Game Theory

Microeconomics II
Game Theory
Matthias Messner
April 22, 2015
Introduction
These lecture notes summarize some of the more advanced arguments regarding the chapter
on Game Theory. The emphasis of these notes is not on spelling out in all details all the
material that has been covered in class. Rather the aim is to provide the student with a concise
summary of the technically and conceptually most difficult arguments. So these notes are not
supposed to be a substitute for the textbook. Instead, they should be seen as a supplement to
the recommended textbook.
The text contains a number of Remarks. Typically, a remark explains some technical
expression that has been used in the preceding paragraph (highlighted in italic characters).
Essentially, they play the role of a in-text footnote.
What is a game?
What is a game? We will not bother to give a general formal definition of the concept game.
Doing so would require tons of notation and terminology. For our purposes it is enough to
keep the following rather informal definition in mind: A game is a situation of interactive
decision making; that is, a situation where multiple individuals have to take decisions which
determine not only their own wellbeing but also the wellbeing of (a subset of) the other involved
individuals.
In what follows we will discuss different types of games. We will start out with the simplest
ones and as we continue we will introduce ever more complex types of games.
1
Microeconomics 2 - Prof. Matthias Messner 2
Static games with complete information
Defining a static game
The standard way to represent a static game is by way of the so called normal form of the game.
The normal form of a games is composed by the following elements
The set of players I = {1, 2, . . . I}.
A set of actions/strategies for each player i = 1, . . . , I, denoted by S i , (here we use

the terms actions and strategies synonymously; we will see later that the two concepts
coincide only in static games of complete information).
Some more useful notation regarding strategies:
A typical element of S i is denoted by si ; a vector s = (s1 , . . . , sI ) S 1 . . . S I is called
a strategy profile or strategy combination; the set of all strategy combinations is denoted
by S .
For strategy combinations of all players except player i we write si S 1 . . . S i1
S i+1 . . . S I ; the set of all such combinations are S i ; we use this notation to write
(si , si ) for a complete strategy combination.
A payoff function for each player i = 1, . . . , I, ui : S 1 . . . S I R; ui tells us what

the payoff of player i is for each possible combination of strategies that the players might
choose.
In a static game all players choose simultaneously an action/strategy.1 Depending on the

final combination of strategies that the players pick each one of them gets a payoff as specified
by their payoff functions.
The expression complete information refers to the assumption that all aspects of the game
(who are the other players, what can everyone do, what are everyones payoffs) are common
knowledge among the players (everyone knows them, everyone knows that everyone knows
them, everyone knows that everyone knows that everyone knows them etc.)
When we describe a game through the three elements listed above (set of players, strategy
sets, payoff functions) we also say that we are presenting the game in its normal form. The
normal form representation has to be distinguished from the extensive form representation that
we will discuss later.
1
Everything that we will have to say about static games applies also to games where players move sequentially
but cannot observe each others actions.
Example: The prisoners dilemma
C DC
C 5, 5 0, 20
DC 20, 0 1, 1
Dominant and dominated strategies, iterated elimination of dominated strategies
What should we expect players to do when the payoff from their actions depends on what the
other players do? The answer to this is straightforward only if the best action that I can take
does not depend on what the others do.
We say that a strategy s0i of player i (strictly) dominates the strategy s00
i if he is strictly better
0 00
off by playing si than by playing si no matter what the other players do. Formally:
ui (s0i , si ) > ui (s00

i , si ) for all si S i
In this case we also say that s00 0 0

i is dominated by si . The strategy si is said to be dominant if it
dominates every other strategy of player i, i.e. when the above condition does not only hold for
s00 0
i but for all si S i \{si }.
If every player has a dominant strategy, then we should expect that everyone uses it. Notice
that in the prisoners dilemma game the strategy C dominates the strategy CD. Thus, the
outcome that we should expect to obtain in that game is (C, C).
Conversely, if player i has a strategy s00 0
i that is dominated by a strategy si then we can
conclude that this player should never use the strategy s00 i . While this may not allow us to say
what exactly the player will do, it at least tells us what he will certainly not do.
The idea of eliminating dominated strategies can be pushed further. In particular, we can
do the following: we eliminate from everyones strategy set the strategies that are dominated.
Doing so will give us a new game with reduced strategy sets. For this new game we can then
go on and ask if any player has any dominated strategies in this new game. To see what this
means, consider the following game:
L M R
U 1, 4 2, 3 3, 2
C 2, 0 1, 2 4, 1
D 2, 1 1, 0 0, 1
Regarding this game we can make the following observations: i) No player has a dominant
strategy; ii) Player 1 has no dominated strategy; for player 2 the strategy R is dominated by M.
We can therefore conclude that he would never use the strategy R.
If we eliminate R from the picture, we obtain a reduced game that looks as follows:
L M
U 1, 4 2, 3
C 2, 0 1, 2
D 2, 1 1, 0
In this reduced game, still no player has a dominant strategy. But Player 1s strategy C is now
dominated by both of his other two strategies, U and D. Thus, Player 1 should never use C and
so we can eliminate it. Doing so leaves us with the following game
L M
U 1, 4 2, 3
D 2, 1 1, 0
In this game Player 1 has no dominant strategy. Player 2 instead now has a dominant strategy,
namely L. But if Player 1 knows that Player 2 will play L, then it is optimal for him to play D.
So the final outcome of the game is the strategy profile (D, L).
When the above described procedure of iterated elimination of dominated strategies leads
to a unique prediction, then we say that the game is dominance solvable.
Nash Equilibrium
Unfortunately, there are many games that are not dominance solvable. Just consider the fol-
lowing example
L R
U 10, 10 0, 0
D 0, 0 1, 1
Clearly, for Player 1 it is optimal to choose U if Player 2 plays L. But if Player 2 chooses R
than it is better for Player 1 to go with D. A perfectly analogous argument shows that Player
2s optimal strategy depends on what Player 1 does.
What should we do in such situations? John Nash (A beautiful mind) has argued that a
solution for such a game should have the property that it is self-enforcing. That is, if every
player thinks that the other players will behave according to what the solution prescribes, then
no one should have an incentive to deviate from what he should do according to this solution.
Formally, this leads us to the following solution concept
Definition 1. A strategy combination (s1 , . . . , sI ) constitutes a Nash Equilibrium if for every
i and every si S i we have
ui (si , si ) ui (si , si ).
The idea behind this concept is as follows: Since no player knows what the other players do
they all form expectations about what the others do and then act optimally in accordance with
their expectations. According to Nash a strategy profile s should be considered a reasonable
outcome of the game only if it is the case that every player i is indeed happy to choose si when
he correctly guesses that the other players are choosing si .
What is the NE in the above described game? We have observed earlier that Player 1 wants
to pick U if Player 2 chooses L. Conversely, Player 2 wants to take L if he thinks that Player 1
chooses U. Thus, the strategy combination (U, L) is a NE.
But notice that this is not the only NE. It is easy to verify that also the combination (D, R)
constitutes a NE. So from this simple example we immediately see that there need not be a
unique NE.
Relation between the concept of Nash equilibrium and dominance arguments If every
player i has a dominant strategy si , then the strategy profile (s1 , . . . , sI ) is the unique NE of
the game. Conversely, if (s1 , . . . , sI ) is a NE of some game, then all strategies si survive the
iterative elimination of dominated strategies.
Calculating Nash equilibria when players have a continuum of strategies A NE is a strat-

egy combination with the property that each player is responding optimally to the equilibrium
strategies of the other players. In all games that we have encountered so far, all players had only
a finite number of (pure) strategies at their disposal. In economic applications it is often more
natural to assume that the set of strategies of a player is a continuum (economic agents often
choose objects like quantities or prices or investment levels etc., i.e. things that are finely divis-
ible). We will encounter such games in the chapter on Market Power (monopoly, oligopoly).
There we will also see how we can find the Nash equilibria of such games with large strategy
spaces.
Existence of Nash Equilibrium and mixed strategies
Does there always exist a NE? Before we answer this question, let us consider the game played
between a goalkeeper and a field player who face each other in a penalty kick. The goalkeeper
chooses the row, while the field player chooses the column.
L R
L 2, 0 0, 2
R 0, 2 2, 0
Clearly none of the strategy combinations (L,L), (L,R), (R,L) or (R,R) constitute a NE. Does
this mean that there is no NE. The answer is Yes and No. The answer is Yes if we do not allow
the players to randomize between their pure strategies. If we allow them to randomize then
a Nash equilibrium does exist. By a random, or mixed, strategy we mean that they can make
choices of the type I go left with probability p and right with probability 1 p. Allowing for
such randomizations means that we increase the sets of strategies that the players have at their
disposal.
Suppose that both players mix with probability 1/2 between their strategies. It is straight-
forward to check that this is a NE in the game where we allow for mixed strategies. To see this
consider Player 1. What is this players payoff from playing L if he thinks that Player 2 mixes
fifty-fifty between his two strategies?
He will get 2 with probability 1/2 and 0 with probability 1/2. Thus in expectation he gets 1.
But the same happens if he plays R. So he is completely indifferent between his two strategies
if the other player mixes fifty-fifty. If that is the case then that means that he would get the
same payoff of 1 also if he mixes himself with an arbitrary probability p. In particular, he gets
payoff 1 when he adopts a fifty-fifty mixing. Since for Player 2 the same observations apply, it
follows that both players mixing with 1/2 probability is a NE.
The crucial message from this example is that by allowing for mixed strategies we have
found an equilibrium in a game that does not allow for a NE in pure strategies. This trick always
works in games where every player has only finitely many pure strategies at his disposal.
Proposition 1. Every normal form game with finitely many players and finite strategy sets
admits at least one NE in either pure or mixed strategies.
A final remark on mixed strategy equilibria. Suppose we have some equilibrium of a nor-
mal form game where player i is randomizing over the two pure strategies si and s0i with prob-
abilities p and p0 , respectively (of course p + p0 = 1). The payoff from the mixed strategy is
given by the p times the payoff that playing si yields, plus p0 times the payoff that playing s0i
yields. Therefore, mixing can be an optimal choice only if player i is indifferent between the
two pure strategies. Thus, whenever in equilibrium a player is mixing over some set of pure
strategies, it must be the case that every pure strategy in that set would yield him the same
payoff.
Dynamic games of complete information
In many situations of strategic interaction the players do not choose their actions simultane-
ously at a single point of time. Instead the interaction may continue over multiple stages and
players might have the opportunity to make a choice at several of those stages. When we de-
scribe such games we therefore need to specify the order in which players interact and what
actions they can take at each instant where they have to make a choice. Furthermore, it will be
necessary to specify what players know about the actions of their predecessors (i.e. are they
able to observe what actions have been played so far or are those actions not observable?).
Combining these additional elements of the description of the game with the elements that
we already know from the normal form representation we obtain the so called extensive form
representation of a game.
Game tree, perfect vs. imperfect information
Graphically dynamic games are most conveniently described with the help of a game tree. A
game three is a collection of nodes that are connected through arcs (branches of the tree). Each
node represents either an instant where some player has to take a decision (decision node) or
it represents a situation where the game ends (terminal nodes). The tree starts from a single
initial decision node. The branches that emanate from a given node represent the actions that
the player who has to choose at that node can take. A branch that emanates from a given
decision node can never lead back to this node or to any earlier decision node. From each
given node there is exactly one way to get back to the initial node (i.e. once two branches of
the tree separate they never grow together anymore). The terminal nodes represent situations
where the game is finished. For each of the possible endings of the game we have to specify
what the players get. Thus each terminal node is associated with the players final payoffs.
The following example represents a simple two player game. At the initial node it is P1
(Player 1) who has to take an action. In particular he has to decide between L and R. After
P1 is done, it is P2s turn. That is, P2 has to choose at both of the other two decision nodes.
At the first one of his nodes he can either play l or r; in the second case his choice is between
l0 and r0 . With P2s action the game ends. The numbers associated to the four terminal nodes
correspond to the payoffs of the two players. For instance, if player 1 chooses L and player two
plays l then the first player gets a payoff a while the second player receives b.
1b
HH
L HR
2
r HH 2
Hr
l @ r l0 @ r0
@ @
r @r r @r
a, b c, d e, f g, h
Figure 1: A simple extensive form game of perfect information
The above game is a game of perfect information. That is, it is a game where players at
the moment where they have to move can observe perfectly what actions have been chosen by
their predecessors. In this case the game has only two stages. The player who has to move at
the second stage, P2, knows which action P1 has chosen before him.
Games of imperfect information are games where players cannot always perfectly observe
what their predecessors have done. As an example consider the following game:
1
bPP
L PP R
PP
p p p p p p p p p p p p p p 2p p p p p p p p p p p P
rp p pPpP
p r
@ @
l @r l @r
@ @
rp p p p p p p p1p p p p p @ p@p r rp p p p p p p p1p p p p p @p@p r
A A A A
L 0 A R 0 L 0 A R 0 L 00 A R 00 L 00 A R00
A A A A
A A A A
r Ar r Ar r Ar r Ar
a, b c, d e, f g, h j, k m, n o, p q, s
Figure 2: A simple extensive form game of imperfect information
In the above example P2 does not know what action P1 has chosen on the first stage. Thus,
he is not able to distinguish the two decision nodes at which he has to move. We indicate this
through the dashed line that connects the two nodes. In the same way, when P1 has to choose at
the third stage he cannot observe what P2 has done on the second stage. He only knows what
he himself has done on the first stage. Thus he can distinguish the first two decision nodes
from the third and the fourth. But he cannot distinguish between the first two and between
the last two. If a player cannot distinguish two decision nodes, then that means that he cannot
condition his actions on those nodes.
A set of decision nodes that a player cannot distinguish is called an information set. In a
game with perfect information every decision node constitutes an information set. In a game
with imperfect information, the number of information sets is smaller than the number of deci-
sion nodes.
Strategies and normal form representation of dynamic games: In dynamic games we

have to distinguish carefully between actions and strategies. Consider again the first one of the
above two games. There P2 has two actions at his disposal at each one of the decision nodes
where he has to make a move. At the first node he can choose between the actions l and r and
at the second one he has to pick between l0 and r0 . So an action is what a player can do at a
certain decision node.
A strategy is a complete contingent plan of actions that the agent intends to implement at
each one of his information sets. Since P2 has to choose at two information sets (he is able to
distinguish the two decision nodes at which he has to make a move and so they each constitute
an information set) and at each of the two information sets he has two actions to pick from, he
has four different strategies: (l, l0 ), (l, r0 ), (r, l0 ), (r, r0 ).

How many strategies does P1 have? P1 moves only at the initial node where he can choose
one of two actions (L or R). Since he has only one information set where he has two actions it
follows that he has only two strategies which coincide with his two actions.
In the second game it is P2 who has only one information set. Thus his set of strategies
coincides with the set of actions that he can choose from at this information set. P1 has three
information sets and at each one of them he has two actions at his disposal. Thus, he has 23 = 8
strategies.
Once we have determined the set of strategies that each player has at his disposal in the
dynamic game, we may also represent the game in normal form. The normal form of the game
represented in Figure 1 is
ll0 lr0 rl0 rr0

L a, b a, b c, d c, d
R e, f g, h e, f g, h
For the game in Figure 2 instead we obtain the following normal form
l r
LL0 L00 a, b e, f
LL0 R00 a, b e, f
LR0 L00 c, d g, h
LR0 R00 c, d g, h
RL0 L00 j, k o, p
RL0 R00 m, n q, s
RR0 L00 j, k o, p
RR0 R00 m, n q, s
Games with perfect information and backward induction Dynamic games of perfect in-
formation can be solved by backward induction. If players are commonly known to be rational,
then it is easy to predict the players who have to make the final moves in a game (i.e. the play-
ers who move at decision nodes that are not followed by any other decision nodes anymore)
should do. Those players should simply make a payoff maximizing decision. For instance in
the game represented in Figure 1, P2 (who is the one who moves at the last decision nodes of
the game tree) should choose l at his first information set if and only if b > d; at the other node
instead he should pick l0 if and only if f > h.
Once players can foresee what will happen at the final decision nodes it is straightforward
to determine what they should do at the next to last stage of the game. Consider again the game
in Figure 1 and assume that b > d and h > f . As we observed before, in this case P2s optimal
strategy is lr0 . But if P2 chooses lr0 then P1 knows that L will give him a payoff of a, while R
will lead to a payoff of g. Thus, P1 should go with L if a > g. Assuming that this condition
holds the backwards induction procedure leads us to solution (L, lr0 ). The payoffs associated
to these strategies are of course a for P1 and b for P2.
As a second example consider the game represented below. It is straightforward to see that
at each stage of the game each one of the two players would want to go to the left, given that
the opponent would want to do so in the remaining part of the game. In particular, for P2 it
is optimal to choose l0 at the last stage since doing so delivers the payoff 5 which exceeds the
payoff (4) that the player could get by picking r0 . Given the behavior of P2 on the last stage,
at the next to last stage it is optimal for P1 to choose the move L0 over R0 since the first yields
a payoff of 3 while the latter would only yield 2. If P1 chooses L0 on the third stage then P2
would get 2 if the play of the game would ever reach the third stage. But on stage 2 P2 has no
interest to move to stage three (by choosing r) since he can get 3 by playing l. Foreseeing this,
P1 should choose L on the first stage since doing so yields a payoff of 1 while continuing (by
choosing R) would deliver a payoff of 0. The backward induction method therefore delivers
the solution (LL0 , ll0 ). And the payoffs that the player earn by choosing these strategies are 1
for P1 and 0 for P2.
1b
@
L @R
@
r @2r
@
1, 0 @
l @r
@
r @1r
@
0, 3 @
L0 @ R0
@
r @2r
@
3, 2 @
l0 @ r0
@
r @@r
2, 5 5, 4
Figure 3: Solving a game by backward induction
Backward induction explicitly exploits the fact that players choose their actions sequen-
tially. It is easily seen that backward induction generates a unique solution for games of perfect
information that end after finitely many rounds of play (provided that players get different
payoffs at different terminal nodes so that they are never indifferent).

It is natural to ask how the backward induction solution relates to the Nash equilibria.
Clearly backward induction produces solutions that are also Nash equilibria. On the other
hand, not every Nash equilibrium is consistent with backward induction. To see this consider
the following simple market entry game.
There is a market which is currently dominated by a single firm (player M for monopo-
list). A potential competitor (player E for entrant) has to decide whether or not to enter in
this market. If he decides to stay out, the game ends and the monopolist will make a profit of
2 while the entrant will have a payoff of 0. If E enters, then the monopolist has to decide how
to react to the entry. He can either decide to behave in an accommodating way, or he can fight
the competitor. Fighting hurts not only the competitor but also the incumbent himself (both get
1). Behaving in an accommodating way yields both players a payoff of 1.
Below we provide both the game tree for the extensive form representation and the normal
form representation of the game.
Eb
@@
ne @Re
@
@
@
r @Mr
@
0, 2 f
@@
@Ra
@
@
@
r @r
@
1, 1 1,1
Figure 4: Game tree of the market entry game
f a
ne 0, 2 0, 2
e 1, 1 1, 1
The underlining of the payoffs in the normal form indicates the players best responses. From
these best responses we can see that the game admits two NE: (ne, f ) and (e, a). In the game
tree the two equilibria are represented by the colored arrows (red for (ne, f ) and blue for (e, a)).
In the red equilibrium, (ne, f ), player M adopts a strategy that specifies that he would
fight the new competitor should he enter. Given this threat of a fight, it is then optimal for the
player E not to enter in the first place. The fact that E stays out in turn implies that M never has
to execute his fighting strategy. It is exactly for this reason that fighting is a best response for
player M.
Observe that M would never want to implement his plan to fight E if he ever had to do
so. In this sense his threat to fight lacks credibility. Thus the NE (ne, f ) that relies on this
non-credible threat of player M to do something suboptimal for himself should he ever have to
make a move, is not very convincing.
If we solve the game by backward induction we can never obtain a solution that has such
an undesirable feature. Backward induction guarantees that each player chooses optimally at
every of his decision nodes (given the behavior of all players in the subsequent part of the
game). In the entry game player M is the one who moves at the second stage. At that stage it is
optimal to choose a. Given this, it is optimal for player E to enter. Thus, backward induction
delivers as solution the blue NE.
Subgame perfect equilibria The method of backward induction is well defined only for
games of perfect information. But the problem of NE that rely on threats that are not credible
arises also in games with imperfect information. To see this consider the following modified
version of the market entry game. In this game, after the entry of the new competitor both
players have to decide about their behavior. In particular, both of them can decide between
fighting the opponent and adopting an accommodating behavior. This decision has to be taken
simultaneously. Due to this latter assumption the game is now a game of imperfect information.
We depict the corresponding game tree below.
Eb
@@
ne @@Re
@
@
r @@Mr
0, 2 f
@@
@@Ra
@
@
pr p p p p p p E
p p p p p p@p@
p r
A A AA
f A Aa f AA a
AAU AAU
r Ar r Ar
A A
2, 2 0, 1 1, 0 1, 1
Figure 5: Game tree of the market entry game
Next we derive the normal form for this game in order to find all the NE.
a f
ne, a 0, 2 0, 2
ne, f 0, 2 0, 2
e, a 1, 1 0, 1
e, f 1, 0 2, 2
As can be seen from the normal form representation there are three NE: (e, a; a), (ne, a; f )
and (ne, f ; f ). In the extensive form above these three equilibria are indicated by the arrows
in blue, green and red. In two of the three NE player E stays out. Moreover, in both of these
equilibria at least one of the two players plans to fight his opponent. How convincing are these
plans to fight the opponent?
Consider the part of the game that starts after the entry of E. We can view that part of
the game as a (simultaneous move) game in its own right. In this smaller game each one of
the two players has a dominant strategy, namely a. Thus, neither of them would ever want to
fight should they really reach the part of the game where they have to decide between fighting
and accommodating. Thus, also in this case the threat to fight the opponent after an entry is a
best response only when Player E stays out. Conversely, for Player E staying out is part of an
optimal strategy only if Player M threatens to fight him upon entry. But we have just seen that
it would never be in Ms interest to carry out such a threat. Thus the equilibria that rely on this
threat are not very reasonable equilibria.
In games of imperfect information we cannot use backward induction to identify equilib-
ria that rely on some players threat to carry out some non-optimal action at some point of
the game. But there is an equilibrium concept that generalizes the basic idea underlying the
concept of backward induction (the requirement that players should behave optimally at every
information set where they have to move) to games of imperfect information: subgame perfect
equilibrium.
Subgame perfection relies exactly on the type of arguments that we have alluded to in the
above discussion where we have concluded that equilibria in which any of the players plans
to fight his opponent at the second stage are unreasonable because fighting is not part of an
equilibrium of the game that starts at the second stage. Subgame perfection generalizes this
idea by requiring that the equilbrium strategies that players adopt must be such that that they
prescribe equilbrium behavior in every subgame of the overall game. In order to make this
point more clear, we first have to define what a subgame is.
A subgame of a given extensive form game
a) starts at a decision node that constitutes by itself an information set;
b) contains all decision and terminal nodes that follow the decision node at which it starts;
c) does not cut any information sets; that is, decision nodes of the subgame belong only
to information sets that are composed entirely of other decision nodes that belong to the
subgame.
Both versions of the market entry game that we have seen above have two subgames: the
entire game, and the part of the game that starts at the decision node that follows an entry of E.
Definition 2 (Subgame perfect equilibria). A NE is subgame perfect if the players strategies

form an equilibrium in every subgame.
Notice that in both versions of the market entry game subgame perfection rules out all NE
in which either of the players plans to fight on the second stage. Thus, if we require equilibria
to be subgame perfect we get rid of all the undesirable equilibria.
Repeated Games
Suppose we are given a finite game G (in either normal or extensive form). This basic game can
be used to construct a more complex extensive form game by simply playing it several times in
a row. In particular, the game that we obtain if G is repeated T times and where every player at
the beginning of each new round can fully observe the actions that everyone has played in the
preceding rounds, is called a repeated game. We denote this repeated game by GT . The basic
building block of GT , i.e. the game G, is called stage game. If T is finite we refer to GT as
a finitely repeated game while in the case T = (the game never ends) we say that GT is an
infinitely repeated game.
Finitely repeated games
Suppose that the prisoners dilemma game is played twice in a row by two players. The payoffs
in the repeated game are simply given by the sum of payoffs that the players collect in each
round of play. The details of the stage game are as follows:
c dc
C 5, 5 0, 20
DC 20, 0 1, 1
In order to find the subgame perfect equilibrium (SPE) of the game consider first the game
played on stage 2 of the game. Independently of what has happened at the first stage of the
game, the (sub-) game that the players play in the second round (the second repetition of the
prisoners dilemma) is a game that has a unique Nash equilibrium, namely, (C, c). Thus, in
every SPE it must be the case that players plan to confess on the second round, no matter what
happens in round 1.
Both players know that both of them will confess in round 2 no matter what happens in
round 1. So we can simply add the corresponding second period payoff, (5, 5), to the payoffs
of the stage game played in round 1.
c dc
C 10, 10 5, 25
DC 25, 5 6, 6
This payoff matrix describes what players will get for each combination of first period actions
given that they will confess in the second round. We see that for each player it is optimal to
confess in round one irrespective of what first period action he expects his opponent to take.
Since both the first period and the second period behavior is pinned down uniquely it
follows that there is only one SPE, composed of the following two equilibrium strategies
(C, C, C, C, C) (player 1) and (c, c, c, c, c) (player 2). [Question: Why are these strategies writ-
ten as vectors with 5 components? Can you give an interpretation to the five components? If
not, then you should draw the game tree for the repeated game and try to figure out what a
strategy in this repeated game is.]
The crucial insight from the above analysis is that the behavior in the twice repeated pris-
oners dilemma is simply given by a repetition of what players do in the equilibrium of the
static version of the game (i.e. the stage game). That is, in the equilibrium of the repeated
game, each player plans to take at each one of his information sets the action that he takes in
the equilibrium of the static game.
This insight generalizes in the following sense: Whenever we have a finitely repeated game
with a stage game that has only one Nash equilibrium, then the repeated game has a unique
SPE. In this SPE all players plan to repeatedly play their equilibrium strategy from the stage
game, irrespective of the history of the game.
Things get more complicated when we consider finitely repeated games that are built from
stage games that admit multiple Nash equilibria (NE). Also in those games it is true that strate-
gies that prescribe to play in each period the strategies of one of the NE of the stage game,
independently of what has happened in the past, yields a SPE of the repeated game. But there
are might be also other equilibria. To see this consider the repeated game in which two players
play twice the following stage game.
l m r
L 1, 1 5, 0 0, 0
M 0, 5 4, 4 0, 0
R 0, 0 0, 0 3, 3
It is easy to verify that this stage game has two NE: (L, l) and (R, r). As we mentioned already
above, there is one SPE in which player one plans to always play L independently of what
happened in the game and player two responds with always playing l irrespectively of what
happened in the game. There is of course also a SPE where players repeatedly play R and r.
But there is another SPE where
- on the first stage P1 chooses M and P2 plays m
- and where the second period behavior prescribed by the equilibrium strategies depends
in the following way on what happened in round 1:
If the action pair chosen in period 1 is (M, m) then in period 2 P1 plays R and P2
plays r.
If the action pair chosen in period 1 is not (M, m) then in period 2 P1 plays L and
P2 plays l.
You should convince yourself that this is indeed a SPE!
Infinitely repeated games
In finitely repeated games the equilibrium analysis is often strongly driven by the last period
effect. Since there is a point where the game ends we know how people will behave in the last
period. Once we know that we can determine what they do in the next to last period and so on
and so forth. As we have seen in the preceding section this implies that there can be only one
SPE when the stage game has a unique NE. Thus, if we were to model the interaction between
two firms who compete over a prolonged period of time by setting prices as a finite repetition
of the static Bertrand game, we would arrive at the same conclusions that we obtained from the
static model (firms always choose prices equal to marginal costs). A way to avoid last period
phenomena is to assume that the interaction never ends or that there is at least always a chance
that it will continue for another round.
When a game is played infinitely many times, then we can no longer assume that the payoffs
in the repeated game are given by the sum of payoffs that the players acquire in each round.
Instead we assume that players discount future payoffs by a common discount rate (0, 1)
and they maximize the sum of these discounted payoffs. That is, if player i expects that he will
get payoff ui in period t + 1, at the beginning of the game in period 1 (when he decides about
his strategy) he assigns value t ui to this payoff.
In infinitely repeated games it is often possible to sustain cooperative behavior between the
players that cannot be sustained in the stage game or in finite repetitions of the static game.
To see this consider an infinitely repeated prisoners dilemma with the following stage game
payoffs
c dc
C 5, 5 0, 20
DC 20, 0 1, 1
We will argue now that if is sufficiently large (sufficiently close to 1), then the infinitely
repeated prisoners dilemma admits a SPE in which players cooperate along the equilibrium
path.2
Suppose both players adopt the following strategy:
Do not confess in period one and continue with this action also in the following
periods as long as both players in the preceding periods have chosen not to confess.
If instead one of both players chooses at some point to confess then play confess
in all subsequent periods.
Notice that if both players stick to this strategy they will never confess. Thus, each one of them
will earn in each period a payoff of 1. Thus, their payoff in the repeated game is

X 1
t1 (1) = .
t=1
1
Suppose a player contemplates if he could do better by deviating at some point to confess.

Given the strategy of the opponent, if doing so is optimal at some later period it must also
be optimal to do it right away in period 1. So suppose the player contemplates to deviate
immediately in the first period. He knows that the other player will start with do not confess.
Responding with confess yields a first period payoff of 0. But the player also knows that
forever thereafter the other player will always play confess and the best way to react to that
is to confess as well. But that means that from period 2 onwards the player will obtain 5. The
overall payoff is thus

X
0+ t1 (5) = 5.
t=2
1
This payoff is larger than the payoff that the player gets if he does not deviate only if
5 > 1 < 1/5.
Thus, if > 1/5, then the player has no incentive to deviate.

2
The equilibrium path of a game corresponds to the sequence of implemented actions. What a player intends to
do at an information set that is never reached is not part of the equilibrium path.
This shows that both players following the above described strategy is a Nash equilibrium
of the repeated game. It also tells us that players never want to deviate in any subgame that starts
after a history where everyone has always been playing do not confess. Do the strategies also
form a NE after a history where a deviation has already occurred? The answer is yes. After
a deviation both players are supposed to always confess. But if the other player is always
confessing then it is obviously optimal to confess as well. So summing up we can say that both
players playing the strategy under consideration constitutes a SPE of the repeated game.
The strategy used in this prisoners dilemma is an example of a grim or trigger strategy: a
deviation triggers an unconditional reversion to a bad behavior of both players. They are not
the only type of strategies that can be used to sustain cooperative behavior. Another type of
strategies that form a SPE and lead to cooperative behavior along the equilibrium path are so
called tit-for-tat strategies:
Play do not confess in t = 1 and also in every other period t provided that in t 1
the implemented action pair was either (DC, dc) or (C, c). In all other cases play
confess.
Games of incomplete information
So far we have taken it for granted that all players are completely informed about the structure
of the games they are involved in. In particular, we have assumed that every player knows
both his own payoffs and the payoffs of all other players. We will now relax this assumption
and consider situations where players may be only incompletely and asymmetrically informed
about payoffs.
As a first example consider the following simultaneous move game. Two firms must choose
whether or not to enter a market. If only one firm enters, then that firm earns a profit of 1. If
both firms enter, then they both earn zero profit.
Entering the market generates a cost ci for player i = 1, 2. The entry cost for firm 2 is
c2 = 1/4. Firm 1s cost is uncertain. With probability 1/2 the entry cost is low (c1 = 0) and
with probability 1/2 the entry cost is high (c1 = 1/2). Firm 1 learns the value of its entry cost
before deciding whether or not to enter the market. Firm 2 instead does not know the other
firms type at the moment of the decision.
How can we analyze this game? In particular, what does it mean that player 2 thinks that
player 1 has low or high cost with probability 1/2 each. Idea: we can view the cost type of
firm 1 as the choice of another player (nature) who moves first and who is known to choose
one of the two cost levels with equal probability (think of nature as a player who has only this
random action at its disposal). With this additional player we obtain a game of complete but
imperfect information that we can represent with the following game tree (there are no payoffs
for the player nature since that player has only one - random - action available; so there is no
real choice of that player to be analyzed).
Nb
HH
c1 = 0(1/2) H
HH c1 = 1/2(1/2)
H
1r HH 1
Hr
%e %e
e % e ne e % e ne
% e % e
% e % e
rp%p p p p p p p p p p p p p ep rp p p p p p p p2p p p p p p p pr%p p p p p p p p p p p p p ep r
A A A A
A A A A
e A ne e A ne e A ne e A ne
A A A A
r Ar r Ar r Ar r Ar
A A A A
0, 14 1, 0 0, 43 0, 0 1 , 1
2 4
1 3
2 , 0 0, 4
0, 0
Figure 6: The game tree for the game with simultaneous entry
For this extensive form game we can now derive the normal form; and for that normal
form we can derive the Nash equilbria. P1 has two information sets at which he has to move
corresponding to his two types (low or high entry cost type). Thus, a strategy of P1 specifies
what every type of his intends to do. Since each type can choose between two actions, P1 has
four strategies. P2 can neither observe the move of nature nor can he observe the move of P1.
Thus, all decision nodes at which he has to take an action belong to the same information set.
This means that he only has two strategies.
In calculating the payoffs we have to take into account that the move of nature is a random
move. For the strategy pair (e, e; e), P1 will either get a payoff of 0 (if nature chooses c1 = 0)
or 1/2 (if nature chooses c1 = 1/2). Since nature is choosing the two cost levels with equal
probability P1s expected payoff is 1/4. Similarly, P2s (expected) payoff is (1/4) (1/2) +
(1/4) (1/2) = 1/4. All other (expected) payoffs are calculated in a perfectly analogous
way.
e ne
e, e 1/4, 1/4 3/4, 0
e, ne 0, 1/4 1/2, 0
ne, e 1/4, 1/4 1/4, 0
ne, ne 0, 3/4 0, 0
Since the above normal form game has been derived from a game with incomplete information
we call it a Bayesian normal form. The Nash equilibria of a Bayesian normal form game are
called Bayes Nash equilibria (henceforth, BNE). We can see that the above Bayesian normal
form game admits three BNE: (e, e; ne), (e, ne; e) and (ne, ne; e).
The reason why we have started our analysis of games with incomplete information with an
example in which (some) players are only partially informed about the payoffs of the game is
that one can always interpret uncertainty about the other elements of the structure of the game
(who are the players? what actions can they take?) as uncertainty about the payoffs. We will
not discuss this in any more detail but will just take it for granted that a game with incomplete
information is a game where some players have only partial information about the payoffs of
the game.
Given this observation we can define a static game with incomplete information by the
following elements
i) A set of players: {1, . . . , I};
ii) a set of actions for each player i, Ai , i = 1, . . . , I;
iii) a set of types for each player T i ;
iv) a probability distribution over profiles of types p;
v) a payoff function ui for each player i, where
ui : A1 . . . AI T 1 . . . T I R.
With the concept type of a player we describe what a player knows about the payoffs. The
idea here is that every player knows that each players type is drawn from the distribution p.
Each player learns his own type before he has to choose his action; no one can observe the type
of the others. In our leading example P1 had two possible types (described by the level of the
entry cost). P2 had one type only.
In all our examples we will only encounter games with two players. Moreover, just as in
our example there will always be one informed player (P1) and one uninformed player (P2).
Therefore also everything that follows will be defined for situations with these characteristics.
We will write for the type set of P1, T (without subscript); we will also assume that this set
contains K elements, denoted by tk , k = 1, . . . , K.
In our leading example we have seen that we can think of the Bayesian game as a situation
where first nature determines the types of P1 and then the players make simultaneously their
moves. Suppose that the players think about what they will do in the game before nature
determines P1s type. Then, since P1 will observe the move of nature, he should make a fully
conditional plan that specifies what every type of his should do (in case that type is chosen by
nature). In other words, a strategy of P1 is a function s1 : T A1 (In the example, the strategy
of P1 was a function of his cost type). As usual, write for the set of all such functions/strategies
S 1 . P2 does not observe the move of nature and thus his set of strategies, S 2 coincides with the
set of actions A2 .
We are now ready to formally define what a Bayes-Nash equiilbrium is.
Definition 3 (Bayes-Nash equilibrium - BNE). A Bayes-Nash equilibrium of the above de-
scribed static two-player games with incomplete information is a strategy combination (s1 , s2 ),
(where s1 : T A1 , s2 S 2 = A2 ) such that
X X
p(tk )u1 (s1 (tk ), s2 , tk ) p(tk )u1 (s1 (tk ), s2 , tk ) for all s1 S 1 (1)
k k
and
X X
p(tk )u2 (s1 (tk ), s2 , tk ) p(tk )u2 (s1 (tk ), s2 , tk ) for all s2 S 2 . (2)
k k
Notice that condition (5) says that the strategy s1 : T A1 must be a best response to P2s
equilibrium strategy s2 . This condition is often expressed in the following equivalent way: For
every k = 1, . . . , K we have
u1 (s1 (tk ), s2 , tk ) u1 (a1 , s2 , tk ) for all a1 A1 . (3)
Written in this form the equilbrium condition for the first player requires that he must choose
his plan/strategy such that every type of his is responding in an optimal way to the equilibrium
strategy of P2.
To see that the two conditions (5) and (3) are indeed equivalent assume first that (3) does
not hold for k0 . That is for type tk0 there is an action a01 such that
u1 (s1 (tk0 ), s2 , tk0 ) < u1 (a01 , s2 , tk0 ). (4)
But then also (5) cannot hold for s1 defined as follow: s1 (tk ) = s1 (tk ) for all k , k0 and
s1 (tk0 ) = a01 . Thus, (5) can hold only if (3) holds.
Conversely, suppose that condition (3) is violated; i.e. there is a strategy s1 : T A1 such
that
X X
p(tk )u1 (s1 (tk ), s2 , tk ) < p(tk )u1 (s1 (tk ), s2 , tk ). (5)
k k
If the sum on the rhs is larger than the sum on the lhs it must be the case that for at least
one k (say for k0 ) the corresponding element of the sum on the rhs is strictly larger than the
corresponding element of the sum on the lhs. But that means that for k0 the condition (3) must
be violated as well (for a1 = s1 (tk0 )).
In simple games where it is feasible to write down the normal form of the game, the BNE
are most easily obtained through that normal form (as we have done in the example).
Dynamic games with incomplete information and Perfect Bayesian Equilibrium (PBE)
BNE can be computed also for dynamic games with incomplete information. In order to do so
we first derive the (Bayesian) normal form of the dynamic game and then we use that normal
form to compute the BNE. We illustrate this procedure with the help of the following example.
There are two players. P1 has to decided whether or not to offer a gift to P2. If the gift is
offered P2 has to decide whether or not to accept the gift. If the gift is not offered then each
player gets a payoff of zero. The value of accepting a gift depends on the type of P1. If P1
is a friend (type=A; which nature chooses with probability pA (0, 1)) then the gift will be
something nice and valuable and so P2 will be better off by accepting it (more concretely, his
payoff is 2; as usual, numbers associated with the terminal nodes of the game tree are payoffs)
than by rejecting it (0). If on the other hand P1 is an enemy then the value of the gift is v < 2;
notice that if v < 0 then it would be better to reject the gift whenever it comes from the enemy
type. Both types of P1 prefer that the gift is accepted (2) over it being rejected (-1). The game
is represented in the the following tree.
Nb
A(pA ) HH
HHN(pN )
H
1
r
HH1
Hr
H
NR HH NR
R R H
r HHr
0, 0 0, 0
pr p p p p p p p p p p p p 2p p p p p p p p p p p p p r
@ @
@ @
a @r a @r
@ @
r @r r @r
@ @
2, 2 1, 0 2, v 1, 0
Figure 7: The extensive form of the gift giving game (version 1)
Our next step is to derive the normal form of this game. From the figure above we see that
P1 has to move at two information sets and at each one of them he has two available actions
(offering or offering the gift). Consequently, he has four strategies. P2 moves only at one
information set at which he can choose between two actions (accept or reject). Thus, also the
number of strategies is two. The normal form representation of the above game therefore takes
the following form.
a r
R, R 2, 2pA + vpN -1, 0
R, NR 2pA , 2pA pA , 0
NR, R 2pN , vpN pN , 0
NR, NR 0, 0 0, 0
Observe that since pA , pN (0, 1) P1 has a unique best response to both of his opponents
strategies. If P2 plays a then it is strictly optimal for P1 to always offer the gift, i.e. to play
(R, R); if instead P2 plays r then the best reply for P1 is (NR, NR) (never to offer the gift). So
there can be only equilibria in which P1 plays either (R, R) or (NR, NR). Notice that if P1 plays
(NR, NR) then P2 is indifferent between a and r, which means that r is a best response. But
then ((NR, NR); r) must be an equilbrium. What is the best response to (R, R) depends on the
sign of
2pA + vpN = 2pA + v(1 pA ) = (2 v)pA + v.
If this expression is positive (i.e. if pA v/(2 v)) then accepting is optimal for P2 when P1
plays (R, R). In this case ((R, R); a) is an equilibrium of the game. If instead pA < v/(2 v),
then P2s best response to (R, R) is r and thus there can be no equilibrium in which (R, R) is
played.
In the analysis of sequential games of complete information we have seen that they may
admit NE which are not very convincing since they are induced by the threat of some player
to do something at some information set that he would not want to carry out if the game really
reached that information set. We have seen that one way to deal with this issue is to restrict
attention to those NE which are subgame perfect (in games of perfect information the subgame
perfect equilibria can be obtained by backward induction).
The above analyzed example shows that similar issues of unreasonable/non-credible equi-
lbria arise also in dynamic games of incomplete information. To see this remember that
((NR, NR); r) is a BNE of the game for all admissible values of pA and v. This equilibrium
is certainly not a very convincing one when v > 0 since it relies on the unreasonable threat of
P2 to reject any gift even though accepting a gift could only increase the payoff. P2s plan to
reject the gift is a best reply to P1s strategy only because under the latter P2s information set
cannot be reached (P1 does not offer the gift). P1s choice never to offer the gift is an optimal
choice only because he expects P2 to reject the gift. That he would form such a belief does
not seem very convincing given that he knows that conditional on the gift being offered, P2s
unique optimal choice would be to accept it.
Can we use the concept of subgame perfection in order to rule out such undesirable equilib-
ria (which rely on non-credible threats)? Unfortunately, the answer to this question is negative.
Subgame perfection requires that the equilibrium strategies are such that they also form equi-
libria in every subgame of the overall game. The requirement that the equilibrium strategies
must induce equilbria also in the subgames can have bite only if there are any subgames apart
from the overall game. But that is not the case in games with incomplete information. Those
games do not have any proper subgames (i.e. subgames that are not the entire game itself). The
reason lies in the way in which we model the incompleteness of information. We do so by as-
suming that the game starts with an initial move by nature which is unobservable to one of the
players. The fact that there is someone who cannot see what happened on the first stage of the
game implies that all sub-trees of the overall game tree are connected trough some information
sets of this player. Thus none of those subtrees represents a proper subgame. As an example
consider the gift-giving game that we analyzed earlier. In that game the only information sets
that contain only one node are the two nodes at which P1 has to move. But the two parts of the
tree that emanate from those two nodes are linked through the only information set of P2.
Since we cannot apply the concept of SPE (subgame perfect equilibrium) we need another
concept that helps us to get rid of the undesirable equilibria. One of the equilibrium concepts
that has been designed for this purpose is Perfect Bayesian Equilibrium (PBE). PBE can be
applied whenever we have a dynamic game with incomplete information in which players can
observe the actions taken by their predecessors. So from now on we will only consider such
games. To further simplify the definition of our equilibrium concept we will restrict attention
to games with only two players (an informed player, P1, and and uninformed player, P2) and
two stages. On the first stage the informed player P1 makes a move, while on the second stage
the uninformed player P2 responds.
The basic idea behind PBE is similar to the one behind SPE. Under SPE players each
player should respond optimally to the other players strategies in every subgame. Also in a
PBE players strategies should satisfy a similar sequential rationality condition. In particular,
they should specify optimal behavior (best responses) in every continuation game. The concept
of a continuation game has to be distinguished carefully from the concept subgame. A
continuation game can start at any information set, i.e. also at information sets that contain
multiple nodes of the game tree. Consider the gift giving game that we have considered above.
This game does not have any proper subgames. In particular, notice the only information set
at which P2 has to make a move contains more than one node of the game tree. Thus, the part
of the game that starts at that information set is not a subgame. Still though it is meaningful
to require that the strategy of P2 must specify an action for this information set that he would
want to follow through in case the information set is indeed reached. This is exactly the kind
of requirement that must be satisfied in a PBE: each player must adopt a strategy such that at
each of his information sets the (continuation) strategy constitutes a best reply to the strategies
of the other players.
What is optimal at an information set that contains multiple nodes depends on what the
player thinks about how likely each node in the information set is. For instance consider again
the gift-giving game and suppose that v < 0. In that case accepting the gift is an optimal choice
for P2 if he thinks that he is at the left node of his information set (which corresponds to the
case where the gift comes from a friendly type). If instead he thinks that he is at the right node
of his information set (which would mean the gift comes from the hostile type) he should avoid
the gift. In what follows we will refer to players assessments regarding the chances of being
at a certain node in a given information set as their beliefs.
Notice that in the simple games that we are considering (two players, one informed, one
uninformed, two stages, observable actions) only the second player can have information sets
that contain multiple nodes of the game tree. Moreover, the nodes in an information set can
differ only by natures move (since the moves of P1 are observable). Thus, a belief of P2 at any
of his information sets corresponds to a probability distribution over the set of possible types of
P1. In what follows we will write (t|a1 ) for the probability that P2 assigns to P1 being of type
t at the information set that contains all nodes of the tree that follow after action a1 is taken by
any of the types of P1.
Since what is an optimal action for P2 at a given information set depends on his beliefs at
that information set, a PBE not only specifies the strategies that the two players plan to adopt,
but it also specifies a belief system, , for P2. Of course, the beliefs that P2 can hold should be
reasonable. In particular, it is reasonable to require that these beliefs should be consistent with
the two pieces of information that the player has (in equilibrium) with respect to the type of
P1: i) the probability distribution with which nature picks the type of P1 and ii) the equilibrium
strategy of P1. In a PBE it is required that the beliefs of P2 are derived from these two elements
using Bayes rule whenever that is possible. What exactly this means will be discussed in more
detail below. At this point we are ready to give a definition of PBE for the games of our interest.
Remember that A1 is the set of possible actions of P1. Denote by A1 the set of all actions of P1
after which P2 has to move (i.e. the game ends if P1 chooses a1 A1 \A, while for each a1 A
there is an information set at which P2 has to move).
A PBE equilibrium (of the simple games we are considering) is a a pair of strategies (s1 , s2 ),
where s1 : T A1 and s2 : A A2 , and a belief system for P2 satisfying the following
conditions:
i) for all k K, s1 (tk ) solves maxa1 A1 u1 (a1 , s2 (a1 ), tk ),

ii) for all a1 A1 , s2 (a1 ) solves maxa2 A2 (tk |a1 )u2 (a1 , a2 , tk ),
P
kK
iii) for each a1 A1 and each k K, (tk |a1 ) is determined through Bayes rule if that rule
is applicable (more details on this below).
Condition i) says that for each type of P1 the strategy of P1 should prescribe an optimal
action given the expected reaction of P2. Condition ii) requires that at each information set (i.e.
after each action of P1 after which the game does not end), P2 responds optimally to P1 given
his beliefs about P1s type. That is, P2 should not choose just any best reply to P1s strategy.
Instead, he should choose his plan of action such that he would want to follow through with
any part of the plan should he ever get into a position of having to implement that part of the
plan; i.e. he should not make plans (parts of) which he would not wish to carry out. Condition
iii) specifies how the beliefs of P2 are determined. They should be derived using Bayes rule
whenever possible. In order to understand what exactly this means, let us consider once more
the gift giving game.
Nature
b
HH
A(pA ) HHN(pN )

1 H
HH1
r Hr
HH
NR H NR
R R HH
r
Hr
0, 0 0, 0
2
h1 pr p p p p p p p p p p p p p p p p p p p p p p p p p r h2
@ @
@ @
a @r a @r
@ @
r @r r @r
@ @
2, 2 1, 0 2, v 1, 0
Figure 8: Gift giving game
In this simple game P2 has only one information set. This information set is reached only
if P1 chooses a strategy according to which at least one of his types offers the gift (action R).
Notice that the first node in P2s information set is reached if nature chooses the friendly type
and P1 offers the gift if he is the friendly type. The second node is reached if nature chooses
the hostile type and P1 offers the gift if he is of the hostile type. P2 is aware of these two
paths to his information set. Thus, when he knows the strategy of P1 and the probabilities with
which nature picks P1s type, then he can compute what the probability of each node in the
information set is conditional on this information set being reached.
i) Suppose that for some reason P2 is convinced that P1 uses the strategy (s1 (A), s1 (B)) =
(NR, R). Under this assumption the probability that the information set of P2 is reached
is
Pr(a1 = R) = Pr(t = A)Pr(a1 = R|t = A)+Pr(t = N)Pr(a1 = R|t = N) = pA 0+pN 1 = pN .
Consequently we have
(A|R) = Pr(t = A|a1 = R)

Pr(t = A)Pr(a1 = R|A) 0
= = = 0.
Pr(t = A)Pr(a1 = R|t = A) + Pr(t = N)Pr(a1 = R|t = N) pN
Thus, if P2 thinks that P1 plays the strategy (s1 (A), s1 (N)) = (NR, R), then whenever his
information set is reached he can be sure that the type of P1 is N (only that type ever
offers the gift). Thus, whenever P2s information set is reached it is optimal to accept the
gift if and only if v 0.
ii) Next consider the possibility that P2 is convinced that P1 uses the strategy (s1 (A), s1 (B)) =
(R, NR). In this case the probability that P2 places on P1 being of type A conditional on
his information set being reached is 1. In fact, in this case the information set is reached
if and only if nature picks the friendly type of P1. In slightly more formal terms:
Pr(t = A)Pr(a1 = R|t = A) pA

(A|R) = = = 1.
Pr(t = A)Pr(a1 = R|t = A) + Pr(t = N)Pr(a1 = R|t = N) pA
Since conditional on his information set being reached, P2 is certain that the gift has
come from the friendly type of P1, his unique optimal choice is to accept the gift.
iii) The third possibility is that P2 thinks that P1 adopts the strategy (s1 (A), s1 (B)) = (R, R).
In this case the information set of P2 is reached with probability one. Which one of the
two nodes is reached depends on the choice of nature:
Pr(t = A)Pr(a1 = R|t = A) pA

(A|R) = = = pA .
Pr(t = A)Pr(a1 = R|t = A) + Pr(t = N)Pr(a1 = R|t = N) 1
In this case the optimal choice of P2 conditional on his information set being reached
depends not only on the value of v but also on the exact value of pA (and pN = 1
pA ). Rejecting the gift always yields 0 (irrespective of which type has offered the gift).
Accepting yields 2 if the type of P1 is A and v if the type of P1 is N. In expectation
accepting thus generates a payoff of
2(A|R) + v(N|R) = 2pA + vpN = 2pA + v(1 pA ) = (2 v)pA + v

which is positive if and only if pA v/(2 v). Hence, if the friendly types probability
is larger than v/(2 v), then P2s unique optimal choice is to accept; if instead pA <
v/(2 v) then the unique optimal choice is to reject the gift.
iv) The last possibility is that P2 thinks that P1 plays the strategy (s1 (A), s1 (B)) = (NR, NR).
In this case the conditioning event (that is, the event that P2s information set is reached)
has zero probability, i.e. Pr(a1 = R) = 0 (neither type of P1 offers the gift). But that
means that we cannot use the formula
Pr(t = A)Pr(a1 = R|t = A)

Pr(t = A)Pr(a1 = R|t = A) + Pr(t = N)Pr(a1 = R|t = N)
to compute the probability of A conditional on reaching the information set of P2, (A|R)
(this is why in part iii) of the definition of PBE we have specified that Bayes rule should
be applied whenever possible.
How can we determine P2s beliefs then? Since Bayes rule cannot be applied we will
simply consider all possible beliefs. We have seen earlier that accepting the gift is the
unique optimal choice of P2 if and only if (A|R) > v/(2 v); for (A|R) < v/(2 v)
instead the unique optimal choice for P2 is to reject.
Notice the difference to the case iii). There the condition (A|R) > v/(2 v) was
equivalent to pA > v/(2 v). This is no longer the case in the current situation since we
cannot use Bayes rule to link (A|R) to pA .
In the points i) to iv) above we have derived P2s beliefs for every possible strategy of
P1 and we have also computed P2s best responses. In order to identify a PBE of the game,
what remains to be done is to check when the assumed strategy of P1 is a best response to the
strategy with which P2 would want to respond to it. Clearly, if P2 plans to accept the gift both
types of P1 would want to offer the gift. Conversely, both types of P1 prefer not to offer the
gift if P2 plans to reject the gift. Combining these observations with our insights from points
iii) and iv) above we thus get the following two types of equilibria:
The strategy combination ((R, R); a) and the belief = (pA , pN ) form a PBE if pA
v/(2 v).
We have just observed that (R, R) is a best reply a. Conversely, we have seen under
point iii) above, that P2s belief at his information set is = ((A|R), (N|R)) = (pA , pN )
when P1 plays (R, R); and the optimal action given this belief is a if and only if pA
v/(2 v).
If v 0 then ((NR, NR); r) together with any , satisfying (h1 ) v/(2 v), form a
PBE.
Not offering the gift is certainly a best response for P1 if P2 plans to reject any gift he
might be offered. Conversely, we have seen under point iv) above that the belief of P2
can be anything if P1 plays (NR, NR). If we choose such that (A|R) v/(2 v)
(notice that v 0 implies that v/(2 v) [0, 1)) then rejecting the gift is optimal.
Comparing the set of PBE with the set of BNE of the game reveals two important features
of PBE. First, for every set of parameters (i.e. for all values of v and pA ) the set of perfect
Bayesian equilibrium strategy profiles is a subset of the BNE strategy profiles (much in the
same way as the set of subgame perfect equilibria is a subset of the Nash equilibria). The
difference between the two sets of equilibrium strategy profiles is that the profile ((NR, NR); r)
is a BNE for all values of v and pA , while it can be part of a PBE only when v 0. We have
argued earlier that in the case v > 0 it seems hardly convincing that P2 would ever make the
plan to reject the gift, given that he could only benefit from accepting it. PBE excludes exactly
this type of unreasonable equilibrium behavior. I.e. PBE rules ((NR, NR), r) out as equilibrium
strategy profile exactly when adopting the plan to reject a gift (choosing strategy r) cannot be
justified in a reasonable way.
As a further remark on the PBE of the above game, notice that in both types of equilibria
both types of P1 adopt the same action. We refer to equilibria with this characteristic (i.e. with
the property that all types of P1 do the same thing) as pooling equilibria. Pooling equilibria
have to be distinguished from the so called separating equilibria. Separating equilibria are
equilibria in which different types of P1 adopt different actions.
Further remarks: Signaling In the preceding sections we have considered two stage games
where first an informed player takes an action which can be observed by a second (uninformed)
player who then makes a choice on the second stage of the game. Games of this type are called
signaling games since through his strategy the first player may (partially) reveal his information
(he signals what he knows). Therefore the first player is often referred to as sender while the
second player is often labeled as receiver.
Examples:
i) A worker who privately observes his productivity/ability chooses his level of education.
The firm observes the choice of the worker (but not his productivity) and decides about
what wage to offer to the worker.
ii) The owner of a firm who wants to go public (i.e. sell (part of) his firm on the stock
market) knows the value/profitability of his firm. He decides about the share of the firm
that he wants to sell. Potential buyers (who do not know the value of the firm) observe
the owners choice and decide what they are willing to pay for the stocks on offer.
To get a better understanding of these type of games and of how we can find their PBE (in
pure strategies) consider the game represented in the following game tree.
1, 3 4, 0 2, 4 0, 1
r r r r
@@ @@
@ @
L@ R L@ R
@rp p p p p p p p p p p p Receiver
p p p p p p p p p p p p p p p p p@
p r
U U
1/2 Nature
b 1/2
Sender t1 r rSender t2
D D
Receiver
pr p p p p p p p p p p p p p p p p p p p p p p p p p p p p p r
@ @
L @R L @R
@ @
r @r
@ r @@r
2, 1 0, 0 1, 0 1, 2
Figure 9: A signaling game: two types, two actions for each player
Are there any pooling equilibria?
1) Pooling on U:
Suppose that there is a PBE in which both types of P1 choose U. Then P2s belief upon
observing U must be U = (t1 |U) = 1/2 (also (t2 |U) = 1 U = 1/2). While the
belief at the second information set, D (= (t1 |D)) is not pinned down by Bayes rule.
Given U = 1/2, the optimal choice of P2 after observing U is L (doing so yields 3/2 +
4/2 = 7/2 while R only yields 1/2).
The optimal choice at the second information set depends on D . In particular, L is
optimal if and only if D 2(1 D ), or equivalently, iff D 2/3.
Now that we know what P2 may believe and may do if P1 adopts the strategy (s1 (t1 ), s1 (t2 )) =
(U, U) we can ask when this strategy is an optimal choice for P1.
Notice that if P2 chooses L both upon observing U and upon observing D, then type t1
of P1 would prefer D over U. If on the other hand, P2 chooses L upon observing U and
R upon observing D then both types of P1 are best off by choosing L. Thus the following
strategies and beliefs form a PBE: s1 = (s1 (t1 ), s1 (t2 )) = (U, U), s2 = (s2 (U), s2 (D)) =
(L, R), U = 1/2, D 2/3.
2) Pooling on D: If there is such a PBE then in that PBE we must have that D = 1/2.
Consequently, s2 (D) = R. But that would imply that type t1 of P1 would get payoff 0
by playing D. That cannot be optimal since going up (playing U) would give him at the
very least 1. Thus, there can be no PBE where both types of P1 go down.
Separating equilibria:
1) Separating strategy s1 = (U, D):

This strategy implies U = 1, D = 0. Thus, the best reply of P2 is s2 = (L, R). With
these strategies both types of the sender receive a payoff of 1. Type t2 can improve upon
this payoff by deviating to U (which yields 2) and wo we can conclude that there is no
separating equilibrium in which P1 plays s1 = (U, D).
2) Separating strategy s1 = (D, U):

This strategy implies U = 0, D = 1. Given these beliefs the best reply of P2 is
s2 = (L, L). But if P2 always chooses L then (U, D) is optimal for P1. Thus the following
strategies and beliefs form a PBE: s1 = (s1 (t1 ), s1 (t2 )) = (D, U), s2 = (s2 (U), s2 (D)) =
(L, L), U = 0, D = 1.

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Microeconomics II

April 22, 2015

Static games with complete information

Defining a static game

The set of players I = {1, 2, . . . I}.

A set of actions/strategies for each player i = 1, . . . , I, denoted by S i , (here we use

A payoff function for each player i = 1, . . . , I, ui : S 1 . . . S I R; ui tells us what

In a static game all players choose simultaneously an action/strategy.1 Depending on the

Example: The prisoners dilemma

Dominant and dominated strategies, iterated elimination of dominated strategies

ui (s0i , si ) > ui (s00

In this case we also say that s00 0 0

Calculating Nash equilibria when players have a continuum of strategies A NE is a strat-

Existence of Nash Equilibrium and mixed strategies

Dynamic games of complete information

Game tree, perfect vs. imperfect information

Strategies and normal form representation of dynamic games: In dynamic games we

has four different strategies: (l, l0 ), (l, r0 ), (r, l0 ), (r, r0 ).

ll0 lr0 rl0 rr0

Figure 3: Solving a game by backward induction

payoffs at different terminal nodes so that they are never indifferent).

Figure 4: Game tree of the market entry game

Figure 5: Game tree of the market entry game

a) starts at a decision node that constitutes by itself an information set;

Definition 2 (Subgame perfect equilibria). A NE is subgame perfect if the players strategies

Finitely repeated games

- on the first stage P1 chooses M and P2 plays m

You should convince yourself that this is indeed a SPE!

Infinitely repeated games

Suppose a player contemplates if he could do better by deviating at some point to confess.

5 > 1 < 1/5.

Thus, if > 1/5, then the player has no incentive to deviate.

Games of incomplete information

i) A set of players: {1, . . . , I};

ii) a set of actions for each player i, Ai , i = 1, . . . , I;

iii) a set of types for each player T i ;

iv) a probability distribution over profiles of types p;

v) a payoff function ui for each player i, where

u1 (s1 (tk ), s2 , tk ) u1 (a1 , s2 , tk ) for all a1 A1 . (3)

u1 (s1 (tk0 ), s2 , tk0 ) < u1 (a01 , s2 , tk0 ). (4)

Figure 7: The extensive form of the gift giving game (version 1)

i) for all k K, s1 (tk ) solves maxa1 A1 u1 (a1 , s2 (a1 ), tk ),

Figure 8: Gift giving game

Pr(a1 = R) = Pr(t = A)Pr(a1 = R|t = A)+Pr(t = N)Pr(a1 = R|t = N) = pA 0+pN 1 = pN .

(A|R) = Pr(t = A|a1 = R)

Pr(t = A)Pr(a1 = R|t = A) pA

Pr(t = A)Pr(a1 = R|t = A) pA

2(A|R) + v(N|R) = 2pA + vpN = 2pA + v(1 pA ) = (2 v)pA + v

Pr(t = A)Pr(a1 = R|t = A)

Are there any pooling equilibria?

1) Separating strategy s1 = (U, D):

2) Separating strategy s1 = (D, U):

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