WIRTSCHAFTSUNIVERSITÄT WIEN

DEPARTMENT OF STRATEGY AND INNOVATION

INSTITUTE FOR MARKETS AND STRATEGY

SBWL Decision Sciences

Game Theory I: Strategic Behavior

Lecture I-5
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 Organization

▪ E$ standings after 14 experiments:

• Average: E$ 609.5
• Minimum: E$ 74.00
• Maximum: E$ 930.00

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 Organization
1000

E$
900

800

700

600

500

400

300

200

100

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14

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 Organization
▪ Homework assignment 1 results are out.

▪ Homework assignment 2 will be handed out today, due on

Wednesday before next lecture.

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 Recap
▪ What is a Nash equilibrium?
▪ How can we find Nash equilibria?

▪ What is a subgame perfect equilibrium?

▪ How can we find subgame perfect equilibria?

▪ What is the SPNE of a finitely repeated game?

▪ What are social preferences?

▪ What is inequality aversion? What is reciprocity?

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 Organization
▪ A game is defined by: Players, Strategies, Payoffs
▪ Game payoffs are utility payoffs. They depend on the preferences of
players, and are not necessarily equal to $$$ payoffs.
▪ → We have to know the preferences of players!
Otherwise we solve the wrong game.
• Experiments:
– Experiment 8: Dictator game
– Experiment 9: Ultimatum game
– Experiment 10: Repeated Ultimatum game
– Experiment 11: Market game
▪ → And we assume rationality of all players. But what if they aren’t?
• Experiment 12: Centipede Game
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 Experiment 12
▪ Centipede game
a) Derive the subgame perfect Nash equilibrium for the one-shot
game (game played only for one round). Prove that the
equilibrium you found is indeed one. Are there more Nash
equilibria, which are not subgame perfect?

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 Experiment 12
▪ Centipede game
1 2 3 4 5 6 7 8 9 10
A: 96
A B A B A B A B A B B: 32

A: 3 A: 1.5 A: 6 A: 3 A: 12 A: 5.5 A: 24 A: 11.5 A: 48 A: 22.5

B: 1 B: 4 B: 2 B: 8.5 B: 4 B: 17 B: 8 B: 34 B: 16 B: 68

▪ The only subgame perfect Nash equilibrium:

(“down at every node”, “down at every node”)
▪ → When observing players playing this game, given these
strategies, the only outcome we will observe will be A
choosing down at the very first node.
▪ There are more than one Nash equilibria (but all of them
involve going “down” at the first and second node).
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 Experiment 12
▪ Data
b) Analyze the data set of experiment 12. How do
participants behave? Do you observe different behavior
over time, over the 3 rounds of the game?
c) How would you explain the behavior of participants?

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 Experiment 12
▪ When do participants choose down?
1 2 3 4 5 6 7 8 9 10
A: 96
A B A B A B A B A B B: 32

A: 3 A: 1.5 A: 6 A: 3 A: 12 A: 5.5 A: 24 A: 11.5 A: 48 A: 22.5

B: 1 B: 4 B: 2 B: 8.5 B: 4 B: 17 B: 8 B: 34 B: 16 B: 68

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 Limited depth of reasoning
▪ How far can you think?
▪ Cognitive psychology:
• short term memory capacity limit of 7±2 “chunks”
• Embedding creates cognitive problems
Four levels: “The movie that the script that the novel
that the producer whom she thanked discovered
became was made into was applauded by the critics.”
▪ k-level thinking models
• Players have different levels of rationality, which can be expressed
by a level k. Думаю, що всі інші теж 0
• Level-0 players play some simple strategy which is not dependent
on other players’ behavior. Examples: random, just cooperate, ...
• Level-k>0-players play a best response to the distribution of
players of levels 0 to k-1. варіанту,
Думають, що всі інші k-1 або нижчі. Але вони не розглядають
що суперник теж k

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 Limited depth of reasoning
▪ Example1 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10
A: 96
A B A B A B A B A B B: 32

A: 3 A: 1.5 A: 6 A: 3 A: 12 A: 5.5 A: 24 A: 11.5 A: 48 A: 22.5

B: 1 B: 4 B: 2 B: 8.5 B: 4 B: 17 B: 8 B: 34 B: 16 B: 68
оці 2 - це тобто якщо ти 0, ти або
level 0 рандомно, або не думаючи. і ще
ти думатимеш, що всі такі як ти.
тому безлімітна кооперація.
тому "вниз" на 9 або 10. (чи то 9,
чи 10 залежитьчи від того, чи ти
А, чи В).

Якщо ти 1, то ти вирахуюш
стратегію 0 і обереш "вниз" на 7
▪ Level 0: go down at last move, i.e. 9/10 чи 8

Якщо ти рівень 2, то ти
▪ Level 1: best response (BR) against level 0: go down at 7/8 думатимеш, що інші або 1, або
0. Треба змішана стратегія, аби
▪ Level 2: BR against 0 and 1: mix of down at 7/8 or 5/6 вирахувати, ким є інший (1 чи 0)
і базуючись на цьому обрати

▪ Level 3: BR against 0, 1, 2: mix of down at 7/8, 5/6, 3/4 свою стратегію: це або вниз на
5-6, або вниз на 7-8

▪ Level 4: BR to 0, 1, 2, 3: mix of down at 7/8, 5/6, 3/4, 1/2 ітд

▪ … more levels …
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 Limited depth of reasoning
▪ What are the issues with this level-k reasoning approach?
• All depends on choice of level-0 behavior. (Is it random? Is it an
„intuitive“ choice? What does „intuition“ mean?)

• Frequency of levels can be econometrically estimated (maximum

likelihood estimation), but should be constant across games.

• It‘s not an equilibrium concept. (It‘s always better to have a higher

level.)

• The applicability of the model is limited to simple games. (In

particular, we cannot use any other tools of game theory to analyze
(more complex) games under the assumption of level-k behavior.)

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 Take-aways
▪ A game is defined by: Players, Strategies, Payoffs
▪ → We have to know the preferences of players! Otherwise we
may solve the wrong game.
▪ Utilities over game outcomes might depend on other’s payoffs or
intentions.

▪ → We assume rationality of all players. But people may not be

rational.
▪ We can model bounded rationality. But then we cannot use our
traditional game-theoretical tools and concepts anymore.

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 Experiment 13

▪ Repeated price competition with 2 firms

a) Derive all Nash equilibria for the one-shot game (game
played only for one round). Prove for each equilibrium
you found that it is indeed one. Show that there are no
other equilibria.
b) Derive the subgame perfect equilibrium for the 10-
rounds repeated game.

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 Experiment 13
Player 2
0.08 0.12
▪ The Nash
equilibrium of the
12* 0 one-shot game is:
0.08
• Player 1: Choose
Player 1

12* 24 *
price of 0.08.
24* 17.5 • Player 2: Choose
0.12
0 17.5 price of 0.08.

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 Experiment 13
▪ The equilibrium of the repeated game (repeated with the same
players) corresponds to playing the one-shot equilibrium in each
repetition.
▪ Why? Backward induction!
• In the very last repetition, what is the equilibrium of the game?
• The unique one-shot equilibrium! That means, behavior in the
very last round is completely independent of any behavior
before.
• Thus, in the second last round, as behavior has no impact on
how players will behave in the last round, the game is played as
if it is the last game.
• The same is true for the second-to-last round, etc.etc., until we
arrive at the first round.
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 Recap: Finitely repeated games theorem
▪ Theorem:
• If a game G has a unique subgame perfect Nash equilibrium,
then there exists a unique subgame perfect Nash equilibrium in
the finitely repeated game G(T) in which the subgame perfect
Nash equilibrium of the game G is played in each repetition.

• Proof: We find the SPNE of the T times repeated game by

rollback. The SPNE solution for the last repetition T will be the
SPNE of the one-shot game. So play in the second-to-last
repetition T-1 cannot change what comes after in T. As a result,
the SPNE solution for the second-to-last repetition T-1 will also
be the SPNE of the one-shot game. Etc. etc. until the first
repetition.

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 Experiment 13
▪ The subgame perfect Nash equilibrium of the repeated game is:
• Player 1: Choose price of 0.08 in each round.
• Player 2: Choose price of 0.08 in each round.

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 Experiment 13
▪ What about punishing strategies. E.g., both play: “I start with a high
price, but I will select a low price whenever I see the other selecting a
low price?” Is this an equilibrium?
▪ No:
• A best response to someone playing this strategy would be: I do
the same, only that in the very last period I choose a low price.
• A best response against that would be to defect in the second-to-
last period …. etc. etc.
▪ Even if the other guy believes my punishing strategy, and plays
cooperatively, I myself would have an incentive to choose another
strategy.
→ Even in the repeated game, there is only one unique Nash
equilibrium. There are no other Nash equilibria
(for example, involving not credible threats or similar).
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 Experiment 13
▪ Data
c) Analyze the data set of experiment 13. What do people do? Can
you observe specific patterns of behavior over time?

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 Experiment 13

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 Experiment 13

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 Experiment 13

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 Experiment 13
▪ Data
d) Compare the results of theoretical and data analysis to
experiment 2 (simultaneous price competition, conducted in
tutorial 1 and analyzed in lecture 2). What are the most
important differences between experiment 13 and experiment
2?

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 Experiment 13
▪ For the competition game of experiment 2, we had a similar prediction
of behavior as for the game of this experiment: all firms set the lowest
price.
▪ In experiment 2 we observed that this was indeed the case: already in
the 1st round, the equilibrium price was reached, and most individual
price offers were at the equilibrium in the 2nd round, with very few
deviations.
▪ In experiment 13, we observe more cooperation but still not full
cooperation.
▪ Generally speaking:
• Groups of 2: better coordination on collusion.
• Same partner in all rounds: potential of punishment!

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 Dilemma games
▪ A dilemma game is a game where
• individual rationality and
• group rationality
suggest different ways of behavior
▪ In other words: given behavior of other group members, what’s best
for the individual is not best for the group.
▪ General problem:
• negative external effects of my behavior on others
are not “internalized“
• Others’ profit reduction when I undercut
• Team’s loss in marks when I do not contribute = don’t
• Friends’ loss when I take too much for myself affect or
bother me
• Partner’s loss if I do not cooperate
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 Dilemma games: Examples
▪ Collusion of firms (also experiments 2, 3, 7)
• “Group” rationality: all choose monopoly price and share the
resulting monopoly profits
• Individual rationality: undercutting others’ prices yields high profits
• Outcome: competitive prices, all firms make less profits than when
cooperating
▪ Note: this outcome is good for a larger group: the society

▪ Means to solve the dilemma:

• Communication
• Commitment to price matching policies
• Reputation / repeated interaction

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 Dilemma games: Examples
Provision of public goods
• non-excludable: nobody can be excluded
• non-rival: one’s consumption does not hurt others
• Public transport, streets and sidewalks, …
• Group rationality: everybody benefits if provided
• Individual rationality: free-ride on others’ contributions
• Outcome: public goods are not (or under-) provided

Means to solve the dilemma

• Observation and punishment
• Define thresholds from which public good is provided
• →everybody is “marginal” → multiple equilibria

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 Dilemma games: Examples
▪ Common pool resources (very similar to public goods)
• Imagine a pond with a number of fishermen. Each fisherman can fish
how many he likes, but if too many fish are caught, the fish will die out
• Group rationality: fish as much as optimal long term
• Individual rationality: given other fisherman reduce, just fish a little
more which does not hurt myself
• Outcome: everybody fishes more

▪ Other examples: fertilizers and water salinisation, air pollution,

carbon emissions

▪ Means to overcome the dilemma:

• Tax or tradable quotas – costs to society are internalized
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 Dilemma games
▪ The prototype: The Prisoner‘s dilemma
WIFE

Confess Deny

10 years 25 years
Confess
10 years 1 year
HUSBAND
1 years 3 years
Deny
25 years 3 years

▪ Unique Nash equilibrium in dominant strategies

▪ If the other confesses, I should confess
▪ If the other denies, I should confess

▪ I am not sure what the other does: Murder by numbers

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 Dilemmas
▪ Behavioral/strategic aspects of social dilemmas:
• Repetition with the same persons
• Positive reciprocity, conditional cooperation
• Negative reciprocity, punishment
• Counter-punishment

▪ Things known to influence cooperation in social dilemmas

• Group size • Communication
• Benefits from cooperation • Gender
• Leadership • Culture

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 Infinity
▪ We started with most restrictive assumptions: complete information, full
rationality, selfish players

Application Game theory with above We get better predictions when

assumptions helps us to relaxing the assumption of …
understand …
Markets the incentives of buyers and sellers, -
the value of timing and
commitment
Bargaining bargaining power based on the selfish players
rules of the interaction → social preferences
Centipede the fragility of cooperation, and the full rationality
need to think about others’ depth → bounded rationality
of reasoning
Infinite social the power of the “shadow of the -
dilemma future”
… … …
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 Experiment 14

▪ Dilemma of unknown (probabilistic) length

a) Write down this game as exact and concise as you can. Derive
at least one subgame perfect Nash equilibrium of this game.
Show that the equilibrium you found is indeed subgame
perfect.
b) Can cooperation be achieved in this game by rational, egoistic
players? How could they reach it?

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 Experiment 14
▪ Dilemma of unknown (probabilistic) length
Player 2 ▪ Backward induction?
0.08 0.12 → No defined end, so no rollback
possible!
0.08
12* 0 → Any round is equal, as the expected
number of rounds to play stays the same
Player 1

12* 24*
in each round.
24* 17.5
0.12 ▪ What now?
0 17.5 ▪ Is 0.08/0.08, played in
all rounds, still an
δ=0.9 equilibrium?
▪ Yes.
But there are more!
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 Experiment 14
Player 2
0.08 0.12
12* 0
Player 1

0.08
12* 24*
24* 17.5
0.12
0 17.5

▪ Assume players choose the following strategies:

• Player 1: I choose a low price all the time.
• Player 2: I choose a low price all the time.

▪ This is a Nash equilibrium. Given the strategy of the other guy,

I have no incentive to ever deviate from this.

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 Experiment 14
▪ Subgames in infinite games
• A subgame is a game which starts at some decision node after
the root node of the original game.
• In an infinite game with a fixed discount factor/continuation
probability per repetition,
• every subgame looks exactly like the original game.

• Thus, an equilibrium found for the overall infinite game (from

the perspective of the very first node) must also be an
equilibrium in any subgame that starts later.
• Thus, any equilibrium we find for the overall infinite game
must be subgame perfect.

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 Experiment 14
▪ Assume the following grim trigger strategies: “I start
Player 2
0.08 0.12 with cooperating. If you cooperate, then I will
12* 0
Player 1

0.08
12* 24*
continue cooperating. If you defect once, from the
next round on I will defect forever.”
24* 17.5 

0.12
0 17.5 t =1
 t
=
1− 
▪ Is playing these strategies an equilibrium?
▪ Say I comply with the strategy, then my expected profit is:

0.9
17.5 + 0.9 17.5 + 0.9 17.5 + ... = 17.5 +  0.9t 17.5 = 17.5 +
2
17.5 = 175
t =1 1 − 0.9
▪ If I deviate once, and then always have no cooperation:

0.9
24 + 0.9 12 + 0.9 12 + ... = 24 +  0.9t 12 = 24 +
2
12 = 132
t =1 1 − 0.9
▪ Is the punishment credible? Yes: It’s the one-shot Nash!!!
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 Experiment 14

▪ Data
c) Analyze the data set of experiment 14. Do you see any pattern
in the interactions of the two players?

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 Experiment 14

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 Experiment 14

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 Experiment 14

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 Infinitely repeated games
▪ Some players might have limited foresight such that they see a game as
infinite.
▪ A game might actually be infinite, or has a certain continuation
probability after each round.
▪ Does this change rational behavior in such games?
▪ Yes:
• Backward induction is not feasible anymore, thus arguments relying
on rollback cannot be applied.
• Rather, each repetition of the game can be seen as having the same
future prospects → solving for one round (under the shadow of the
future!) should yield a solution for all rounds.
▪ Note: Playing the one-shot equilibrium in each round is still an
equilibrium in the infinitely repeated game. But there are others now …

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 Infinitely Repeated games theorem
▪ If a game G has a unique Nash equilibrium, then there exists a unique
subgame perfect Nash equilibrium in the infinitely repeated game
G(T∞) in which the Nash equilibrium of the game G is played in each
round t.

▪ So, playing the Nash equilibrium of the one-shot game in each round
is always one Nash equilibrium of the infinitely repeated game.

▪ But there are likely more Nash equilibria in the infinitely repeated
game.

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 Infinitely repeated games
Player 2 ▪ How to interpret δ ?
D C
2 1
D
2 6
6 5
C
1 5
δ

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 Infinitely repeated games
und 1
Player 2 ▪ How to interpret δ ?
D C
2 1 a) Game continuation probability:
D
2 6 with a probability of δ the game is
6 5 continued. Thus, in expected terms,
C seen from today, the next game is
1 5
Player 2 δ played for amounts of δ · X, etc.
und 2 D C b) Discount factor: right now, money
δ2 δ1
D
δ2 δ6
earned next year is less valuable to
δ6 δ5 us than money earned today. So
C
δ1 δ5 when a game is played infinitely,
Player 2 income from later rounds is less
und 3 D C
δ valuable than today’s income. 1 – δ
δ2 2 δ2 1 is this loss of value for each round in
Player 1

D 2
δ 2 δ2 6 the future, seen from today.
δ2 6 δ2 5
C
δ 2 1 δ2 5 … c) Product of both
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 Infinitely repeated games
Let C, D, H, and L be the utility payoffs Player 2
from a dilemma game, with H > C > D > L. D C
Let 0 p 1 be the probability that the
D L
game continues after a round. D

Player 1
D H
Let 0 d 1 be the discount factor per
round. Let δ = p · d. H C
C
L C

Define a Tit-for-tat strategy as: “I play C in the first round, and in

each other round I play whatever the other player played before.”
Is mutual Tit-for-tat an equilibrium in this game?

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 Infinitely repeated games
▪ Is one-time defection worthwhile? Player 2
▪ If a player complies, then her net present D C
¥
value is
å
C + dC + d t ×C D L
t=2 D

Player 1
D H
▪ If a player defects once against
T4T her net present value is ¥ H C
H + d L + åd t ×C
C
L C
t=2
▪ So she should one-time defect if
¥ ¥
H -C
H + d L + åd ×C > C + dC + åd ×C Þ
t t
>d
t=2 t=2
C- L
▪ If loss from punishment (C-L) is large or benefit from defecting (H-
C) is small or the next round has relatively high value, then one-
time defection does not pay.
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 Infinitely repeated games
Is all-time defection worthwhile? 
 Player 2
 =
 t

1− 
If a player complies, then his net t =1 D C
present value is 

C +   C = C +
t
C D L
t =1 1−  D

Player 1
D H
If a player defects forever against T4T then
his net present value is  H C

H +  t  D = H +
C
D L C
t =1
1− 
So he should defect if
H+

1− 
DC+

1− 
C  H −C


C − D 1− 
 H −C

1
C − D 1− 
−1
If loss from continued punishment (C-D) is high or one-time benefit
from defection (H-C) is low or the future has a high value, then all-
time defection does not pay.
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 Infinitely repeated games
▪ Folk Theorem (Friedman 1971):
• Let G be a static n-person game with complete information. Let
e = (e1, ..., en) be the payoff vector in a Nash equilibrium of G and
let x = (x1, ..., xn) be a feasible payoff vector in G, and let xi > ei
for all players i .
• If  close enough to 1, then there exists a subgame perfect
Nash equilibrium of the infinitely repeated game G(,  ) which
implements the payoff vector x als average payoff.
▪ In other words: any feasible payoff combination (x1, ..., xn) (with xi >
ei for all players i) can be implemented by some trigger strategies in
an infinite game.

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 Infinitely repeated games Player 2
▪ What does that mean? D C
• Payoff vectors 2 1

Player 1
D
• Feasible payoff vectors 2 6
• with xi > ei for all players i 6 5
C
1 5
▪ Folk theorem: Each point in the green
area can be implemented as average (1,6)
payoff, by a) playing a combination plan 6 (5,5)
over the 4 cells and b) threatening to
always play (2,2) if somebody deviates

Player 2
from this plan
▪ Note: (2,2) is a credible threat, as it is a
stage game equilibrium, and worse (2,2)
than any payoff in the green area. (6,1)
0 Player 1 6
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 Take-aways

▪ Not all people are fully rational. We can model bounded

rationality. But then we cannot use the standard game-
theoretical tools and concepts anymore.

▪ If the shadow of the future is important enough, almost

anything can be an equilibrium.

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 Experiments

▪ Now experiments ...

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