Basic Assumptions of the Game Theory

1. Individualism: Two separate branches of game theory. Cooperative and non-cooperative . In

non-cooperative game theory the individuals are unable to enter into binding and enforceable
agreements with one another. Due to this assumption non-cooperative game theory is
inherently individualistic.

2. Rationality: Individuals are assumed to act in their own self-interest. This corresponds to the
fact that individuals are able to determine the outcome of their actions and, have preferences
over these outcomes.

3. Mutual Interdependence: By mutual interdependence we mean that the welfare of any one
individual in a game, at least partially, determined by the actions of other players in the game.
Each individual determines his/her optimal response in order to achieve the most desirable
outcome.

Defining Games: Key Ingredients

1. Players: who are the decision makers? People? Governments? Companies? Somebody
employed by a company? For there to be interdependence we need to have at least two
players.
2. Strategies: what can the players do? Enter a bid in an auction? Decide whether to end a
strike? Decide when to sell a stock? Decide how to vote?
3. Payoffs: what motivates players? Do they care about some profit? A payoff is what a player
will receive at the end of the game.

Defining Games: Two Standard Representations

1. Normal – Form (or Strategic - Form, Matrix - Form): List what payoffs get as a function of
their actions.
 Players move simultaneously (choose a strategy)
 The combination of strategies chosen by the players determines a payoff for each player.
2. Extensive – Form: Includes timing of moves.
 Players move sequentially, represented as a tree. Chess: white player moves, then black player
can see white’s move and react.
 Keeps track of what each player knows when he or she makes each decision. Poker: bet
sequentially – what can a given player see when they bet?

Defining Games: The Normal – Form

• Finite, n-person normal form game: ⟨N, S, u⟩:

• Players: N = {1,…, n} is a finite set of n , indexed by i.
• Strategy profile for player i, Si
• s = (s1,…,sn) ∈ S = S1 × … × Sn is a strategy profile.
• Utility function or Payoff function for player i: ui : S → R
• u = (u1 ,…, un), is a profile of utility functions.

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Defining Games: The Normal - Form

• An n-player game with strategy spaces (s1,…,sn) and utility (or payoff) functions (u1 ,…, un) is
denoted by,

G   S1 ,..., S n ; u1 ,..., un 

The Normal – Form Games: The Standard Matrix Representation

• Writing a 2-player game as a matrix:

• “Row” player is player 1, “column” player is player 2.
• rows correspond to actions s1 ∈ S1, columns correspond to actions s2 ∈ S2 .
• cells listing utility or payoff values for each player: the row player first, then the column.

Solution Techniques for Static Games

 A solution to a game is a prediction of what each player will do in the game, where the
solution gives one optimal strategy for each player. Many different solution techniques have
been proposed for different types of games.

 For static games two broad solution techniques have been applied.

i. The technique based on the concept of dominance.

ii. The technique based on the concept of equilibrium.

Strictly Dominated Strategy

• A strategy is said to be strictly dominated if another strategy gives improved payoffs whatever the
other players do in the game.

• A rational player never plays a strictly dominated strategy. A player who knowingly plays a
strictly dominated strategy is said to be irrational and he/she cannot be maximizing his/her
payoff.
• For iterated dominance people must not only be rational but also assume that other players are
rational. (common knowledge)

Formal Definition: Let si and s′i be two strategies for player i, and let S−i be is the set of all
possible strategy profiles for the other players.

si strictly dominates s′i if

s i  S i , ui  si , s i   ui  si, s i 

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Iterated Elimination of Strictly Dominated Strategy
• Example: Let’s consider a game in which there are two strategies for player 1 and three
strategies for player 2. S1={Up, Down} and S2={Left, Middle, Right}

Player 2

Left Middle Right

Up 1,0 1,2 0,1

Player 1
Down 0,3 0,1 2,0

• For Player 2 Right is strictly dominated by Middle. Since 2>1 and 1>0. Player 2 never plays
«Right» Eliminate it from the matrix.
• For Player 1 neither «Up» nor «Down» is strictly dominated by the other.

Player 2

Left Middle

Up 1,0 1,2

Player 1 Down 0,3 0,1

• For Player 1 Down is strictly dominated by Up. Since 1>0. Player 1 never plays «Down».
Eliminate it from the matrix.

Player 2

Left Middle

Up 1,0 1,2
Player 1

Player 2 plays Middle since 2>0. Then the solution of the game is {Up, Middle} = {1 , 2}

Middle
Up 1,2

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 . Example: Consider the following game.

P2
LEFT CENTER RIGHT
P1 UP 4,3 5,1 6,2
MIDDLE 2,1 8,4 3,6
DOWN 5,9 9,6 2,8

I. For Player 2 “Center” is strictly dominated by “Right”. Since 2>1 , 6>4 and 8>6. Player 2 never
plays “Center”. We can eliminate this strategy from the strategy space (or profile).

LEFT RIGHT
The Reduced Example Game Step I
UP 4,3 6,2
MIDDLE 2,1 3,6
DOWN 5,9 2,8

II. For Player 1 “Middle” is strictly dominated by “Up” since 4>2 and 6>3. Player 1 never plays
“Middle”. We can eliminate it from the matrix.

LEFT RIGHT The Reduced Example Game Step II

UP 4,3 6,2
DOWN 5,9 2,8

III. For Player 2 “Right” is strictly dominated by “Left”. Since 3>2 and 9>8. Player 2 never plays
“Right”.

LEFT
UP 4 ,3
DOWN 5,9

The Reduced Example Game Step III

Player 1 plays “Down” since 5>4. Then the solution of the game is {Down, Left} = {5 , 9}

LEFT
DOWN 5,9

The Reduced Example Game Step IV

*More generally, we want to be able to make this assumption for as many iterations as might be needed.
That is, we must be able to assume not only that all players are rational, but also that all players know that
all the players are rational, and that all the players know that all the players know that all players are

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 rational, and so on, ad infinitum. This assumption is called common knowledge and is usually made in
game theory.

Nash Equilibrium

Pure-Strategy Nash Equilibrium: Rational players think about actions that the other players might
take. Players form beliefs about one another’s behavior. So, to maximize his/her payoff, he/she would
select the strategy that yields the greatest expected payoff given his/her belief. Such a strategy is called a
best response (or best reply).
Definition: Best Response. Suppose player i has some belief s i  S i about the strategies played by
s  Si is a best response if ui ( si , si )  ui ( si, si ) for every si  Si .
the other players. Player i’s strategy i
s
We define the best response correspondence as the set of best responses player i has to  i . It is
important to note that the best response correspondence is set-valued. That is, there may be more than one
s i , then player i can do no
best response for any given belief of player i. If the other players stick to
s i . (Will be explained in detail with
better than using any of the strategies in the best response set of
some examples).
* *
Definition: Pure Strategy Nash Equilibrium. The strategy profile ( si , si ) is a pure-strategy Nash
u ( s* , s* )  ui ( si , s* i ) for each player i and for each si  Si .In a Nash
equilibrium if, and only i i i
equilibrium, no player i has an incentive to choose a different strategy when everyone else plays the
strategies prescribed by the equilibrium. It is quite important to understand that a strategy profile is a
Nash equilibrium if no player has incentive to deviate from his strategy given that the other players
do not deviate. When examining a strategy for a candidate to be part of a Nash equilibrium (strategy
profile), we always hold the strategies of all other players constant.

*Keep in Mind: Nash equilibrium is a strategy profile. Finding a solution to a game involves finding
strategy profiles that meet certain rationality requirements. In strict dominance we required that none of
the players’ equilibrium strategy is strictly dominated. In Nash equilibrium, we require that each player’s
strategy is a best response to the strategies of the other players.

Example: Consider the following game. List the best response strategies for each player. (Label the
Best Response as BR) Then find the pure strategy Nash equilibrium(s).

P2

LEFT CENTER RIGHT

UP 2,2 1,4 4,4
MIDDLE 3,3 1,0 1,5
DOWN 1,1 0,5 2,3

P1

Player 1’s best responses to action by Player 2

BR1 ( L)   M  BR1 (C )   U , M  BR1 ( R)   U 

, ,

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Player 2’s best responses to action by Player 1

BR2 (U )   C , R BR2 ( M )   R BR2 ( D)   C

, ,