Mas-Colell, Whinston, Green:

Chapter 9.C-9.D
Sequential rationality and
forwards induction
Sequential rationality

2
 Setting (1): Dynamic games
• A dynamic game is a game with several moves
• Examples:
– nim, chess, poker
• Counter-examples (one-shot or static games):
– matching pennies, prisoner's dilemma, bank run
 Setting (2): Imperfect information
• Some moves are not observable to all players
• Examples (natures makes unobservable move):
– poker
• Examples (player makes unobservable move):
– prisoner's dilemma
• Counter-examples (all moves observable):
– nim, chess
 Setting: Dynamic games
• Let T be the portion of game tree G emanating
at a node of perfect information n.
• Assume that all information sets involving
nodes in T are completely contained in T.
• Then T is a subgame of G.
 Example 1: Entry Game

u[E] 2 -1 3 -1 0
u[I] 1 -1 0 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
 Example 1: Entry Game

u[E] 2 -1 3 -1 0
u[I] 1 -1 0 -1 2

acc fight acc fight

Firm I
in2 in1 out

not subgames Firm E

 Nash Equilibria
(1) in1 – accommodate
(2) out – fight

u[E] 2 -1 3 -1 0
u[I] 1 -1 0 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
Both NE are SP, but (2) is strange ...
“fight if entry” is dominated by “accommodate if entry”
=> Firm E knows Firm I will not fight => E will enter (in1)

u[E] 2 -1 3 -1 0
u[I] 1 -1 0 -1 2

acc fight acc fight

(2) out – fight
Firm I
is not
in2 in1 out sequentially
rational
Firm E
 Sequential rationality
• replaces subgame perfection in games with
imperfect information (i.e., games without
subgames).
• Under a strategy s, a strategy of player i, si,
is not sequentially rational if it includes
moves (“fight”) at some information sets
(“in1—in2”) that would not be optimal if
that information sets were reached (even if
they are never actually reached by s).
What have we achieved? (not much)
“fight if entry” is dominated by “accommodate if entry”:
=> the game at (in1—in2) becomes a “pseudo”-subgame.

u[E] 2 -1 3 -1 0
u[I] 1 -1 0 -1 2

acc fight acc fight

Firm I “accommodate”
in2 in1 out dominates
“fight”
Firm E
 Sequential rationality
• replaces subgame perfection in games with
imperfect information (i.e., games without
subgames).
• Under a strategy s, a strategy of player i, si,
is not sequentially rational if it includes
moves (“fight”) at some information sets
(“in1—in2”) that would not be optimal if
that information sets were reached (even if
they are never actually reached by s).
 Example 1 modified
-1 3
-1 0
u[E] 2 0.5 3 -1 0
u[I] 1 -1 -2 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
 Example 1 modified
Firm I: “accommodate” “in2”, but “fight” “in1”.
Firm E: “in1” if “accomodate”, “out” if “fight”.

u[E] 2 0.5 3 -1 0
u[I] 1 -1 -2 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
Is there an equilibrium?
 Example 1 modified
Equilibrium condition I:
Firm I is indifferent between “accomodate” and “fight”.

u[E] 2 0.5 3 -1 0
u[I] 1 -1 -2 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
How can Firm E make Firm I indifferent?
 Example 1 modified
Answer: Mixed strategy:
p=prob(in1|enter); (1-p)=prob(in2|enter)

u[E] 2 0.5 3 -1 0
u[I] 1 -1 -2 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
What value p* of p makes Firm I indifferent?
 Example 1 modified
Answer: Mixed strategy:
p=prob(in1|enter); (1-p)=prob(in2|enter)

u[E] 2 0.5 3 -1 0
u[I] 1 -1 -2 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
What will Firm E do?
 Example 1 modified
Equilibrium condition E:
Firm E must be indifferent between “in1” and “in2”.

u[E] 2 0.5 3 -1 0
u[I] 1 -1 -2 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
How can Firm I make Firm E indifferent?
 Example 1 modified
mixed strategy
q=prob(fight|enter); (1-q)=prob(accomodate|enter)

u[E] 2 0.5 3 -1 0
u[I] 1 -1 -2 -1 2

acc fight acc fight

Firm I
in2 in1 out

Firm E
What value of q makes Firm E indifferent?
 Solution
• Mixed strategy equilibrium
• Firm E chooses a probability p for “in1 if enter”
that makes Firm I indifferent between
“fight” and “accommodate”.
• Firm I chooses a probability q for “fight if
enter” that makes Firm E indifferent
between and “in1” and “in2”.
• The equilibrium is sequentially rational.
 Beliefs
• A system of beliefs b in extensive form game G
is a specification of a probability b(x)∈[0,1] for
each decision node x in G such that ∑x∈Hb(x) = 1
for all information sets H.
• In words: a system of beliefs specifies, for each
information set, a probabilistic assessment by
the player who moves at that information set
of the relative likelihoods of being at each of
the sets various decision nodes,conditional on
play having reached that information set.
 Sequential rationality
• Denote a player who moves at information
set H by i[H] and her utility by ui[H].
• A strategy s in extensive form game G is
sequentially rational at information set H
given a system of beliefs b if:

E[ui[H]|H,b,si[H],s-i[H]] ≥ E[ui[H]|H,b,s'i[H],s-i[H]]
 Perfect Bayesian Equilibrium
• Strategies must be sequentially rational given
beliefs.
• Beliefs must be consistent with the strategies.
(--> Nash equilibrium: players have correct
beliefs about their opponents' strategy choices).

If completely mixed strategies (prob(H)>0):

Beliefs have to satisfy Bayes rule.
 Forward induction
• Backward induction:
Players decides on optimal action based on
opponents optimal play at later points in the
game.
What is likely to happen?
• Forward induction:
Players decides on optimal action based on
opponents optimal play at earlier points in the
game.
What could have happened previously?