/ D 1; a contradiction with our initial assumption. Therefore
1 .S/ D 0 and the equilibrium strategies within this class are the pairs .1 ; 2 / satisfying
1
1 .S/ D 0; 2 .SC /  ; and 2 .SC / C 2 .C C / D 1:
2
Two examples: player 1 selects C for sure and player 2 either randomizes between SC and C C
with equal probabilities or plays C C for sure. 

2.4 Two-player zero-sum games

2.4.1 Security levels
Consider a game in normal form N D ff1; : : : ; ng; fS1 ; : : : ; Sn g; fu1 ; : : : ; un gg, where each set of
pure strategies Si is assumed to be finite.4 The security level or maxmin value of player i is defined
4
The same ideas and definitions apply to the case where each Si is replaced by .Si / and the payoff functions are
extended to expected utility.

27
as follows. If player i chooses si , the players worst possible payoff in the game is obtained by
minimizing ui .si ; s i / in si 2 Si . Maximizing this minimum payoff over si 2 Si gives the security
level (or maxmin value) of player i ,

vi D max min ui .si ; s i /:

si 2Si s i 2S i

For interpretation, vi is the largest payoff player i can guarantee for him or herself in the game
independently of the choice of the other players. In terms of computation, the procedure for deter-
mining vi in a finite game consists of finding the minimum values

vi .si / D min ui .si ; s i /; for all si 2 Si ;

s i 2S i

and defining the quantity vi as the maximum over all vi .si /, i.e,

vi D maxfvi .si;1 /; vi .si;2 /; : : : ; vi .si;jSi j /g: (5)

For instance, if si is a strategy of player i attaining the minimum in (5), then si guarantees a
payoff of at least vi to player i whatever the choices of the other players are. In other words, for
all si 2 S i ,

ui .si ; s i /  0 min ui .si ; s 0 i / D vi .si / D vi ;

s i 2S i

since si 2 arg maxsi0 2Si mins 0 i 2S i ui .si0 ; s 0 i / . We refer to si as a maxmin strategy. Conversely,
if si guarantees the maxmin value vi , then

u1 .si ; s 0 i /  max min ui .si ; s i / for all s 0 i 2 S i

si 2Si s i 2S i

) min ui .si ; s i /  max min ui .si ; s i /;

s i 2S i si 2Si s i 2S i

whence mins i 2S i
ui .si ; s i / D vi , i.e., si maximizes mins i 2S i
ui .si ; s i /.
Example 22 (MSZ). The game with payoff matrix shown in figure 46 is represented by

N D ff1; 2g; fS1 ; S2 g; fu1 ; u2 gg;

where S1 D fT; M; Bg and S2 D fL; Rg. The security levels of players 1 and 2 can be found as
follows. For player 1:

s1 D T v1 .T / D minfu1 .T; L/; u1 .T; R/g D minf2; 2g D 2

s1 D M v1 .M / D minfu1 .M; L/; u1 .M; R/g D minf3; 10g D 10

s1 D B v1 .M / D minfu1 .B; L/; u1 .B; R/g D minf 100; 3g D 100

) v1 D maxf2; 10; 100g D 2:

For player 2:

28
 s2 D L v2 .L/ D minfu2 .T; L/; u2 .M; L/; u2 .B; L/g D minf1; 0; 2g D 0

s2 D R v2 .R/ D minfu2 .T; R/; u2 .M; R/; u2 .B; R/g D minf 20; 1; 3g D 20

) v2 D maxf0; 20g D 0:

The strategy that guarantees at least the maxmin value v1 D 2 to player 1 is s1 D T , while the
maxmin strategy of player 2 is s2 D L and it guarantees at least the security level v2 D 0. 

Player 2 Player 2
L R L C R

T 2; 1 2; 20 T 0; 1 1; 2 7; 3

Player 1 M 3; 0 10; 1 Player 1 M 4; 6 2; 0 3; 2

B 100; 2 3; 3 B 9; 0 0; 3 0; 4

Figure 46: Example 22. Figure 47: Example 23.

Example 23 (Binmore). The normal form N of the game is shown in figure 2. The sets of
strategies are S1 D fT; M; Bg and S2 D fL; C; Rg. The security levels are computed as follows.
For player 1:

s1 D T v1 .T / D minfu1 .T; L/; u1 .T; C /; u1 .T; R/g D minf0; 1; 7g D 0

s1 D M v1 .M / D minfu1 .M; L/; u1 .M; C /; u1 .M; R/g D minf4; 2; 3g D 2

s1 D B v1 .M / D minfu1 .B; L/; u1 .B; C /; u1 .B; R/g D minf9; 0; 0g D 0

) v1 D maxf0; 2; 0g D 2:

For player 2:

s2 D L v2 .L/ D minfu2 .T; L/; u2 .M; L/; u2 .B; L/g D minf1; 6; 0g D 0

s2 D C v2 .L/ D minfu2 .T; C /; u2 .M; C /; u2 .B; C /g D minf2; 0; 3g D 0

s2 D R v2 .R/ D minfu2 .T; R/; u2 .M; R/; u2 .B; R/g D minf3; 2; 4g D 2

) v2 D maxf0; 0; 2g D 2:

The security strategies of players 1 and 2 are, respectively, s1 D M and s2 D R. 

29
Remark 24. In a 2  2 game, in order to find the security level of player 1 it is sufficient (but
not necessary) to identify the saddle point (if any) of the payoff function u1 W S1  S2 ! R: if
.s1 ; s2 / 2 S1  S2 satisfies

u1 .s1 ; s2 /  u1 .s1 ; s2 /  u1 .s1 ; s2 / for all .s1 ; s2 / 2 S1  S2 ; (6)

then v1 D u1 .s1 ; s2 /. In fact, the first inequality in (6) implies

min u1 .s1 ; s2 /  u1 .s1 ; s2 /

s2 2S2

) v1 D max min u1 .s1 ; s2 /  min u1 .s1 ; s2 /  u1 .s1 ; s2 /: (7)

s1 2S1 s2 2S2 s2 2S2

Now using the second inequality, we obtain

u1 .s1 ; s2/  max u1 .s1 ; s2/: (8)

s1 2S1

Because u1 .s1 ; s2 /  mins2 2S2 u1 .s1 ; s2 / for all s1 2 S1 , we also have

max u1 .s1 ; s2/  max min u1 .s1 ; s2 / D v1 : (9)

s1 2S1 s1 2S1 s2 2S2

Putting together (7), (8) and (9):

v1  u1 .s1 ; s2/  max u1 .s1 ; s2/  max min u1 .s1 ; s2 / D v1 ;

s1 2S1 s1 2S1 s2 2S2

and thus v1 D u1 .s1 ; s2 /. Likewise, the maxmin value of player 2 can be found by inspecting the
payoff function u2 W S1  S2 ! R: given any profile of strategies .s1 ; s2 / 2 S1  S2 such that

u2 .s1 ; s2 /  u2 .s1 ; s2 /  u2 .s1 ; s2 / for all .s1 ; s2 / 2 S1  S2 ;

we have v2 D u2 .s1 ; s2 /. 

Remark 25. The converse to remark 24 is not true in general. For instance, in example 22, the
maxmin value of player 1 is attained by the strategy profile .T; L/, and yet it is not a saddle point
of the payoff function u1 . 

Remark 26. If s  is a NE of a normal form game N , then ui .s  /  vi . This statement is readily

verified as ui .si ; s  i /  ui .si ; s  i / for all si 2 Si , and thus ui .si ; s  i /  mins i 2S i ui .si ; s i /.
Taking the maximum of the right-hand side of the last inequality reveals

ui .si ; s  i /  max min ui .si ; s i / D vi : 

si 2Si s i 2S i

2.4.2 Equilibrium in pure strategies

A two-person zero-sum game in normal form is represented by the sets of strategies available to
the players, S1 and S2 , and the payoff function u1 W S1  S2 ! R of player 1. For notation, the
strategies of player 1 are numbered from 1 to M : S1 D fs11 ; : : : ; s1M g . Similarly, the N strategies
available to player 2 are listed as S2 D fs21 ; : : : ; s2N g. Note that in this game

u1 .s1 ; s2 / C u2 .s1 ; s2 / D 0 for all .s1 ; s2 / 2 S1  S2 ;

30
and the relevant information about the payoffs is contained in the function u1 . Therefore, the
payoff matrix is often written in terms of the payoffs of the first player only. More concretely, the
payoff matrix is fully described by

A D akl ;

where

u1 .s1k ; s2l / D akl and u2 .s1k ; s2l / D akl :

Example 27. Two players simultaneously show one or two fingers in each hand. The right hand
indicates the players guess about the opponents left hand. Each player has 4 strategies available.
For instance, s1 D .x; y/, x; y 2 f1; 2g, where x is the number of fingers shown in the players left
hand, and y is the number of fingers player 1 shows in the right hand. Therefore, strategies can be
represented by pairs of numbers:

S1 D S2 D f.1; 1/; .1; 2/; .2; 1/; .2; 2/g:

When only one player guesses correctly the choice of the opponent, that players payoff is equal
to the sum of the fingers shown by him or herself. Otherwise the game is a draw and payoffs are
zero. The payoff matrix is shown in figure 48. 

Player 2
.1; 1/ .1; 2/ .2; 1/ .2; 2/

.1; 1/ 0 1 2 0

.1; 2/ 1 0 0 1
Player 1
.2; 1/ 2 0 0 2

.2; 2/ 0 1 2 0

Figure 48: Example 27.

The solution concept of a two-person zero-sum is closely related to the configuration of the
maxmin values of the players. Recall the definition of v 1 as the largest payoff player 1 can guar-
antee independently of the choice of strategy of player 2. It can be expressed as

v1 D max min u1 .s1 ; s2 /

s1 2S1 s2 2S2

D max min akl :

k l

31
Similarly, for player 2

v2 D max min u2 .s1 ; s2 /

s2 2S2 s1 2S1

D max min u1 .s1 ; s2 /

s2 2S2 s1 2S1

D min max u1 .s1 ; s2 /

s2 2S2 s1 2S1

D min max akl :

l k

Define the maxmin and minmax value of the game, respectively, as

v D v1 D max min akl and vx D v2 D min max akl :

k l l k

We refer to s1 2 S1 as a maxmin strategy if

u1 .s1 ; s2 /  v for all s2 2 S2 ;

and to s2 2 S2 as a minmax strategy when

u1 .s1 ; s2/  vx for all s1 2 S1 :

Put differently, s1 2 S1 is a maxmin strategy if, and only if,

min u1 .s1 ; s2 / D v
s2 2S2

(i.e., s1 maximizes mins2 2S2 u1 .s1 ; s2 /). Similarly, s2 is a minmax strategy if, and only if,

max u1 .s1 ; s2/ D vx;

s1 2S1

(that is, s2 minimizes maxs1 2S1 u1 .s1 ; s2 /).

The reason we are rewriting the maxmin value of player 2 as a minmax lies in the purely
competitive nature of the game. Players 1 and 2 have conflicting interests in any zero-sum game,
and thus instead of using the maxmin value v2 of player 2 we work instead with the minmax value
of the game, which guarantees a payoff of at most vx in the sense: u1 .s1 ; s2/  vx for all s1 2 S1
when s2 is a minmax strategy.
A two-player game is said to have a value when v D vx. In this case we call v v D vx
the value of the game, and refer to any maxmin and minmax strategies of the players as optimal
strategies.
Remark 28. In order to check whether a game has a value, it suffices to verify is the inequality
v  vx holds, as the reverse inequality vx  v is always verified:

max u1 .s10 ; s2 /  u1 .s1 ; s2 /  min

0
u1 .s1 ; s20 / for all .s1 ; s2 / 2 S1  S2
s10 2S1 s2 2S2

) min max u1 .s10 ; s2 /  u1 .s1 ; s2 /  max min u1 .s1 ; s20 /: 

s2 2S2 s1 2S1
0 0 s1 2S1 s2 2S2

32
 Player 2 Player 2
D E F G L C R

A 2 3 4 1 T 1 4 2

Player 1 B 5 2 2 3 Player 1 M 2 3 4

C 4 1 3 2 B 0 2 7

Figure 49: Example 29. Figure 50: Example 30.

Example 29 (Dresher). Consider the game whose payoff matrix is shown in figure 49. The
maxmin and minmax values of the game can be found using the following procedure.

s1 D A minfa11 ; a12 ; a13 ; a14 g D minf2; 3; 4; 1g D 1

s1 D B minfa21 ; a22 ; a23 ; a24 g D minf5; 2; 2; 3g D 3

s1 D C minfa31 ; a32 ; a33 ; a34 g D minf4; 1; 3; 2g D 1

) v D maxf 1; 3; 1g D 1; and s1 D C is a maxmin strategy

s2 D D maxfa11 ; a21 ; a31 g D maxf2; 5; 4g D 5

s2 D E maxfa12 ; a22 ; a32 g D maxf3; 2; 1g D 3

s2 D F maxfa13 ; a23 ; a33 g D maxf4; 2; 3g D 4

s2 D G maxfa14 ; a24 ; a34 g D maxf 1; 3; 2g D 2

) vx D minf5; 3; 4; 2g D 2; and s2 D G is a minmax strategy:

This game does not have a value (at least when only pure strategies are considered), since vx D
2 > 1 D v. For interpretation, player 1 has a maxmin strategy s1 D C , which satisfies the
inequality u1 .C; s2 /  1 for all s2 2 S2 , and player 2 has a minmax strategy G, which gives a
payoff to player 1 that is bounded above by 2 (i.e., u1 .s1 ; G/  2 for all s1 2 S1 ). The maxmin
and minmax strategies C and G are nevertheless not optimal by definition since the game does not
have a value. 

Example 30. In the game shown in figure 30 we compute the maxmin and minmax values as
before.

33
 s1 D T minfa11 ; a12 ; a13 g D minf1; 4; 2g D 1

s1 D M minfa21 ; a22 ; a23 g D minf2; 3; 4g D 2

s1 D B minfa31 ; a32 ; a33 g D minf0; 2; 7g D 2

) v D maxf1; 2; 2g D 2; and s1 D M is a maxmin strategy

s2 D L maxfa11 ; a21 ; a31 g D maxf1; 2; 0g D 2

s2 D C maxfa12 ; a22 ; a32 g D maxf4; 3; 2g D 4

s2 D R maxfa13 ; a23 ; a33 g D maxf2; 4; 7g D 7

) vx D minf2; 4; 7g D 2; and s2 D L is a minmax strategy:

This game has a value v D 2, and the maxmin and minmax strategies M and L are optimal. Note
that u1 .M; L/ D v D u1 .T; R/ D 2, but strategies T and R are not optimal (for instance player 1
can guarantee a larger payoff by playing M instead of T ). 
There is a close connection between the value of a game and the payoff attained by any pair of
optimal strategies. As the next proposition shows, when it exists the value of a game is attained by
any pair of optimal strategies.
Proposition 31. If the game has a value v, and s1 and s2 are optimal strategies, then v D
u1 .s1 ; s2/.
Proof. By definition, a maxmin strategy satisfies u1 .s1 ; s2 /  v for all s2 2 S2 , and in particular
u1 .s1 ; s2/  v. By a similar argument, this using the definition of a minmax strategy, we find
u1 .s1 ; s2 /  v for all s1 2 S1 , and thus u1 .s1 ; s2 /  v. Therefore u1 .s1 ; s2 / D v.
There is also a close relation between the concept of value and the NE of a zero-sum game. To
make the argument precise, recall that a saddle point of the function u1 is a pair .s1 ; s2/ such that
u1 .s1 ; s2 /  u1 .s1 ; s2 /  u1 .s1 ; s2 / for all .s1 ; s2 / 2 S1  S2 : (10)
Proposition 32. The saddle point .s1 ; s2 / of u1 is characterized by the equations
min u1 .s1 ; s2 / D v; max u1 .s1 ; s2 / D vx; and vx D v:
s2 2S2 s1 2S1

Proof. If .s1 ; s2 / is a saddle point, it follows from (10) that

max min u1 .s1 ; s2 /  min u1 .s1 ; s2 /  u1 .s1 ; s2/  max u1 .s1 ; s2 /  min max u1 .s1 ; s2 /:
s1 2S1 s2 2S2 s2 2S2 s1 2S1 s2 2S2 s1 2S1

Hence vx D v D mins2 2S2 u1 .s1 ; s2 / D maxs1 2S1 u1 .s1 ; s2 /. Conversely, if all three equations are
satisfied,
min u1 .s1 ; s2 / D max u1 .s1 ; s2/  u1 .s1 ; s2 /  min u1 .s1 ; s2 / D max u1 .s1 ; s2/;
s2 2S2 s1 2S1 s2 2S2 s1 2S1

whence u1 .s1 ; s2 /  u1 .s1 ; s2 /  u1 .s1 ; s2 / for all s1 2 S1 and s2 2 S2 .

34
Proposition 33. The following statements are equivalent in a two-player zero-sum game.
(i) The games has a value, and s1 and s2 are optimal strategies.
(ii) The strategy profile .s1 ; s2 / is a saddle point of the game.
(iii) The strategy profile .s1 ; s2 / is a NE of the game.
Proof. The equivalence between (i) and (ii) follows from proposition 32. Finally, the strategy
profile .s1 ; s2/ is a NE if, and only if, u1 .s1 ; s2/  u1 .s1 ; s2 / for all s1 2 S1 , and u1 .s1 ; s2 / 
u1 .s1 ; s2 / for all s2 2 S2 . This is the same as saying that .s1 ; s2 / is a saddle point of u1 .

Player 2
L C R

T 1 2 3

Player 1 M 4 5 6

B 0 6 0

Figure 51: Example 34.

Example 34. Consider the zero-sum game whose payoff matrix is shown in figure 51. The strategy
profile s  D .B; R/ is the only NE of this game. The equilibrium strategy profile is also a saddle
point of the payoff function of player 1:
u1 .B; R/ D maxfu1 .T; R/; u1 .M; R/; u1 .B; R/g D maxf 3; 6; 0g
u1 .B; R/ D minfu1 .B; L/; u1 .B; C /; u1 .B; R/g D minf0; 6; 0g:
By proposition 33, the game has a value v D 0, and s1 and s2 are optimal strategies. This can be
also verified by first computing the maxmin and minmax values of the game as usual.

s1 D T minfa11 ; a12 ; a13 g D minf1; 2; 3g D 3

s1 D M minfa21 ; a22 ; a23 g D minf4; 5; 6g D 6

s1 D B minfa31 ; a32 ; a33 g D minf0; 6; 0g D 0

) v D maxf 3; 6; 0g D 0; and s1 D B is a maxmin strategy

s2 D L maxfa11 ; a21 ; a31 g D maxf1; 4; 0g D 4

s2 D C maxfa12 ; a22 ; a32 g D maxf2; 5; 6g D 6

s2 D R maxfa13 ; a23 ; a33 g D maxf 3; 6; 0g D 0

) vx D minf4; 6; 0g D 0; and s2 D R is a minmax strategy:

35
Conclusion: v D vx D 0 D u1 .s1 ; s2/, and s1 D B and s2 D R are optimal strategies. 

2.4.3 Equilibrium in mixed strategies

A two-player zero-sum game in strategic form consists of a set of players, sets of strategies, and
expected payoff functions: N D ff1; 2g; f.S1 /; .S2 /g; fu1 ; u2 gg, where ui is now the expected
payoff function of player i and has the set .Si / as its domain. Here we assume that jS1 j D M
(player 1 has M pure strategies) and jS2 j D N (player 2 has N pure strategies). Assume all pure
strategies are enumerated as s11 ; s12 ; : : : ; s1M for player 1, and as s21 ; s22 ; : : : ; s2N for player 2. A
mixed strategy for player 1 is a function
M
X
1 W S1 ! R such that 1 .s1k /  0 for all k; and .s1k / D 1:
kD1

Symmetrically, for player 2 a mixed strategy is a function

N
X
2 W S2 ! R such that 2 .s2l /  0 for all l; and .s2 / D 1:
lD1

It is convenient to denote a mixed strategy of playerP1 by a vector x D .x1 ; : : : ; xM / in which each

component is non-negative (xk  0 for all k) and M kD1 xk D 1. Similarly, for player 2 we write
PN
an element of .S2 / also as vector y D .y1 ; : : : ; yN / such that yl  0 for all l and lD1 yl D 1.
If we denote the payoff matrix of player 1 as A D akl with akl D u1 .s1k ; s2l /, the expected
payoff of a strategy profile .1 ; 2 / D .x; y/ can be written as
X
E .u1 / D 1 .s1 /2 .s2 /u1 .s1 ; s2 /
.s1 ;s2 /2S1 S2

M X
X N
D xk yl akl
kD1 lD1

D hx; Ayi:
In this setting, the definitions of maxmin and minmax values of the game are, respectively,
v D max min hx; Ayi and vx D min max hx; Ayi:
x2.S1 / y2.S2 / y2.S2 / x2.S1 /

It is not difficult to show that vx  v. A much less obvious observation is due to von Neumann
(1928): the minmax and the maxmin values are always equal when mixed strategies are allowed in
the game. This fact is a consequence of the following theorem.
Theorem 35 (von Neumann (1928)). Given any M  N matrix A D akl , there exist vectors
x  2 RM and y  2 RN , and a number v 2 R such that
M
X M
X
xk akl  v for all l; xk  0 for all k; xk D 1
kD1 kD1

M
X N
X
yl akl  v for all k; yl  0 for all l; yl D 1:
lD1 lD1

36
 Since every game has a value v, let x  and y  denote optimal strategies. By definition,
hx  ; Ayi  v for all y 2 .S2 /; and hx; Ay  i  v for all x 2 .S1 /;
or, equivalently,
min hx  ; Ayi D max min hx; Ayi and max hx; Ay  i D min max hx; Ayi:
y2.S2 / x2.S1 / y2.S2 / x2.S1 / y2.S2 / x2.S1 /

Therefore, the concepts of optimal strategies, saddle point of the game, and NE are all related as
in proposition 33.
Proposition 36. The following statements are equivalent.
(i) The vectors x  2 .S1 / and y  2 .S2 / are optimal strategies.
(ii) The strategy profile .x  ; y  / is a saddle point of the game: hx; Ay  i  hx  ; Ay  i 
hx  ; Ayi for all .x; y/ 2 .S1 /  .S2 /.
(iii) The strategy profile .x  ; y  / is a NE of the game.
Example 37. Consider the modified matching pennies game described by the following matrix:
" #
2 1
AD :
1 1
In order to solve the maxmin problem, we first compute the expected payoffs given the pure strate-
gies of player 2.
y D .1; 0/ E .u1 / D hx; Ayi D 2x1 x2 D 3x1 1

y D .0; 1/ E .u1 / D hx; Ayi D x1 C x2 D 1 2x1 :

Because 3x1 11 2x1 , x1  52 , we obtain

(
3x1 1; if x1  25
min hx; Ayi D
y2.S2 / 1 2x1 ; if x1  25 :

To find a maxmin strategy x  we maximize the function miny2.S2 / hx; Ayi and obtain x  D . 25 ; 53 /
as a solution. Since every game has a value v, we must have v D miny2.S2 / hx  ; Ayi D 51 .
Finally, compute the minmax strategy by looking at the expected payoffs given the choices of pure
strategies by player 1.
x D .1; 0/ E .u1 / D hx; Ayi D 2y1 y2 D 3y1 1

x D .0; 1/ E .u1 / D hx; Ayi D y1 C y2 D 1 2y1 :

Maximizing the expected payoff in x: 3y1 1  1 2y1 , y1  52 and thus

(
3y1 1; if y1  52
max hx; Ayi D
x2.S1 / 1 2y1 ; if y1  52 :

The maxmin strategy is y  D . 25 ; 53 /. The pair .x  ; y  / contains the optimal strategies and is both
a saddle point and a NE of the game. 

37
3 Producer and consumer surplus
Consider a firm whose technology is described by the cost function q 7! c.q/. Denote by F D
c.0/ its fixed cost, and by cV .q/ D c.q/ c.0/ its variable cost. If the firm is paid Rq when it
produces and sells q, then the profit is  D R c.q/. Define Rq as the minimum revenue that
induces the firm to produce the quantity q rather than 0. By definition Rq satisfies the inequality

Rq c.q/ D Rq cV .q/ F  R0 F D R0 c.0/;

which is equivalent to Rq  cV .q/ when R0 D 0. Therefore, Rq D cV .q/. When the firm is paid
R and produces q, we define the producer surplus at q, denoted by PS.q/, by

PS.q/ D R Rq D R cV .q/: (11)

For example, R D pq when the firm charges a constant unit price p, and the producer surplus
becomes pq cV .q/. More in general, the producer surplus in (11) represents the difference
between the actual revenue and the lowest revenue that induces the firm to produce q. The producer
surplus is closely related to the firms profit and its marginal cost:
Z q
PS.q/ D .q/ C F D R c 0 .t /dt:
0

Example 38. Consider a (single-output) production technology with constant returns, c.q/ D cq.
The producer surplus becomes PS.q/ D R cq, where R stands for the firms total revenue.
When the firm charges the same price for each unit of the good it sells, and the inverse market
demand is p.q/, the surplus has the expression PS.q/ D p.q/q cq. In this case PS equals total
profit. 

Example 39. Suppose the cost function is c.q/ D 2q C 1, and the inverse market demand is
given by the expression p.q/ D 5 q. Then PS.q/ D R .2q C 1/ 1 D R 2q. When
R D p.q/q D 5q q 2 , the producer surplus is PS.q/ D 3q q 2 . 

The concept of consumer surplus is symmetric: it is the difference between how much the
consumer pays to buy q units and the maximum amount that he or she is willing to pay for those q
units. We assume that the consumer has preferences represented by the quasi-linear utility function
.q; z/ 7! u.q; z/ D v.q/ C z, where z is the amount of money that is left after the consumer
purchases q units of the commodity. In other words, z represents the resources available to buy
other goods. Let Rq denote how much the consumer pays for q. For notation, the consumers
income is m. The gross benefit (the consumers total propensity to pay for q) associated with the
consumption of q is the greatest Rq that induces the consumer to buy, and thus satisfies

u.q; m Rq /  u.0; m/ , v.q/ C m Rq  v.0/ C m

, Rq  v.q/ v.0/:

Hence Rq D v.q/ v.0/. Sometimes we refer to v.q/ v.0/ as the gross consumer surplus. The
(net) consumer surplus at q, denoted by CS.q/, is the difference between the total propensity to
pay and the amount R that is actually paid:

CS.q/ D Rq R D v.q/ v.0/ R:

38
In other words, it is the difference between the amount of money actually paid and the maximum
amount that the consumer would be willing to pay for the good rather than do without it. For
example, if the consumer faces a constant unit price p, then R D pq. In this case the consumer
demand can be found by maximizing u.q; z/ subject to the constraint pq C z  m. Under certain
assumptions the maximum is characterized by the FOC p D v 0 .q/, which induces the inverse
demand function p.q/ D v 0 .q/. The gross consumer surplus at q is the area under the demand
curve, and the consumer surplus CS.q/ is the difference between the gross surplus and the revenue
of the producer:
Z q
CS.q/ D p.t /dt R D v.q/ v.0/ p.q/q: (12)
0

A hypothetical inverse demand function can always be defined by p.q/ D v 0 .q/, and he consumer
be required to pay R (not necessarily equal to p.q/q). In this case the consumer surplus at q is the
expression after the first equality sign in (12).

Example 40. The consumer has preferences over .q; z/, and they can be represented by the utility
function
B 2
u.q; z/ D q C Aq Cz:
2
v.q/

The inverse demand induced by u is p.q/ D A Bq in the range

R q of q where p.q/  0. Computing
the consumer surplus at q: CS.q/ D 2B q 2 C Aq R D 0 p.t /dt R. When the consumer
spends R D p.q/q, the expression simplifies to CS.q/ D B2 q 2 . 
p 1
Example 41. Consider u.q; z/ D 2 qCz. The inverse demand associated with u is p.q/ D q 2 .
p
Finding the consumer surplus: CS.q/ D 2 q R. For the case where R D p.q/q: CS.q/ D
p p p
2 q q D q. 

39