Daystar University

FACULTY OF COMMERCE

ECO 610 MANAGERIAL ECONOMICS

Lecture Five: Strategic Decisions and Game Theory

5.0 INTRODUCTION

Decisions can be classified as either non-strategic or strategic. Non-strategic decisions do

not involve other players, so their actions need not be considered. On the other hand,
strategic decisions are characterized by interactive payoffs. Interactive payoffs mean that
the outcome of your decision depends on both your actions and the actions of others. For
example, an oligopolistic firm wishing to maximize its profits by changing the product
price, the quantity of the product that it sells, the level of advertising, and so on, must
take into consideration all possible reactions of its competitors. Every action taken by the
firm and the reactions of the competitors would result to different payoffs or outcomes.
Under strategic decisions, the optimal choice of the firm may change, depending on what
it believes its competitors will do.

The study of such strategic decisions is the subject matter of game theory. Game theory is
concerned with the choice of the best or optimal strategy in conflict situations. For
example, game theory can help a firm determine the conditions under which lowering its
price would not trigger a ruinous price war, and whether the firm should build excess
capacity to discourage entry into the industry even though this lowers the firm’s short-run
profits.

5.1 BASIC DEFINITIONS IN GAME THEORY

A game is a formal representation of a situation in which a number of individuals interact

in a setting of strategic interdependence. By that, we mean that each individual’s welfare
depends not only on his or her own actions but also on the actions of other individuals.

All game theoretic models are defined by a common set of five parameters. They include:

I. The Players: are the decision-makers whose behavior we are trying to explain and
predict. The decisions of all players determine the outcome. Game theory models
describe both the identity of the players and their number, as changes in either can
alter play.

II. The Feasible Strategy Set: A player’s strategy is a complete contingent plan
describing the actions he or she will take in each conceivable evolution of the game.
They are all the possible actions of the players that can be given a nonzero
probability of occurring. For example, the choices to change price, develop new

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 products, undertake a new advertising campaign, building new capacity, and all
other such actions that affect the sales and profitability of the firm and its rivals.

III. The Outcomes or Consequences: Each strategy of a player intersects all

combinations of the strategies of others to form the outcome matrix. A particular
outcome is defined by the strategy choice of each player. For example, in the war
between America and Iraq, assume that each country had only two strategies:
America could either use ground attack (GA) or air strike (AS); and Iraq could
either use Weapon of Mass Destruction (WMD) or Conventional Weapon (CW).

For each possible strategy that America could adopt, there were a number of
strategies (reactions) available to Iraq. Note that because there are two players,
and each has two strategic options, there are four possible outcomes (AS, WMD;
AS, CW; GA, WMD; and GA, CW).

IV. The Payoffs: These are the players’ preferences (i.e., utility functions) over the
possible outcomes. Each possible combination of strategies (outcome) by the
players has a corresponding payoff. For example, the payoff is usually expressed in
terms of the profits or losses of a firm as a result of the firm’s strategies and the
rival’s responses. The table giving the payoffs from all strategies open to a player
and the rival’s responses is called the payoff matrix.

V. The Order of Play: The model specifies the order in which players reveal their
chosen strategy. Models are simultaneous if all players reveal their strategy without
knowing the strategy of others. In other words, if all players commit to a strategy
before learning the strategies of others, then the game is simultaneous.

Sequential games are non-simultaneous games which specify the order of play.

5.3 VISUAL REPRESENTATION OF A GAME

There are two ways of presenting payoffs in game theory: in a payoff matrix form, or an
extensive form.

The Payoff Matrix Form Representation of a Game

Consider a market comprising of two firms, Firm A and firm B, and a choice of two
strategies for each: advertise or do not advertise. Each firm expects to earn higher profits
if it advertises than if it does not. But the actual level of profits for each firm depends on
whether the rival firm advertises or not. Thus, each firm’s strategy (i.e., advertise or do
not advertise) can be associated with each of the rival’s strategies (also to advertise or not
to advertise). The possible outcomes and payoffs are illustrated by the payoff matrix in
table 5.1.

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 Table 5.1 Payoff Matrix for an Advertising Game
Firm B
Advertise Don’t Advertise
Advertise 4, 3 5,1
Firm A
Don’t Advertise 2,5 3,2

 The first number in each of the four cells refers to the payoff (profit) for firm A,
while the second is the payoff (profit) for firm B.
 From the table, if both firms advertise, firm A will earn a profit of 4, and firm B
will earn a profit of 3 (the top left cell of the payoff matrix).
 The bottom left cell of the payoff matrix shows that if firm A doesn’t advertise
and firm B does, Firm A will have a profit of 2, and firm B will have a profit of 5.
The other payoffs in the second column of the table can be similarly interpreted.

The Extensive Form Representation of a Sequential Game

The extensive form is also called the game tree representation of a game. The extensive
form captures who moves when, what action (strategy) each player can take, what players
know when it is their turn to move, what the outcome is as a function of the actions taken
by the players, and the players’ payoffs from each possible outcome.

Figure 5.1 shows the game tree of the war between America and Iraq. It is assumed that
the two players move sequentially, rather than simultaneously. In particular, America
attacks Iraq (Air Strike, AS, or Ground Attack, GA) first. Then, after seeing America’s
choice, Iraq chooses her strategy (use Weapon of Mass Destruction, WMD, or
Conventional Weapon, CW).

Figure 5.1: Game Tree of War between America and Iraq

America

AS GA

Iraq Iraq

WMD CW WMD CW

America’s payoff 0 -3 2
3
1
Iraq’s payoff -2 -1 -3

 The game starts at an initial decision node represented by an open square, where
America (player 1) makes her move, deciding whether to use air strike or ground
attack.
 Each of the two possible choices for America is represented by a branch from this
decision node.

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 At the end of each branch is another decision node represented by a solid square, at
which Iraq (player 2) can choose between two actions, use weapon of mass
destruction or conventional weapon, after seeing America’s choice.
 The initial decision node is referred to as player 1’s decision node; the latter two as
player 2’s decision nodes.
 After Iraq’s (player 2’s) move, we reach the end of the game, represented by terminal
nodes. At each terminal node, we list the players’ payoffs arising from the sequence
of moves leading to that terminal node.

The Extensive Form Representation of a Simultaneous Game

In the sequential game presented above, we have assumed that when it is the turn of Iraq
(player 2) to take action, she is able to observe all her rival’s (America’s) previous
moves. This is a game of perfect information.

However, all simultaneous games are played with imperfect information. That is, when it
is a player’s turn to make a move, he or she does not know at which decision node the
other player is. The reason for this ignorance is that the player has no opportunity to
observe something about what has transpired in the game.

If the advertising game earlier presented (see table 5.1) is such that firm A and firm B
simultaneously make decision as to whether to advertise or not to advertise, the game tree
would be as presented in figure 4.2 below.

Figure 5.2: Game Tree of Simultaneous Advertising Game

Firm A

Advertise Don’t Advertise

Firm B

Advertise Don’t Advertise Don’t

Advertise Advertise

Firm A’s payoff 4 5 2 3

1 5 2
Firm B’s payoff 3

 The figure is identical to the one of sequential games except that a circle is drawn
around firm B’s two decision nodes to indicate that these two nodes are in a single
information set. The meaning of this information set is that when it is firm B’s
turn to make a choice of its action, it cannot tell which of these two nodes it is at
because firm A has not revealed its strategy.

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Example Two: Matching Pennies
There are two players, denoted 1 and 2. Each player simultaneously puts a penny down,
either heads up or tails up. If the two pennies match (either both heads up or both tails
up), player 1 pays 1 dollar to player 2; otherwise, player 2 pays 1 dollar to player 1.

We present the payoff matrix table as follows:

Table 5.2 Payoff Matrix for the Matching Pennies Game

Player 2
Head Tail
Head -1, 1 1,-1
Player 1
Tail 1,-1 -1, 1

The game tree for this simultaneous game is presented in figure 5.3 below

Figure 5.3: Game Tree of Simultaneous Matching Pennies Game

Player 1

Head Tail

Player 2

Head Tail Head Tail

Player 1’s payoff -1 1 -1

1

-1 -1 1
Player 2’s payoff 1

 A circle has been drawn around player 2’s two decision nodes to indicate that
these two nodes are a single information set.
 Similarly note that because the moves are made simultaneously, player 1 is
equally unable to observe player 2’s choice. This implies that as long as each
player cannot observe each other’s choices, the timing of moves is irrelevant. By
this logic we can also describe this game with a game tree that reverses the
decision nodes of players 1 and 2 in figure 5.3.

Definition: A game is one of perfect information if each information set contains a single
decision node (e.g., figure 4.1). Otherwise, it is a game of imperfect information (e.g.,
figure 5.2 and 5.3).

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4.4 STRATEGIES

A central concept of game theory is the notion of a player’s strategy.

Definition: A strategy is a complete contingent plan, or decision rule, that specifies how
the player will act in every possible distinguishable circumstance in which he or she
might be called upon to move.

It is worthwhile to consider what the players’ possible strategies are for games of perfect
information, and those of imperfect information.

Case 1: Defining all Possible Strategies in the War between America and Iraq

America’s Strategy

A strategy for America (player 1) in the sequential game specifies her move at the game’s
initial node. America has two possible strategies: use air strike (AS) or ground attack
(GA).

Iraq’s Strategy

Specifies how she will fight at each of her two information sets, that is, how she will
attack if America uses AS and how she will attack if America picks GA.

Iraq has four possible strategies:

 Strategy 1 (S1): Use WMD if America uses AS

 Strategy 2 (S2): Use WMD if America uses GA
 Strategy 3 (S3): Use CW if America uses AS
 Strategy 4 (S4): Use CW if America uses GA

Case 2: Defining all Possible Strategies in the Advertising Game

Firm A’s Strategy

Firm A has two possible strategies in the simultaneous advertising game: advertise or not
to advertise.

Firm B’s Strategy

But firm B now only has two possible strategies, “advertise” and “don’t advertise,”
because the firm now has only one information set. Firm B can no longer condition its
action on firm A’s previous action.

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Dominant Strategies

In attempting to predict the outcome of a game, it is important to identify any possible

dominant strategy of the players. A strategy is said to be dominant for player 1 if it
maximizes uniquely player 1’s payoff for any strategy that player 1’s rival might play.

If a player has a dominant strategy, we should expect him or her to play it. Referring back
to the war game between America and Iraq:

Table 5.3 Payoff Matrix for War Game between America and Iraq
Iraq
WMD CW
AS 0, -2 3, -1
America
GA -3, -3 2, 1

America’s Preferred Strategy

 We determine America’s preferred strategy by comparing its payoffs, given the
rival’s strategy. For example, if Iraq does use WMD (i.e., moving down the left
column of table 5.3), we see that America’s payoff would be 0 if it uses air strike
(AS) and -3 if it uses ground attack (GA). Given that America would suffer great loss
should it use ground attack strategy, her most preferred strategy is AS (air strike).
 If Iraq uses conventional weapon (CW) (i.e., moving down the right column),
America’s payoff would be 3 if it uses AS and 2 if it uses GA. America’s payoff will
be highest if it uses AS.
 America’s payoff would always be greater if it uses AS than if it uses GA regardless
of what Iraq does. Therefore, air strike is the dominant strategy for America.

Iraq’s Preferred Strategy

 If America does use AS (i.e., moving across the AS row), Iraq’s payoff would be -2 if
it uses WMD and -1 if it uses CW. Iraq suffers relatively less loss by using CW.
 If America uses GA (move across the GA row), Iraq’s payoff would be -3 if it uses
WMD and 1 if it uses CW. Iraq’s preferred strategy in this case is to use CW.
 No matter what America does Iraq’s dominant strategy is to use conventional
weapons (CW).

Equilibrium of the war game is {America uses Air Strike, Iraq uses Conventional
Weapon}.

Example 2: The Advertising Game (See table 5.1)

Payoff Matrix for an Advertising Game

Firm B
Advertise Don’t Advertise
Advertise 4, 3 5,1
Firm A
Don’t Advertise 2,5 3,2

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Firm A’s Equilibrium Strategy
 If firm B chooses to advertise, firm A would maximize its payoff by also advertising
(payoff 4 > payoff 2).
 If firm B chooses not to advertise, firm A would maximize its payoff by advertising
 Dominant strategy for firm A is to Advertise irrespective of firm B’s strategies.

Firm B’s Equilibrium Strategy

 If firm A chooses to advertise, firm B would maximize its payoff by also advertising
(firm B’s payoff with advertising is 3 and without advertising is 1).
 If firm A chooses not to advertise, firm B would maximize its payoff by advertising
(firm B’s payoff with advertising is 5 and without advertising is 2).
 Firm B’s dominant strategy is to advertise always.

Equilibrium of the advertising game is {Firm A advertises, Firm B advertises}.

Dominated Strategy

A player’s strategy is said to be dominated if there exist some other alternative strategy
that yield him greater payoff regardless of what other players do.

One approach to finding solution to a game theory problem having no clear dominant
strategy is to identify the dominated strategies and eliminating them. Note that no player
would ever play a dominated strategy, because he or she will always be worse off playing
the strategy. The iterative process of eliminating the dominated strategies may proceed
until each player is left with only one playable strategy (i.e., dominance solvable).

Example 1:
Table 5.4 shows a payoff matrix of a game involving Firm A and Firm B that must decide
on a pricing policy for a new product. Each firm knows that the rival firm will introduce a
similar competing product. Because Firm A’s product is expected to enter the market
slightly sooner than Firm B’s, Firm A announces its prices first. Firm A can choose one
of the following three prices: $1.00, $1.35, or $1.65. Firm B will reveal its price later.
Because it is second to market, its possible price points are two: $0.95 and $1.30. The
payoffs represent profits.

Table 5.4 Payoff Matrix for the Pricing Policy Game

Firm B’s Pricing Policy
$0.95 $1.30
Firm A’s 1, -1 -1, 1
$1.00
Pricing
$1.35 -1, 1 1,-1
Strategies
$1.65 -2, 5 -3, 2

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Steps towards identifying firm A’s and B’s optimal pricing strategies:
Note that to be able to reach an equilibrium we must assume that the players are rational,
and they would never play a dominated strategy. That is, a player must know not only
that his rival is rational but also that the rival know that he is.

 Check whether there exist any dominated strategies for each firm. To identify
dominated strategy for Firm A, consider each strategy of Firm B and determine which
amongst the three pricing strategies of Firm A yields the lowest payoff. For example,
$1.00 pricing policy is most preferred for Firm A if Firm B selects $0.95 pricing
policy. The $1.35 pricing policy is Firm A’s preferred policy given Firm B’s $1.30
pricing policies. Note that the $1.65 pricing policy for firm A is dominated by both
pricing policies ($1.00 and $1.35).
 Eliminate Firm A’s dominated strategy (eliminate pricing policy of $1.65).

Table 5.4b Firm A’s Dominated Strategy ($1.65) is eliminated

Firm B’s Pricing Policy
Firm A’s $0.95 $1.30
Pricing $1.00 1, -1 -1, 1
Strategies $1.35 -1, 1 1,-1

 The same procedure could continue to be used to eliminate the dominated strategy
until it is possible to clearly identify each firm’s optimal strategy.
 In this example we notice that there is no longer a dominated strategy in the reduced
matrix. Also note that no dominant strategy exists.
 The reduced form matrix gives us a situation of pure conflict: what one player wins,
the other loses. Such a game is called a zero-sum game. There would be no unique
prediction for this game. Firm A’s price choice of $1.00 will be met by a counter
offer of $1.30 by Firm B. Alternatively, an offer of $1.35 by Firm A is met with a
counter offer of $0.95 by Firm B.

Example 2:
Consider the following payoff matrix of player 1and player 2

Player 2
Product A Product B Product C
Player 1 Product D 3, 6 7, 1 10, 4
Product E 5, 1 8, 2 14, 7
Product F 6, 0 6, 2 8, 5

Using iterative elimination of dominated strategies approach, we can find the equilibrium
of the game.

 Starting from the view point of player 1, if the player is rational he will see that the
strategy of producing product D is dominated, so he will never play it. If player 2
knows that player 1 is rational and will never produce product D, then its product C
strategy is dominant (this is observable after eliminating player 1’s product D).

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 Player 1’s product D strategy is eliminated.
Player 2
Product A Product B Product C
Player 1
Product E 5, 1 8, 2 14, 7
Product F 6, 0 6, 2 8, 5

 Having identified player 2’s dominant strategy we can eliminate strategy product A
and product B.

Player 2’s product A and B are eliminated

Player 2
Product C
Player 1
Product E 14, 7
Product F 8, 5

 Finally, given player 2’s dominant strategy (product C), player 1 would only have to
make a choice between product E and F. He will choose product E because it gives
him the highest payoff. The equilibrium of the game is: {player 1 chooses product 1
and player 2, product C}.

Note the following:

 In the matrix form games, we measure the degree of rationality by the rounds of
iterative eliminations needed to reach the equilibrium. Three rounds of eliminations
were required in example 2. An individual may be rational for games with few
degrees of rationality (few rounds of elimination) but not for those requiring many
degrees.

 Too few games have dominant strategy equilibrium. The prediction in games without
dominance can be achieved by finding a Nash Equilibrium (named after John Nash,
the Princeton University mathematician who first formalized the notion in 1951).

4.5 NASH EQUILIBRIUM

It is the most widely used solution concept in game theory.

Definition: A strategy profile s  ( s1 ,...., s N ) constitutes a Nash equilibrium if for every

player i  1,..., N ,
ui ( si , si )  ui ( si' , si ) for all alternative strategies, si' .

In words, a strategy profile s  ( s1 ,...., s N ) constitutes a Nash equilibrium if for every

player, strategy si yields a payoff that is greater than all the payoffs generated by other
alternative strategies, si' , given the rival’s strategy s i .

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In a Nash equilibrium, each player’s strategy choice is a best response to the strategies
actually played by his rival.

Example 1:
Consider the example presented above.
Player 2
Product A Product B Product C
Player 1 Product D 3, 6 7, 1 10, 4
Product E 5, 1 8, 2 14, 7
Product F 6, 0 6, 2 8, 5

The following procedure can be used to identify a Nash equilibrium:

 For each strategy, indicate the behavior of the other. For example, if player 1knew
(with certainty) that player 2 will produce product A, what will he do? By looking
at the first numbers in each cell of the product A column, we observe that player
A receives 3 if he introduces product D, 5 if product E, and 6 if product F. Since 6
is the highest of the three payoffs, player 1 would introduce product F. Circle
player 1’s payoff to show that it is the highest payoff given player 2’s choice of
product A.
 Do the same for strategies product B and C to find player 1’s best response. Note
that player 1 selects product E given that player 2 selects product B (circle 8).
Player 1 selects product E given that player 2 selects product C (circle 14).
 Now, follow the same procedure for player 2. For example, if player 1 produces
product D, what should player 2 choose? By looking at the second numbers in
each cell of the product D row, we observe that the maximum payoff that player 2
can receive is 6 by producing product A (put a square around payoff 6). Do the
same for strategies product E and product F. Note that player 2 selects product C
if player A selects E (put a square around 7). Also, player 2 selects product (C) if
player 1 selects product F (put a square around 5).
 The resulting matrix is illustrated below.

Player 1 Player 2

Product A Product B Product C

Product D 3, 6 7, 1 10, 4

Product E 5, 1 8, 2 14 , 7

Product F 6 0 6, 2 8, 5

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 Any cell with both a circle and a square is a Nash equilibrium. In this game, the Nash
equilibrium is for player 1 to produce E (and receive 14) and player 2 to produce C
(and receive 7). Thus, we can say that a Nash equilibrium is a meeting of best
responses. Once the Nash equilibrium is reached, no player is willing to unilaterally
change behavior.

Example 2:
Payoff Matrix for an Advertising Game
Firm B
Advertise Don’t Advertise
Advertise 4, 3 5,1
Firm A
Don’t Advertise 2,5 3,2
 If firm A chooses to advertise, the best response for firm B is to advertise (put a
square around 3 in row 1).
 If firm A does not advertise, the best response for firm B is to advertise (put a square
around 5 in row 2).
 Now follow the same procedure for player A. If firm B chooses not to advertise, the
best response for player A is to advertise (put a circle around 5 in column 2).
 If firm B chooses to advertise, the best response for player A is to advertise (put a
circle around 4 in column 1).
 Both a circle and a square appear in Advertise, Advertise. Therefore, the Nash
equilibrium is firm A and firm B should advertise.

Note that similar results were arrived at when we used the approach of identifying
dominant strategies of each player in section 4.4 above.

Assignment:

Q1. Consider a two-player simultaneous-move game shown in the payoff matrix table
below.

Player 2
L M R
Player 1 Product U 5, 3 0, 4 3, 5
Product N 4, 0 5, 5 4, 0
Product D 0, 4 0, 4 5, 3

Find the Nash equilibrium.

5.6 GAMES OF INCOMPLETE INFORMATION: BAYESIAN NASH

EQUILIBRIUM

Up to this point, we have assumed that players know all relevant information about each
other, including the payoffs that each receives from the various outcomes of the game.
Such games are known as games of complete information. This assumption is, however,

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very strong. In many circumstances, players have what is known as incomplete
information about each other. For instance, when a bank is deciding whether or not to
give a loan to a borrower, it might not know with certainty whether it is dealing with an
honest borrower or a defaulter. The payoffs of the bank will, therefore, depend on the
type of borrower it is dealing with.

Another good example is when a new entrant firm is making decision as to whether or
not to venture into a market. It may not be sure what type of incumbent firm (hostile or
accommodating) it is dealing with. Whether the new entrant firm will survive or not
depends on the type of incumbent firm existing in the market. That is, the payoff of the
entrant would vary depending on the type of incumbent firm.

In the two examples above, players possess asymmetric information, which incomplete
information game models summarize in the form of player “types.” A type consists of
player characteristics that are unknown to others (e.g., honest or defaulter; hostile or
accommodating; strong or weak). Specific types are represented by different payoff
functions. So, a hostile type has a different payoff function relative to an accommodating
type.

Owing to the uncertainty involved in games of incomplete information, it can be

imagined that nature makes the first move, choosing realizations of random variables that
determines each player’s preference type, and each player observes the realization of only
his own random variable. A game of this sort is known as a Bayesian game.

Example 1:
Firm E needs to decide whether it should enter a product market where Firm D is an
incumbent. Firm E is uncertain of the reaction of Firm D if Firm E decides to enter the
market. If Firm D is “hostile,” then Firm E expects it to lower price and defend its
market. If Firm D is “accommodating,” then Firm E expects it to keep its prices high, and
allow Firm E to enter the market. Owing to the uncertainty associated with Firm D’s type
(hostile or accommodating), assume that Firm D is a hostile type with probability μ,
while the firm is an accommodating type with probability (1-μ).

The extensive form (game tree) of this Bayesian game is represented in figure 5.4.

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 Figure 5.4: Game tree of Bayesian game between Firm D and Firm E

NATURE

Hostile (μ) Accommodating (1- μ)

Firm E
Enter Don’t enter Don’t enter
Enter

Firm D Firm D

Price Price Price Price Price Price Price Price

low high low high low high low high

Firm E
Payoff
4 8 6 6 4 8 6 6
12 10 6 4 4 16 6 8
Firm D
Payoff

 In figure 5.4, nature moves first and determines the game types (in this case whether
Firm D is the hostile type or the accommodating type). The probability that Firm D
will be the hostile type is μ, while the probability that Firm D will be the
accommodating type is (1-μ).
 Firm E decision nodes are circled because it cannot observe what type Firm D is
(hostile or accommodating). However, Firm D knows whether it is the hostile type or
the accommodating type.
 Although Firm D knows its type (hostile or accommodating), it does not observe the
action choice (enter or don’t enter) of Firm E. That is why at each type Firm D’s
decision nodes are circled (the final sets of decision nodes).

Table 5.5 represents specific types by different payoff functions.

Table 5.5: Hostile or Accommodating Incumbent Firm D

A. Payoff Matrix when Incumbent Firm D is Hostile

Firm D
Price low Price high
Enter the market 4, 12 8, 10
Firm E
Don’t enter the market 6, 16 6, 4

B. Payoff Matrix when Incumbent Firm D is Accommodating

Firm D
Price low Price high
Enter the market 4, 4 8, 16
Firm E
Don’t enter the market 6, 6 6, 8

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Note that the payoffs for Firm E are identical across parts A and B. The incomplete
information is about Firm D, not Firm E. Only the payoffs of Firm D change.

Observe that if Firm E knew the true type of Firm D (hostile or accommodating), its
decision would be easy. When Firm D is the hostile type (part A), the Nash equilibrium
would be for Firm E not to enter the market and for Firm D to price low (to fight to
maintain market dominance). When Firm D is the accommodating type (part B), the Nash
equilibrium would be for Firm E to enter the market and for Firm D to price high
(allowing entry).

However, Firm E does not know the true type of Firm D. For this reason we find a
Bayesian Nash equilibrium for the incomplete information game.

BAYESIAN NASH EQUILIBRIUM

We want to define an equilibrium concept for Bayesian games. To do so, we must first
define the players’ pure strategy spaces in such a game. Recall that a player’s strategy is a
complete contingent plan.

A pure strategy for player i in a Bayesian game is a function si(θi) that gives the player’s
strategy choice for each realization of his type θi.

In the Bayesian game presented above, a pure strategy (a complete contingent plan) for
Firm D can be viewed as a function that for each possible realization of Firm D’s
preference type indicates what action it will take. Hence, Firm D has four possible pure
strategies:
(i) Price low if it is the hostile type, price low if it is the accommodating type
(ii) Price low if it is the hostile type, price high if it is the accommodating type
(iii) Price high if it is the hostile type, price low if it is the accommodating type
(iv) Price high if it is the hostile type, price high if it is the accommodating type

Notice, however, that Firm E does not observe Firm D’s type, and so a pure strategy for
Firm E in this game is simply a choice of either “enter the market” or “don’t enter the
market.”

In a Bayesian game, each player i has a payoff function ui ( si , si , i ) , where θi is called
player i’s type, which is chosen by nature, and is observed only by player i. It is assumed
that the probability distribution of the θi’s is common knowledge among all players.

Defining a Bayesian Nash Equilibrium:

Each player’s strategy must be a best response to the other players’ strategies. That is,
Bayesian Nash equilibrium is simply a Nash equilibrium in a Bayesian game.

We find the Bayesian Nash Equilibrium by comparing the expected payoff from a given
pure strategy with that of alternative pure strategies. Using the example presented above:

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If Firm D is the hostile type, it must choose “price low” with probability 1 because this is
that type’s dominant strategy.
 If Firm E enters, it earns a payoff of 4
 If Firm E does not enter it earns a payoff of 6

Likewise, the accommodating type of Firm D also has a dominant strategy: “price high.”
the accommodating type, its dominant strategy would be price high.
 If Firm E enters, it earns a payoff of 8
 If Firm E does not enter it earns a payoff of 6

Given that Firm E has only two pure strategies (enter or not enter the market), Firm E
must compare the expected payoff from entering the market with the expected payoff
from not entering the market.

Firm E’s expected payoff from entering the market is

.4  (1   )8
where, μ is the probability that Firm D is hostile and (1-μ) is the probability that Firm D
is accommodating.

Firm E’s expected payoff from not entering the market is

.6  (1   )6

What is Firm E’s best response?

Given the behavior by Firm D, Firm E’s best response is:
(i) To choose to enter the market if the expected payoff from entering the market is
greater than the expected payoff from not entering the market. That is,

 .4  (1   )8   .6  (1   )6
 .4   .8  8   .6   6  6
  .4  2
2  4
2 1
   or  
4 2

1
(ii) To choose not to enter the market if 
2
1
(iii) To be indifferent as to whether or not to enter the market if 
2

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5.7 STRATEGIC FORESIGHT: THE USE OF BACKWARD INDUCTION

Good managers use strategic foresight in making decisions. We define strategic foresight
as the ability to make decisions today that are rational given what is anticipated will
happen in the future. For example, a manager builds extra capacity today because he or
she believes (correctly) that the demand will increase in the near future. Using strategic
foresight also helps managers understand that decisions have both short- and long-term
consequences.

Game theory formally models strategic foresight through what is called backward
induction. We use backward induction to solve games by looking to the future,
determining what strategy players will choose (anticipation) then choosing an action that
is rational, based on these beliefs. Backward induction is most easily seen in extensive-
form games, because of their ability to map out the choices of players.

Backward Induction in Finite Games of Perfect Information

Figure 5.5 shows America-Iraq war game in extensive form.

Figure 5.5: Game Tree of War between America and Iraq

America

AS GA

Iraq Iraq

WMD CW WMD CW

America’s payoff 0 -3 2
3
1
Iraq’s payoff -2 -1 -3

 Since America attacks first, it is assumed that it will reach its decision first. After
seeing the decision of America, Iraq then decides whether to use conventional
weapons (CW) or weapon of mass destruction (WMD).
 America wants to make a decision today that maximizes its payoff, given its vision of
the future. This it can achieve by using backward induction. That is, America must
anticipate the future actions of others, and then choose actions that are rational.

 The following steps should be taken when using backward induction.

(i) Determine optimal actions for moves at the final decision nodes in the tree (in this
example determine Iraq’s optimal behavior). This is achieved by comparing the
payoffs of final player at each decision node).

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 o Iraq would prefer CW if America was to use GA (notice payoff (1) for CW >
payoff (-3) for WMD).
o Iraq would prefer CW if America was to use AS since payoff for CW (-1) >
payoff for WMD (-2).

(ii) Given that these will be the actions taken at the final decision nodes, proceed
upwards to determine optimal actions to be taken by the first player (in this case
America). This second step is accomplished by replacing Iraq’s decision nodes by
payoffs that will result from Iraq’s optimal behavior.

Figure 5.5b: Reduced Game after Solving for Iraq’s Optimal Behavior

America

Air Ground
Attack Attack

2
America’s payoff 3
1
-1
Iraq’s payoff

 Notice that this reduced game is a very simple single-player decision problem in
which America’s optimal decision is identified by now comparing its payoffs (3 and
2).America’s optimal decision is to use Air Attack since it is guaranteed higher payoff
of 3 compared with the payoff of 2 for ground attack.
 Also note that by use of backward induction we have been able to identify the
sequentially rational Nash equilibrium strategy profile (America use Air Strike, Iraq
uses conventional weapon if America uses air strike).

Example 2
Consider the following predation game. Firm E (for entrant) is considering entering a
market that currently has a single incumbent (firm I). If it does so (playing “in”), the
incumbent can respond in one of two ways: It can either accommodate the entrant, giving
up some of its sales but causing no change in the market price, or it can fight the entrant,
engaging in a costly war of predation that dramatically lowers the market price.

The extensive and payoff matrix representations of this game are depicted in figure 5.6.

Figure 5.6: Extensive and Payoff matrix of the Predation Game

Firm I
Fight if Firm E plays in Accommodate if Firm E plays “in”
Out 0, 2 0, 2
Firm E
In -3,-1 2, 1

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 Firm E

In
Out

0 Fight Accommodate
2

Firm E’s payoff -3 2

-1 1
Firm I’s payoff

Note the following:

 Examining the payoff matrix, we see that this game has two pure strategy Nash
equilibrium:
(i) Firm E remains out of the market, Firm I fights if firm E plays “in”.
(ii) Firm E enters, Firm I accommodates if firm E plays “in”.

Although the first strategy profile (out, fight if firm E plays “in”) is a Nash equilibrium,
yet, it is not a sensible prediction for this game. If firm E was to use strategic foresight, it
can foresee that if it does enter, the incumbent will, in fact, find it optimal to
accommodate (by doing so, firm I earns 1 rather than -1).
 Hence, the incumbent’s strategy “fight” if firm E plays “in” is not credible.
 This example illustrates that in dynamic games the Nash equilibrium concept may not
give sensible prediction, and so the need for use of backward induction.

Using Backward Induction

 First, identify Firm I’s optimal decision in the post-entry stage of the game. Firm I’s
optimal decision is to accommodate if firm E enters (payoff of accommodating (1) >
payoff of fighting (-1)).
 Second, determine firm E’s optimal behavior earlier in the game given the
anticipation of what will happen after entry. The reduced extensive form game in
which firm I’s post-entry decision is replaced by the payoffs that will result from firm
I’s optimal post-entry behavior is shown in figure 5.6b.

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 Figure 5.6b

Firm E

Out In

2
Firm E’s payoff 0 1
2
Firm I’s payoff

 Firm E’s optimal decision is to play “in” since the payoff of (2) is greater than 0
(payoff of staying out).
 Therefore, the sequential rational Nash equilibrium strategy profile is (Firm E plays
in, Firm I accommodates if firm E plays “in”).

Example 3
Consider the three-player finite game of perfect information depicted in figure 5.7.
Figure 5.7a
Player 1

L R

Player 3 Player 2

v r a b

Player 3 Player 3
2 -1
0 5
1 6 v r v r

Player1’s 3 5 0 -2
4 -1 2
Player 2’s
payoff 1
2 4 7 0
Player 3’s
payoff
payoff

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Use backward induction to identify sequentially rational Nash equilibrium strategy
profile for player 1, 2 and 3.

Solution
 The arrows in figure 5.7a indicate the optimal play (of player 3) at final decision
nodes of the game. Comparison is done of players 3’s payoffs (row 3 of payoffs) and
the strategy with highest payoff is selected at each of the player’s decision node.

Figure 5.7b
Player 1

L R

Player 2
-1
5
6 a b

Player 1’s payoff 5 0

Player 2’s payoff 4 -1
4 7
Player 3’s payoff

 In figure 5.7b, the first round reduced game in a backward induction procedure is
formed by replacing the final decision nodes by the payoffs that result from optimal
play (by player 3) once these nodes have been reached. The arrows in figure 4.7b
indicate the optimal play (of player 2) at final decision nodes of the reduced game
(compare the second row of payoffs and select player 2’s strategy with highest payoff
at each of the player’s decision node).

Figure 5.7c
Player 1

L R

Player 1’s payoff -1 5

Player 2’s payoff 5 4
6 4
Player 3’s payoff

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 Figure 5.7c represents the reduced game derived in the next stage of the backward
induction, when the final decision nodes of the reduced game in figure 5.7b are
replaced by the payoffs arising from optimal play at these nodes (again indicated by
arrows). Finally compare the payoffs of player 1 (-1 and 5 in row 1 of payoffs) and
select the players strategy with highest payoff (in this case R).

Identifying the Nash equilibrium strategy profile

The backward induction procedure therefore identifies the strategy profile (σ1, σ2, σ3) in
which

σ1 (player 1’s optimal strategy) = R

σ2 (player 2’s best response strategy) = a if player 1 plays R, and
r if player 1 plays L

 3 ( Player 3' s best response strategy )  r if player 1 plays R and player 2 plays a
v if player 1 plays R and player 2 plays b


Note that this strategy profile is a Nash equilibrium of this three-player game.

4.8 REPEATED GAMES

Our earlier analysis has only concentrated on a one-shot game. That is, a game is played
between players only once without any chance of repeating the game. It is worthwhile to
note that the prospects of a game being repeated again and again can change player
actions.

We illustrate the strategic effect of repeated play using a stylized example from a class of
games known as prisoner’s dilemmas. The story behind this game is as follows: Two
individuals are arrested for allegedly engaging in a serious crime and are held in separate
cells. The interrogators try to extract a confession from each prisoner. Each is positively
told that if he is the only one to confess, then he will be rewarded a light sentence of 1
year while the uncooperative prisoner will go to jail for 10 years. However, if he is the
only one not to confess, then it is he who will serve the 10-year sentence. If both confess,
they will both be shown some mercy: they will each get 5 years. Finally, if neither
confesses, it will still be possible to convict both of a lesser crime that carries a sentence
of 2 years. Each player wishes to minimize the time he spends in jail (or maximize the
negative of this, the payoffs that are depicted in table 5.6).

Table 5.6: The Prisoner’s Dilemma

Player 2
Don’t Confess Confess
Don’t Confess -2,-2 -10, -1
Player 1
Confess -1,-10 -5, -5

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The Nash equilibrium of this game is for both prisoners to confess. To see why, note that
playing “confess” is each player’s best strategy regardless of what the other player does.
In other words “confess” is a dominant strategy for each player in a game that is only
played once.

Observe that both prisoners can be better off if each does not confess (each would serve a
jail term of 2 years), but they are afraid that the other prisoner will then confess and only
serve a jail term of 1 year, while the one that chooses not to confess serves a 10-year jail
term. Thus, if both prisoners are going to engage in criminal activities for a single
instance, then we expect the rational choice for both prisoners to be “confess.”

However, if the same scenario is repeated every time they are caught after committing
crimes together, they will realize that by failing to trust each other is expensive. Every
time they are caught and confess they would serve 5 years in jail instead of 2 years when
they co-operate and do not confess.

Strategically, the key difference between one-shot games and those that are repeated is
the presence of a future. A future introduces behavior not possible in a one-shot game.
Reputation, trust, promises, threats, and reciprocity need a future to exist. Therefore, a
betrayal of trust may lead to gains in the present, but these may be outweighed by future
losses.

In infinitely repeated games, we can have equilibrium where both prisoners reach
mutually beneficial outcomes by not confessing. The risk of one prisoner cheating and
confessing, leading to the other serving a 10-year jail term is mitigated through the threat
of future punishment. The threats to punish must, however, be credible. Cooperative
behavior between the prisoners is easier to maintain in an infinite horizon game because
the future always looms. But, in finite horizon games the future grows smaller as we
approach the last period.

In a finite horizon prisoner’s dilemma game that is repeated for only a finite number of
times T, the unique Nash equilibrium involves T repetitions of the one-shot prisoner’s
dilemma equilibrium in which “confess” is the dominant strategy. This is a simple
consequence of backward induction: In the last period, T, we must be at the Nash
equilibrium (confess, confess) regardless of what has happened earlier. But, then, in
period T-1 we are, strategically speaking, at the last period, and the equilibrium (confess,
confess) solution must arise again. And so on, until we get to the first period. In
summary, backward induction rules out the possibility of more cooperative behavior in
the finitely repeated prisoner’s dilemma game.

However, in an infinitely repeated game, things can dramatically change. The prisoners
can follow the following strategies:
 Prisoner i’s strategy calls for him not to confess in period t = 1. Then, in each period t
> 1, prisoner i chooses not to confess if in every previous period both prisoners have
not confessed.

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 Otherwise, prisoner i choose to confess if his partner defected in the previous period
and confessed.

This type of strategy is called a Nash reversion strategy: Players cooperate until someone
deviates, and any deviation triggers a permanent retaliation in which the one-shot Nash
strategy (confess, confess) is the equilibrium. Therefore, if the prisoners use the Nash
reversion strategy defined above, then both will end up choosing “Don’t confess” in
every period, so that they now serve a jail term of 2 years each instead of 5 years without
cooperation.

Application of the Prisoner’s Dilemma in Pricing Competition

The concept of prisoner’s dilemma can be applied in a duopolistic pricing competition.
Firms in a duopolistic competitive market could be faced with two options: charge a high
monopolistic price (Pm), or allow competition to lead to competitive low price (Pc) in the
market. The payoff matrix of this type of pricing competition is presented in table 5.7.

Table 5.7: Pricing as a Prisoner’s Dilemma

Firm2’s pricing strategy
Price Pm Price Pc
Firm 1’s Price Pm 10, 10 3, 23
pricing strategy Price Pc 23, 1 5, 5

The Nash equilibrium of this game is for both firms to sell their products at competitive
low price (Pc) and earn $5 million. Both firms can be better off if each maintains a high
monopolistic price (Pm), but a problem arises from the fear that the other firm would
drop its price and steal the market. In the event that this happens, the firm that charges the
high price Pm earns $1 million, while the low pricing firm earns $23 million.

Therefore, in a one-shot pricing competition we expect both firms to keep price low. In
an infinitely repeated pricing competition, however, the firms would have an incentive to
collude so that they could both charge a monopoly price (Pm), and earn $10 million each.
Each firm adopts a Nash reversion strategy: firm i chooses monopoly price Pm in period t
= 1. Then, in each period t > 1, the firm chooses Pm if in every previous period both
firms chose Pm. Otherwise, firm i will choose the competitive price (Pc) if the other firm
defected in the previous period and chose Pc. The equilibrium, therefore would be “Pm,
Pm”.

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