Teoria de Juego

INTRODUCTION TO
GAME THEORY
Lecture 1: Intro and Motivational Examples
January 8, 2024
Course Information
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Course Information
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Course Information
Ñ Solving the problem sets and participating in

the seminars and lectures is very important!
Ñ Note: seminars 10%, lectures + experiments 5%
Course Information
Ñ Solving the problem sets and participating in

the seminars and lectures is very important!
Ñ Note: seminars 10%, lectures
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+ experiments 5%
Course Information
Course Information
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Course Information
Course Information - Schedule
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Course Information - Schedule
project presentations 10%
Game theory
Éin a nutshell:
ÒGame theory is the study of strategic

interactions, which are interactions between
2 or more players who have to choose
strategies that lead to outcomes or payoffs
that depend on the strategies chosen by all
players.Ó
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Game theory
Éin a nutshell:
ÒGame theory is the study of strategic

interactions, which are interactions between
2 or more players who have to choose
strategies that lead to outcomes or payoffs
that depend on the strategies chosen by all
players.Ó
We start with single-agent decision theory.
Game theory Ñ origins

Ñ In 1944/47 John von Neumann and Oskar
Morgenstern publish
ÒTheory of Games and Economic Behavior,Ó
where they introduce:
Ñ Game theory (cooperative + non-cooperative)
Ñ Expected utility theory.
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John von Neumann
Quiz:
Read John von NeumannÕs Wikipedia page and answer:
Which of the following is false:

(a) At the age of six he could converse in Greek and divide two 8-digit
numbers in his head.
(b) John von Neumann belonged to a group called ÒThe MartiansÓ.
(c) He was involved in the Manhattan Project, working on
thermonuclear reactions and the hydrogen bomb.
(d) He contributed to mathematics, statistics, economics, computer
science and physics, including quantum mechanics and nuclear
physics.
(e) He loved fast cars and even participated in formula one car races.
(f) He designed and promoted the policy of Mutually Assured
Destruction (MAD).
John von Neumann

Quiz:
Read John von NeumannÕs Wikipedia page and answer:
Which of the following is false:

(a) At the age of six he could converse in Greek and divide two 8-digit
numbers in his head.
(b) John von Neumann belonged to a group called ÒThe MartiansÓ.
(c) He was involved in the Manhattan Project, working on
thermonuclear reactions and the hydrogen bomb.
(d) He contributed to mathematics, statistics, economics, computer
science and physics, including quantum mechanics and nuclear
physics.
(e) He loved fast cars and even participated in formula one car races.
(f) He designed and promoted the policy of Mutually Assured
Destruction (MAD). 8 / 339
John von Neumann?
John von Neumann?
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John von Neumann? É no!
The essential ingredients

The essential ingredients defining a
game are:
players N = {1, 2, É, n}
and for each i in N:
actions Ai = {a1, a2, É, am}
payoffs ui : A1 x É x An -> R
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The essential ingredients
The essential ingredients defining a
game are:
players N = {1, 2, É, n}
and for each i in N:
actions Ai = {a1, a2, É, am}
payoffs ui : A1 x É x An -> R
We will study this in more detail in a few weeks.
Note: Many types of interactions are games!
Applications
Game theory started out as a mathematical
discipline and has eventually been applied to
various fields such as:
Ñ Economics, Business, Strategy
Ñ Political Science, Law, Political Philosophy
Ñ International Relations, Military Strategy
Ñ Environmental Sciences, Climate
Ñ Biology, Medicine, Neuroscience
Ñ Computer Science, Logic
Ñ etc.
We will see various applications in class.
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Application: Telecom market
¥ We want to understand strategic interactions.
Example: Major entry in French Mobile telecom market.

Consumers gained considerably from added varieties and
also from lower prices.
See: ÒMarket entry,

fighting brands and tacit
collusionÓ (AER, 2021)
Bourreau, Sun, Verboven
(¬4.6bn ~ 7.7% of industry; 2012-14)

Originally: Orange, Bouygues, SFR; then also Free.
Application: The Tragedy of the Commons

Garrett Hardin, Science, 1968
Ñ Consider an agricultural village that has a large
common field (the ÒcommonÓ) where the villagers graze
their sheep.
Ñ Suppose a sheep costs c to buy (and maintain etc.).
Ñ Suppose that the produce of all the sheep depends on how many
sheep are being grazed on the common, and takes the form f(x).
Ñ Originally few villagers graze their sheep (<< 60).
Ñ Over time the population of villagers grows, but they somehow
agreed to keep the number of sheep low (< 60-65).
Ñ As the number of villagers keeps growing it becomes
harder to limit the number of sheep.
Question: How many sheep do you expect there to be?
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Ñ Suppose the production function of x sheep f(x) and the cost
function of maintaining x sheep c(x) are as below.
Question: How many sheep do you expect there to be?

Ñ For the collective decision solve fÕ(x) = cÕ(x) or 260-4x = 20.
which yields x* = 60 and f(60) = 8400, AP(60) = 140.
x*
This is the cooperative outcome.

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Note:
Solve: Max f(x)-c(x)
FOC fÕ(x) - cÕ(x) = 0, SOC ok
=> solve fÕ(x) = cÕ(x).
x*

Note:
Solve: Max f(x)-c(x)
FOC fÕ(x) - cÕ(x) = 0, SOC ok
=> solve fÕ(x) = cÕ(x).
x*

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Ñ For the individual decision solve f(x)/x = c or 260-2x = 20.
which yields x** = 120 and f(120) = 2400, AP(120) = 20.
x**
This is a non-cooperative outcome.

Note:
Solve: keep adding sheep
as long as f(x)/x > c(x)/x. Why?
=> stop at f(x)/x = c(x)/x = c.
x**

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Note:
f(120) = 2400 << f(60) = 8400
AP(120) = 20 << AP(60) = 140
=> f(120) - c(120) = 0!
x**

The tragedy of the commons can be used as a basic model for
studying the tension between possible cooperative and non-
cooperative outcomes in many similar situations such as:
Ñ overfishing in common waters

Ñ over-logging in large forests
Ñ using clean air or water
Ñ emitting CO2 and other greenhouse gases
Ñ etc.
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Edward O. WilsonÕs Half-Earth Project
From the article ÒA Global Deal for

NatureÓ in Science, 2019, on the
UNÕs program of formally preserving
30% by 2030.
COP15, UN Biodiversity Agreement

Target 3 (of 23 Targets for 2030) 12/22
Edward O. WilsonÕs Half-Earth Project
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Progress at the UN: High Seas Treaty
The Guardian, March 5, 2023

The Treaty enters into force once
60 countries sign and ratify it:
https://highseasalliance.org/
So far 84 countries have signed:

https://highseasalliance.org/treaty-ratification/
Distinguishing types of games
A key aspect in game theory is learning to

distinguish types of games. That is, different
types of strategic situations.
Apparently small differences in payoffs within a

game can sometimes make a big difference to
the structure of the game and hence to the
type of game and of the interaction implied.
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Some examples
A social dilemma game.
Both players have a Òdominant strategyÓ to play

Defect.
Some examples
A social dilemma game.

ÒPrisonerÕs dilemmaÓ
Both players have a Òdominant strategyÓ to play

Defect.
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Some examples
The social dilemma is resolvedÉ

ÒPrisonerÕs delightÓ
Now both players have a Òdominant strategyÓ to play

cooperate. This is no longer a social dilemma game.
Some examples
A pure coordination game.

ÒTrafficÓ
This a coordination and common payoff game.

Both drivers want to drive on the same side for the
same direction.
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Some examples
Another coordination game.

ÒBattle of the sexesÓ
Players have Òcommon interestsÓ and also some

ÒconflictÓ.
Some examples
A strictly competitive game.

ÒMatching penniesÓ
Row player wants to match, while Column player

wants to mismatch the tossed pennies.
Players have Òopposite interestsÓ.
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Some examples
Another strictly competitive game.

ÒRock-paper-scissorsÓ
Players still have Òopposite interestsÓ.
Nash equilibrium Ñ intuitively
A profile of actions is a Nash

equilibrium if no player has an
incentive to unilaterally change his or her
own action.
or
Given the profile of actions of the
opponent(s) each player is playing a
best response to that profile.
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Introduction to Game Theory
Topic 1. Decision Theory
Fabrizio Germano
Universitat Pompeu Fabra
Winter 2024
UPF, Introduction to Game Theory, Winter 2024 Topic 1, Slide 1
Uncertainty
· So far (in Intro to Micro and Micro I), consumers and firms knew
the exact consequences/outcomes of their actions.
Example A firm knows its profits given its level of production.
· But often there can be UNCERTAINTY about the payoffs
associated to different actions (e.g., due to unknown future prices).
Example
- A farmer might have to choose whether to cultivate carrots or potatoes,
- but when he makes the decision, he’s uncertain about the profits that
he’ll obtain,
- since the best choice depends on weather conditions, future prices,
demand conditions... none of which he controls.
· Gap between actions and consequences.
· Decision theory shows us how to deal with this gap.
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Example
Uncertainty
· You want to open a shop in a touristic area for the summer.

· You can open either an ice-cream parlor or a bookshop
specialized in travel guides and maps.
· The problem: profits are uncertain, as they depend on a
variable θ that you don’t control.
Table: Actions, States, Consequences

θ1 θ2
ice-cream 6 0
bookshop 2 2
Example
Risky alternatives
· Suppose θ is the weather: if it’s sunny, you’ll sell a lot of

ice-cream; if it rains, you’ll sell nothing.
· The profit from the bookshop doesn’t depend on the weather.
sun rain
ice-cream shop 6 0
bookshop 2 2
· The realizations of the random variable θ follow a probability

distribution.
Fundamental problem of Decision Theory: how to use the

information on possible payoffs and probabilities to choose between
risky alternatives. (Topic 1 of this IGT course)
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Example
Strategic interaction
· Now suppose θ is the decision of a neighbor that may open a

tobacco shop or an ice-cream parlor.
· Your potential benefits depend on the decision of the
neighbor.
tobacco ice-cream
ice-cream shop 6 0
bookshop 2 2
· The neighbor won’t choose what to do randomly (following a

probability distribution); he’ll choose what’s “best for him”!
Fundamental problem of Game Theory: determine what action to
choose in a context where a player’s payoff also depends on the
actions of other players. (Topics 2–8 of this IGT course)
A formal approach to decision-making
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Where are we going?
The key concepts we need to know are:
· Basic setup with actions, states of nature and consequences

· Space of lotteries (L)
· Expected value of a lottery
· St. Petersburg Paradox
· Preferences over lotteries

· Expected utility of a lottery
· Estimating an expected utility function over lotteries
· Certainty equivalent
· Attitudes towards risk
· risk averse – risk neutral – risk loving
· Applications: asset purchase – insurance – portfolio choice
A formal approach to decision-making
· set of actions (alternatives) A = {a1 , a2 , ..., a3 }

· set of possible realizations of the state of nature
Θ = {θ1 , θ2 , ..., θm }
· set of consequences (outcomes) C = {c11 , c12 , ..., c3m }
Table: Example with 3 = 2 and m = 3

θ1 θ2 θ3
a1 c11 c12 c13
a2 c21 c22 c23
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· θ can take any of m different values in Θ = {θ1 , θ2 , ..., θm }.
· Realizations of θ follow a probability distribution.
· Value θi occurs with probability pi .
m
· We assume that for all i, pi ~ 0 and ∑ pi = 1.
i =1
In a risky situation, we don’t know what will happen but we know

what could happen (the different values of the state of nature) and
its likelihoods (the probabilities).
Example We don’t know what the weather will be, but we know it
can be sunny or rainy and we know the probabilities.
Decision Theory
exploits the information given by probabilities and the information
about agents’ preferences in order to make recommendations for
making “good decisions” j help to choose the “favorite lottery”.
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The farmer’s example
Table: The farmer’s decision

cold warm
tangerines 0 100
apples 20 100
oranges -10 140
cherries 40 40
Suppose the probability of cold weather is p = 12 .
set of actions A = { }
set of possible realizations of state of nature θ = { }

probabilities p = { }
set of consequences C = { }
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Lotteries
· A formal representation of each risky action/alternative:
· a set of consequences (in this case, monetary payoffs), each
with an associated probability pi :
L = ïp1 , ..., pm | x1 , ..., xm ð .
· L is called a lottery.
· The set of all such lotteries is denoted by L.
Back to the farmer’s example:

The lotteries are:
Lt =
La =
Lo =
Lc =
Tree representation: ...

What should the farmer choose?
Rational behavior
· An individual is rational if s/he has well defined objectives

(preferences) and makes decisions according to them.
· It’s convenient to work with numerical indicators of

preferences (utilities) so that rational behavior can be
expressed as a maximizing behavior.
· How to assign utility numbers to lotteries that represent

individual preferences so we can evaluate different lotteries?
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The Expected Value
Can we use the expected value of a lottery?
· If maximizing e ’s, is the objective of the decision maker,

then the expected value of the lotteries (i.e., the expected
profits) could potentially be a good utility function (i.e., a
good representation of the decision maker’s preferences).
· The expected value of L = ïp1 , ..., pm | x1 , ..., xm ð is the sum

of all its possible consequences weighted by their respective
probabilities:
m
E (L) = ∑ p i xi .
i =1
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Back to the farmer’s example.
Expected value of the farmer’s lotteries:

E ( Lt ) =
E ( La ) =
E ( Lo ) =
E ( Lc ) =
If the farmer is an “expected value maximizer”, then his preference

ranking is
Spoiler : an expected value maximizer is also called risk neutral.
· Do real people use the expected value to choose between

lotteries?
· Is the expected value a good criterion to choose between

lotteries?
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An experiment
What is your most preferred lottery?
An experiment
E (L) = 11, 000 > 10, 000 = E (L2 )
· So, expected value maximizers would choose lottery L.

· But if people dislike risk (i.e., they are risk averse), they’ll
probably choose L2 .
· In other words, the expected value may not be a good
criterion for people that dislike risk.
· There is considerable empirical evidence that many people are

not expected value maximizers and therefore the expected
value is not an appropriate utility representation of their
preferences over risky alternatives.
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The Saint Petersburg Game
· Consider the game in which you pay a fixed fee and then you
toss a coin repeatedly until it turns up heads in which case the
game stops and you get:
· 2e if the coin comes up heads in the first toss
· 4e if heads in the second toss
· 8e if heads in the third toss
· 16e if heads in the fourth toss
· etc.
· How much would you be willing to pay to play this game?
· You can think of it as a lottery: LSP = .
· How much would you be willing to pay to participate in the
lottery LSP ?
The Saint Petersburg Game: Class Experiment

· How much would you be willing to pay to play this game?
60 60
50 50
Frequency in group T3
Frequency in group T1
40 40
30 30
20 20
10 10
0 0
0 20 40 60 80 100 0 20 40 60 80 100
Amount of money stated (100 means '100 or more') Amount of money stated (100 means '100 or more')
Figure: Outcome of the experiment for T1 (left) and T3 (right).

Note: 100 really stands for “g 100” because some said 1,000, 10,000, 1,000,000 etc.;
some even said “infinity” (∞) or “all my money.”
Excluding “g 100” or “infinity” the averages were:

· 4.5 (18.2) for group T1 and 4.8 (12.4) for group T3.
(In parentheses the averages using 100 for “g 100” or “infinity”.)
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The Saint Petersburg Paradox
1 1 1
The lottery LSP = 2, 4, 8, . . . | 2, 4, 8, . . . has expected value:
1 1 1 1
E (LSP ) = (2) + (4) + (8) + (16) · · ·
2 4 8 16
= 1+1+1+1+···
= ∞.
Yet, people are typically willing to pay substantially less than

E (LSP ) to participate in this lottery. Often even less than 10e .
· What does this mean?

· What does it imply about the expected value?
Where are we going?

SO FAR the key concepts we have learned are:
NEXT we turn to the following:

· Attitudes towards risk
· risk averse – risk neutral – risk loving
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Expected Utility Theory
Expected Utility Theory

· Individuals typically treat different monetary values in a
different way.
· In particular, expected value need not be an appropriate
representation of preferences.
· If preferences over risky alternatives satisfy certain
“consistency conditions”, then there exists a utility function
u (·) defined on consequences such that for all lotteries
L = ïp1 , ..., pm | x1 , ..., xm ð and L2 = ïp12 , ..., pn2 | x12 , ..., xn2 ð,
m n
2 2 2
∑ p i u ( xi ) ~ ∑ i i .

LL ô p u x
i =1 i =1
· The “consistency conditions” are assumptions that the

underlying preference relation () is complete, transitive,
continuous and satisfies independence.
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The von Neumann-Morgenstern utility function
· The vNM utility function u (·) is defined on consequences

(or monetary outcomes).
· It allows the construction of a utility function U (·) defined on
lotteries (L).
· U (L) – the expected utility of lottery L – is linear with
respect to probabilities and is given by:
m
U (L) = ∑ p i u ( xi )
i =1
where L = ïp1 , ..., pm | x1 , ..., xm ð.

Economic agents choose the lottery with highest expected utility.
NOTE: The expected value is a special case of the expected utility

function!
Indeed, if the vNM utility function u (x ) = x, then expected utility

U (L) equals expected value E (L):
m m
U (L) = ∑ p i u ( x i ) = ∑ p i xi = E ( L ) .
i =1 i =1
In this case u (·) is linear in money outcomes (xi ’s) and U (·) is
linear in both probabilities and money outcomes (pi ’s and xi ’s).
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Example
· Suppose an economic agent has preferences that can be
represented by an expected utility function U (·) over lotteries
:
with von Neuman-Morgenstern utility function u (x ) = x.
· Which lottery will this agent choose?
Calculate and compare expected utilities:

U ( L1 ) =
U ( L2 ) =
He’ll choose lottery
Again the same lotteries L1 and L2 .
What if expected value maximizer?
E ( L1 ) =
E ( L2 ) =
He would have chosen lottery
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Example
Compute the expected utility of the St Petersburg lottery LSP for
two individuals with:expected utility preferences with vNM utility
functions u1 (x ) = x and u2 (x ) = log x.
· Which individual would prefer to receive 5e for sure (L5 )

rather than play the lottery LSP for free?

· U1 (LSP ) =
· U1 ( L 5 ) =
· Individual 1 prefers
· U2 (LSP ) =
· U2 ( L 5 ) =
· Individual 2 prefers
Example
· Which individual would prefer to receive 5e for sure

(L5 = ï1|5ð) rather than play the lottery LSP for free?

· U1 (LSP ) j 2.41
· U1 (L5 ) j 2.24
· Individual 1 prefers LSP .
· U2 (LSP ) j 1.39
· U2 (L5 ) j 1.61
· Individual 2 prefers 5e for sure.
Who seems to be more risk averse?
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Example
· Which individual would prefer to receive 5e for sure

(L5 = ï1|5ð) rather than play the lottery LSP for free?

· U1 (LSP ) j 2.41
· U1 (L5 ) j 2.24
· Individual 1 prefers LSP .
· U2 (LSP ) j 1.39
· U2 (L5 ) j 1.61
· Individual 2 prefers 5e for sure.
Who seems to be more risk averse? Individual 2.
Preference representations
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A few more details about preferences and utility functions
Let X be a set of alternatives.

A preference relation over the set X is a binary relation over X .
Let X , Y * X be two alternatives.
· If X ° Y , we say X is weakly preferred to Y .
· If X { Y we say that X is strictly preferred to Y .
· If X > Y we say X is indifferent to Y .
Recall that X ° Y and Y ° X implies X > Y , and X { Y means
X ° Y but not Y ° X .

Let X be a set of alternatives.
· The preference relation ° defined on X is complete, if, for
any two alternatives X , Y * X , we have either X ° Y ,
Y ° X or both.
· We say ° is transitive, if, for any three alternatives,
X , Y , Z * X , we have that X ° Y , Y ° Z implies X ° Z .
Suppose X is now the set L of lotteries over monetary outcomes.

· We say ° defined on L satisfies the Independence Axiom, if
for any three lotteries L, L2 , L22 * L and for any α * [0, 1] a
probability, we have that, if L ° L2 , then we also have:
αL + (1 2 α)L22 ° αL2 + (1 2 α)L22 .
vNM preferences are preferences on L that are complete,

transitive, “continuous” and satisfy the Independence Axiom.
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A utility function U : X ³ R represents ° if, for any two

X , Y * X , we have X ° Y ñó U (X ) g U (Y ).
If U (·) represents °, then, for any two alternatives X , Y * X :
· X weakly preferred to Y ñó U (X ) g U (Y ).
· X strictly preferred to Y ñó U (X ) > U (Y ).
· X indifferent to Y ñó U (X ) = U (Y ).
Representations of vNM Preferences are not unique
· If U and V represent preferences over lotteries with vNM

utility functions over monetary outcomes u and v respectively,
where v (x ) = αu (x ) + β with α > 0, then U and V
represent the same preferences.
· That is, U (L) g U (L2 ) if and only if V (L) g V (L2 ), for any
two lotteries L and L2 .
Remark: a function of the form f (z ) = αz + β, with α > 0, is
called a positive affine transformation.
· An expected utility function U (·) representing vNM
preferences is determined up to positive affine transformations.
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Proof.
L L2 ñó U (L) g U (L2 )
õ
m n
∑ p i u ( xi ) g ∑ pi2 u (xi2 )
i =1 i =1
õ ( α > 0)
m n
α ∑ pi u (xi ) + β g α ∑ pi2 u (xi2 ) + β
i =1 i =1
õ
m n
∑ p i v ( xi ) g ∑ pi2 v (xi2 )
i =1 i =1
õ
V (L ) g V (L2 )
Application: freedom to choose the origin and unit of

measure for utility function u
Suppose some individual has preferences that can be represented

1
by function u with u (x ) = 10 2 x + 1 . We’d like to have a utility
representation such that w (0) = 0 and w (10) = 1. (We’ll see
later why we could be interested in this!)
Method 1
· Check with u:
1
u (0) = 10 2 = 9.
0+1
³ u isn’t satisfactory.
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· Construct v subtracting 9 from u:
1 x
v (x ) = u (x ) 2 9 = 1 2 = .
x +1 x +1
· The new function represents the same preferences (why?) and

satisfies our 1st condition since v (0) = 0+0 1 = 0.
· But it still doesn’t satisfy the 2nd condition since v (10) = 10

11 .
³ v isn’t satisfactory.
· Construct a new w dividing v by 10

11 :
11 11x
w (x ) = v (x ) = .
10 10(x + 1)
· The function obtained represents the same preferences and is

satisfactory since w (0) = 10(00+1) = 0 and
×10
w (10) = 1011(10 +1)
= 1.
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Method 2:
Let us write w (x ) = αu (x ) + β so that w (to be determined) will
represent the same preferences as u (assuming that α > 0).
Now find α and β such that
0 = w (0) = αu (0) + β = 9α + β = 0
1
1 = w (10) = αu (10) + β = α(10 2 ) + β
11
This system of 2 linear equations with two variables α and β has a
11
unique solution: α = 10 and β = 2 99
10 . Hence,
11 99 11x
w (x ) = u (x ) 2 = .
10 10 10(x + 1)
Since α > 0, w is a positive affine transformation of u. So, w
represents the same preferences as u. And of course, by
construction, it satisfies the two conditions w (0) = 0 and
w (10) = 1.
Estimation of the utility function U: The Investor Example
An investor has to choose between two risky projects. You are a

consultant. You have information about the profit levels in four
different scenarios. You obtain an estimation of the probabilities of
every outcome:
Retail store Oil well

Probability Wealth Probability Wealth
0.021 200 0.830 200
0.410 160 0.005 160
0.559 130 0.001 130
0.010 60 0.164 60
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Should the expected profits be used?
We have to choose between two lotteries
whose expected values (expected profits) are
E (L) = 0.021 × 200 + 0.41 × 160 + 0.559 × 130 + 0.01 × 60 = 143.07

E (L2 ) = 0.83 × 200 + 0.005 × 160 + 0.001 × 130 + 0.164 × 60 = 176.77
The oil well L2 should be chosen if the investor is risk neutral. Yet,
you should check his attitude toward risk before giving any advice.
How to estimate the utility function U?

· Set of consequences/outcomes is C = {60, 130, 160, 200}.
· We have to assign a utility number to each outcome.
· Fix the utility of the best and worst consequences (why can
we do this?!):
u (60) = 0
u (200) = 1
· Now we assess the utility of the remaining consequences by

means of the so-called reference lottery which has the best
and worse outcomes as possible consequences:
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Assessing the utility of 160e
· Ask your client: what is the probability p that makes 160e
with certainty indifferent to the reference lottery?
· Suppose that the answer is p = 0.05.

· In that case, we know that lotteries L and L0.05 must have the
same expected utility, that is
u (160) = 0.05u (60) + 0.95u (200) = 0.05 × 0 + 0.95 × 1 = 0.95,
from which it follows that the utility of 160e is 0.95.
Of course, different people could have given different

answers and hence would have different utilities!
Assessing the utility of 130e
· Now we ask what is the probability p that makes 130e with

certainty indifferent to the reference lottery.
· Suppose that the answer is p = 0.15 (why larger than
p = 0.05?).
· In that case we obtain
u (130) = 0.15u (60) + 0.85u (200) = 0.15 × 0 + 0.85 × 1 = 0.85
from which it follows that the utility of 130e is 0.85.
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The estimated vNM utility function
Euros 60 130 160 200
Utility 0 0.85 0.95 1
The optimal investment decision
The best investment opportunity is the one with higher expected

utility. Using the vNM utility function u (·) that we just estimated,
we can now compute the expected utility U (·) of both lotteries:
U (L) = 0.021u (200) + 0.41u (160) + 0.559u (130) = 0.88565

U (L2 ) = 0.83u (200) + 0.005u (160) + 0.001u (130) = 0.8356
³ The retail store investment is better than the oil well.
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Summary of decision-making “recipe”
1. Identify set of actions, states of nature, and outcomes (no

model can exactly reproduce the real world, so we need to
make simplifying assumptions to reduce the problem to what’s
really important);
2. uncover preferences over outcomes and translate them into

utilities;
3. assess probabilities of each state of nature;
4. calculate expected utility of each action and choose the action

that maximizes expected utility.
A graphical analysis of expected utility
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Expected Utility in a Graph
L = ïα, 1 2 α | x1 , x2 ð
remember: 0 f α f 1 (α is a probability)
Steps to determine graphically the expected utility

1. Represent the lottery on the horizontal axis, that is, the
outcomes of the lottery, x1 and x2 , and its expected value,
E (L).
2. Draw a vertical line starting from each of the two outcomes,

x1 and x2 , until you hit the graph of the utility function (let’s
call these points A and B).
3. Draw the linear segment from A to B.
4. From the point E (L) on the horizontal axis draw a vertical

line until it hits the line segment AB. The height of this line
is the expected utility U (L) of lottery L.
Important note: If you have two points, A and B, say, A = (1, 1) and B = (3, 4), then
C = 13 A + 23 B = ( 37 , 39 ) j (2.33, 3). If you draw A, B, C , you can see that C is on the
line between A and B, from A it’s 2/3 of the way towards B. Draw this!
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Example of a graphical analysis
Initial Wealth and Investment
· an investment project can yield a profit of 40 if things go well
and a loss of 20 if things go wrong
· a long experience with projects of this type show that they fail
one out of three times
· initial wealth of the investor ω = 30
· utility function u is
Should he invest?
· compare 2 lotteries: invest (L) and not invest (H )
· remember to add the initial wealth to the outcomes of each
lottery (level of final wealth may be important to investor)
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Investor should
Exercise: same preferences, but richer investor: ω = 60
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Investor should
Where are we going?


NEXT we turn to the following:

· Attitudes towards risk: risk averse / neutral / loving
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Certainty Equivalent
Certainty Equivalent
The certainty equivalent of a lottery L is the amount of money

C (L) such that the agent is indifferent between having C (L) and
participating in L.
u [C (L)] =p u (x ) + (1 2 p ) u (x 2 )
ô C (L) =u 21 [p u (x ) + (1 2 p ) u (x 2 )]
In particular, we have that:
U (L) = U (ï1 | C (L)ð) = 1 · u (C (L)) = u (C (L)).
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Graphical representation of the certainty equivalent
Take p = 1/2.
Graphical representation of the certainty equivalent
Take p = 1/2.
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Example of computation of a certainty equivalent
Suppose your vNM utility function is u (x ) = x 0.62 .
· Consider the lottery L = ï 12 , 21 | 20, 280ð.
· What is your certainty equivalent C (L) for this lottery?

Recall the formula for the certainty equivalent:
u [C (L)] = p u (x ) + (1 2 p ) u (x 2 )
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Recall the formula for the certainty equivalent:
u [C (L)] = p u (x ) + (1 2 p ) u (x 2 )
· Which in general implies:
C (L) = u 21 [U (L))] = u 21 [p u (x ) + (1 2 p ) u (x 2 )]
· And in this case:

1/0.62
1 0.62 1
C (L) = 20 + 2800.62 = 121.968.
2 2
Different attitudes towards risk
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Attitudes towards risk
With expected utility there are three types of risk attitudes.

· Risk neutral
· Risk averse
· Risk loving.
Attitudes towards risk

· Risk neutral
· Risk averse
· Risk loving.
But how should we define or distinguish them?
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Actuarially equivalent lotteries
· Two lotteries are called actuarially equivalent if they have
the same expected value.
· Given a lottery L, let L7 denote the degenerate lottery that
gives with certainty (probability 1) the expected value of L.
E (L) = pb + (1 2 p )d = E (L7 )
Attitude towards risk (risk averse/neutral/loving) is

determined by the reaction of the individual when comparing two
lotteries with the same expected value: a risky lottery L and its
actuarially equivalent degenerate lottery L7 (with no risk).
Risk Neutral
· A decision maker is said to be risk neutral if he is always
indifferent between the uncertain lottery L and the actuarially
equivalent certain lottery L7 .
· A decision maker is risk neutral if and only if his vNM utility
function u is linear.
Proof.
Compare the expected utilities of L and L7 :
U (L7 ) = u (pb + (1 2 p ) d ) = pu (b ) + (1 2 p ) u (d ) = U (L)
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Risk Averse
· A decision maker is said to be risk averse if he always prefers
the certain lottery L7 to the actuarially equivalent uncertain
lottery L.
· A decision maker is risk averse if and only if his vNM utility
function u is strictly concave.
Proof.
Compare the expected utilities of L and L7 :
U (L7 ) = u (pb + (1 2 p ) d ) > pu (b ) + (1 2 p ) u (d ) = U (L)
Risk Loving
· A decision maker is said to be risk loving if he always prefers

the uncertain lottery L to the actuarially equivalent certain
lottery L7 .
· A decision maker is risk loving if and only if his vNM utility
function u is strictly convex.
Proof.
Homework.
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Summary of ttitudes towards risk
· Risk neutral (linear u (·))
· Risk averse (strictly concave u (·))
· Risk loving (strictly convex u (·)).
Summary of attitudes towards risk
risk averse ô L7 { L ô u strictly concave

risk neutral ô L7 > L ô u linear
risk loving ô L { L7 ô u strictly convex
If u is differentiable, then concavity/convexity depends on the sign

of the second derivative:
u 22 (x ) < 0 ô risk
u 22 (x ) = 0 ô risk
u 22 (x ) > 0 ô risk
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Certainty equivalent and risk aversion
The relation between the certainty equivalent and the expected
value of a lottery characterizes the attitude towards risk:
risk averse ô C (L) < E (L) for all L

risk loving ô C (L) > E (L) for all L
risk neutral ô C (L) = E (L) for all L
Proof.
Risk aversion means that
2 2

p u (x ) + (1 2 p ) u (x ) < u p x + (1 2 p ) x
or, equivalently,
u 21 [pu (x ) + (1 2 p )u (x 2 )] < px + (1 2 p )x 2 .
Experiment on Risk Attitudes

You were presented with various choices (9) which basically amounted to choosing
between Options A and B below:
We record when subjects switch from preferring an A-lottery to preferring a B-lottery.

The earlier (= smaller number N) the switch the more risk averse the subject.
Risk averse if switch at 1-7; risk loving if switch at 8-9
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The outcomes for Group T1 were:

The outcomes for Group T3 were:
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And graphically, for both groups the outcomes were:
Where are we going?

· Attitudes towards risk: risk averse / neutral / loving
NEXT we turn to the:

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Applications
Applications
· Application 1. Buying and selling risky assets

· Application 2. Insurance contracts
· Application 3. Optimal portfolio
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Application 1. Buying and selling risky assets
Application 1. Buying and selling risky assets

Setup and two questions
· A risky asset yields 12 with probability 0.25 and 0 otherwise.

:
· An individual with utility u (x ) = x has wealth ω = 4.
We consider two questions:

1. If the individual owns the risky asset, at what price would he
be willing to sell it?
2. If the individual does not own the risky asset, at what price
would he be willing to buy it?
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Determining the selling price
· There are two alternatives: “not sell” and “sell”.
· If x denotes the selling price (to be determined!), the two

alternatives can be represented by the lotteries
· He will sell if U (L2 ) g U (L1 ).
· The expected utility of not selling is
1 3 1: 3: 5
U ( L1 ) = u (16) + u (4) = 16 + 4= .
4 4 4 4 2
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· The agent will sell for a price x if it gives him an expected

utility U (L2 ) g 25 .
· Hence, the minimum price to make him sell is the solution to

: 5
U ( L2 ) = u ( 4 + x ) = 4+x = .
2
· Solving the equation we get x = 2.25.
· So, the minimum price at which he is willing to sell is 2.25.
Determining the buying price

· Assume the individual does not own the risky asset and wants to
determine whether he should buy it.
· We have to compare two lotteries: “buy at price y ” (L3 ) and “not
buy” (L4 ).
· Compute the expected utilities

1: 3: :
U ( L3 ) = 16 2 y + 4 2 y and U (L4 ) = 4 = 2.
4 4
· The individual will be willing to buy as long as the price y is such
that U (L3 ) g U (L4 ).
· We obtain the maximum buying price solving the equation
1: 3:
16 2 y + 4 2 y = 2. (How do you solve this?)
4 4
· The solution is y = 1.9868, less than the selling price. Why?
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Buying and selling a risky asset – risk averse
Recall:
· The risky asset can be written as L = ï 14 , 43 | 0, 12ð.
:
· The individual has utility u (x ) = x and wealth ω = 4.
· Let ps denote the selling price and pb the buying price.
We obtained ps = 2.25 and pb = 1.98.
4
p s =2.25, p b =1.98 L 1 =+0.25,0.75|4,16+
3
U(L 1 ) u(x)=x 0.5
2
u(4+ps )
U(L 3 ) u(4)
1 L 3 =+0.25,0.75|4-p b ,16-p b +
5 10 15 20
Note that ps = 2.25 > 1.98 = pb and both are < E (L) = 3.
Buying and selling a risky asset – risk neutral

Recall:
· Again, the risky asset is L = ï 41 , 43 | 0, 12ð.
· The individual now has utility u (x ) = x and wealth ω = 4.
We now obtain ps = 3 and pb = 3.
15 L 1 =+0.25,0.75|4,16+
p s =3, p b =3
10 u(x)=x
u(4+ps )
U(L 1 )
u(4)
5
U(L 3 )
L 3 =+0.25,0.75|4-p b ,16-p b +
0 5 10 15 20
Note that ps = 3 = pb = E (L).

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Buying and selling a risky asset – risk loving
Recall:
· Again, the risky asset is L = ï 41 , 43 | 0, 12ð.
· The individual now has utility u (x ) = x 1.2 and wealth ω = 4.
We now obtain ps = 3.33 and pb = 3.68.
35
30 p s =3.33, p b =3.68
25 L 1 =+0.25,0.75|4,16+
20 u(x)=x 1.2
u(4+ps )
15
U(L 1 ) u(4)
10
U(L 3 )
5
L 3 =+0.25,0.75|4-p b ,16-p b +
5 10 15 20
Note that now ps = 3.33 < 3.68 = pb and both are > E (L) = 3.
Experiment on buying and selling a risky asset
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Experiment on buying and selling a risky asset
Note: In both groups the average selling price is significantly higher

than the average buying price.
Application 2. Insurance contracts
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Application 2. Insurance contracts
· An insurance contract is a contract in which the insured pays
a relatively small and certain fee (premium) to the insurer in
exchange for the insurer’s promise to compensate the insured
in case of an uncertain event that causes financial/personal
loss (accident, robbery, fire, death, etc.).
· The contract establishes the premium the insurer has to pay
and the compensation x paid by the insurer.
· The insurance contract is a contract of transfer of risk: the
insurance company accepts the insured’s risk in exchange for
the premium. When the contract includes an excess
(franquicia), part of the risk remains in the hands of the
insured individual.
· The insurance mechanism doesn’t change the risk probabilities
or consequences.
Insurance: Notation
ωg0 initial wealth
0fd fω loss
p probability of fire
x fd compensation in case of fire
s price of a unit of insurance
Insurance as a lottery:
This gives a family of insurance contracts, Lx , one for each level of

compensation x (where x * [0, d ]).
x
Note: We also use the notation Lz where z = d * [0, 1].
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Full and partial insurance
Given a family of insurance contracts, Lx (x f d).

· If x = 0 we get the no insurance case as represented by
lottery L0 .
· If x = d we get full insurance as represented by a riskless
lottery Ld : the payoff is always ω 2 s d.
x
Note: When using Lz where z = d * [0, 1], we have L0 and L1 .
The optimal insurance contract
Given all the other variables, the economic agent has to choose the
level of insurance x that maximizes expected utility
max f (x ) = p u (ω 2 d 2 sx + x ) + (1 2 p ) u (ω 2 sx )
x
s.t. 0fx fd
The first order condition for an interior maximum is

p (1 2 s ) u 2 (ω 2 d 2 sx + x ) 2 s (1 2 p ) u 2 (ω 2 sx ) = 0.
An interior solution 0 < x < d means partial insurance.

Often you will get a corner solution with x = 0 (no insurance) or
x = d (full insurance).
· We will come back to this after the next example.
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Insurance contracts: a numerical example
An industrial plant is worth 1.000.000e. The probability of a fire is

1 per thousand. If there is a fire the plant has a residual value of
400.000e. The attitude towards risk of the owner is summarized
by a von Neumann-Morgenstern utility function
10.000.000
u (x ) = 100 2 .
x
We ask two questions:
1. Would the entrepreneur accept to pay 1.200e for a full
insurance contract to cover the risk of fire?
2. Is that contract attractive for a risk neutral insurance
company?
Insurance contracts example: the two alternatives

For both agents (plant owner and insurance company) we
compare the initial situation of no insurance (x = 0; z = 0) with
the situation of full insurance contract (x = d; z = 1).
The initial situation for the plant owner and the insurance
company can be described by lotteries L0 and B0 , respectively.
If they agree on the full insurance contract their situation is

described by lotteries L1 and B1 , respectively.
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Full insurance contract example: solution
Assume the insurance company is risk neutral so that its expected
utility equals expected value. It decides between B0 and B1 .
E ( B0 ) = 0
E (B1 ) = 600e
³ The expected utility (=value) for the insurance company is

higher with the insurance contract (B1 { B0 ).
The plant owner has the above utility function u (x ) and decides
between L0 and L1 . Computing the expected utility we get:
U (L0 ) = 0, 999 u (1.000.000) + 0, 001 u (400.000) = 89, 985
U (L1 ) = u (998.800) = 89, 988
³ The expected utility for the plant owner is higher with the
insurance contract (L1 { L0 ).
Full insurance: plant owner’s decision (graphical)

Recall:
· No insurance corresponds to the risky asset:
L0 = ï0.001, 0.999 | 400, 1000ð (in 1,000s of euros).
· Insurance company offers full insurance at pI = 1200.
· Full insurance corresponds to safe asset L1 = ï1 | 998.8ð.
100
90 U(L 1 ) -- with full insurance
U(L 0 ) -- without insurance
80 u(x)=100- 10.000
x
u(1000-pI )=U(L1 )
70
U(L0 )
60
U(L 1 ) > U(L 0 )
0 200 400 600 800 1000
· Note that U (L1 ) > U (L0 ).

· Plant owner prefers to buy the full insurance at 1200e.
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UPF, Introduction to Game Theory, Winter 2024 Topic 1, Slide100
Partial insurance: plant owner’s decision (graphical)
Recall:
L0 = ï0.001, 0.999 | 400, 1000ð (in 1,000s of euros).
· Insurance company offers partial insurance at pI = 1.2 · z, where
z = dx is the fraction of 600 insured (so that s = 1.2/600 = 0.002).
· Lz = ï0.001, 0.999 | 400 + 600z 2 1.2z, 1000 2 1.2z ð for 0 f z f 1.
U(L 1/2 ) -- with 1/2 insurance
88.9
f(x) = 0.001u(400+(1-s)x)+0.999u(1000-sx)
j
88.8
U(L 1 ) -- with full insurance 1.8033*10^10+4.4965*10^7 x-100 x 2
2.0040*10^8+499599.1984 x-x 2
88.7
U(L1/2 )
U(L1 )
88.6
U(L0 )
88.5
x = amount insured
0 100 200 300 400 500 600
· The optimal partial insurance contract is at:

z 7 = 1/2 that gives L1/2 = ï0.001, 0.999 | 700 2 0.6, 1000 2 0.6ð.
· The plant owner prefers to insure half the loss (x 7 = 300) at 600e.
Partial insurance contract: plant owner’s decision

Recall:
L0 = ï0.001, 0.999 | 400, 1000ð (in 1,000s of euros).
· The optimal partial insurance contract is at z 7 = 1/2 and yields
expected utility U (L1/2 ) > U (L1 ) > U (L0 ).
100
90 U(L 1/2 ) -- with 1/2 insurance

u(x)=100- 10.000
80 x
u(1000-pI )=U(L1 )
70 U(L0 )
U(L1/2 )
60
U(L 1/2 ) > U(L 1 ) > U(L 0 )
0 200 400 600 800 1000
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Recall:
L0 = ï0.001, 0.999 | 400, 1000ð (in 1,000s of euros).
expected utility U (L1/2 ) > U (L1 ) > U (L0 ), where
· L1/2 = ï0.001, 0.999 | 700 2 0.6, 1000 2 0.6ð.
100

u(x)=100- 10.000
80 x
u(1000-pI )=U(L1 )
70 U(L0 )
U(L1/2 )
60
U(L 1/2 ) > U(L 1 ) > U(L 0 )
0 200 400 600 800 1000

Recall:
L0 = ï0.001, 0.999 | 400, 1000ð (in 1,000s of euros).
expected utility U (L1/2 ) > U (L1 ) > U (L0 ), where
· L1/2 = ï0.001, 0.999 | 700 2 0.6, 1000 2 0.6ð.
92
88 U(L 0 ) -- without insurance

u(x)=100- 10.000
x
86 u(1000-pI )=U(L1 )
U(L0 )
84
U(L1/2 )
82
700 800 900 1000 1100
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Insurance markets
· As we have seen, the possibility of mutually advantageous

contracts is clear when there are differences in the attitude
toward risk. In the previous example the insurance company
was happy to take the risk of the plant owner in exchange for
a certain amount of money. Maybe this does not come as a
surprise since the insurance company was risk neutral.
· So, is it possible to have an insurance market in a society

where all agents are identical and risk averse?
· We shall show that the answer is in the affirmative: identical

risk averse individuals have an incentive to insure each other
and share their risk.
Example: a hunter community

· Suppose that on a small island there are two hunters with
identical vNM utility function
30x
u (x ) =
x +4
where x represents the number of deer.
· It is easily verified that the second derivative is negative
240
u 22 (x ) = 2 <0
(x + 4)3
so that the vNM utility function is strictly concave. Hence,
both hunters are risk averse.
· When an individual goes hunting he gets 2 units of deer.
From time to time (with probability 20%) a hunter gets ill and
cannot go hunting. In that case he gets nothing.
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Solving the hunters’ insurance problem
The lottery L0 represents the situation of a hunter without any
insurance contract.
Suppose now that they decide to insure themselves and share the
risk: if one of them gets ill, they will share what the other gets.
The lottery L1 represents this situation: there are 3 possible
outcomes:
1. With probability 0.64 both are healthy and each gets 2 deer.
2. With probability 0.04 both are ill and both get 0 deer.
3. With probability 0.32 one of them is ill and the other is
healthy. In that case they consume 1 deer each.
Solving the hunters’ insurance problem
Computing the expected utilities we see that it is better for both

to insure:
30 × 0 30 × 2

U (L0 ) = 0.2 × + 0.8 × =8
0+4 2+4
U (L1 ) = 0.04 × 0 + 0.32 × 6 + 0.64 × 10 = 8.32
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Application 3. Optimal portfolio
Application 3. Optimal portfolio
· We have saved an amount of ω = 100e. We consider making

an investment.
· There is a riskless asset H that gives zero returns.
· There is a risky asset L such that:
– if things go well (prob. 35 ) we obtain 40% of profits,
– if things go wrong (prob. 25 ) we lose 50%.
· Suppose we assume vNM preferences with vNM utility

function u (x ) = ln x.
· Should we invest in the risky asset L?
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Comparing the two assets
Let H and L be the two lotteries that result from investing all the
money in one asset.
The expected value of the risky asset is
E (L) = 0.6 × 140 + 0.4 × 50 = 104.
So, the expected return of the risky asset is 4%.

The best asset is the one giving a higher expected utility:
U (H ) = ln(100) = 4.605
U (L) = 0.6 ln(140) + 0.4 ln(50) = 4.529
Hence, it is better not to invest in the risky asset.

Optimal portfolio
Suppose we could also decide to invest only a fraction of our wealth
in the risky asset. There is a whole range of possible portfolios.
· Let z denote the fraction of our wealth that we decide to
invest in the risky asset, and denoting by Lz the lottery we are
confronted with, we get:
· The payment for each state of nature consists of two parts:

– For the favorable state, the first part 100(1 2 z ) represents the
returns of the riskless asset, and the second part 100z (1 + 0.4)
represents the returns of the risky asset.
– For the unfavorable state, similarly, the first part 100(1 2 z )
represents the returns of the riskless asset, and the second
100z (1 2 0.4) the returns of the risky asset.
The portfolios are parametrized by z. What is the best z?
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Solving the optimal portfolio problem
We obtain the optimal portfolio z 7 by solving the following

optimization problem:
max f (z ) = U (Lz ) = 0.6 u (100(1 + 0.4z )) + 0.4 u (100(1 2 0.5z ))

z
s.t. 0 f z f 1.
The first order condition is:

0.24 0.2
f 2 (z ) =
2 = 0.
1 + 0.4z 1 2 0.5z
Solving it we get z 7 = 0.2.
· The optimal portfolio consists in investing 20% of our wealth

in the risky asset.
Solving the optimal portfolio problem
Comparing the three possibilities

specializing in the riskless asset U (H ) = 4.605
specializing in the risky asset U (L) = 4.529
optimal portfolio: diversification U (L0.2 ) = 4.609
we see that the optimal diversification provides higher utility than

specialization.
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Appendix: Preferences without Uncertainty
(Review from Micro I)
Preferences over a finite set of alternatives

Example. You won a weekend trip to a Northern European city!
Survey questions:
· Amsterdam vs Berlin?
· Berlin vs Copenhagen?
· Copenhagen vs Dublin?
· Dublin vs Amsterdam?
· Copenhagen vs Amsterdam?
· Berlin vs Dublin?
A possible answer for each question of X vs Y was of the form:
1: “I prefer X to Y .” (X { Y )
2: “I prefer Y to X .” (Y { X )
3: “I am indifferent betweem X and Y .” (X > Y )
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preference relation
Let X be a set of alternatives – for example list of cities as in survey.

A preference relation over the set X is a binary relation over X .
Let X , Y * X be two alternatives.
· If X ° Y , we say X is weakly preferred to Y .
· If X { Y we say that X is strictly preferred to Y .
· If X > Y we say X is indifferent to Y .
Here X ° Y and Y ° X implies X > Y , and X { Y means X ° Y but
not Y ° X .
Intuitively, you can think of the preference relation as expressing
something similar to the natural order over the real numbers, denoted by
the symbols g, > and =.

complete and transitive preferences
Let X be a finite set of alternatives.

· The preference relation ° defined on X is complete, if, for any two
alternatives X , Y * X , we have either X ° Y , Y ° X or both.
· We say ° is transitive, if, for any three alternatives, X , Y , Z * X ,
we have that X ° Y , Y ° Z implies X ° Z .
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Survey questions:
Possible answers for each question were:
· 1: X { Y , 2: Y { X , 3: X > Y .
Which of the following satisfy transitivity and completeness?
(1, 2, 1, 2, 1, 1), (1, 1, 1, 1, 2, 1), (1, 1, 1, 2, 2, 1), (1, 3, 1, 2, 2, 2), (3, 1, 1, 2, 1, 1).
In a class survey at least 90% were complete and transitive, and less than
10% violated only transitivity.
(1, 2, 1, 2, 1, 1) ñó Copenhagen { Amsterdam { Berlin { Dublin.

Survey questions:
Possible answers for each question were:
· 1: X { Y , 2: Y { X , 3: X > Y .
Which of the following satisfy transitivity and completeness?
(1, 2, 1, 2, 1, 1), (1, 1, 1, 1, 2, 1), (1, 1, 1, 2, 2, 1), (1, 3, 1, 2, 2, 2), (3, 1, 1, 2, 1, 1).
In a class survey at least 90% were complete and transitive, and less than
10% violated only transitivity.
(1, 2, 1, 2, 1, 1) ñó Copenhagen { Amsterdam { Berlin { Dublin.
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ranking and utility function
It can be shown, that if an individual’s preference relation ° over a finite

set of alternatives X is complete and transitive, then the individual can
fully rank the objects in order of preference (allowing for indifference).
· She can assign a real-valued index u (x ) (a level of “utility”) to each
alternative x * X , such that x ° y ñó u (x ) g u (y ).
And vice versa, if she can can assign a real-valued index to each x * X
(or she can fully rank all alternatives in any subset of X ), then her
preferences over X are complete and transitive.
Preferences that are complete and transitive are said to be rational.

Topic 2. Simultaneous Games
Fabrizio Germano
Winter 2024
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Test 1
Test 1 will be done in class on Tuesday, February 6th.
It will be done online through Aula Global and will cover:
· Topic 1 (Decision Theory)

· Topic 2 (Simultaneous Games I)
Everything from these topics will be covered.

Questions will be multiple choice (10 questions).
Seminar sessions and TA’s

Seminars 1-7 take place in weeks 3, 4, 5, 6, 7, 8 and 9.
· In particular, they start this week!
· Seminar participation counts 10% – only active participation!
TA’s are assigned as follows:

G1: Seminar groups 101, 102, 103 (Wednesday in 13.108)
· Amil Camilo Moore (amil.camilo@upf.edu)
G2: Seminar groups 201, 202, 203(Thursday in 13.004)

· Anqi Ye (anqi.ye@upf.edu) (occasionally: Sixuan Li and F. G.)
G3: Seminar groups 301, 302, 303 (Wednesday in 20.059)

· Lara Alper (lara.alper@upf.edu)
G4: Seminar groups 401, 402, 403 (Thursday in 13.006)

· Amil Camilo Moore (amil.camilo@upf.edu)
Seminars 1-6 cover problem sets 1-6 and in seminar 7 you will present
your final projects. Also see the syllabus for more info.
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Preliminaries
We consider simultaneous games defined by the list:
G = (N, (Si )i *N , (ui )i *N )
where:
· N is the set of players
· Si is the set of pure strategies of player i
· ui are utilities of player i.
We assume that N and each Si are finite and the players know G .
Players are utility maximizers with utilities ui .
Preliminaries
G = (N, (Si )i *N , (ui )i *N )
where:
Note: Here, in Topics 2, 3, we only consider pure strategies.
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Preliminaries
G = (N, (Si )i *N , (ui )i *N )
where:
Note: Here, in Topics 2, 3, we only consider pure strategies.
Later, in Topics 4, 5, we also consider so-called mixed strategies, where
players can randomize over pure strategies.
Preliminaries
In general, with n players, a pure strategy profile is a vector

s = (s1 , . . . , sn ) that leads to utilities or payoffs (u1 (s ), . . . , un (s )).
Example. Consider the 2-player game G (battle of the sexes):
1\2 s21 s22
G= s11 4, 2 0, 0
s12 0, 0 2, 4
Players 1 and 2’s payoffs at the profile s = (s11 , s21 ) are:
u1 (s ) = u1 (s11 , s21 ) = 4
u2 (s ) = u2 (s11 , s21 ) = 2.
Note: When writing s21 , we mean player 2’s strategy 1.
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Preliminaries
Sometimes it’s easier or more natural to label strategies by A, B, or
X , Y or other labels, similarly for players.
Example. Consider the 2-player game G (battle of the sexes):
W \H Ballet Boxing
G= Ballet 4, 2 0, 0
Boxing 0, 0 2, 4
Players W and H’s payoffs at the profile s = (Ballet, Boxing ) are:
uW (s ) = uW (Ballet, Boxing ) = 0
uH (s ) = uH (Ballet, Boxing ) = 0.
Note: When writing s = (Ballet, Boxing ) the first entry (Ballet)

is row player’s (W ) and the second is column player’s (H) strategy.
Writing down a game...

What is the Split or Steal game Sarah and Steven are playing?
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Steven \ Sarah Split Steal

GSplitcor cSteal = Split 50, 50 0,100
Steal 100, 0 0, 0
How can you analyze this game? What do you expect people to
play? What are the “equilibria”?

Steven \ Sarah Split Steal

GSplitcor cSteal = Split 50, 50 0,100
Steal 100, 0 0, 0
How can you analyze this game? What do you expect people to
play? What are the “equilibria”?
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Where are we going?
After introducing the setup of simultaneous games, we study how
players might behave, and how we can rationalize their choices.
Key concepts we will learn are:
· Iterated elimination of strictly dominated strategies
· Strictly dominant and strictly dominated strategy
· Iterated elimination of weakly dominated strategies
· Weakly dominant and weakly dominated strategy
· Best response and rationalizable strategies
· Nash equilibrium in pure strategies (Topic 3) and later in

mixed strategies (Topic 5)
The concepts learned here will be used and revisited in the rest of
this class and in other classes in microeconomics, IO and elsewhere.
Iterated Elimination of Strictly Dominated

Strategies
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Strict Dominance
Definition
The strategy si * Si strictly dominates ti ;= si if it gives a strictly
higher payoff than ti against every strategy profile of the opponents:
u i ( s i , s 2 i ) > u i ( ti , s 2 i ) for all s2i * S2i .
When this happens, we say the strategy ti is strictly dominated by si .
Strict Dominance
Definition
Example 1. Consider the following game:
1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2
· Are there any strictly dominated strategies?

Yes, now L strictly dominates R and so R is strictly dominated by L.
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Strict Dominance
Definition
1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2

Yes, L strictly dominates R and so R is strictly dominated by L.
Strict Dominance
1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 0 1, 5 6, 2

No, in particular, R is not dominated by neither L nor M.
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Strict Dominance
1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 0 1, 5 6, 2

No, in particular, R is not dominated by neither L nor M.
Strict Dominance
Definition
The strategy si * Si is strictly dominant if it strictly dominates every
strategy ti * Si with ti ;= si :
u i ( si , s 2 i ) > u i ( ti , s 2 i ) for all ti ;= si and for all s2i * S2i .
Note that si gives player i a strictly higher payoff than any other strategy
of player i no matter what the opponents are playing.
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Strict Dominance
Definition
of player i no matter what the opponents are playing.

1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 6 1, 5 6, 2

Yes, now both M and R are strictly dominated by L.
· Are there any strictly dominant strategies? Yes, L.
Strict Dominance
Definition
of player i no matter what the are opponents playing.

1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 6 1, 5 6, 2

Yes, now both M and R are strictly dominated by L.
· Are there any strictly dominant strategies? Yes, L.
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Iterated Elimination of Strictly Dominated Strategies
Example 4. Consider again the game of Example 1:

1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2
· What is your “predicted” outcome for this game?
Example 4. Consider again the game of Example 1:

1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2
· What is your “predicted” outcome for this game? Strategy R

for player 2 is strictly dominated by L and can be eliminated.
· What else can we do?
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What is your “predicted” outcome for this game? (T , L)
Start with : 1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2
Eliminate R: 1\2 L M R
T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2
Eliminate B (how?): 1\2 L M R

T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2
Eliminate M (how?): 1\2 L M R

T 2, 3 3, 0 0, 1
B 0, 3 1, 5 6, 2
This extends to a general procedure.


Start with:
G = (N, (Si )i *N , (ui )i *N )
Define recursively:
(1)
G (1) = (N, (Si )i *N , (ui )i *N )
where
· Si(1) = set of strategies not strictly dominated for i in G .
· Si \Si(1) = i’s strictly dominated strategies in G .
and further, for any k g 2:
(k )
G (k ) = (N, (Si ) i * N , ( ui ) i * N )
where
· Si(k ) = set of strategies not strictly dominated for i in G (k 21) .
· Si(k 21) \Si(k ) = i’s strictly dominated strategies in G (k 21) .
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Clearly:
(1) (2) (k )
Si § Si § Si § · · · § Si
and since G is finite, there exists K < ∞ such that
(K ) (K +1)
Si = Si = · · · , for all i * N.
(K )
Set Si∞ = Si and G ∞ = (N, (Si∞ )i *N , (ui )i *N ).
Definition
The set Si∞ is the set of (pure) strategies of player i that survive
iterated elimination of strictly dominated strategies (IESDS).
Sometimes we also refer to Si∞ as the set surviving iterated strict
dominance (ISD). In the previous example S1∞ = T and S2∞ = L.
Note: Si∞ does not depend on the order of elimination.

What does IESDS assume about the players’ reasoning?
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S ∞ and Common Knowledge of Rationality
To predict that only strategies in S ∞ will be played, in two-player
games, we need to assume that:
1. Players 1 and 2 are rational.

2. Players 1 and 2 know that both are rational.
3. Players 1 and 2 know that both know that both are rational.
4. Players 1 and 2 know that both know that both know that
both are rational.
..
.
where by rational we mean players maximize (expected) utility
given their information, which here includes knowing the game.
· Extrapolating 1-4 “ad infinitum” defines what is often referred

to as common knowledge of rationality.
· We will come back to this if time permits.
Consider the following prisoner’s dilemma game:

1\2 C D
C 21, 21 210, 0
D 0, 210 29, 29
(1)
Here Si∞ = Si = {D }. (Why?)
What do we need to assume to predict S ∞ = {(D, D )}?
Note: Here the strategies D are strictly dominant for both players, so that the
profile (D, D ) is also what is called a dominant strategy equilibrium (DSE ).
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Consider the following prisoner’s dilemma game:

1\2 C D
C 21, 21 210, 0
D 0, 210 29, 29
(1)
Here Si∞ = Si = {D }. (Why?)
What do we need to assume to predict S ∞ = {(D, D )}?
Note: Here the strategies D are strictly dominant for both players, so that the
profile (D, D ) is also what is called a dominant strategy equilibrium (DSE ).
Prisoner’s Dilemmas – Class Experiment (2022)

Last year’s IGT classes played two prisoner’s dilemma type games:
Here you played: 64% A and 36% B (T1) and 81% A and 19% B (T3).
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Prisoner’s Dilemmas – Class Experiment (2023)
You played the same two prisoner’s dilemma type games:
Dominance Solvability
· If after the iterated elimination of strictly dominated strategies

(ISD) a single strategy profile survives (S ∞ = {s ∞ }), the
game is said to be dominance solvable.
· The profile s ∞ can be a prediction of play in games that do not have a

dominant strategy equilibrium (DSE ).
· However, if there is a (DSE ), then that profile coincides with s ∞ and the
two concepts are “compatible.”
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Iterated Elimination of Weakly Dominated
Strategies
Weak Dominance
Here’s an alternative, weaker notion of dominated strategy.
Definition
The strategy si * Si weakly dominates ti ;= si if it gives a weakly
u i ( s i , s 2 i ) g u i ( ti , s 2 i ) for all s2i * S2i ,
and there is at least one t2i * S2i such that:
u i ( s i , s 2 i ) > u i ( ti , t 2 i ) .
When this happens, we also say ti is weakly dominated by si .

The strategy si * Si is weakly dominant if it weakly dominates every
strategy ti * Si with ti ;= si .
· If si is strictly dominated then it is also weakly dominated but not vice
versa.
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Iterated Elimination of Weakly Dominated Strategies

The notion of weak dominance leads to a procedure analogous to
iterated elimination of strictly dominated strategies (IEDS or S ∞ ),
where strategies that are weakly dominated are eliminated
sequentially.
· The corresponding concept is referred to as Iterated
elimination of weakly dominated strategies (IEWDS or SW ∞ ).
However, although it might eliminate more strategies, it is

problematic since the resulting set SW
∞ is not always uniquely
determined and may depend on the order of elimination.
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The notion of weak dominance leads to a procedure analogous to
iterated elimination of strictly dominated strategies (IEDS or S ∞ ),
where strategies that are weakly dominated are eliminated
sequentially.
· The corresponding concept is referred to as Iterated
elimination of weakly dominated strategies (IEWDS or SW ∞ ).
However, although it might eliminate more strategies, it is

problematic since the resulting set SW
∞ is not always uniquely
determined and may depend on the order of elimination.
Example 1. Consider the game:

1\2 L R
T 1, 1 0, 0
M 1, 1 2, 1
B 0, 0 2, 1

· What is the prediction if we use iterated strict dominance?
· And what if we use iterated weak dominance?
· Are there weakly dominated srategies?
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Consider the same game and start eliminating T :
1\2 L R 1\2 L R
T 1, 1 0, 0 T 1, 1 0, 0
Eliminate T : Eliminate L:
M 1, 1 2, 1 M 1, 1 2, 1
B 0, 0 2, 1 B 0, 0 2, 1

1\2 L R 1\2 L R
T 1, 1 0, 0 T 1, 1 0, 0
M 1, 1 2, 1 M 1, 1 2, 1
B 0, 0 2, 1 B 0, 0 2, 1
· Here the prediction is in {M, B } × {R } with outcomes (2, 1).
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1\2 L R 1\2 L R
T 1, 1 0, 0 T 1, 1 0, 0
M 1, 1 2, 1 M 1, 1 2, 1
B 0, 0 2, 1 B 0, 0 2, 1
· Here the prediction is in {M, B } × {R } with outcomes (2, 1).
Now change the order of elimination and start with B:
1\2 L R 1\2 L R
T 1, 1 0, 0 T 1, 1 0, 0
Eliminate B: Eliminate R:
M 1, 1 2, 1 M 1, 1 2, 1
B 0, 0 2, 1 B 0, 0 2, 1
· Here the prediction is in {T , M } × {L} with outcomes (1, 1).

Recall:
Definition
The pure strategy si * Si is a weakly dominant strategy if
ui (si , s2i ) g ui (ti , s2i ), for all ti * Si , s2i * S2i ,
and there exists at least one t2i * S2i such that:
ui (si , t2i ) > ui (ti , t2i ) for all ti * Si , ti ;= si .
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Recall:
Definition
The pure strategy si * Si is a weakly dominant strategy if
ui (si , s2i ) g ui (ti , s2i ), for all ti * Si , s2i * S2i ,
and there exists at least one t2i * S2i such that:
ui (si , t2i ) > ui (ti , t2i ) for all ti * Si , ti ;= si .
Weak dominance (or also IEWDS) may eliminate the unique Pareto
efficient Nash equilibrium.
1\2 A B 1\2 A B
A 2, 2 0, 2 A 2, 2 0, 2
B 2, 0 1, 1 B 2, 0 1, 1
Iterated weak dominance is nonetheless very widely used in

practice, especially when the various procedures lead to the same
unique outcome.
We will see some examples in class and in the seminars.
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Application: Duel
In Seminar 3 you will discuss a stylized constant sum game version

of a duel that can also be solved using Iterated Dominance
arguments.
Application: Guessing Game (or Beauty Contest Game)
· Choose a real number between 0 and 100 (both included).
· The winner is the player that chooses the number that is

closest to 2/3 the average; in case of a tie all winners share
the prize equally.
· We will come back to this game later in this topic.

· For now, notice it can be solved by Iterated Dominance
arguments.
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Where are we going?
Key concepts we learned are:
· Strictly dominated and strictly dominant strategy
· Weakly dominated and weakly dominant strategy
Next we study:
· Best response and rationalizable strategies
Then we study:
· Nash equilibrium in pure strategies (Topic 3).
IMPORTANT:
· Test 1 will be next Tuesday, February 6, in class.
· It will cover Topics 1 and 2.
· We will do it online through Aula Global.
Rationalizability
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Rationalizability
So far we studied rationalization of choice based on the

idea that rational players do not play strategies that are strictly
(or weakly) dominated.
Invoking what we called common knowledge of rationality we
extended this to iterated deletion of such dominated strategies.
We now explore a related concept based on the idea that players
do not play strategies that are never a best response to some
beliefs about the possible strategies of the opponents.
Best Response
· The basic ingredient in the concept of rationalizability is that

of a best response to some strategy profile of the opponents.
Definition
The pure strategy si * Si is a best response to the strategy
profile of the opponents s2i * S2i if:
ui (si , s2i ) g ui (ti , s2i ), for all ti ;= si .
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Best Response

Definition
· si for player i gives the highest possible payoff against s2i .

· si gives i a payoff that is greater or equal the payoff of any
other strategy ti against s2i .
Best Response

Definition

· The strategy profiles s2i * S2i play the role of player i’s beliefs
about what the opponents might play.
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Rationalizability
Rationalizability is a recursive concept based on three ideas:
· Rational players form beliefs about what other players play.
· They best respond to those beliefs.
· There is common knowledge of rationality.
Rationalizability
Rationalizability is a recursive concept based on three ideas:
· Rational players form beliefs about what other players play.
· They best respond to those beliefs.
· There is common knowledge of rationality.
Definition
The (pure) strategy si * Si is “a best response” if there exists a
strategy profile of the opponents s2i * S2i such that:
ui (si , s2i ) g ui (ti , s2i ), for all ti * Si , ti ;= si .
In words, if it is a best response to some profile s2i * S2i .

Strategy si is “never a best response” if there is no profile s2i
such that si is a best response to s2i .
· The strategy profile of the opponents s2i * S2i is to be seen as player i’s
belief about what the opponents might play.
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Rationalizability
1\2 a b c
x 1, 3 1, 0 2, 3
y 6, 1 0, 4 1, 0
It can be checked that all strategies of players 1 and 2 are best

responses for some profile of the opponent.
In particular:
· Player 2’s strategies a and c are both best responses to the
belief s1 = x.
· But c is weakly dominated for player 2.
The concept of rationalizability does not eliminate the strategy c

while IEWDS does eliminate it.
Rationalizability
1\2 a b c
x 1, 3* 1*, 0 2*, 3*
y 6*, 1 0, 4* 1, 0
It can be checked that all strategies of players 1 and 2 are best

responses for some profile of the opponent.
In particular:
· Player 1’s strategy x is a best responses to belief s2 = b or
s2 = c. Also, y is a best responses to s2 = a.
· Player 2’s strategies a and c are a best response to s1 = x.
Also, b is a best responses to s1 = y .
The concept of rationalizability does not eliminate the strategy c

while IEWDS does eliminate it.
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Rationalizability
Example 2. Consider now the game:

1\2 a b c
x 1, 1 1, 0 2, 3
y 6, 1 0, 4 1, 0
Now player 2’s strategy a is never a best response.

In fact, it can be checked that
· Player 2’s strategy a is not a best response to any belief s1
(whether x or y ) and hence it is never a best response.
· But a is not strictly dominated. (Why not?)
The concept of rationalizability eliminates the strategy a, while

IESDS does not eliminate it (and neither does IEWDS).
Rationalizability
Example 2. Hence if player 2’s strategy a is not rationalizable, then
we can eliminate it and obtain a smaller subgame, in which we can
further check for non-rationalizable strategies:
1\2 a b c
x 1, 1 1, 0 2, 3
y 6, 1 0, 4 1, 0
Now player 1’s strategy y is not rationalizable so we can eliminate it, and
then we can further eliminate player 2’s strategy b.
1\2 a b c 1\2 a b c
x 1, 1 1, 0 2, 3 x 1, 1 1, 0 2, 3
y 6, 1 0, 4 1, 0 y 6, 1 0, 4 1, 0
Finally, the unique rationalizable profile is R = {(x, c )}.
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Rationalizability
Example 2. Hence if player 2’s strategy a is not rationalizable, then
we can eliminate it and obtain a smaller subgame, in which we can
further check for non-rationalizable strategies:
1\2 a b c
x 1, 1 1, 0 2, 3
y 6, 1 0, 4 1, 0
Now player 1’s strategy y is not rationalizable so we can eliminate it, and
then we can further eliminate player 2’s strategy b.
1\2 a b c 1\2 a b c
x 1, 1 1, 0 2, 3 x 1, 1 1, 0 2, 3
y 6, 1 0, 4 1, 0 y 6, 1 0, 4 1, 0
Finally, the unique rationalizable profile is R = {(x, c )}.

· This requires completing the whole elimination process!
Rationalizability
Start again with:
G = (N, (Si )i *N , (ui )i *N )
Define recursively:
(1)
G (1) = (N, (Si )i *N , (ui )i *N )
where now
· Si(1) = set of strategies that are best responses for i in G .
· Si \Si(1) = i’s strategies that are never a best response in G .

and further, for any k g 2:
(k )
G (k ) = (N, (Si ) i * N , ( ui ) i * N )
where
· Si(k ) = set of strategies that are best responses for i in G (k 21) .
· Si \Si(k ) = i’s strategies that are never a best response in G (k 21) .

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Rationalizability
Again:
(1) (2) (k )
Si § Si § Si § · · · § Si
and since G is finite, there exists K < ∞ such that:
(K ) (K +1)
Si = Si = · · · , for all i * N.
(K )
Set Ri = Si .
Definition
The set Ri is set of rationalizable strategies of player i and
R = ×i *N Ri is the set of rationalizable strategy profiles of the
game G .
Note: Again Ri∞ does not depend on the order of elimination.
But does this differ and how does this differ from the set obtained with
iterated strict dominance? In general, Ri ;= Si∞ , because rationalizability
can eliminate strategies that are not strictly dominated (see Example 2).
Limits of Rationalizability
In many cases the concept of rationalizability does not have much

bite. (What are examples?)
· To increase the prediction power of the rationality based
equilibrium concepts seen so far, we invoke a further
assumption: the beliefs have to be correct.
· As we will see, this idea is precisely embodied by the most
important concept in game theory: Nash equilibrium.
Before we turn to that, we first look at some experiments.
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Application: Guessing Game or Beauty Contest Game
· Choose a real number between 0 and 100 (both included).
· The winner is the player that chooses the number that is

closest to 2/3 the average; in case of a tie all winners share
the prize equally.
Why (Keynesian) beauty contest?
In the 1950s in the US, beauty contests were popular in the Sunday
newspapers. Given a series of photos of women, readers were asked to
cast a vote on the most beautiful. Prizes were distributed among the
readers that had voted for the woman that received most votes.
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Why (Keynesian) beauty contest?
”It is not a case of choosing those [faces] that, to the best of one’s
judgment, are really the prettiest, nor even those that average opin-
ion genuinely thinks the prettiest. We have reached the third degree
where we devote our intelligences to anticipating what average opin-
ion expects the average opinion to be. And there are some, I believe,
who practice the fourth, fifth and higher degrees.”
Keynes, General Theory of Employment, Interest and Money, 1936.
Keynes believed that such guessing behavior was at work on the

stock market with people pricing shares not based on what they
think their fundamental value is, but rather on what they think
everyone else thinks their value is, or what everybody else would
predict the average assessment of the value to be.
See also:
· John Kay, “The parable of the ox” Financial Times, 24 July, 2012.
Application: Guessing Game and Iterated Dominance
IEWDS is one possible procedure to solve this game (see PS#2).
· Any number > 66.67 is weakly dominated by 66.67 (= 2/3 of 100).

· All strategies above 66.67 can be eliminated (so S (1) = [0, 66.67]).
W
· Any number > 44.44 weakly dominated by 44.44 (= 2/3 of 66.67).
· All strategies above 44.44 can be eliminated (so S (2) = [0, 44.44]).
W
· etc. etc.
· With multiplicative factor 2/3, key numbers are 67, 44, 30, etc.
∞ = {0}).
· The process continues until all numbers > 0 are eliminated (SW
· The guessing game is dominance solvable.
Note: The version in PS#2 is a discrete version with S = {1, 2, . . . , 100} and with a
different multiplicative factor defining the target average, and so is somewhat different
from the one on these slides (with S = [0, 100]).
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What knowledge of the agents does IEWDS procedure assume?
What knowledge of the agents does IEWDS procedure assume?

Let R denote Rationality and K denote Knowledge. Then:
si > 66.67 weakly dominated by 66.67
R
66.67 g si > 44.44 weakly dominated by 44.44 after deleting (66.67, 100]
R+KR
R+KR+KKR
R+KR+KKR+KKKR
. .
.. ..
si = 0
∞ uniquely surviving srategy.
Common knowledge of rationality!
Note: Strictly speaking, you need to assume a little bit more to eliminate weakly
dominated strategies, e.g., Cautiousness to unexpected behavior.
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Some Behavioral Game Theory
Experimental Evidence
Source: Rosemarie Nagel

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Experimental Evidence
Application: Guessing Game and Level-k Reasoning

In general, the model of k-level reasoning assumes some 0-level for the irrational
players, also referred to as L0-players.
· L0 or level-0 players: these are “random”, “intuitive” or “spontaneous” players.
Then it considers various hierarchical types of players:
· L1 or level-1 players: these best respond to L0.
· etc.
The theory has been used to explain behavior in various lab experiments.
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Application: Guessing Game and Level-k Reasoning
In general, the model of k-level reasoning assumes some 0-level for the irrational
players, also referred to as L0-players.
· L0 or level-0 players: these are “random”, “intuitive” or “spontaneous” players.
Then it considers various hierarchical types of players:
· etc.
The theory has been used to explain behavior in various lab experiments.
In the 2/3-guessing game, we have:

· L0 chooses 50
· L1 chooses 33.33 (= 2/3 of 50)
· L2 choose 22.22 (= 2/3 of 33.33)
· L3 chooses 14.81 (= 2/3 of 22.22)
· etc.
With multiplicative factor 2/3, key numbers are 50, 33, 22, 15, etc.
· This seems to explain some of the main spikes observed in the data.
Application: Guessing Game – Class Experiment (T1-2022)
In the guessing games done in class we have:
Recall:
· L0 chooses 50 (L0), L1 — 33.33 (A), L2 — 22.22 (B), L3 — 14.81 (C)
Applying iterated weak dominance gives:
· One round: 66.67 (D1), Two rounds: 44.44 (D2), Three rounds, four rounds, ...
∞ = S ∞ = 0 (EQ).
· The unique equilibrium prediction is SW
The winner of the actual game said 19 (target was 18.92).
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Recall:
· L0 chooses 50 (L0), L1 — 33.33 (A), L2 — 22.22 (B), L3 — 14.81 (C)
∞ = S ∞ = 0 (EQ).

Recall:
· L0 chooses 50, L1 — 33.33, L2 — 22.22, L3 — 14.81
∞ = S ∞ = 0 (EQ).
The winner of the actual game said 27.3 (target was 26.19).
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Recall:
· L0 chooses 50, L1 — 33.33, L2 — 22.22, L3 — 14.81
∞ = S ∞ = 0 (EQ).

Topic 3. Nash Equilibrium I
Fabrizio Germano
Winter 2024
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Test 1
Test 1 will be done in class on Tuesday, February 6th.
It will be done online through Aula Global and will cover:
· Topic 1 (Decision Theory)

· Topic 2 (Simultaneous Games I).
Everything from these topics will be covered.

Preliminaries
G = (N, (Si )i *N , (ui )i *N )
where:
· A strategy profile s * S = S1 × · · · Sn is usually written as
s = ( s 1 , s 2 , . . . , sn ) .
· ui : S ³ R are utilities of player i.
Note: Here (in Topics 2, 3), we only consider pure strategies.
Later (in Topics 4, 5) we also consider so-called mixed strategies, where
players can choose randomizations over pure strategies.
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Where are we going?
Key concepts we learned were:
· Strictly dominant and strictly dominated strategy
· Weakly dominant and weakly dominated strategy
· Best reponse and rationalizable strategies
Now, we’ll study:
· Nash equilibrium in pure strategies (Topic 3) and later in mixed
strategies (Topic 5)
· Strict Nash equilibrium
We’ll also briefly talk about:
· Risk dominance and strategic uncertainty
The concepts learned here will be used and revisited in the rest of this class and
in other classes in microeconomics, IO and elsewhere.
Nash Equilibrium
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Example
Consider the following game:
1\2 D E F
A 2, 0 0, 3 0, 4
B 0, 0 1, 1 0, 0
C 0, 4 0, 3 2, 0
Example
1\2 D E F
A 2, 0 0, 3 0, 4
B 0, 0 1, 1 0, 0
C 0, 4 0, 3 2, 0
· What would you play as player 1?

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Example
1\2 D E F
A 2, 0 0, 3 0, 4
B 0, 0 1, 1 0, 0
C 0, 4 0, 3 2, 0

What is special about the profile (B, E )?
Example
1\2 D E F
A 2, 0 0, 3 0, 4
B 0, 0 1, 1 0, 0
C 0, 4 0, 3 2, 0

Which strategies are rationalizable?

What strategies survive IESDS? And IEWDS?
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Best Response
· The basic ingredient in the concept of Nash equilibrium is that
of a best response to the opponents’ strategy profile.
Definition
The pure strategy si * Si is a best response to the strategy profile
of the opponents s2i * S2i if:

Best Response
· The basic ingredient in the concept of Nash equilibrium is that
of a best response to the opponents’ strategy profile.
Definition
The pure strategy si * Si is a best response to the strategy profile
of the opponents s2i * S2i if:

Note: We already had this with rationalizability.
· A, B, C and D, E , F were all best responses to some profiles
in the previous example.
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Mutual Best Response – Example
1\2 D E F
A 2, 0 0, 3 0, 4
B 0, 0 1, 1 0, 0
C 0, 4 0, 3 2, 0

· B is a best response to E (Why?)
· E is a best response to B (Why?)

1\2 D E F
A 2, 0 0, 3 0, 4
B 0, 0 1, 1 0, 0
C 0, 4 0, 3 2, 0

Formally:
· For player 1: u1 (B, E ) g u1 (A, E ) and u1 (B, E ) g u1 (C , E ).
· For player 2: u2 (B, E ) g u2 (B, C ) and u2 (B, E ) g u1 (B, F ).
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1\2 D E F
A 2, 0 0, 3 0, 4
B 0, 0 1, 1 0, 0
C 0, 4 0, 3 2, 0

Formally:
Each player best responds to what the opponent actually plays!
Are there other such profiles of mutual best-responses?

1\2 D E F
A 2*, 0 0, 3 0, 4*
B 0, 0 1*, 1* 0, 0
C 0, 4* 0, 3 2*, 0

Formally:
Each player best responds to what the opponent actually plays!
Are there other such profiles of mutual best-responses? No.
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Best Response Correspondence
As mentioned, sometimes there are multiple best responses.

Therefore, we can define the set of best responses of player i,
BRi (s2i ), to the profile of the opponents s2i * S2i :
· BRi (s2i ) = {si * Si | si is a best response to s2i }.
We can also define the map that assigns to each profile of the
opponents s2i * S2i the set of best responses of player i, BRi (s2i ):
· BRi : S2i ³ Si , s2i 7³ BRi (s2i ).
This map is called player i’s best response correspondence (and
not function because it.is not always uniquely defined and so is not
a function in general).
· In some applications, BRi is single-valued and is a function
and is then called i’s reaction function.
Nash Equilibrium
Definition
A strategy profile s = (s1 , . . . , sN ) * S is a Nash equilibrium if,
for every player i * N, si is a best response to s2i (si * BRi (s2i )),
that is, if, for every i * N,
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Nash Equilibrium
Definition
· Or, more compactly:
si * BRi (s2i ) for all players i * N.
Nash Equilibrium
Definition
· Or, more compactly:
si * BRi (s2i ) for all players i * N.
The difference with rationalizability is that in a Nash equilibrium

players are not just playing a best response to some beliefs.
· They are playing a best response to each others’ strategies.
· With two players, they are playing mutual best responses.
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John Nash in Barcelona (November, 2007)
Examples
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Example: Pure Coordination Game
The payoffs are described in the following matrix:
1\2 X Y
X 3, 3 0, 0
Y 0, 0 1, 1
What are the Nash equilibrium profiles?

Are there strictly or weakly dominated strategies?
Example: Pure Coordination Game
1\2 X Y
X 3, 3 0, 0
Y 0, 0 1, 1

· There are two Nash equilibria: (X , X ), (Y , Y ). (Why?)
· No, no strictly nor weakly dominated strategies.
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Example: Battle of the Sexes
Husband
Ballet Boxing
Wife Ballet 4*, 2* 0, 0
Boxing 0, 0 2*, 4*

· There are two Nash equilibria: (Ballet, Ballet ), (Boxing , Boxing ).
· No, again no strictly nor weakly dominated strategies.
The game is a coordination game.
Finding a Nash equilibrium...

Bar scene from the film A Beautiful Mind
What is the game Nash and his friends are playing?
Write a two-player version and find the Nash equilibria?
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Example: Bar scene from the film A Beautiful Mind
The payoffs are described in the following matrix for the two-player case:
1\2 Blonde Brunette A Brunette B
Blonde 0, 0 10, 5 10, 5
Brunette A 5, 10 0, 0 5, 5
Brunette B 5, 10 5, 5 0, 0

Blonde 0, 0 10, 5 10, 5
Brunette A 5, 10 0, 0 5, 5
Brunette B 5, 10 5, 5 0, 0
· There are four Nash equilibria:

(Blonde, Brunette A), (Blonde, Brunette B )
(Brunette A, Blonde ), (Brunette B, Blonde ).
· What is recommended by Nash in the film (that they all choose a
brunette) is precisely not a Nash equilibrium! (Why not?)
At (Brunette A, Brunette B ) and (Brunette B, Brunette A) neither
player is playing a best response!
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Blonde 0, 0 10*, 5* 10*, 5*
Brunette A 5*, 10* 0, 0 5, 5
Brunette B 5*, 10* 5, 5 0, 0
· There are four Nash equilibria:

(Blonde, Brunette A), (Blonde, Brunette B )
(Brunette A, Blonde ), (Brunette B, Blonde ).
· What is recommended by Nash in the film (that they all choose a
brunette) is precisely not a Nash equilibrium! (Why not?)
At (Brunette A, Brunette B ) and (Brunette B, Brunette A) neither
player is playing a best response!
Nash Equilibrium and Strict Nash Equilibrium

Recall:
Definition
for every player i * N, si is a best response to s2i , that is, if for
every i * N,
The following is a more stringent notion of Nash equilibrium.

Definition
A Nash equilibrium s * S is strict if, for every i * N,
ui (si , s2i ) > ui (ti , s2i ), for all ti ;= si .
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Example: Battle of the Sexes Revisited
Consider this version of the Battle of the Sexes game:
1\2 X Y
X 4*, 2* 0, 0
Y 0, 0 2*, 4*
What are the Nash equilibrium profiles? Are they strict?

1\2 X Y
X 4*, 2* 0, 0
Y 0, 0 2*, 4*

There are two Nash equilibria: (X , X ), (Y , Y ).
· 1. Check that (X , X ) is strict:
u1 ( X , X ) > u1 ( Y , X ) , 4 > 0
u2 (X , X ) > u2 (X , Y ), 2 > 0.
Both players strictly better off playing si = X against s2i = X .
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1\2 X Y
X 4*, 2* 0, 0
Y 0, 0 2*, 4*

There are two Nash equilibria: (X , X ), (Y , Y ).
· 1. Check that (X , X ) is strict:
u1 ( X , X ) > u1 ( Y , X ) , 4 > 0
u2 (X , X ) > u2 (X , Y ), 2 > 0.
Both players strictly better off playing si = X against s2i = X .
· 2. Check that (Y , Y ) is strict:
u1 ( Y , Y ) > u1 ( X , Y ) , 2 > 0
u2 (Y , Y ) > u2 (Y , X ), 4 > 0.
Both players strictly better off playing si = Y against s2i = Y .
Nash Equilibrium and Iterated Dominance

Fix a game.
Strict dominance and Rationalizability
· If rationalizability or if the iterated elimination of strictly dominated
strategies leads to a unique profile surviving (R = {s }, S ∞ = {s }),
then that profile is always a Nash equilibrium that is strict.
· Rationalizability and the iterated elimination of strictly dominated
strategies can never eliminate a Nash equilibrium nor a strict Nash
equilibrium.
Weak dominance
· If the iterated elimination of weakly dominated strategies leads to a
unique profile surviving (SW∞ = {s }), then that profile is a Nash
equilibrium, but not necessarily strict.

· The iterated elimination of weakly dominated strategies may
eliminate one or more Nash equilibria from the game, but it never
eliminates a strict Nash equilibrium.
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Example: Split or Steal Revisited
The payoffs are described in the following matrix (in £1000’s):
1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0
1. Check that (Split, Split ) is not a Nash equilibrium:

1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0
· si = Split is not a best response to s2i = Split for both players:
u1 (Split, Split ) s u1 (Steal, Split ), 50 s 100
u2 (Split, Split ) s u2 (Split, Steal ), 50 s 100.
· Both players are strictly better off deviating to Steal if s2i = Split.
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1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0
2. Check that (Split, Steal ) is a Nash equilibrium:

1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0
2. Check that (Split, Steal ) is a Nash equilibrium:
· Both players now are playing a best response:
u1 (Split, Steal ) g u1 (Steal, Steal ), 0 g 0
u2 (Split, Steal ) g u2 (Split, Split ), 100 g 50.
· Neither player has an incentive to deviate.
· (Split, Steal ) is not a strict Nash eq. as player 1’s inequality is not strict:
u1 (Split, Steal ) o u1 (Steal, Steal ), 0 o 0.
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1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0
3. Check that (Steal, Split ) is a Nash eq. but is not strict:

1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0

· This is similar to checking is for (Split, Steal ). (See 2.)
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1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0

4. Check that (Steal, Steal ) is a Nash eq. but is not strict:

1\2 Split Steal
Split 50, 50 0, 100
Steal 100, 0 0, 0

4. Check that (Steal, Steal ) is a Nash eq. but is not strict:
· Both players are playing a best response:
u1 (Steal, Steal ) g u1 (Split, Steal ), 0 g 0
u2 (Steal, Steal ) g u2 (Steal, Split ), 0 g 0.

· Neither player has an incentive to deviate.
· (Steal, Steal ) is not a strict Nash eq. because neither inequality is strict:
u1 (Steal, Steal ) o u1 (Steal, Steal ) 0 o 0.
u2 (Steal, Steal ) o u2 (Steal, Split ), 0 o 0.

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1\2 Split Steal

Split 50, 50 0*, 100*
Steal 100*, 0* 0*, 0*
What does elimination of weakly or strictly dominated strategies imply?

1\2 Split Steal

Split 50, 50 0*, 100*
Steal 100*, 0* 0*, 0*

· There are three Nash equilibria:
(Steal, Split ), (Split, Steal ), (Steal, Steal ).
· Split is weakly dominated for both players (but not strictly!).
· Steal is weakly dominant for both players (again not strictly).
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1\2 Split Steal

Split 50, 50 0*, 100*
Steal 100*, 0* 0*, 0*

Note: Careful with the elimination of weakly dominated strategies.
· It eliminates Split for both players.
· Hence it eliminates two Nash equilibria: (Steal, Split ), (Split, Steal ).
· The unique profile that survives IEWDS (Steal, Steal ) is also a Nash
equilibrium (but also not strict).

1\2 Split Steal

Split 50, 50 0*, 100*
Steal 100*, 0* 0*, 0*

Note: Careful with the elimination of weakly dominated strategies.
· It eliminates Split for both players.
· Hence it eliminates two Nash equilibria: (Steal, Split ), (Split, Steal ).
· The unique profile that survives IEWDS (Steal, Steal ) is also a Nash
equilibrium (but also not strict).
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More Examples
Example: Fishermen’s Dilemma

narrative from environmental evonomics
Consider two fishermen fishing in the same small pond.
They can choose to fish moderately (X ) or to fish a lot (Z ).
1\2 X Z
X 3, 3 1, 4
Z 4, 1 2, 2
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Example: Fishermen’s Dilemma
narrative from environmental evonomics
Consider two fishermen fishing in the same small pond.
They can choose to fish moderately (X ) or to fish a lot (Z ).
1\2 X Z
X 3, 3 1, 4
Z 4, 1 2, 2

· The unique Nash equilibrium is the profile (Z , Z ).
· Yes, the game is solvable by strict dominance.
· The profile of strictly dominant strategies (Z , Z ) coincides with the
Nash equilibrium.
This game also has the structure of a prisoner’s dilemma and is related to
the tragedy of the commons game that we discussed in the first class.
Example: Advertising Game

narrative from industrial organization
Two firms producing similar products. They can choose not to advertise
their product (X ) or to advertise it (Z ).
· Total market worth 6M, advertising campaign costs 1M.
· No extra demand “generated” in aggregate with advertising.
1\2 X Z
X 3, 3 1, 4
Z 4, 1 2, 2

· The unique Nash equilibrium is the profile (Z , Z ).
· Again, the game is solvable by strict dominance.
· This game has the same structure as the prisoner’s dilemma.
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Example: Dove-Hawk Game I – Prisoner’s Dilemma
narrative from biology
Consider two predators competing or fighting for a prey and incurring a
cost from playing a hawkish strategy (Hawk).
· If the both play Dove they share the prey.
· If one plays Hawk and the other Dove, then Hawk gets the prey
and incurs a low cost.
· If both play Hawk they share the prey and both incur the cost of 1.
1\2 Dove Hawk
Dove 3, 3 1, 4
Hawk 4, 1 2, 2
· The unique Nash equilibrium is the profile (Hawk, Hawk ).
· Again, the game is solvable by strict dominance.
· This game has the same structure as the prisoner’s dilemma.
Example: Dove-Hawk Game II – Chicken Game

cost from playing a hawkish strategy (Hawk) but facing an extra cost
when both play Hawk.
and incurs a cost of 1.
· If both play Hawk they each end up with 0.
1\2 Dove Hawk
Dove 3, 3 1, 4
Hawk 4, 1 0, 0
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Example: Dove-Hawk Game II – Chicken Game
cost from playing a hawkish strategy (Hawk) but facing an extra cost
when both play Hawk.
· If both play Hawk they each end up with 0.
1\2 Dove Hawk
Dove 3, 3 1, 4
Hawk 4, 1 0, 0
· There are two Nash equilibria: (Dove, Hawk ), (Hawk, Dove ).
· Both are strict.
Note: This version of the Dove-Hawk game is also called chicken game:
· (Hawk, Hawk ) is not a Nash equilibrium here.
Example: Dove-Hawk Game III – Chicken Game

cost from playing a hawkish strategy (Hawk) but facing an even higher
cost when both play Hawk.
· If both play Hawk they each end up with 21 (serious injuries).
1\2 Dove Hawk
Dove 3, 3 1, 4
Hawk 4, 1 21, 21
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cost from playing a hawkish strategy (Hawk) but facing an even higher
cost when both play Hawk.
· If both play Hawk they each end up with 21 (serious injuries).
1\2 Dove Hawk
Dove 3, 3 1, 4
Hawk 4, 1 21, 21
· There are still two Nash equilibria: (Dove, Hawk ), (Hawk, Dove ).
· Both are strict.
Note: This version of the Dove-Hawk game is still a chicken game:
· (Hawk, Hawk ) is definitely not a Nash equilibrium here!
¡

narrative from (intl.) politics: Catalonia 2017, Cuba 1962 ... Ukraine 2022, 2023
Suppose they face even higher costs when the both play Escalate:
1\2 Give In Escalate

Give In 3, 3 1*, 4*
Escalate 4*, 1* 21, 21
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Give In 3, 3 1*, 4*
Escalate 4*, 1* 21, 21

· Two Nash equilibria: (Give In, Escalate ), (Escalate, Give In ).
· Both are strict.


Give In 3, 3 1*, 4*
Escalate 4*, 1* 21, 21

· Both are strict.
Note: It’s still a chicken game. Many conflicts have this structure.
· (Give In, Give In ) is not a Nash equilibrium. (Why not?)
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Give In 3, 3 1*, 4*
Escalate 4*, 1* 21, 21

· Both are strict.
Note: It’s still a chicken game. Many conflicts have this structure.
· (Give In, Give In ) is not a Nash equilibrium. (Why not?)
· In some cases, there is the possibility to communicate between the two
parties (diplomacy, negotiation etc.). This can contribute to diminishing
the tension and may make the more moderate or cooperative outcome
possible.
· Repetition of the game can also contribute to making cooperation
possible (e.g., the outcome (3, 3)) as we will see in Topic 8.
Example: Stag Hunt Game

Consider two hunters that go hunting together.
Each one can choose to hunt the stag (S) which provides a large and
tasty meal or to hunt the smaller and less tasty hare (H).
1\2 S H
S 5, 5 0, 3
H 3, 0 3, 3
This game is a coordination game.

· There are two Pareto-ranked Nash equilibria (S, S ) and (H, H ).
· Both are strict.
· The lower paying (H, H ) is safe.
· The higher paying (S, S ) requires coordination.
Sometimes when there are multiple equilibria, players face strategic
uncertainty: they are not sure what their opponents will play.
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Strategic Uncertainty and (p, q )-Dominance
Consider again the stag hunt game:
1\2 S H
S 5, 5 0, 3
H 3, 0 3, 3
Suppose you are considering whether to play S, but you are unsure of
whether you opponent will also play S (strategic uncertainty):
· How confident should you be that your opponent will also play S?

1\2 S H
S 5, 5 0, 3
H 3, 0 3, 3
We look for the smallest p * [0, 1] such that, if you believe your opponent
will play S with at least probability p, then you also want to play S.
· Find smallest p such that:
p · 5 + (1 2 p ) · 0 = p · 3 + (1 2 p ) · 3 ó p = 3/5.
Do the same calculation for player 2 to get q = 3/5.

· We say (S, S ) is a ( 35 , 53 )-dominant Nash equilibrium.
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1\2 S H
S 5, 5 0, 3
H 3, 0 3, 3
We look for the smallest p * [0, 1] such that, if you believe your opponent
will play S with at least probability p, then you also want to play S.
· Find smallest p such that:
p · 5 + (1 2 p ) · 0 = p · 3 + (1 2 p ) · 3 ó p = 3/5.
Do the same calculation for player 2 to get q = 3/5.

· We say (S, S ) is a ( 35 , 53 )-dominant Nash equilibrium.

1\2 A B
A 2, 2 0, 2
B 2, 0 1, 1
· What kind of (p, q )-dominance does the Nash eq. (A, A) have?
· What about (B, B )? (Find smallest p and q.)
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1\2 A B
A 2, 2 0, 2
B 2, 0 1, 1
· What kind of (p, q )-dominance does the Nash eq. (A, A) have?
· What about (B, B )? (Find smallest p and q.)
Example 2. Consider an asymmetric stag hunt game:
1\2 S H
S 6, 5 0, 2
H 4, 0 4, 2
· What kind of (p, q )-dominance does (S, S ) have here?

· What about (H, H )? (Always find the smallest p’s and q’s.)

1\2 A B
A 2, 2 0, 2
B 2, 0 1, 1
· What kind of (p, q )-dominance does the Nash eq. (A, A) have? (1,1)
· What about (B, B )? (Find smallest p and q.) (0,0)
Example 2. Consider an asymmetric stag hunt game:
1\2 S H
S 6, 5 0, 2
H 4, 0 4, 2
· What kind of (p, q )-dominance does (S, S ) have here? (2/3, 2/5)
· What about (H, H )? (Always find the smallest p’s and q’s.) (1/3, 3/5)
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Application: Multi-Person Coordination Games
Consider the following coordination game:
· N players have to choose a number from the set {1, 2, . . . , 7}.
· The payoff to a player depends on his number and on the
lowest number chosen as follows:
From: Van Huyck, Battalio, Beil, American Economic Review, 1990.

· What are the Nash equilibria?
· How confident are you that all others choose a number X that
is g the number you choose?
Application: Multi-Person Coordination Games

Consider the following coordination game:
· N players have to choose a number from the set {1, 2, . . . , 7}.
· The payoff to a player depends on his number and on the
lowest number chosen as follows:
From: Van Huyck, Battalio, Beil, American Economic Review, 1990.

· What are the Nash equilibria?
· How confident are you that all others choose a number X that
is g the number you choose?
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Multi-Person Coordination Games – Experiments
Some statistics the two coordination games (A and B) above.
35 35
30 30
25 25
Choices in T1
Choices in T3
20 20
A A
15 15
B B
10 10
5 5
0 0
0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7
X X
· T1:
· Choosing 1: 6 in A and 35 in B
· Average payoff: 0.29 in A and 0.70 in B
· T3:
· Average payoff: 0.42 in A and 0.70 in B

Topic 4. Zero Sum Games
Fabrizio Germano
Winter 2024
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UPF – Introduction to Game Theory, Winter 2024 Topic 4, Slide 1
What would you play?
1\2 A B C
A 2, 2 3, 1 0, 2
B 1, 3 2, 2 3, 2
C 2, 0 2, 3 2, 2
· What would you play as Player 1?

What would you play?
1\2 A B C
A 2, 2 3, 1 0, 2
B 1, 3 2, 2 3, 2
C 2, 0 2, 3 2, 2

· What is the Nash equilibrium?
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Nash equilibrium vs secure payoff
Example 1.
1\2 A B C
A 2, 2 3, 1 0, 2
B 1, 3 2, 2 3, 2
C 2, 0 2, 3 2, 2
· Are the payoffs (2, 2) at (A, A) “secure”?

· Player 1 could get 0 if player 2 plays C . In fact, 0 is his
“secure” payoff if he chooses A.
· How do you evaluate player 1’s and 2’s strategies C ?
· How do you evaluate strategy profile (C , C )?
· What are expected payoffs there?
· Are they “secure”?

Example 1.
1\2 A B C
A 2, 2 3, 1 0, 2
B 1, 3 2, 2 3, 2
C 2, 0 2, 3 2, 2
· Are the payoffs (2, 2) at (A, A) “secure”? No.

· Player 1 could get 0 if player 2 plays C . In fact, 0 is his
“secure” payoff if he chooses A.
· How do you evaluate player 1’s and 2’s strategies C ?
They guarantee a payoff of 2.
· How do you evaluate strategy profile (C , C )?
It’s not Nash but it guarantees a payoff of 2.
· What are expected payoffs there? (2, 2).
· Are they “secure”? Yes!
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Example 2.
1\2 A B
A 9, 10 8, 9.9
B 10, 10 -1000, 9.9

· What is player 1’s guaranteed payoff if he plays his Nash
equilibrium strategy?
· What are player 1’s guaranteed payoff if he plays the other
strategy?
Example 2.
1\2 A B
A 9, 10 8, 9.9
B 10, 10 -1000, 9.9
· What is the Nash equilibrium? (B, A).

· What is player 1’s guaranteed payoff if he plays his Nash
equilibrium strategy? -1000.
· What is player 1’s guaranteed payoff if he plays the other
strategy? 8.
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Some objectives of Topic 4
We analyze games from a different viewpoint than Nash eq.

We ask what sure or expected payoffs can the player guarantee
herself no matter what the opponent is doing.
This leads to the notions of:
· secure strategies
· secure payoffs
· maxminimization procedure.
We start with two player zero-sum or constant-sum games.

We also introduce the notion of mixed strategy.
Maxminimization in pure strategies
The notion of a secure strategy is based on calculating worst case

scenarios.
Fix a two player game G = ({1, 2}, S1 × S2 , (u1 , u2 )).
· The worst payoff that player i can get is always:
Wi (si ) = min ui (si , sj )

s j * Sj
· Wi (si ) gives the lowest payoff player i can get if he selects

strategy si , or, in other words, if he selects si he will get at
least Wi (si ) – regardless of what the other player chooses.
· A security strategy gives player i the best of the worst cases.
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Recall:
Wi (si ) = min ui (si , sj )
sj * Sj
Definition A pure strategy s i * Si is a pure security (or

maxmin) strategy if it solves
max Wi (si ).
si * Si
Player i’s pure security (or maxmin) payoff level (i.e., with pure
strategies) is maxsi *Si Wi (si ).
The security payoff level can also be written as
max Wi (si ) = max min ui (si , sj ). (1)

s i * Si s i * Si sj * S j
A security strategy gives player i the best of the worst cases.

Example 3.
1\2 A B
A 4, 2 0, 6
B 2, 4 6, 0
· The worst payoffs for players 1 and 2 are given by:
W1 (A) = 0, W1 (B ) = 2 and W2 (A) = 2, W2 (B ) = 0
· The pure security strategies are:

· They give pure security payoffs:
· That is, by playing their pure security strategies players 1 and
2 can secure or guarantee themselves payoffs:
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Example 3.
1\2 A B
A 4, 2 0, 6
B 2, 4 6, 0

W1 (A) = 0, W1 (B ) = 2 and W2 (A) = 2, W2 (B ) = 0
· The pure security strategies are:
B for player 1 and A for player 2.
· They give pure security payoffs:
max{0, 2} = 2 for player 1 and max{2, 0} = 2 for player 2.
· That is, by playing their pure security strategies players 1 and
2 can secure or guarantee themselves payoffs:
2 and 2 respectively.
· But can they do better? In some sense, yes.
The pure security strategies just defined correspond to what is

called the maxminimization procedure. The name derives from
the above expression in Eq. (1) above.
This is a “conservative” procedure that gives “guaranteed” payoffs
(sure or expected) no matter what the opponents do.
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So far we have studied maxminimization using pure strategies, but

in many cases, for example, in repeated interactions, players may
have the possibility of randomizing over their strategies.
This can lead to both better and more stable outcomes.
To see this, you can ask:
· What is the security strategy profile played by the two players

in the game above? (B, A).
· Is this a Nash equilibrium? No.
· Is there a Nash equilibrium in the game?
No, not in pure strategies. Though in mixed strategies, yes.
Mixed strategies
We now allow players to randomize over their pure strategies.

· What does this mean?
· Consider again the game above:
1\2 A B
G = A 4, 2 0, 6
B 2, 4 6, 0
As we saw, there is no pure strategy Nash equilibrium.

· In such games the players want to be unpredictable, they do
not want to disclose their actual pure strategy.
· This is where the randomization becomes useful.
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Mixed strategies
1\2 A B
G = A 4, 2 0, 6
B 2, 4 6, 0
Player 1 In this game player 1 could flip a coin and play A half of
the time and B the other half.
· IF player 2 could somehow exactly predict the outcome of 1’s
coin tosses, then 1’s expected payoff is 1. (Why 1?)
· You might be better off with the pure security strategy
calculated above as it would guarantee a payoff of 2.
· BUT if, 1’s randomized strategy is unpredictable, then:

1 1 1 1 1 1 1 1
u1 , ,A = 4 + 2 = 3 and u1 , ,B = 0 + 6 = 3.
2 2 2 2 2 2 2 2
Player 1 can guarantee a higher expected payoff than the one he
could guarantee with his pure security strategy (which was 2).
· Can he do better? No. (Why?)
· What about player 2?
Mixed strategies
1\2 A B
G = A 4, 2 0, 6
B 2, 4 6, 0
Player 2 Suppose player 2 now (secretly) flips a coin and plays A

half the time and plays B the other half.
Then, assuming again that player 1 cannot outguess his coin toss,
his expected payoff would be

1 1 1 1 1 1 1 1
u2 A, , = 2 + 6 = 4 and u2 B, , = 4 + 0 = 2.
2 2 2 2 2 2 2 2
In other words, player 2 now can guarantee an expected payoff of
2, which is what he could guarantee for sure without any coin toss.
· Can he do better?
3 1

Yes, for example, if he plays 4 4 , his expected payoff is 3.
,
· Can he improve on 34 , 41 ? What is the best player 2 can do?

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Mixed strategies
1\2 A B
G = A 4, 2 0, 6
B 2, 4 6, 0
1 1

Could the randomized or mixed strategies above ( 2 2 for player
,
1 and 34 , 41 for player 2) be some kind of Nash equilibrium? Yes!

Are they secure? Yes!
· How can we formalize this?
We first formally introduce the notion of a mixed strategy

(assuming opponents cannot predict the outcomes of the
randomization).
Mixed strategies
Definition
· Si = set of pure strategies of player i (with #Si = Ki ).
· si = (si1 , . . . , siKi ) is a pure strategy of i.
· Σi = set of mixed strategies of player i.
· σi = (σi1 , . . . , σiKi ) is a mixed strategy of i.
· σik * [0, 1] is the probability that σi assigns to sik * Si .
· Σi = is the set of probability distributions over Si .
Formally, for i = 1, 2:
n o
Σi = σi = (σi1 , . . . , σiKi ) * [0, 1]Ki σi1 +···+ σiKi =1 .
In the example above, since for both players we only have two
strategies (Ki = 2), we can write:
Σi = σi = (σi1 , σi2 ) * [0, 1]2 | σi2 = 1 2 σi1 , i = 1, 2.

It can be parametreized by just one variable, σi1 .

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Mixed strategies
The set of mixed strategies of player i is a (Ki 2 1)-simplex:
n o
1 Ki Ki 1 Ki
Σi = σi = (σi , . . . , σi ) * [0, 1] σi + · · · + σi = 1 .
Figure: Simplices of dimension 0, 1, 2, and 3.
· A k dimensional simplex is called a k-simplex.

· It is formed by taking the convex hull of k + 1 points.
· A 0-simplex is a point.
· A 1-simplex is a line segment (between two zero simplices).
· A 2-simplex is a triangle (with three 1-simplices as “faces”).
· A 3-simplex is a tetrahedron (with four 2-simplices as “faces”).
· Etc.
Maxminimization in mixed strategies
We now define the maxminimization procedure with mixed

strategies and calculate security strategies and security payoffs
when players are allowed to use mixed (or randomized) strategies
and where we assume that opponents, though they cannot predict
the outcome of the randomization (whether you toss heads or tail).
Again, the notion of a security strategy is based on calculating the
best worst case scenarios.
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Fix a two player game G = ({1, 2}, Σ1 × Σ2 , (u1 , u2 )).
Players are allowed to use mixed strategies σi * Σi , i = 1, 2.
· The worst expected payoff that player i can get is:
Wi (σi ) = min ui (σi , sj )
s j * Sj
· Wi (σi ) gives the lowest expected payoff player i can get if he

chooses mixed strategy σi , meaning that, if he chooses σi he
will get at least Wi (σi ) – regardless of what the other player
chooses.
· A security strategy gives player i the best of the worst cases.
Notice that the definition of Wi would not change if we allowed

player j to choose σj * Σj instead of just sj * Sj . Why?
Payoffs achieved by player j mixing two strategies, given mixed strategy
σi of player i, are convex combinations of the payoffs achieved with pure
strategies sj , and so the worst payoff already achieved by a pure strategy.

Definition A mixed strategy σi * Σi is a security (or maxmin)
strategy if it solves
max Wi (σi ). (2)
σi *Σi
Player i’s security (or maxmin) payoff level is

v i = maxσi *Σi Wi (σi ).
· The security payoff level can also be written as
v i = max Wi (σi ) = max min ui (σi , sj ) = max min ui (σi , σj ).

σi *Σi σi *Σi sj *Sj σi *Σi σj *Σj
Notice again that none of our definitions change if we allow player

j to choose σj * Σj instead of just sj * Sj . Why? Because Wi
does not change; see above.
The above procedure of deriving the maxmin strategies and payoffs
(Eq. (2)) defines the maxminimization procedure with mixed
strategies.
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Example
Consider the same game as above.
1\2 A B
σ11 = prob. 1 plays A, σ12 = 1 2 σ11 = prob. 1 plays B

A 4, 2 0, 6 σ21 = prob. 2 plays A, σ22 = 1 2 σ21 = prob. 2 plays B
B 2, 4 6, 0

W1 (σ1 ) = min{u1 ((σ11 , 1 2 σ11 ), A), u1 ((σ11 , 1 2 σ11 ), B )}
= min{4σ11 + 2(1 2 σ11 ), 0σ11 + 6(1 2 σ11 )}
1
2 + 2σ11 if σ11 f

= min{2 + 2σ11 , 6 2 6σ11 } = 2
6 2 6σ11 else
W2 (σ2 ) = min{u2 (A, (σ21 , 1 2 σ21 )), u2 (B, (σ21 , 1 2 σ21 ))}
= min{2σ21 + 6(1 2 σ21 ), 4σ21 + 0(1 2 σ21 )}
3
4σ21 if σ21 f

1 1 4
= min{6 2 4σ2 , 4σ2 } =
6 2 4σ21 else
· What is the best guaranteed payoff players can obtain?

Example (cont.)
u1 u2
6 6
5 5
4 u1(Ã1,A) 4 u2(A,Ã2)
3 u1(Ã1,B) 3 u2(B,Ã2)
W1(Ã1) W2(Ã2)
2 2
1 1
Ã11 Ã21
0.2 0.4 0.6 0.8 1.0 0.2 0.4 0.6 0.8 1.0
Figure: Game G : The functions W1 (left) and W2 (right) (these are the
minimum of the red and blue lines) and player 1 and 2’s security strategies
(achieved at the maximum of W1 at σ11 = 21 at which player 1’s payoff is
v 1 = 3 for player 1 and achieved at the maximum of W2 at σ12 = 34 at which
player 2’s payoff is v 2 = 3 for player 2.
The maxminimization procedure with mixed strategies can lead

to better expected outcomes than if we only allow players to use
pure strategies. In some games the maxminimization procedure
may not make sense but in others it does.
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Example (cont.)
Figure: Game G : The saddle point of the game G with the plane u1 = 3.
Player 1’s payoffs are in green (player 2’s payoffs are u2 = 6 2 u1 ). The plane
at u1 = 3 shows the saddle point. Both player 1 and player 2 can guarantee a
payoff of 3. (Player 1 by playing σ1 = ( 12 , 21 ) and player 2 by playing
σ2 = ( 34 , 41 ).)
Example (cont.)
Maximize Wi with respect to player i’s mixed strategies.

· Draw Wi (·) for both players and you will find that the
(mixed) security strategies are to choose σ11 = 21 for player 1
and σ12 = 43
· They give expected security payoffs of W1 21 = 3 for player

3

1 and W2 4 = 3 for player 2.
· In other words, by playing their (mixed) security strategies
players 1 and 2 can secure or guarantee themselves expected
payoffs of 3 and 3 respectively.
· This is better (in expected terms) than what they could do
with pure security strategies.
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Two player zero-sum and strictly competitive games
A class of games where the maxminimization procedure makes a
lot of sense are the so-called strictly competitive games, formally:
Definition A strictly competitive game is a two-player game
where the following holds for any two pure strategy profiles
s, s 2 * S = S1 × S2 ,
u1 (s ) g u1 (s 2 ) if and only if u2 (s ) f u2 (s 2 ).
In other words, if one player is better off, then the other is worse
off.
· Notice that an implication is that in a strictly competitive
game we have for any two pure strategy profiles s, s 2 * S,
u1 (s ) = u1 (s 2 ) if and only if u2 (s ) = u2 (s 2 )
and
u1 (s ) > u1 (s 2 ) if and only if u2 (s ) < u2 (s 2 ).

Some Examples: Which are strictly competitive?
1\2 L R
L 1, 1 0, 0
R 0, 0 1, 1
1\2 A B C
1\2 A B
A 4, 4 3, 1 0, 2
A 9, 10 8, 9.9
B 1, 3 3, 3 3, 2
B 10, 10 -1000, 9.9
C 2, 0 2, 3 2, 2
1\2 A B 1\2 H T
A 4, 2 0, 6 H 1, -1 -1, 1
B 2, 4 6, 0 T -1, 1 1,-1
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A more narrow class, but one that shares a lot of properties in
common with the strictly competitive games are the zero-sum
games.
Definition A two player zero-sum game is a two-player game
where the following holds at any pure strategy profile s * S,
u1 ( s ) = 2 u2 ( s ) .
Or alternatively, u1 (s ) + u2 (s ) = 0; in other words, whatever one
player earns, the other loses.
· A slight generalization are the two player constant-sum games,
where the following holds at any pure strategy profile s * S,
u1 ( s ) + u2 ( s ) = C ,
for some constant C * R. When C = 0 you get back the
zero-sum games.
· Every constant-sum game is strictly competitive but not all
strictly competitive games are constant-sum.
The Minmax Theorem

· Formulated and proved by John von Neumann in 1928,
it’s one of the first results established in Game Theory.
· “As far as I can see, there could be no theory of games [...] without
that theorem [...] I thought there was nothing worth publishing until
the Minmax Theorem was proved.”
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Minmaximization in Mixed Strategies
· The minmax payoff level can be written as
v i = min Bi (σj ) = min max ui (si , σj ) = min max ui (σi , σj ),

σj *Σj σj *Σj si *Si σj *Σj σi *Σi
where
Bi (σj ) = max ui (si , σj ).
si * Si
Note:
· v i is the lowest payoff player i can be forced to accept.

· v i is the highest payoff player i can secure.
· In zero-sum games: v i = v i = v ; in general: v i g v i .
Example (cont.) – minmaximization

1\2 X Y

A 4, 2 0, 6 σ21 = prob. 2 plays X , σ22 = 1 2 σ21 = prob. 2 plays Y
B 2, 4 6, 0
B1 (σ2 ) = max{u1 (A, (σ21 , 1 2 σ21 )), u2 (B, (σ21 , 1 2 σ21 ))}
= max{4σ21 + 0(1 2 σ21 ), 2σ21 + 6(1 2 σ21 )}
3
6 2 4σ21 if σ21 f

= max{4σ21 , 6 2 4σ21 } = 4
4σ21 else
B2 (σ1 ) = max{u1 ((σ11 , 1 2 σ11 ), X ), u1 ((σ11 , 1 2 σ11 ), Y )}

= min{2σ11 + 4(1 2 σ11 ), 6σ11 + 0(1 2 σ11 )}
1
4 2 2σ11 if σ11 f

1 1 2
= min{4 2 2σ1 , 6σ1 } =
6σ11 else
· What is the lowest payoff player i can be forced to accept?
v i = min Bi (σj ) = min max ui (si , σj ) = min max ui (σi , σj ).
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Example (cont.) – minmaximization
u1 u2
6 6
5 5
4 u1(A,Ã2) 4 u2(Ã1,X)
3 u1(B,Ã2) 3 u2(Ã1,Y)
B1(Ã2) B2(Ã1)
2 2
1 1
Ã2X Ã1A
0.2 0.4 0.6 0.8 1.0 0.2 0.4 0.6 0.8 1.0
Figure: Game G : The functions B1 (left) and B2 (right) (these are the
maximum of the red and blue lines) and player 2 and 1’s strategies of forcing
the lowest acceptable payoffs (achieved at the minimum of B1 at σ12 = 43 at
which player 1’s payoff is v 1 = 3 for player 1 and achieved at the minimum of
B2 at σ11 = 21 at which player 2’s payoff is v 2 = 3 for player 2.
The Minmax Theorem

This is one of the first results established in game theory.
Minmax Theorem [von Neumann, 1928] For any two player zero-sum
game there exists a value v * R and mixed strategies, σ1 and σ2 , such
that,
v 1 = u1 ( σ 1 , σ 2 ) = v = 2 u2 ( σ 1 , σ 2 ) = 2 v 2 .
Note: v = v 1 = max min u1 (σ1 , σ2 ) = min max u1 (σ1 , σ2 )

σ1 *Σ1 σ2 *Σ2 σ2 *Σ2 σ1 *Σ1
= min max (2u2 (σ1 , σ2 )) = 2 max min u2 (σ1 , σ2 ) = 2v 2 .

σ2 *Σ2 σ1 *Σ1 σ2 *Σ2 σ1 *Σ1
Or, alternatively stated, there exists a value v * R and mixed strategies, σ1 and σ2 ,
such that,
(i) given player 2’s strategy σ2 , the best possible payoff for player 1 is v
(= v 1 = u1 (σ1 , σ2 ) = maxσ1 *Σ1 u1 (σ1 , σ2 )),
(ii) given player 1’s strategy σ1 , the best possible payoff for player 2 is 2v
(= v 2 = u2 (σ1 , σ2 ) = maxσ2 *Σ2 u2 (σ1 , σ2 )).
There is always a value v such that player 1 guarantees a payoff of

v (= v 1 ) and player 2 guarantees a value of 2v (= v 2 ).
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The Minmax Theorem
· Notice that since u1 = 2u2 we also have,
min max u1 (σ1 , σ2 ) = min max (2u2 (σ1 , σ2 ))
σ2 *Σ2 σ1 *Σ1 σ2 *Σ2 σ1 *Σ1

= 2 max min u2 (σ1 , σ2 ) = 2u2 (σ1 , σ2 ) = v .
σ2 *Σ2 σ1 *Σ1
· Hence, if we define v i = minσj *Σj maxσi *Σi ui (σi , σj ) as the

worst expected payoff level that i can be forced to accept,
then the Minmax Theorem also states that in a zero-sum
game there exists a value v and a mixed strategy profile
(σ1 , σ2 ) at which we have,
u1 (σ1 , σ2 ) = v 1 = v 1 = v and u2 (σ1 , σ2 ) = v 2 = v 2 = 2v .
· The payoffs that players 1 and 2 can guarantee themselves

form a saddle point so that v 1 = v = v 1 and v 2 = 2v = v 2 .
Application: Matching Pennies

Consider the following game
1\2 H T
GMP = H 1, -1 -1, 1
T -1, 1 1,-1
The game does not have an equilibrium in pure strategies but since
it is a zero-sum game it does have a value v .
· What is the value of the game?
· How do yo compute it?
· From the theorem above it suffices to solve player 1’s
maxminimization problem.
· We compute player 1’s worst payoffs:
1
2σ11 2 1 if σ11 f

W1 (σ1 ) = min{1σ11 2 1(1 2 σ11 ), 21σ11 + 1(1 2 σ11 )} = 2
1 2 2σ11 else
· It is easy to check that this function is maximized at σ11 = 12 ,
which leads to an expected payoff for player 1 of 0.
· This is the value of the game.
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Matching Pennies (cont.)
1\2 H T
GMP = H 1, -1 -1, 1
T -1, 1 1,-1
In other words, we have

1 1 1 1 1 1 1 1
0 = u1 , , , = 2 u2 , , ,
2 2 2 2 2 2 2 2
· Both players can guarantee themselves an expected payoff of

0, and this is the best they can do.
· The profile 21 , 21 , 12 , 12 is also the unique Nash

equilibrium in mixed strategies.
Figure: Game GMP : The saddle point of the matching pennies game GMP with
the plane u1 = 0. Player 1’s payoffs are in green (player 2’s payoffs are
u2 = 2u1 ). The plane at u1 = 0 shows the saddle point. Both player 1 and
player 2 can guarantee a payoff of 0.
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the plane u2 = 0. Player 2’s payoffs are in red (player 1’s payoffs are
u1 = 2u2 ). The plane at u2 = 0 shows the saddle point. Again, both player 1
and player 2 can guarantee a payoff of 0.
u1(Ã1,Ã2)
u2(Ã1,Ã2)
v
both players’ payoffs. Player 1’s payoffs are in green and 2’s in red. The plane
at v = 0 shows the value. Both players guarantee a payoff of 0 and are playing
optimally.
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Application: Dominance Solvable Game
1\2 A B
GDS = A 2, -2 1, -1
B -2, 2 0, 0
This game does have an equilibrium in pure strategies and

moreover is solvable by elimination of strictly dominated strategies.
We will check that since it is a zero-sum game it also has a value v .
Application: Dominance Solvable Game

1\2 A B
GDS = A 2, -2 1, -1
B -2, 2 0, 0
This game does have an equilibrium in pure strategies and

moreover is solvable by elimination of strictly dominated strategies.
We will check that since it is a zero-sum game it also has a value v .
· What is the value of the game? v = 1.
· How do yo compute it? Here it’s sufficient to note that player
1’s strategy A strictly dominates strategy B, and so 1 can
guarantee a payoff of 1, while the best player 2 can do is play
B and guarantee 21.
· The following shows that the maxminimization procedure
(though unnecessary in this case) also gives the result.
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Dominance Solvable Game (cont.)
Solve the players maxminimization problems.
· Compute player 1’s worst payoffs:
2
4σ11 2 2 if σ11 f

W1 (σ1 ) = min{2σ11 2 2(1 2 σ11 ), σ11 + 0(1 2 σ11 )} = 3
σ11 else
· This function is maximized at σ11 = 1 (note this is not the

intersection point!) which leads to an expected guaranteed
payoff for player 1 of 1. This is the value of the game.
· Hence, v = 1 = v 1 and v 2 = 2v = 21 by the Minmax Thm.
· But let’s check that v 2 = 2v = 21.
· Compute player 2’s worst payoffs:
W2 (σ2 ) = min{22σ21 2 1(1 2 σ21 ), 2σ21 + 0(1 2 σ21 )} = 21 2 σ21
· This function is maximized at σ12 = 0, which leads to an

expected guaranteed payoff for player 2 of 21.
Dominance Solvable Game (cont.)

In other words, we have:
v 1 = 1 = u1 ((1, 0) , (0, 1)) = 2u2 ((1, 0) , (0, 1)) = 2v 2 .
· Player 1 guarantees a payoff of 1 and player 2 a payoff of 21.

· The profile ((1, 0) , (0, 1)) (= (“A”,“B”)) is the unique Nash
equilibrium of the game (when allowing for mixed strategies).
u1 u2
2 2
1 1
u1(Ã1,A) u2(A,Ã2)
Ã11 Ã21
u1(Ã1,B) u2(B,Ã2)
0.2 0.4 0.6 0.8 1.0 W1(Ã1) 0.2 0.4 0.6 0.8 1.0 W2(Ã2)
-1 -1
-2 -2
Figure: Game GDS : The functions W1 (left)and W2 (right) which are the
minimum of the red and blue lines, and player 1’s security strategy achieved at
the maximum of W1 at σ11 = 1 at which player 1’s payoff is v 1 = 1; and player
2’s security strategy (achieved at the maximum of W2 at σ12 = 0 at which
player 2’s payoff is v 2 = 21.
180 / 339
Application: Military Attack – see also PS #3
Consider the following situation:
· You are a military commander and you have a single plane

which can strike one of three possible targets: A, B, C .
· The enemy has one anti-aircraft missile battery that can be
assigned to one of the targets.
· The number of enemy troops at the three targets is 4, 3 and 2
at A, B, and C respectively.
· If your plane attacks the military target where the anti-aircraft
missile battery is stationed the attack is unsuccessful and
results in zero loss of enemy troops.
· You wish to maximize, and the enemy wishes to minimize, the
expected troop losses. What target will you send your plane
to? A, B, or C ?
How can you formalize such a situation?

Military Attack (cont.)
The situation can be formalized by the following zero-sum game,

where the payoffs are the attacker’s (player 1 or the row player).
1\2 A B C
A 0 4 4
GMA =
B 3 0 3
C 2 2 0
σ11 = prob. 1 plays A, σ12 = prob. 1 plays B, σ13 = prob. 1 plays C = 1 2 σ11 2 σ12

σ21 = prob. 2 plays A, σ22 = prob. 2 plays B, σ23 = prob. 2 plays C = 1 2 σ21 2 σ22
This game does not have an equilibrium in pure strategies.

· How do you compute it?
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From the theorem above it suffices to solve player 1’s
maxminimization problem.
· As we did with the previous examples, we compute player 1’s
worst payoffs (where here: σ1 = (σ11 , σ12 , 1 2 σ11 2 σ12 )):
W1 (σ1 ) = min{u1 (σ1 , A), u1 (σ1 , B ), u1 (σ1 , C )}
= min{0σ11 + 3σ12 + 2(1 2 σ11 2 σ12 ), 4σ11 + 0σ12 + 2(1 2 σ11 2 σ12 ),
4σ11 + 3σ12 + 0(1 2 σ11 2 σ12 )}
= min{2 2 2σ11 + σ12 , 2 + 2σ11 2 2σ12 , 4σ11 + 3σ12 }
· It can be checked that W1 is now defined by three planes, in

fact as the minimum of three planes (see figure below).
· Moreover, these three planes intersect at a unique point at
which they all yield the same best worst payoff.
· This point can be computed by solving:
2 2 2σ11 + σ12 = 2 + 2σ11 2 2σ12 and 2 + 2σ11 2 2σ12 = 4σ11 + 3σ12 ,
3
· This implies σ11 = 13 4 3 4 6
, σ12 = 13

and σ1 = 13 , 13 , 13 .

The following graph shows the three planes defining W1 , defined
respectively by:
2 2 2σ11 + σ12 , 2 + 2σ11 2 2σ12 , and 4σ11 + 3σ12 .

Note that they are plotted for all values of σ11 , σ12 * [0, 1], but in
fact, only the values that also satisfy σ11 + σ12 f 1 are relevant.
Figure: Game GMA : The three planes 2 2 2σ11 + σ12 , 2 + 2σ11 2 2σ12 , and
3 4
4σ11 + 3σ12 defining the function W1 . These intersect at (σ11 , σ12 ) = ( 13 , 13 ).
182 / 339
· It can be checked that the security strategies for the two
players are:

3 4 6 7 5 1
( σ1 , σ2 ) = , , , , , .
13 13 13 13 13 13
· These imply that player 1 can guarantee himself a payoff of
24
v = v 1 = 13 j 1.8 and player 2 a payoff of v 2 = 2v .
Figure: Game GMA : The function W1 (obtained as the minimum

of the
3 4
three planes) and player 1’s security strategy (σ11 , σ21 ) = 13 , 13
24
(achieved at the maximum of W1 ) at which player 1’s payoff is v 1 = 13 .

· It can be checked that player 1 can guarantee himself a payoff
24
of v = v 1 = 13 j 1.8 and player 2 a payoff of v 2 = 2v .
· It can also be checked that the security strategy

3 4 6 7 5 1
( σ1 , σ2 ) = , , , , ,
13 13 13 13 13 13
is the unique Nash equilibrium of the game.
Experiment: In the experiment you did in class, the population

frequencies of choices for Player 1 were:
· T1: (0.36, 0.44, 0.20) ó v1 = 1.72 (2022: (0.18, 0.71, 0.11), v1 = 0.94)
· T3: (0.26, 0.48, 0.14) ó v1 = 1.56 (2022: (0.22, 0.62, 0.16), v1 = 1.20)
Compared with the security strategy

3 4 6
σ1 = , , j (0.23, 0.31, 0.46),
13 13 13
there appears to be a bias in favor of attacking at B (and also A)
and against attacking at C in both groups T1 and T3.
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Application: Penalty Kicks in Soccer
In Seminar 3, you will see an application of the Minmax Theorem
to penalty kicks in soccer.
· Using empirical data from real soccer games and international
tournaments you will compute that the value of a penalty kick
to the team shooting it (in terms of the expected probability
of scoring) is approximately vK j 80%.
England vs. Italy, penalty shootout, UEFA Eurocup final, July 2021
Nash equilibria and the Minmax Theorem – for later!

We have the following relationship for any Nash equilibrium of an arbitrary two
player game.
Proposition Let (σ17 , σ27 ) * Σ1 × Σ2 be a (mixed) Nash

equilibrium for any two player game. Then the payoffs at the
profile (σ17 , σ27 ) satisfy:
ui (σ17 , σ27 ) g v i , for i = 1, 2.
And if, moreover, the game is zero-sum, then we also have:
u1 (σ17 , σ27 ) = v 1 = v 1 = v and u2 (σ17 , σ27 ) = v 2 = v 2 = 2v .
In particular, if the game is zero-sum, then:

· A security strategy profile (σ1 , σ2 ) constitutes a Nash equilibrium.
· A Nash eq. profile (σ17 , σ27 ) constitutes a security strategy profile.
· Both profiles always yield payoffs (v , 2v ) = (u17 , u27 ).
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Nash equilibria and the Minmax Theorem – for later!
The proof of this, which uses the existence of Nash equilibria in arbitrary finite
normal form games, implies the Minmax Theorem when the game is zero-sum.
Proof To see the first statement, notice that from the definition of a mixed
Nash equilibrium,
ui (σi7 , σj7 ) g ui (σi , σj7 ), for any σi * Σi .
By definition of the minimum we also have,
ui (σi , σj7 ) g min ui (σi , σj ), for any σi * Σi .

σj *Σj
Therefore, combining the two, we have,
ui (σi7 , σj7 ) g min ui (σi , σj ), for any σi * Σi ,

σj *Σj
and in particular,
ui (σi7 , σj7 ) g max min ui (σi , σj ) = v i .

σi *Σi σj *Σj
The second statement can be shown by analogous reasoning given that we

have the existence of a mixed strategy equilibrium. ¥
Application: Inspection Game – see PS #4

Consider the following situation.
· Two players: a worker (player 1) and an employer (player 2).
· The employer cannot see whether or not the worker actually works unless
she monitors him.
· The value to the employer of the worker output is 200 if he works and
zero if he does not work.
· The worker’s salary is 100 unless the worker is caught shirking in which
case the worker gets no salary.
· The cost to the worker of working is 50 and the cost to the employer of
monitoring the worker is 10.
· Both players maximize expected value.
The situation can be formalized as follows
1\2 Monitor Not monitor
GI = Work 50, 90 50, 100
Not work 0, -10 100, -100
Will the worker always work? Does the employer have to monitor? This game
does not have a Nash equilibrium in pure strategies and is not zero-sum.
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Inspection Game (cont.)
The security strategies of the players are easily computed as:
σ1 = (1, 0) and σ2 = (1, 0).
The employer always monitors and the worker always works.
However, while for player 1:

v 1 = max min u1 (σ1 , σ2 ) = 50 = u1 (σ1 , σ2 ),
σ1 σ2
for player 2 we have:

v 2 = max min u2 (σ1 , σ2 ) = 210 < 90 = u2 (σ1 , σ2 ).
σ2 σ1
Player 2’s maxmin payoff (= 210) does not coincide with his payoff at the
security strategy profile (= 90).
Moreover, given 1’s security strategy to work, 2 prefers not to monitor.
· The game is not zero-sum and does not satisfy the Minmax Theorem.
· The profile ((1, 0),(1, 0)) or (Work, Monitor ) leads to payoffs of (50, 90)
but is not optimal for both players and hence not Nash.
· There is no pure Nash equilibrium.
· As you show in PS #4, the unique Nash equilibrium is in mixed strategies:
9 1
σNE = (( 10 , 10 ), ( 12 , 21 )) with payoffs (50,80).
Inspection Game (cont.)

u1 u2
100 100
80
50
u1(Ã1,Monitor) u2(Work,Ã2)
60
Ã21
u1(Ã1,Not monitor) u2(Not work,Ã2)
40 W1(Ã1) 0.2 0.4 0.6 0.8 1.0 W2(Ã2)
20 -50
Ã11 -100
0.2 0.4 0.6 0.8 1.0
Figure: Game GI : Player 1 and 2’s maxmin strategies: σ1 = (1, 0)(= Work ) and
σ2 = (1, 0)(= Monitor ) with maxmin payoffs (v 1 , v 2 ) = (50, 210).
Figure: Game GI : There is no saddle point. Maxmin strategies differ from Nash
9 1 1 1
equilibrium, where σ1 = ( 10 , 10 ) and σ2 186
= (/ 339
2 , 2 ) yielding payoffs (50, 80).
Application: Another Non-Zero-Sum Game
· In some games security strategies may make less sense.

· For example, consider the game
1\2 C D
A 1, 0 1, 100
B 0, 0 100, 100
· What are the security strategies here?
Application: Another Non-Zero-Sum Game
· In some games security strategies may make less sense.

· For example, consider the game
1\2 C D
A 1, 0 1, 100
B 0, 0 100, 100
· What are the security strategies here?

· A for Player 1 and D for Player 2 yielding (1, 100).
· But again the game is not zero-sum so that the Minmax
Theorem does not apply and optimality is violated.
· (A, D ) is not a Nash equilibrium!
· The outcome (B, D ) yielding (100, 100) is Nash and seems quite
reasonable.
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Topic 5. Nash Equilibrium II
Fabrizio Germano
Winter 2024
Test 2
Test 2 will be take place on Tuesday, February 27.
It will be done in class online through Aula Global and will cover:
· Topic 3 (Nash Equilibrium I)

· Topic 4 (Zero-Sum Games)
· Topic 5 (Nash Equilibrium II).
Everything from these topics will be covered. Of course we also

assume that you are familiar with Topic 2 (Simultaneous Games I).
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Preparing the Game Projects
Game Project: Identify an interaction as a game!
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Most important for the project:
· Find an interaction that you are interested in analyzing!
· Remember it can be taken from any field or area of life.
· It can but does not have to be taken from economics or business.

Assuming you have identified an interaction you are interested in, what next?
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· You need to specify the game.

Essential elements of a game are:

· players, actions, information, outcomes and utilities/payoffs.
The players, their actions and information are collectively referred to as:
· the rules of the game.
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The modeler’s objective is to use the rules of the game together with the
payoffs to determine the possible “equilibrium outcomes” of the game.
· These give predictions for how the game might be played.
· Ideally you can check whether the predictions match actual play.
Game Project: What are the basic elements of a game?

More specifically...
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First, model the situation of strategic interaction by means of:

Players The agents/individuals that make decisions. Each player’s
objective is to maximize his utility/payoff.
Actions An action or move by a player is a choice she can make. A
player’s action set describes the actions available to her (at a
certain point of the game).
Information What people know when they have to choose an action.


Then, specify:
Payoffs Numerical representation of the agents’ preferences over
outcomes.
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Then, specify:
outcomes.
With all this, analyze the:
Strategies For each player, a complete contingent plan of action.


Then, specify:
outcomes.
Finally, solve for:
Equilibrium For each player, an “optimal” contingent plan.
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Game Project: What is (often) assumed about behavior?

Rationality
· Players have well-defined preferences over all possible outcomes.
· Every player calculates a strategy that best serves (or maximizes) those
preferences.
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Rationality
preferences.
Information, Beliefs, Knowledge and Common Knowledge
· All players have a “common understanding” of the rules of the game.
This includes:
· the list of players;
· the actions and information available to every player;
· the utilities/payoffs of all players for every possible combination of
actions; and
· that every player is rational.

Rationality
preferences.
This includes:
actions; and
Keep in mind that there are important branches of game theory (such as
behavioral game theory) that study bounded rationality in games. This includes
studying the possibility of individuals making errors, having cognitive
limitations, but also the presence of social preferences, etc.
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Nash Equilibrium with a Continuum of Pure
Strategies
Applications: Oligopoly and Industrial Organization

In economics, interactions between firms are often modeled as games
with a continuum of strategies, and the concept of Nash equilibrium is
used prominently to understand firms’ behavior.
Some examples (also discussed in the seminars, in Micro II, etc.) are:
· Cournot games (quantity-setting firms) where the Nash equilibrium
is referred to as the Cournot equilibrium.
· Bertrand games (price-setting firms) where the Nash equilibrium is
referred to as the Bertrand equilibrium.
· Hotelling models (firms choose locations)
· etc.
The theory builds on these to study further games, sequential games, like
the Stackelberg game, entry games, that will be studied in Topic 6.
We now consider briefly games with a continuum of strategies.
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Nash Equilibrium with a Continuum of Strategies
We now allow strategy sets to be continuous, like Xi = [0, 1] or Xi = R + .
· The basic ingredient to the concept of Nash equilibrium remains that of a
best response to the opponents’ strategy.
But with a continuum of strategies:
· We do not consider mixed strategies.
· Player’s best responses will typically be unique (“well-behaved” games) so
we can define best response functions (also called reaction functions).
Definition
The strategy xi * Xi is a best response to the strategy profile of the
opponents x2i * X2i if:
ui (xi , x2i ) g ui (xi2 , x2i ), for every xi2 * Xi .
In “well-behaved” games, this defines a best response function:
fi : X2i ³ Xi , x2i 7³ fi (x2i ) = argmaxxi2 *Xi u (xi2 , x2i ),
also called player i’s reaction function.
A strategy profile x = (x1 , x2 , . . . , xN ) is a Nash equilibrium if:

x i = fi ( x 2 i ) , for every player i = 1, 2, . . . , N.
Application: Duopoly with differentiated products

· Two producers, Apple and Samsung, produce similar but different
products, also called differentiated products.
· The costs for a unit of their product are cA = 20 and cS = 10.
· If they charge prices pA , pS * R + respectively, then:
· Apple faces the following demand for its product:
x A (pA , pS ) = 240 2 2pA + pS .
· Samsung faces the following demand for its product:
x S (pA , pS ) = 120 2 2pS + pA .
· Suppose they both maximize profits and the strategic variables are
their own price (pA for Apple and pS for Samsung).
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· Two producers, Apple and Samsung, produce similar but different
products, also called differentiated products.
· The costs for a unit of their product are cA = 20 and cS = 10.
· If they charge prices pA , pS * R + respectively, then:
· Apple faces the following demand for its product:
x A (pA , pS ) = 240 2 2pA + pS .
· Samsung faces the following demand for its product:
x S (pA , pS ) = 120 2 2pS + pA .
· Suppose they both maximize profits and the strategic variables are
their own price (pA for Apple and pS for Samsung).
· What is the game that this defines?

The game can be described by:
G = (N = {A, S }, (XA = XS = R + ), (ΠA , ΠS )) ,

where
· ΠA (pA , pS ) = (pA 2 20)(240 2 2pA + pS )
· ΠS (pA , pS ) = (pS 2 10)(120 2 2pS + pA )
· XA and XS are strategy spaces corresponding prices in R + .
Maximizing each firm’s profits with respect to their own price, taking as given
the price of the opponent, leads to the following reaction functions:
· fA (pS ) = 70 + pS /4
· fS (pA ) = 35 + pA /4.
Requiring that each firm best responds to the other, gives the two equations:
p p
pA = fA (pS ) = 70 + S and pS = fS (pA ) = 35 + A ,
4 4
which leads to the unique Nash equilibrium: pA = 84 and pS = 56.
· In equilibrium profits are: ΠA = 8192 and ΠS = 4232.
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To visualize the Nash equilibrium, we can plot the firms’ reaction functions:
· fA (pS ) = 70 + pS /4
62
p S (Price charged by Samsung)

· fS (pA ) = 35 + pA /4. 60
58
· You need to invert pA = fA (pS ) 56 fA (pS )

fS (pA )
to plot it as a function of pA . 54
52
· This gives pS = 4pA 2 280.
80 82 84 86 88 90
p A (Price charged by Apple)
The Nash equilibrium occurs at the intersection of the reaction curves:

· pA = 84 and pS = 56,
where each firm best responds to the other.
10 000 5000
4500
£S (Profits of Samsung)
8000
£A (Profits of Apple)
4000
£A (pA ,pS =56) £S (pA =84,pS )

3500
£A (pA ,pS =80) £S (pA =100,pS )

6000
3000
£A (pA ,pS =40) 2500 £S (pA =60,pS )

4000
2000
1500
2000
30 40 50 60 70 80 90 100 20 30 40 50 60 70 80
p A (Price charged by Apple) p S (Price charged by Samsung)
· In equilibrium profits are: ΠA = 8192 and ΠS = 4232.

Nash Equilibrium with Mixed Strategies
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Preliminaries
G = (N, (Si )i *N , (ui )i *N )

where:
· ui : S ³ R are the utilities of player i.
Players are expected utility maximizers with vNM utilities ui .
The mixed extension of G , where each player can choose a mixed
strategy σi * Σi , is well-defined. Recall:
n o
· Σi = σi = (σi1 , . . . , σiKi ) * RKi ∑K k k
k =1 σi = 1, σi g 0, k = 1, . . . , Ki
i
· “2i” refers to i’s opponents, or all players in N other than i;

· S2i = ×j ;=i Sj and Σ2i = ×j ;=i Σj and write (σi , σ2i ) * Σi × Σ2i ;
· s * S is a strategy profile and σ * Σ a mixed strategy profile.
Preliminaries
In the mixed extension of a game, player i’s expected payoff at a given strategy
profile σ * Σ is given by:
Ui (σ) = ∑ ui (s )Πj *N σj (sj ),
s *S
where s = (s1 , . . . , sn ) is a pure strategy profile and σj (sj ) is the probability
that player j’s mixed strategy σj assigns to his pure strategy sj .
Example. Consider the following game G (battle of the sexes) with the
distribution over outcomes π induced by the mixed strategy profile
σ = (σ1 , σ2 ) = (( 32 , 13 ), ( 41 , 43 )) (also called joint frequencies of play):
1\2 s21 s22 1\2 s21 s22

G= s11 4, 2 0, 0 π (σ) = s11 1
6
1
2
s12 0, 0 2, 4 s12 1
12
1
4
Player 1’s expected payoff at the profile σ is:

2 1 2 3 1 1 1 3
· + u1 (s11 , s22 ) · · + u1 (s12 , s21 ) · · + u1 (s12 , s22 ) · ·
U1 (σ) = u1 (s11 , s21 ) ·
3 4 3 4 3 4 3 4
1 1 1 1 7
= 4· +0· +0· +2· = .
6 2 12 4 6
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Best Response and Nash Equilibrium with Mixed Strategies
· The basic ingredient to the concept of Nash equilibrium is that of a best
response to the opponents’ strategy profile.
Definition
The mixed strategy σi * Σi is a best response to the mixed strategy
profile of the opponents σ2i * Σ2i if:
ui (σi , σ2i ) g ui (τi , σ2i ), for all τi * Σi .
· BRi (σ2i ) = is the set of all mixed strategy best responses of player i to
the profile σ2i .
· It defines a correspondence, BRi : Σ2i ó Σi , σ2i 7³ BRi (σ2i ), where
BRi (σ2i ) is a nonempty, compact and convex valued set.
Definition
A strategy profile σ = (σ1 , . . . , σN ) * Σ is a Nash equilibrium if, for
every player i * N, σi is a best response to σ2i .
· σ * Σ is a strict Nash equilibrium if, moreover, for every i * N,
ui (σi , σ2i ) > ui (τi , σ2i ), for all τi ;= σi .
Example 1: Best Response and Nash Equilibrium

Consider the prisoner’s dilemma game:
1\2 U V
X 3, 3 1, 4
Z 4, 1 2, 2
Player 1’s best response correspondence BR1 (σ2 ) is defined by:

1.0
Ã2 U (Player 2's probability of U)
0.8
n 0.6
σ1X (σ2U ) = 0 for all 0 f σ2U f 1 0.4 BR1 (Ã2 U )
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
Ã1 X (Player 1's probability of X)

1.0
0.8
n 0.6
σ2U (σ1X ) = 0 for all 0 f σ1X f 1 0.4 BR2 (Ã1 X )
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
where σ1 = (σ1X , σ1Y ) = (σ1X , 1 2 σ1X ) and σ2 = (σ2U , σ2V ) = (σ2U , 1 2 σ2U ).
202 / 339
Consider the prisoner’s dilemma game:
1\2 U V
X 3, 3 1, 4
Z 4, 1 2, 2
What are the Nash equilibria?

1.0
0.8
0.6
BR1 (Ã2 U )
0.4
BR2 (Ã1 X )
0.2
NE
0.0
0.0 0.2 0.4 0.6 0.8 1.0
They are: A: ((0, 1), (0, 1)), that is, 1 plays Z and 2 plays V .
Consider the coordination game:
1\2 X Y
A 1, 1 0, 0
B 0, 0 2, 3
· What are all the Nash equilibria?

· What are the players’ best response correspondences?
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1\2 X Y
A 1, 1 0, 0
B 0, 0 2, 3

1\2 X Y
A 1, 1 0, 0
B 0, 0 2, 3

2 1.0
σ2X <
ù
0 if 3
ü
ú 0.8
σ1A (σ2X ) = [0, 1] if σ2X = 2

3
0.6
0.4 BR1 (Ã2 X )

2
ü
1 if σ2X
û
> 3 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
Ã1 A (Player 1's probability of A)
204 / 339
1\2 X Y
A 1, 1 0, 0
B 0, 0 2, 3

2 1.0
σ2X <
ù
0 if 3

ü
ú 0.8
σ1A (σ2X ) = [0, 1] if σ2X = 2

3
0.6
0.4 BR1 (Ã2 X )

2
ü
1 if σ2X
û
> 3 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0

3 1.0
σ1A <
ù
0 if 4

ü
ú 0.8
σ2X (σ1A ) = [0, 1] if σ1A = 3

4
0.6
0.4 BR2 (Ã1 A )

3
ü
1 if σ1A
û
> 4 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
where σ1 = (σ1A , 1 2 σ1A ) and σ2 = (σ2X , 1 2 σ2X ).


1\2 X Y
A 1, 1 0, 0
B 0, 0 2, 3

1.0
NE2
0.8
0.6 NE3
BR1 (Ã2 X )
0.4
BR2 (Ã1 A )
0.2
NE1
0.0
0.0 0.2 0.4 0.6 0.8 1.0
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1\2 X Y
A 1, 1 0, 0
B 0, 0 2, 3

1.0
NE2
0.8
0.6 NE3
BR1 (Ã2 X )
0.4
BR2 (Ã1 A )
0.2
NE1
0.0
0.0 0.2 0.4 0.6 0.8 1.0
They are: NE1: ((0, 1), (0, 1)), NE2: ((1, 0), (1, 0)), NE3: (( 34 , 41 ), ( 32 , 31 ))
with payoffs, respectively: NE1: (2, 3), NE2: (1, 1), NE3: ( 23 , 43 ).
Example 3 (α = 0): Best Response and Nash Equilibrium

Consider the game:
1\2 s21 s22
s11 1, 1 0, 0
s12 0, 0 0, 0

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Consider the game:
1\2 s21 s22
s11 1, 1 0, 0
s12 0, 0 0, 0

1 and 2’s best response correspondences BR1 (σ2 ), BR2 (σ1 ):
σ21 = 0 σ11 = 0
( (
[0, 1] if [0, 1] if
σ11 (σ21 ) = σ21 (σ11 ) =
1 if σ21 > 0 1 if σ11 > 0
1.0
B
Ã21 (Player 2's probability of s2 1 )
0.8
0.6
BR1(Ã2)
0.4
BR2(Ã1)
0.2
A
0.0
0.0 0.2 0.4 0.6 0.8 1.0

Consider the game:
1\2 s21 s22
s11 1, 1 0, 0
s12 0, 0 0, 0
· What are the Nash equilibria? A: ((0, 1), (0, 1)), B: ((1, 0), (1, 0)).
1 and 2’s best response correspondences BR1 (σ2 ), BR2 (σ1 ):
σ21 = 0 σ11 = 0
( (
[0, 1] if [0, 1] if
σ11 (σ21 ) = σ21 (σ11 ) =
1 if σ21 > 0 1 if σ11 > 0
1.0
B
0.8
0.6
BR1(Ã2)
0.4
BR2(Ã1)
0.2
A
0.0
0.0 0.2 0.4 0.6 0.8 1.0
207 / 339
Example 3 (α): Best Response and Nash Equilibrium
Consider the following variation of the previous game:
1\2 s21 s22
s11 1, 1 0, 0 for α * R.
s12 0, 0 α, α
· What are the Nash equilibria now?


1\2 s21 s22
s11 1, 1 0, 0 for α * R.
s12 0, 0 α, α

For α < 0, the strategies s11 , s21 are strictly dominant for both players and
there is a unique Nash equilibrium of the form:
· ((1, 0), (1, 0)) which corresponds to the profile (s11 , s21 ).
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1\2 s21 s22
s11 1, 1 0, 0 for α * R.
s12 0, 0 α, α

For α < 0, the strategies s11 , s21 are strictly dominant for both players and
there is a unique Nash equilibrium of the form:
· ((1, 0), (1, 0)) which corresponds to the profile (s11 , s21 ).
For α > 0, the game becomes again a coordination game and we have
again three Nash equilibria of the form:
· ((1, 0), (1, 0)) which corresponds to the profile (s11 , s21 )
· ((0, 1), (0, 1)) which corresponds to the profile (s12 , s22 )

1 1
· ( 1+ α , 1+ α ), ( 1+ α , 1+ α ) .
α α
Properties of Nash Equilibrium

Theorem
(Nash 1951) Every finite simultaneous game has at least one Nash
equilibrium (that may be in mixed strategies).
The proof of this theorem uses a generalization of Brouwer’s fixed

point theorem due to Kakutani.
· A simple version of Brouwer’s fixed point theorem shows that every
continuous function f : [0, 1] ³ [0, 1] has at least one fixed point
(x * [0, 1] such that f (x ) = x).
· This can be substantially generalized (to f a nonempty, compact, convex
valued correspondence, and [0, 1] a nonempty, compact, convex set).
1.0
0.8
0.6
0.4
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
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Let σi * Σi be a mixed strategy of player i, the support of σi is the set

of pure strategies that have strictly positive probability:
supp(σi ) = {sik * Si | σik > 0}.
Examples. As above, let S1 = {a, b }, S2 = {c, d }, S3 = {A, B, C , D }.

· For σ1 = (0, 1), supp(σ1 ) = {b }.
· For τ1 = ( 16 , 56 ), supp(τ1 ) = {a, b }.
· For σ2 = ( 12 , 12 ), supp(σ2 ) = {c, d }.
· For σ3 = ( 13 , 13 , 13 , 0), then supp(σ3 ) = {A, B, C }.
· For τ3 = ( 14 , 0, 43 , 0), then supp(τ3 ) = {A, C }.
Of these examples, only τ1 and σ2 have full support, since only these
satisfy supp(τ1 ) = S1 and supp(σ2 ) = S2 .
A mixed strategy σi * Σi is fully mixed if every pure strategy

sik * Si has strictly positive probability, σik > 0 for all k.
· If σi is fully mixed, it has full support, supp(σi ) = Si .
· A profile σ * Σ is fully mixed if σi is fully mixed for all i * N.
Lemma
If σ * Σ is a mixed Nash equilibrium profile, then for all i * N:
2 2
ui (sik , σ2i ) = ui (sik , σ2i ), for all sik , sik * supp(σi ).
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A mixed strategy σi * Σi is fully mixed if every pure strategy

sik * Si has strictly positive probability, σik > 0 for all k.
· If σi is fully mixed, it has full support, supp(σi ) = Si .
· A profile σ * Σ is fully mixed if σi is fully mixed for all i * N.
Lemma
If σ * Σ is a mixed Nash equilibrium profile, then for all i * N:
2 2
ui (sik , σ2i ) = ui (sik , σ2i ), for all sik , sik * supp(σi ).
In words:
· Any two pure strategies of a player (sik , sik 2 * Si ), used with
strictly positive probability at a Nash equilibrium (σik , σik 2 > 0),
must yield the same expected payoff (ui (sik , σ2i ) = ui (sik 2 , σ2i )).

Consider the matching pennies game:
1\2 s21 s22
s11 1, 21 21, 1
s12 21, 1 1, 21
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1\2 s21 s22
s11 1, 21 21, 1
s12 21, 1 1, 21

1.0
1
σ21 <
ù
0 if
Ã2 1 (Player 2's probability of s2 1 )

ü
ú 2 0.8
σ11 (σ21 ) = [0, 1] if σ21 = 1

2
0.6
0.4 BR1 (Ã2 1 )
1
σ21
ü
1 if
û
> 2 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0

1\2 s21 s22
s11 1, 21 21, 1
s12 21, 1 1, 21

1.0
1
σ21 <
ù
0 if
ü
ú 2 0.8
σ11 (σ21 ) = [0, 1] if σ21 = 1

2
0.6
0.4 BR1 (Ã2 1 )
1
σ21
ü
1 if
û
> 2 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0

1.0
1
σ11 <
ù
1 if
ü
ú 2 0.8
σ21 (σ11 ) = [0, 1] if σ11 = 1

2
0.6
0.4 BR2 (Ã1 1 )
1
σ11
ü
0 if
û
> 2 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
where σ1 = (σ11 , 1 2 σ11 ) and σ2 = (σ21 , 1 2 σ21 ).

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1\2 s21 s22
s11 1, 21 21, 1
s12 21, 1 1, 21

1.0

0.8
0.6
BR1 (Ã2 1 )
0.4 NE
BR2 (Ã1 1 )
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0

1\2 s21 s22
s11 1, 21 21, 1
s12 21, 1 1, 21

1.0
0.8
0.6
BR1 (Ã2 1 )
0.4 NE
BR2 (Ã1 1 )
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
· There is a unique fully mixed Nash equilibrium:

A: (( 21 , 12 ), ( 21 , 12 )) with expected payoffs of (0, 0).
· It coincides with the security strategies (σ1 , σ2 ) = (( 21 , 12 ), ( 12 , 21 )).
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1\2 s21 s22

s11 1, 21 21, 1
s12 21, 1 1, 21
What are the security strategies?

u1 u2
1.0 1.0
0.5 0.5
u1(Ã1,s21 ) u2(s11 ,Ã2)
Ã11 Ã21
u1(Ã1,s22 ) u2(s12 ,Ã2)
0.2 0.4 0.6 0.8 1.0 0.2 0.4 0.6 0.8 1.0
W1(Ã1) W2(Ã2)
-0.5 -0.5
-1.0 -1.0
· The security strategies are (σ1 , σ2 ) = (( 21 , 21 ), ( 12 , 12 )).

· They constitute a Nash eq. and yield an expected payoff of (0, 0).
Example 4.1: Variations on Matching Pennies (see PS#5)

Consider this variation of the matching pennies game:
1\2 s21 s22
s11 2, 21 21, 1
s12 21, 1 1, 21
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Example 4.1: Variations on Matching Pennies (see PS#5)
1\2 s21 s22
s11 2, 21 21, 1
s12 21, 1 1, 21

u1
u2
1.0
1.0
0.5
0.5
u1(Ã1,s21 ) u2(s11 ,Ã2)
Ã11
Ã21
2
u1(Ã1,s2 ) u2(s12 ,Ã2)
0.2 0.4 0.6 0.8 1.0
W1(Ã1) 0.2 0.4 0.6 0.8 1.0
W2(Ã2)
-0.5 -0.5
-1.0
-1.0
· The security strategies are now (σ1 , σ2 ) = (( 52 , 53 ), ( 12 , 12 )).

· Player 1 puts less weight on strategy s11 .
· Putting equal weight ensures 0, decreasing it increases 1’s expected
payoff, until 2 playing s21 or s22 gives same payoff to 1.
· The game is not zero sum and they do not constitute a Nash equilibrium.
Example 4.1: Variations on Matching Pennies

1\2 s21 s22
s11 2, 21 21, 1
s12 21, 1 1, 21
Player 1’s best response correspondence BR1 (σ2 ) is now:

2 1.0
σ21 <
ù
0 if
ü
ú 5 0.8
σ11 (σ21 ) = [0, 1] if σ21 = 2

5
0.6
0.4 BR1(Ã2)
2
σ21
ü
1 if
û
> 5 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
Player 2’s best response correspondence BR2 (σ1 ) is the same:

1 1.0
σ11 <
ù
1 if
ü
ú 2 0.8
σ21 (σ11 ) = [0, 1] if σ11 = 1

2
0.6
0.4 BR2 (Ã1 1 )

1
σ11
ü
0 if
û
> 2 0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0
Player 1’s best response correspondence changes while 2’s does not.
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There is a unique fully mixed Nash equilibrium:
· A’: (( 21 , 12 ), ( 25 , 35 )) with expected payoffs of (1/5, 0).
· Note that only player 2’s strategies change (slightly less weight on s21 to
make 1 indifferent).
1.0

s21 s22
0.8
1\2
s11 2, 21 21, 1 0.6
BR1(Ã2)
s12
A'
21, 1 1, 21 0.4
BR2(Ã1)
0.2
0.0
0.0 0.2 0.4 0.6 0.8 1.0

1.0
s21 s22
0.8
1\2
s11 2, 21 21, 1 0.6
BR1(Ã2)
s12
A'
21, 1 1, 21 0.4
BR2(Ã1)
0.2
The security strategies are: 0.0
· (σ1 , σ2 ) = (( 25 , 53 ), ( 12 , 21 )). 0.0 0.2 0.4 0.6
Ã1 (Player 1's probability of s1 ) 1 1

0.8 1.0
They now differ from the unique Nash equilibrium! (Why?)
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1.0

s21 s22
0.8
1\2
s11 2, 21 21, 1 0.6
BR1(Ã2)
s12
A'
21, 1 1, 21 0.4
BR2(Ã1)
0.2
The security strategies are: 0.0
· (σ1 , σ2 ) = (( 25 , 53 ), ( 12 , 21 )). 0.0 0.2 0.4 0.6
Ã1 (Player 1's probability of s1 )

1 1
0.8 1.0
They now differ from the unique Nash equilibrium! (Why?)
The example shows a fundamental difference between security strategies and

mixed strategy Nash equilibria.
· At the mixed Nash equilibrium each players mixes in a way that makes
the opponent indifferent between his two pure strategies.
· This is not the case with the security strategies in general.
· They depend only on a player’s own payoffs.

Consider this further variation of the matching pennies game:
1\2 s21 s22

s11 20, 21 21, 1
s12 21, 1 1, 21
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1.0
1\2 s21 s22

0.8
s11 20, 21 21, 1 0.6
s12 21, 1 1, 21 0.4

BR1(Ã2)
BR2(Ã1)
0.2
A''
0.0
0.0 0.2 0.4 0.6 0.8 1.0

1.0
1\2 s21 s22

0.8
s11 20, 21 21, 1 0.6
s12 21, 1 1, 21 0.4

BR1(Ã2)
BR2(Ã1)
0.2
A''
0.0
0.0 0.2 0.4 0.6 0.8 1.0

· A”: (( 12 , 21 ), ( 23
2 21 19

, 23 )) with expected payoffs 23 , 0 .
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1.0
1\2 s21 s22

0.8
s11 20, 21 21, 1 0.6
s12 21, 1 1, 21 0.4

BR1(Ã2)
BR2(Ã1)
0.2
A''
0.0
0.0 0.2 0.4 0.6 0.8 1.0

· A”: (( 12 , 21 ), ( 23
2 21 19

The security strategies are:
2 21
, 23 ), ( 21 , 12 )) with guaranteed expected payoffs of 19

· (σ1 , σ2 ) = (( 23 23 , 0 .
· But, is player 2 playing a best response to σ1 at σ2 ?

u1
1\2 s21 s22 20
s11 20, 21 21, 1 15

u1(Ã1,s21 )
s12 21, 1 1, 21 10 u1(Ã1,s22 )

W1(Ã1)
5
Ã11
0.2 0.4 0.6 0.8 1.0

· A”: (( 12 , 21 ), ( 23
2 21 19

2 21

· (σ1 , σ2 ) = (( 23 23 , 0 .
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u1
1\2 s21 s22 20
s11 20, 21 21, 1 15

u1(Ã1,s21 )
s12 21, 1 1, 21 10 u1(Ã1,s22 )

W1(Ã1)
5
Ã11
0.2 0.4 0.6 0.8 1.0

· A”: (( 12 , 21 ), ( 23
2 21 19

2 21

· (σ1 , σ2 ) = (( 23 23 , 0 .
Note that the game is not zero-sum!

u1
1\2 s21 s22 20
s11 20, 21 21, 1 15

u1(Ã1,s21 )
s12 21, 1 1, 21 10 u1(Ã1,s22 )

W1(Ã1)
5
Ã11
0.2 0.4 0.6 0.8 1.0

· A”: (( 12 , 21 ), ( 23
2 21 19

2 21

· (σ1 , σ2 ) = (( 23 23 , 0 .
· But, is player 2 playing a best response to σ1 at σ2 ? No!
· What about player 1? No!
Note that the game is not zero-sum!

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Consider this final(!) zero-sum variation of the matching pennies game:
u1
1\2 s21 s22 20
s11 20, 220 21, 1 15

u1(Ã1,s21 )
s12 21, 1 1, 21 10 u1(Ã1,s22 )

W1(Ã1)
5
Ã11
0.2 0.4 0.6 0.8 1.0
Now the security strategies are:

2 21
· (σ1 , σ2 ) = (( 23 2 21
, 23 ), ( 23 , 23 )).
· Is player 2 now playing a best response to σ1 at σ2 ?
The unique fully mixed Nash equilibrium:
2 21 2 21 19 19

· A”’: (( 23 , 23 ), ( 23 , 23 )) has expected payoffs 23 , 2 23 .

Consider this final(!) zero sum variation of the matching pennies game:
u2
1\2 s21 s22 0.2 0.4 0.6 0.8 1.0

Ã21
s11 20, 220 21, 1 -5

u2(s11 ,Ã2)
s12 21, 1 1, 21 -10

u2(s12 ,Ã2)
W2(Ã2)
-15
-20

2 21
· (σ1 , σ2 ) = (( 23 2 21
, 23 ), ( 23 , 23 )).
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u2
1\2 s21 s22 0.2 0.4 0.6 0.8 1.0

Ã21
s11 20, 220 21, 1 -5

u2(s11 ,Ã2)
s12 21, 1 1, 21 -10

u2(s12 ,Ã2)
W2(Ã2)
-15
-20

2 21
· (σ1 , σ2 ) = (( 23 2 21
, 23 ), ( 23 , 23 )).

u2
1\2 s21 s22 0.2 0.4 0.6 0.8 1.0

Ã21
s11 20, 220 21, 1 -5

u2(s11 ,Ã2)
s12 21, 1 1, 21 -10

u2(s12 ,Ã2)
W2(Ã2)
-15
-20

2 21
· (σ1 , σ2 ) = (( 23 2 21
, 23 ), ( 23 , 23 )).
2 21 2 21 19 19

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1.0
1\2 s21 s22

0.8
s11 20, 220 21, 1 0.6
s12 21, 1 1, 21 0.4

BR1(Ã2)
BR2(Ã1)
0.2
A'''
0.0
0.0 0.2 0.4 0.6 0.8 1.0

2 21
· (σ1 , σ2 ) = (( 23 2 21
, 23 ), ( 23 , 23 )).
2 21 2 21 19 19

Now the game is zero-sum and the security strategies form a Nash equilibrium.

1.0
1\2 s21 s22

0.8
s11 20, 220 21, 1 0.6
s12 21, 1 1, 21 0.4

BR1(Ã2)
BR2(Ã1)
0.2
A'''
0.0
0.0 0.2 0.4 0.6 0.8 1.0

2 21
· (σ1 , σ2 ) = (( 23 2 21
, 23 ), ( 23 , 23 )).
· Is player 2 now playing a best response to σ1 at σ2 ? Now yes!
· What about player 1? Now yes!
2 21 2 21 19 19

Now the game is zero-sum and the security strategies form a Nash equilibrium.
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Nash equilibria and the Minmax Theorem
As stated in Topic 4, we have the following relationship for a Nash equilibrium
of a two player game.

equilibrium for any two player game. Then the Nash equilibrium
payoffs are at least as large as the maxmin payoffs:
u1 (σ17 , σ27 ) g max min u1 (σ1 , σ2 )
σ1 σ2
u2 (σ17 , σ27 ) g max min u2 (σ1 , σ2 )
σ2 σ1
· The Nash equilibrium has to yield at least the maxmin payoffs. (Why?)
Nash equilibria and the Minmax Theorem

As stated in Topic 4, we have the following relationship for a Nash equilibrium
of a two player game.

equilibrium for any two player game. Then the Nash equilibrium
payoffs are at least as large as the maxmin payoffs:
u1 (σ17 , σ27 ) g max min u1 (σ1 , σ2 )
σ1 σ2
u2 (σ17 , σ27 ) g max min u2 (σ1 , σ2 )
σ2 σ1
· The Nash equilibrium has to yield at least the maxmin payoffs. (Why?)
And if, moreover, the game is zero-sum, then we actually have:
u1 (σ17 , σ27 ) = max min u1 (σ1 , σ2 ) = u1 (σ1 , σ2 ) = v 1 = v
σ1 σ2
u2 (σ17 , σ27 ) = max min u2 (σ1 , σ2 ) = u2 (σ1 , σ2 ) = v 2 = 2v .
σ2 σ1
· A security strategy profile (σ1 , σ2 ) constitutes a Nash equilibrium.
· Both profiles yield payoffs (u17 , u27 ) = (v , 2v ).
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What Do Players Need to Know to Play Nash Equilibrium?
Under what assumptions can you expect players to play a Nash

equilibrium?
· Essentially, if they are rational and if they form correct
beliefs about the choices of their opponents.
· In particular, common knowledge of rationality is not enough.
· They also need to know what the opponents are playing.
Note: In zero-sum games, the security strategies coincide with the Nash equilibrium
strategies and the secure payoffs coincide with the Nash equilibrium payoffs.
The reason is that assuming that the opponents are minimizing your payoff (as is
assumed in the maxminimization procedure) leads to correct beliefs about what your
opponent is actually doing.

Topic 6. Sequential Games with Perfect
Information
Fabrizio Germano
Winter 2024
225 / 339
Test 2
Test 2 will be take place on Tuesday, February 27.
It will be done in class online through Aula Global and will cover:
· Topic 3 (Nash Equilibrium I)

· Topic 4 (Zero-Sum Games)
· Topic 5 (Nash Equilibrium II).
Everything from these topics will be covered. Of course we also

assume that you are familiar with Topic 2 (Simultaneous Games I).
Preparing the Game Projects
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· It can but does not have to be taken from economics.

The modeler’s objective is to use the rules of the game together with the
payoffs to determine the possible equilibrium outcomes of the game.
· These give predictions for how the game might be played.
· Ideally you can check whether the predictions match actual play.


Then, specify:
outcomes.
Finally, solve for:
Equilibrium For each player, an “optimal” contingent plan.
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Rationality
preferences.
This includes:
actions; and
Keep in mind that there are important branches of game theory (such as
behavioral game theory) that study bounded rationality in games. This includes
studying limitations on individuals’ formation of beliefs.
Sequential Games of Perfect Information
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Where are we going?
· Sequential game with perfect information (definition)

· Complete contingent plan as strategy
· Backward induction
· Subgame and subgame perfect equilibrium
· Examples
· Credibility of threats
· Order advantages
· Efficiency
· Commitment
· Nash equilibrium and normal form of a sequential game with
perfect information
Sequential Games with Perfect Information

Sequential Games...
Strategic situations with a strict order of play.

1. Player 1 chooses an action from a set of possible actions A1 .
2. Player 2 observes Player 1’s action and then chooses his own action from A2 .
3. Player 3 observes the actions of Players 1 and 2 and then chooses her action
from A3 .
4. etc.
The order of play is captured by a “game tree” that specifies:

· Who plays when and what actions are available (we’ll see many examples).
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Sequential Games...
Strategic situations with a strict order of play.

1. Player 1 chooses an action from a set of possible actions A1 .
2. Player 2 observes Player 1’s action and then chooses his own action from A2 .
3. Player 3 observes the actions of Players 1 and 2 and then chooses her action
from A3 .
4. etc.
The order of play is captured by a “game tree” that specifies:

· Who plays when and what actions are available (we’ll see many examples).
A sequential game is then described by

(N, (Ai )i *N , “game tree”, (ui )i *N ),
where:
· N are the players
· Ai are the actions available for player i at various nonterminal nodes of the tree
· ui are utilities at terminal nodes.

... with Perfect Information
A game has perfect information when at any point in time only

one player makes a move, and knows all the actions that have been
taken until then.
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taken until then.
· To play well, each player must consider:

· “If I make this move, how will my opponents respond?”
Look forward and reason backwards!


taken until then.
· To play well, each player must consider:

· “If I make this move, how will my opponents respond?”
Look forward and reason backwards!
Note: In Topic 7, we will consider games of imperfect information, where

players lack information of previous actions of other players or of random
moves.
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Strategy = Complete Contingent Plan!
Very important:
· A strategy is a complete contingent plan for a given player.
· This means that it needs to specify an action at every decision
node of that player.
So in general, a strategy ;= (is not):
· the moves of a player (individual actions taken by a player) at decision nodes
along a game path;
And a strategy profile ;= (is not):
· a game path (sequence of moves taken in a game);
· the final outcome (obtained vector of payoffs of a game) of a game path.
We will emphasize this repeatedly in the examples that follow.
A Formal Definition of Perfect Information Game

that is OK to forget...
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Writing down a sequential game...
What is the game the Good, the Bad and the Ugly are playing?
Assuming they all have perfect aim and exactly one bullet each!

To start, consider a simpler case—an actual duel—with just two players.
233 / 339

Here are some possibilities:
1. Players 1 and 2 move simultaneously.
2. Player 1 moves first and then player 2 (this could reflect that 1 is “faster”).
4. “Nature” stochastically decides who moves first, so that either case can occur
with some probability, meaning that 1 moves first with probability p and 2
moves first with 1 2 p, and p * (0, 1) is known.


Here are some possibilities:
1. Players 1 and 2 move simultaneously.
4. “Nature” stochastically decides who moves first, so that either case can occur
with some probability, meaning that 1 moves first with probability p and 2
moves first with 1 2 p, and p * (0, 1) is known.
Actions and payoffs: Assume players are so close that if they shoot an
opponent they kill him for sure; and allow for the possibility to shoot in the air.
Also assume players prefer to survive and that as few of the opponents survive,
so, e.g., for player 1:
· 1 { 12 > 13 { 123 { ∅ { 2 > 3 { 23,
where ij means players i and j survive and ∅ means none survive.
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Some different two-player duels:
1\2 2± 2³1
1. Simutaneous: 1± [12] [2]
1³2 [1] [∅]

1\2 2± 2³1
1. Simutaneous: 1± [12] [2]
1³2 [1] [∅]
2. Player 1 moves first: 3. Player 2 moves first:
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4. “Nature” moves first and randomly decides who moves first:
We will compute and describe the equilibria later.


Introducing some terminology:
4. “Nature” moves first and randomly decides who moves first:
A subgame of a game is a subset of the game that starts at a chance node or

proper decision node and that contains the whole “continuation” of the game,
i.e., all “successor” branches and nodes. The whole game is also a subgame.
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· The game is a three-way duel, also called a “truel”.
· It can be studied as a simultaneous game, where all three move at the
same time (see Problem Set #5).
· We study the version where player 1 moves first, then 2 and then 3.
Recall we assume they have perfect aim exactly one bullet each!
We will compute and describe the equilibria later (see also Problem Set #5).
Example 1: The Senate Race Game

· Senator: Alice. Only potential challenger: Bob.
· Alice has to decide whether or not to launch a preemptive advertising
campaign.
· Bob has to decide whether to enter the race or retire.
· 4 possible outcomes: advertise-enter, advertise-retire, do not
advertise-enter, do not advertise-retire.
· Alice’s most preferred outcomes are those in which Bob retires.
Also, given any of Bob’s decisions, she’d prefer to avoid the costs of an
ad campaign.
· The worst (of all four outcomes) for Bob is entering if Alice advertises:
Bob loses badly and loses any chance at a future in politics.
The best for Bob is entering if Alice does not advertise.
Bob considers retiring worse when Alice doesn’t ad (he looks weak) than
when Alice ads (he has a justification to stay out of the race).
· Alice chooses first. Bob decides whether to enter or retire knowing Alice’s
decision.
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The Game Tree is a graphical description of the game.
· It is useful for analyzing sequential games.
· It is also referred to as the extensive form of the game.
· It has decision nodes (associated with a player), branches (associated with
an action) and terminal nodes (associated with a payoff for each player).
enter 1, 1
bob
advertise
retire 3, 3
alice
enter 2, 4
do not advertise
bob
retire 4, 2
· We use numbers 1 to 4 as utility indicators: give 4 points to the first

ranked outcome, 3 to the second, 2 to the third, and 1 to the last.
Model:
Players Alice and Bob.
Actions Alice’s action set is {a, d }. Bob’s action set is {e, r }.
Strategies Alice’s strategy set is {a, d }. Bob’s strategy set is
{e, r } × {e, r } = {(e, e ), (e, r ), (r , e ), (r , r )}.
Information There is perfect information: all players see previous
actions chosen by other players (no hidden actions).
Solution:
Equilibrium Each player is using a strategy that is a best response
to the other players’ strategies (next slide).
Equilibrium path The actual sequence of actions taken when all
players play their equilibrium strategies (next slide).
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Backward Induction Equilibrium
· At a backward induction equilibrium (BIE) each player

chooses an optimal action at every decision node in the game
tree.
· The BIE strategy profile specifies for each player an optimal
action at every decision node of that player.
· The BIE path specifies the sequence of actions taken in
equilibrium, starting from the first decision node.
· The BIE outcome is the set of payoffs of all players at the
terminal node following the equilibrium path.
· To find a backward induction equilibrium, start at the last

decision node(s) (nodes right before a terminal node) and
work backwards.
enter 1, 1
bob
advertise
retire 3, 3
alice
enter 2, 4
do not advertise
bob
retire 4, 2
· Equilibrium strategy profile:

· Equilibrium path (actions actually taken):
· Equilibrium payoffs (equilibrium outcome):
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The equilibrium strategies in the senate race game are:

· For Alice it’s simply:
· a (=advertise).
· She has a single decision node.
· For Bob it’s the contingent plan:
· If Alice advertises, retire; if Alice does not advertise, enter.
· This is written as (r , e ).
· It specifies an action at each of Bob’s decision nodes.
· The overall equilibrium strategy profile is (a, (r , e )).
· The equilibrium path is (a, r ) with outcome (3, 3).
Example 2: An Entry Game
· Firm B is the only grocery store in the city and makes profits of 20e.
· Firm A has an option to make a profit of 5e by investing in an
independent project, but is also considering to enter the grocery business
and to compete for a share of the profits of B.
· Entry requires an investment (sunk cost) of 3e.
· When firm B learns about A’s intentions, B can threaten with a price war
and sell everything at cost price, making zero profits. In this case firm A
would also makes zero profits and lose 3e (the fixed costs).
But firm B can also decide to accommodate and share the profits
peacefully with A.
· The incumbent firm B makes a decision knowing what A has decided.
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· Profits of firm A: Firm A (the potential entrant) has to

decide whether to enter or not. The consequences of its
decision partially depend on B’s decision:
A\B Accommodate Retaliate

Enter 7 -3
· Profits of firm B: Firm B (the incumbent firm) has to

decide whether to accommodate or retaliate. The
consequences of its decision partially depend on A’s decision:
A\B Accommodate Retaliate

Enter 10 0
What would you do as Firm A?
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· If A enters, B has to choose between getting 10 or 0.

· It will choose to accommodate (a).
· Anticipating this, Firm A will decide to enter (e).
· The incumbent’s threat to retaliate (r ) was not credible.
At a backward induction equilibrium:
· Each player plays optimally at every decision node in the
game tree.
· If A enters, B has to choose between getting 10 or 0.

· It will choose to accommodate (a).
· Anticipating this, Firm A will decide to enter (e).
· The incumbent’s threat to retaliate (r ) was not credible.
At a backward induction equilibrium:
· Each player plays optimally at every decision node in the
game tree.
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Important Lesson
Look forward and reason backwards.
Subgame Perfect Equilibrium – perfect information games

· A game is a set of nodes connected with branches.
· A subgame is a subset of these nodes and branches such that:
1. It starts with a decision node of a player.
2. It contains all the successors of that node, and only those.
· The whole game is considered a subgame of itself.
A subgame perfect equilibrium of a sequential game is a strategy

profile that induces a Nash equilibrium on every subgame of the game.
· Subgame perfect equilibrium is a refinement of Nash equilibrium.
· It is the most used concept in sequential games.
· It coincides with backward induction for perfect information games
and is best computed as backward induction eq. on such games.
· We will study a more general version for imperfect information
games in Topic 7.
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enter 1, 1
bob
advertise
retire 3, 3
alice
enter 2, 4
do not advertise
bob
retire 4, 2
· How many subgames are there?

· Subgame perfect equilibrium strategy profile:
· Subgame perfect equilibrium path (actions actually taken):
· Subgame perfect equilibrium payoffs (equilibrium outcome):
· How many subgames are there?

· Subgame perfect equilibrium strategy profile:
· Subgame perfect equilibrium path (actions actually taken):
· Subgame perfect equilibrium payoffs (equilibrium outcome):
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Example 3: The Centipede Game
Players 1 and 2 choose whether to go down (D) or across (A).
What is the subgame perfect equilibrium? How many subgames?


· ((D, D, D ), (D, D )) with payoffs (1, 0)
· The subgame perfect equilibrium path is D.
· 5 subgames.
What are the Pareto efficient outcomes?
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· ((D, D, D ), (D, D )) with payoffs (1, 0)
· 5 subgames.
· (4, 3) and (3, 5)


· ((D, D, D ), (D, D )) with payoffs (1, 0) (compute as backward induction!)
· 5 subgames.
· (4, 3) and (3, 5)
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Order advantages?
· Does it matter (in terms of outcome) who moves first?
· In some cases it doesn’t.

· In many other cases it does.
First mover advantage
Battle of the Sexes played sequentially: A couple is considering

whether to attend the opera or a football match. The husband
prefers the football game. The wife prefers the opera. But both
prefer to go to the same place rather than different ones.
Comparing the equilibrium payoffs in both games we see that both

prefer to choose first.
· The first mover has an advantage here.
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Second mover advantage
Matching Pennies played sequentially: Two players A and B decide

sequentially whether to show heads (H) or tails (T ).
· If both do the same thing, then A gets 1 and B gets 21.
· Otherwise, B gets 1 and A gets 21.
· The second mover has an advantage here.
Example 4: Threeway Duel Game

Game tree: Assume that:
· player 1 moves first, then 2, then 3
· they have perfect aim and one bullet each!
Preferences: Players prefer to survive and that as few of their opponents
survive. To get uniqueness, suppose also that 3 really dislikes 2.
Here [ij ] means players i and j survive, and ∅ means none survive.
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Example 4: Threeway Duel Game
Game tree: Assume that:
· player 1 moves first, then 2, then 3
· they have perfect aim and one bullet each!
Preferences: Players prefer to survive and that as few of their opponents
survive. To get uniqueness, suppose also that 3 really dislikes 2.
By shooting in the air, player 1 actually manages to survive.

Efficiency
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Exercise: Determine the BIE and the efficient outcomes
Consider the game
Recall: (4, 4) and (2, 9) are the only efficient outcomes.

· (3, 3) and (4, 0) are Pareto-dominated by (4, 4).
· (0, 8) is Pareto-dominated by (2, 9).
What is the outcome consistent with backward induction?
· (3, 3) (which is obtained with the profile (a1 , (b2 , b1 ))).
Example 5: The Borrower-Lender Game
· Firm E asks bank B to borrow 100e, promising to pay back

105e in a year’s time.
· The bank can decide to give the loan (y ) or reject it (n).
· If the bank gives the loan, the firm can invest the money and
earn 110e in the course of the year.
· If the firm pays back the lender (p), both make a profit: the
lender gets 5e in interest on the loan and the firm gets 5e
(the part of the profits that remain).
· If the bank gives the loan and the firm defaults (d), the bank
loses 100e and the firm gets 110e.
What will happen?
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· The bank, anticipating that the firm will default (d), does not
give a loan (n).
· If instead of playing (n, d ), they would have played (y , p ) they
would have obtained 5 each, instead of 0 each.
· The bank, anticipating that the firm will default (d), does not
give a loan (n).
· If instead of playing (n, d ), they would have played (y , p ) they
would have obtained 5 each, instead of 0 each.
Basic Lesson
Rational behavior can lead to socially inefficient outcomes.
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Example 5.1: The Borrower-Lender Game – variant 1
· In the basic borrower lender game, the equilibrium outcome

(0, 0) is not efficient since it is Pareto-dominated by (5, 5).
· Legal institutions can be created to enforce contracts.
· Let’s change the game, introducing a legal institution to try
to avoid the inefficient outcome.
Suppose that now the lender can sue the debtor (s) if he refuses to
pay back the loan. Very often the case is won and the debtor is
forced to return the loan and also pay a penalty of 20e to the
government. However, in 40% of the cases the case is lost. The
litigation costs (attorney fees, delays, etc.) for the lender are 75e.
Does this mechanism work?

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No, not really, the bank is not in a better position and will still
prefer not to give the loan (n, f ).

Consider another mechanism: if the debtor loses the case, instead of
paying a fine to the government, he has to pay all litigation costs.
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Yes, now bank has an incentive to sue, and gives the loan (y , s ).
· Slightly changing the game can lead to better outcomes.

Yes, now bank has an incentive to sue, and gives the loan (y , s ).
· Slightly changing the game can lead to better outcomes.
Basic Lesson
Appropriately designed legal institutions to enforce contracts can prevent
bad outcomes.
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Credible Commitments
Credible Commitments: Burning Ships
· A party in a conflict can strengthen its position by cutting off some of its
options to make its threats more credible (e.g., an army that burns the
bridge behind it making retreat impossible).
· A famous example of this tactic is when Hernán Cortés had his men burn
and sink their ships.
· With a force of fewer than six hundred men, Hernán Cortés invaded and
conquered Moctezuma’s Aztec empire.
· The natives of the East Coast told Cortés about the great wealth of the
Aztec Empire, farther into the interior. To prevent his own small force
from deserting because many feared venturing inland, Cortés burned his
ships, leaving no means of escape.
· Let’s see if we can give a game-theoretic explanation of Cortés’ decision...
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Hernán Cortés’ original game
Payoffs are listed in alphabetic order (Cortés first and Moctezuma second),
where f denotes “fight” and r “run away”.
· What would happen if Cortés threatens to fight back if Moctezuma
decides to fight?
decides to fight?
· Moctezuma would be better off running away.
· Is Cortés’ threat to fight credible?
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decides to fight?
· Moctezuma would be better off running away.
· Is Cortés’ threat to fight credible?
No, but if Cortés actually commits and burns and sinks his ships, so that
running away is no longer an option or him, then it is credible.
Hernán Cortés’ game after burning the ships

· Suppose now that Cortés burns his ships, which means that running away
becomes impossible for him.
· If the ships are burned, then running away is not an option, which means
that Cortés’ only remaining option is to fight (f ).
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· In this case, Moctezuma prefers to run away (r ) and get a payoff of 1,

rather than to fight and get a payoff of 0.
· Cortés threat to fight becomes credible after burning the ships.

· In this case, Moctezuma prefers to run away (r ) and get a payoff of 1,

rather than to fight and get a payoff of 0.
· Cortés threat to fight becomes credible after burning the ships.
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Hernán Cortés’ complete game
In the complete game, Hernán Cortés moves first: he decides whether to burn
the ships, B, or whether not to burn them, NB.
· In non-strategic environments, more options is never worse.

· This need not be so in strategic environments.
Hernán Cortés’ complete game

In the complete game, Hernán Cortés moves first: he decides whether to burn
the ships, B, or whether not to burn them, NB.
· In non-strategic environments, more options is never worse.

· This need not be so in strategic environments.
Basic Lesson
You may change your opponents’ actions to your advantage in equilibrium by
committing to remove some of your own.
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Another example of “burning ships”
In the senate race game:

· Bob could sign a contract (for example with his local party)
that obliges him to stay in the race.
· This would ensure that retiring is no longer an option for Bob.
From Extensive to Normal Form Games
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Senate Race Game Revisited
· Consider the senate race game analyzed analyzed earlier: an
incumbent senator (Alice) decides whether to use a preemptive
campaign against a potential challenger (Bob), who has to choose
whether to enter the race.
enter 1, 1
bob
advertise
retire 3, 3
alice
enter 2, 4
do not advertise
bob
retire 4, 2
· A game in normal form requires the specification of

1. The set of players;
2. The strategy set of each player;
3. The payoff function of each player.
Senate Race Game – payoffs in the normal form

· We have to fill in every cell in the matrix by the payoffs that result
from the strategy profile corresponding to the cell.
· For example, determine the payoffs of the strategy profile
(do not adv., (retire, enter)).
· This strategy profile is depicted in the figure by the red colored
actions.
· This strategy profile (do not adv., enter) gives rise to a path (or
sequence of actions) leading to a single terminal node.
· The payoffs associated to that terminal node are (2, 4) and have to
be put in the cell at row do not adv. and column (retire, enter).
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The Senate Race Game – normal form
Senate race game in extensive form:

enter 1, 1
bob
advertise
retire 3, 3
alice
enter 2, 4
do not advertise
bob
retire 4, 2
Senate race game in normal form:
Alice \ Bob (ent,ent) (ent,ret) (ret,ent) (ret,ret)

advertise 1, 1 1, 1 3, 3 3, 3
do not adv. 2, 4 4, 2 2, 4 4, 2
What are the Nash equilibria of this game?

enter 1, 1
bob
advertise
retire 3, 3
alice
enter 2, 4
do not advertise
bob
retire 4, 2

advertise 1, 1 1, 1 3, 3 3, 3
do not adv. 2, 4 4, 2 2, 4 4, 2

· (do not adv ., (ent, ent )) and (adv ., (ret, ent )).
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enter 1, 1
bob
advertise
retire 3, 3
alice
enter 2, 4
do not advertise
bob
retire 4, 2

advertise 1, 1 1, 1 3, 3 3, 3
do not adv. 2, 4 4, 2 2, 4 4, 2

· (do not adv ., (ent, ent )) and (adv ., (ret, ent )).
· Only (adv ., (ret, ent )) is a backward induction equilibrium.
Backward induction equilibria are always Nash equilibria (of both games).
Nash equilibria (of either game) are not necessarily backward induction eq.
· It is easier to find the Nash equilibria in the normal form game.
Application: Ultimatum Game

· Two players: a proposer (player 1) and a responder (player 2),
have to divide 100e.
· Player 1 proposes how to split the 100e between the two players.
· Player 2 can either accept or reject the proposal.
· If player 2 rejects, neither player receives anything.
· If player 2 accepts, the money is split according to the proposal.
· The game is played only once so that reciprocation is not an issue
(it’s what we call a “take it or leave it” offer).
· Suppose offers are made such that the smallest units are cents.
In brief, player 1 offers x to player 2, and player 2 can:
· accept the offer (yes) which leads to outcome (100 − x, x ).
· reject the offer (no) which leads to outcome (0, 0).
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Application: Ultimatum Game – extensive form
What are the backward induction equilibria?

At the backward induction equilibrium:

· Player 2 accepts any amount above or equal to 0.01 (or 0).
· Player 1 offers 0.01 (or 0) to 2 and keeps 99.99 (or 100).
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All Pareto efficient outcomes can be supported as a Nash equilibrium:

· Player 2 accepts any amount above or equal to x (e.g., x = 50).
· Player 1 offers x to 2 and keeps 100 − x (e.g., 100 − x = 50).
· But Player 2 may only accept 90 and so 1 offers 90 and keeps 10.
Application: Ultimatum Game – experimental evidence

General evidence from experimental studies
· Offers below 10% of the total sum at stake are very rare.
· The median offer (half of the proposers offer less than that
and the other half more) is in the 40-50% range.
· In many experiments the 50:50 split is the single most

frequent proposal.
· Proposals that would give the responder less than 20 percent

are rejected about half of the time.
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Experimental results ECO/ADE – 2023
Groups T1 and T3 together:
Probabilities:
T1+T3: 0–10 11–20 21–30 31–40 41–50 51–60 61–70 71–80 81–90 91–100
Prop. 5.5 3.1 13.2 24.3 32.0 14.1 5.5 2.3 0.0 0.0
Resp. 17.9 4.9 10.6 17.9 34.1 8.1 2.4 1.6 1.6 0.1
Experimental results ECO/ADE – this year

Groups T1 and T3 together:
Probabilities:
T1+T3: 0–10 11–20 21–30 31–40 41–50 51–60 61–70 71–80 81–90 91–100
Prop. 7.0 5.4 8.5 17.1 43.4 11.6 3.1 3.9 0.8 3.1
Resp. 16.8 6.2 13.3 17.7 27.4 11.5 4.4 1.8 1.6 0.8
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Experimental results ECO/ADE (previous years knowing BIE)

Experimental results ECO/ADE (previous years knowing BIE)
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Some possible explanations
· Bounded rationality: Players may be unable to do the full

backward induction reasoning.
Although as noted there are many more Nash equilibria!


· Social preferences: Players may have other motives beyond
the pure selfish desire to get as much money as they can.
· Proposers may not want to offer too low amounts.
· They may care about the fairness of the outcome.
· For example, they may be averse to inequality, or may feel
guilt for offering a low amount.
· Responders may not want to accept too low offers.
· They may also care about the fairness of the outcome.
· For example, they may be averse to inequality, or the may feel
envy or anger at receiving a low offer and hence may reject it.
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· Social preferences: Players may have other motives beyond
the pure selfish desire to get as much money as they can.
· Proposers may not want to offer too low amounts.
· They may care about the fairness of the outcome.
· For example, they may be averse to inequality, or may feel
guilt for offering a low amount.
· Responders may not want to accept too low offers.
· They may also care about the fairness of the outcome.
· For example, they may be averse to inequality, or the may feel
envy or anger at receiving a low offer and hence may reject it.
Basic Lesson (you will see more in Behavioral Game Theory)
The money payoffs may not be the same as the utilities of the outcomes!
Dictator Games and Revealed Social Preferences

Giving according to GARP (Andreoni and Miller, 2002)
From Problem Set #3, Question 5 in Micro 1:
In their paper, Andreoni and Miller (2002) test whether subjects behave
rationally when deciding over opportunities of sharing a surplus with another
(anonymous) individual. Subjects are offered various bundles of the form
(x1 , x2 ) where:
· x1 is payment to the subject (payment to self) and
· x2 is payment to an anonymous other (payment to other).
Subjects are presented different budget lines corresponding to incomes and
prices of sharing the surplus. For each of the presented sets of bundles (each
on a different budget line), subjects are asked to select their preferred one.
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From Problem Set #3, Question 5 in Micro 1:
In their paper, Andreoni and Miller (2002) test whether subjects behave
rationally when deciding over opportunities of sharing a surplus with another
(anonymous) individual. Subjects are offered various bundles of the form
(x1 , x2 ) where:
· x1 is payment to the subject (payment to self) and
· x2 is payment to an anonymous other (payment to other).
Subjects are presented different budget lines corresponding to incomes and
prices of sharing the surplus. For each of the presented sets of bundles (each
on a different budget line), subjects are asked to select their preferred one.
The study finds three main types of individuals:
· selfish types (47.2%);
· perfect complements types, with fixed preference for fairness (30.4%);
· perfect substitutes types, showing willingness to substitute allocation to
self with allocation to other depending on relative price (22.4%).
Which of the following figures corresponds to which type of subjects?

150 Choices made by subject 150 Choices made by subject

-- Budget lines offered to subject -- Budget lines offered to subject
Payment to other (x2 )
100 100
50 50
0 0
0 50 100 150 0 50 100 150
Payment to self (x1 ) Payment to self (x1 )
150 Choices made by subject

-- Budget lines offered to subject
100
50
0
0 50 100 150
Payment to self (x1 )
Figure: Which figure represents selfish, complements and substitutes types?

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Origin of Social Preferences
In Topic 8 on Repeated Games, we will learn more about cooperation and the
possible origins of preferences for fairness or inequality aversion.
Figure: From social anthropology book on the origin and history of inequality
Also recommended: Bowles and Gintis (2012) A Cooperative Species: Human
Reciprocity and its Evolution, Princeton University Press.

Topic 7. Sequential Games with Imperfect
Information
Fabrizio Germano
Winter 2024
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Sequential Games with Imperfect Information
Combining Sequential and Simultaneous Moves
So far, we have considered games of purely sequential nature and games of

purely simultaneous nature.
We used
· Game trees (extensive forms) to represent sequential move games.
· Game matrices (normal forms) to represent simultaneous move games.
· However, many strategic situations contain elements of both types of
interactions, so we need to combine both approaches.
We introduce a new, more general solution concept called subgame perfect

Nash equilibrium, which:
· coincides with backward induction equilibrium in sequential games with
perfect information;
· coincides with Nash equilibrium in simultaneous move games;
and which also applies to sequential games of imperfect information.
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From Extensive to Normal Form Games
The Entry Game Revisited

Consider the simple entry game in extensive form we analyzed in Topic 6:
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The Entry Game Revisited
The backward induction equilibrium is easily computed:

· The potential firm (A) enters, the incumbent (B) accommodates.
· (e, a) is the equilibrium profile, e − a the equilibrium path, and
(7, 10) the equilibrium payoffs.
· Is this prediction a Nash equilibrium?
The Entry Game – normal form

7, 10
a
e
B
r -3, 0
A
n
5, 20
The backward induction equilibrium is easily computed:

· The potential firm (A) enters, the incumbent (B) accommodates.
· (e, a) is the equilibrium profile, e − a the equilibrium path, and
(7, 10) the equilibrium payoffs.
· Is this prediction a Nash equilibrium?
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A\B a r
e 7, 10 −3, 0
n 5, 20 5, 20
The backward induction equilibrium in a perfect information game is a Nash

equilibrium in the corresponding normal form game.
· Here (e, a) is a backward induction and a Nash equilibrium.
A\B a r
e 7, 10 −3, 0
n 5, 20 5, 20
The backward induction equilibrium in a perfect information game is a Nash

equilibrium in the corresponding normal form game.
· Here (e, a) is a backward induction and a Nash equilibrium.
· However, there is also another Nash equilibrium:
· (n, r ) with payoffs (5, 20).
· In this equilibrium, Player B plays a weakly dominated strategy.
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Make sure you understand why (n, r ) is a Nash equilibrium.
7, 10
a
e
B
r -3, 0
A
n
5, 20
· Given that B chooses to retaliate, A plays a best response:

· It is better for A not to enter since A would get −3 instead of 5.
· And since A chooses not to enter, B also plays a best reponse:
· It is better for B to retaliate since B gets 20 in any case.
· Strategy r is a successful threat because it is not actually played as it is
off the equilibrium path.
· However, retaliating is not a credible threat because in a sequential game,
once A decides to enter, B would not gain anything by retaliating.
At that stage it is not optimal for B to retaliate and carry out his threat.
From Normal to Extensive Form Games
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From normal to extensive form: Matching Pennies revisited
Consider again the Matching Pennies game:
· Two players, A and B, decide secretly (or simultaneously) whether to
Heads (H) or Tails (T ).
· If players’ decisions are the same, then A wins (payoffs are (1, −1)).
· Otherwise, B wins (payoffs are (−1, 1)).
A\B H T
H 1,-1 -1, 1
T -1, 1 1,-1
Does the following extensive form game describe the Matching Pennies game?
Imperfect information and information set

· The answer is no.
· If the game is played simultaneously, the action of player A is not
observable by B.
· There are hidden actions (imperfect information).
In order to represent the Matching Pennies game in extensive form we must
introduce a new idea: the concept of information set.
Since the game is played simultaneously, player B does not observe A’s action
and therefore cannot identify from which decision node he is moving.
· To indicate this, we draw a dotted line between B’s two decision nodes:
· These two decision nodes belong to the same information set.

· B can either choose H or T .
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Imperfect information and information set
An information set is a subset of decision nodes that:
1. belong to the same player;
2. have the same available actions;
3. the player cannot distinguish
(due to hidden actions at previous node(s)).
Since we cannot distinguish between nodes in the same information set:
· all actions at nodes in the same information set must be the same!
The definition of strategy has to be generalized:
· a strategy is a complete contingent plan specifying an action for every
information set (instead of for every decision node).
In perfect information games every information set consists of a single node.
· When there is at least one information set that contains more than one
decision node we say that there is imperfect information.
Every game can be represented in normal-form as well as in extensive-form.
However, the normal form contains less strategic information.
Games with both simultaneous and sequential moves
Most real games that you encounter consist of smaller components.

Each of the components can have simultaneous or sequential play.
· Being able to analyze the full game typically requires you to
be familiar with both.
We now study one such game.
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A Cournot Entry Game
Consider the following more complex sequential game with imperfect

information.
· It is an entry game in which after the first stage, where the entry decision
is taken, there is a second stage in which the two firms play a
simultaneous move “Cournot game” in deciding production levels.
· In the first stage the potential entrant, B, decides whether to enter the
market (e) or not to enter (n).
· If B enters, there is a second stage.
· Both firms, A and B, decide to accommodate (a), by producing the
Cournot duopoly quantity, or retaliate (r ) producing large quantities
driving down prices.

5, 0
n
a 3, 1
B A
a r 0,-3
e
B
a 2, 0
r
A
r -2,-5
Note: The first payoff is player A’s (alphabetical order).
First write the game in normal form:
A\B (e,a) (e,r) (n,a) (n,r)

a 3, 1 2, 0 5, 0 5, 0
r 0, −3 −2, −5 5, 0 5, 0
(r , (n, a)), (r , (n, r )) and (a, (e, a)) are pure strategy Nash equilibria.
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5, 0
n
a 3, 1
B A
a r 0,-3
e
B
a 2, 0
r
A
r -2,-5
Note: The first payoff is player A’s (alphabetical order).
First write the game in normal form:
A\B (e,a) (e,r) (n,a) (n,r)

a 3, 1 2, 0 5, 0 5, 0
r 0, −3 −2, −5 5, 0 5, 0
(r , (n, a)), (r , (n, r )) and (a, (e, a)) are pure strategy Nash equilibria.
Nash equilibria of the Cournot Entry Game

· We see that there are three pure strategy Nash equilibria:
Profile Path Payoffs
(r , na) n (5, 0)
(r , nr ) n (5, 0)
(a, ea) e − a − a (3, 1)
· Consider the first Nash equilibrium (r , na).
· The strategy profile is represented in the game tree below:
5, 0
n
a 3, 1
B A
a r 0,-3
e
B
a 2, 0
r
A
r -2,-5
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· Consider now the second stage of the game.
a 3, 1
A
a r 0,-3
B
a 2, 0
r
A
r -2, -5
· To analyze this ‘subgame’ of the original game rewrite it in normal form

(first payoff is for player A, the row player).
A\B a r
a 3, 1 2, 0
r 0, −3 −2, −5
· We see that retaliation is a dominated strategy for both players.
· There is a unique Nash (and also dominant strategy) equilibrium in the
‘subgame’, namely, (a, a).

5, 0
n
a 3, 1
B A
a r 0,-3
e
B
a 2, 0
r
A
r -2,-5
· In short, in the first equilibrium of the ‘complete game’ (r , (n, a)), the
incumbent A is threatening with retaliation, but this threat is a
dominated strategy in the subgame!
· In other words, the first Nash equilibrium of the ‘complete game’ says
that the players make irrational decisions in a subgame (since they do not
play according to a NE of that subgame)!
· So, it can happen that some NE of the ‘complete game’ are not
reasonable.
We look for a procedure that can find more ’reasonable’ Nash equilibira...
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Subgame Perfect Nash Equilibrium
Subgames
· A game is a set of nodes connected with branches.
· A subgame is a subset of these nodes and branches such that:

1. It starts with a chance node or an information set containing a
single decision node; also called a proper node.
2. It contains all the successors of a given node, and only those.
3. If it contains one node of an information set, then it contains
all the other nodes of this information set (i.e., the subgame
does not separate the elements of an information set).
· The whole game is considered a subgame of itself.
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Examples of subgames
The following game has 4 subgames:
s ( -3, 1)
a B
t ( 5, 0)
A
n ( 4,-7)
r
a ( 3, 1)
B A
a r ( 1,-2)
e
B
a (-2, -1)
r
A
r (-3, -1)
Examples of subgames?
Are these subgames?
s ( -3, 1)
a B
t ( 5, 0)
A
n r ( 4,-7)
a ( 3, 1)
B A
a r ( 1,-2)
e
B
a (-2, -1)
r
A
r (-3, -1)
s ( -3, 1)
a B
t ( 5, 0)
A
n r ( 4,-7)
a ( 3, 1)
B A
a r ( 1,-2)
e
B
a (-2, -1)
r
A
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Subgame Perfect Nash Equilibrium
We extend the concept of backward induction equilibrium to games of imperfect
information to rule out non-credible threats as in the Cournot Entry Game.
· Instead of “choosing optimally at each decision node,” now we require
“choosing optimally at each information set,” and, as before,
“anticipating that others will be playing optimally too”.
Formally, a strategy profile is a subgame perfect Nash equilibrium (SPNE) if

and only if it induces a Nash equilibrium in each of the subgames of the game.
Note: Threats are now credible if and only if they are part of a SPNE.
· In the case of a simultaneous game, SPNE coincides with Nash
equilibrium.
· In the case of an extensive-form game with perfect information, the
SPNE concept coincides with backward induction equilibrium.
· In general, a SPNE is always a Nash equilibrium of the game (since the
whole game is a subgame), but the reverse need not be true: A Nash
equilibrium need not always be a SPNE.
Recipe for finding SPNE: “Backward Subgame Induction”
· As under backward induction (BI), start at the end of the tree.

· But in contrast to BI, do not choose the “last decision node” but choose
the “last subgame,” meaning, a subgame that does not contain another
(smaller) subgame.
· Write down the normal form game corresponding to this subgame, only
considering the possible actions that can be chosen in this subgame, and
find a NE.
· Replace the subgame by the outcome of the NE you found above and act
as if the tree ends there. Now repeat the previous steps for the new tree.
· Important: If you are looking for all the SPNE, as some subgames may
have multiple (different) NE, you may have to repeat the above steps
multiple times, each time selecting a different NE. This will generate
multiple SPNE.
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Finding SPNE: An example
· Payoffs are written in the order, first A’s, then B’s.
s -3, 1
a B
t 5, 0
A
n
r 4,-7 a 3, 1
B A
a r 1, 0
e
B
a -2, -1
r
A
r -1, -1
· Consider first the simultaneous move subgame and put it in normal form:
A\B a r
a 3, 1 −2, −1
r 1, 0 −1, −1
· The subgame has a unique Nash equilibrium with profile (a, a).
(Why is there no other equilibrium in mixed strategies?)
· So, we know that if the simultaneous move game is played, then the
players will obtain payoffs (3, 1).
· We indicate this by a small payoff vector just above player B’s second
decision node in the complete game.
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or equivalently
· We now continue the calculation of the SPNE by using the new tree:
-3, 1 s -3, 1
a B
4, -7
t 5, 0
A
n
3, 1 r 4,-7
B
e
3, 1
· From which we compute the rest of the SPNE strategies of the players.
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· Overall:
-3, 1 s -3, 1
a B
4, -7
t 5, 0
A
n r
3, 1 4,-7 a 3, 1
B A
3, 1
a r 1, 0
e
B
a -2, -1
r
A
r -1, -1
· Hence, the unique SPNE is ((r , a), (e, a, s )).
Application: Mutually Assured Destruction (MAD)
La Vanguardia, March 1, 2022, Eusebio Val, Putin olvida la doctrina MAD (loco)
https://www.lavanguardia.com/internacional/20220301/8089950/putin-olvida-doctrina-mad-loco.html
287 / 339
Mutually Assured Destruction (MAD)
Joint Strategic Capabilities Plan (US, 1961)
Answer to the question to the Joint Chiefs of Staff: “If your plans for general [nuclear]
war are carried out as planned, how many people will be killed in the Soviet Union and
China?” The answer was in the form of a graph.
from: The Prologue, p. 2, in: The Doomsday Machine: Confessions of a Nuclear War
Planner, 2017, by Daniel Ellsberg.

The Doomsday Machine
Four scenes:
· The war room – Russian ambassador – Hi Dimitri – The Doomsday Machine
from: Dr. Strangelove, or: How I learned to stop worrying and love the bomb (1964)
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Cuba 1962... Ukraine 2022, 2023
MAD is a doctrine of military strategy based on the theory of deterrence.

· Since each superpower has enough nuclear weapons to destroy the other
(even if attacked first), any superpower that begins a nuclear war will
cause the destruction of both itself and its opponent.
· Could this be enough to deter any such attack?
The situation preceding an atomic confrontation can be modelled as follows.
· Two superpowers, 1 and 2, are engaged in a provocative incident,
possibly provoked by 2
· The game starts with superpower 1’s choice to either ignore the incident
(I ) resulting in the payoffs (0, 0), or to escalate the situation (E ).
· Following escalation by superpower 1, superpower 2 can back down (B)
causing it to lose face, resulting in payoffs (2, −2), or it can choose to
proceed to an atomic confrontation situation (A).
Recommended book: The Doomsday Machine: Confessions of a Nuclear War Planner (2017) by Daniel Ellsberg.
Recommended film: Dr. Strangelove, or: How I learned to stop worrying and love the bomb (1964) by Stanley
Kubrick (with Peter Sellers as the US president, a soldier and a chief scientist, possibly John von Neumann).

The atomic confrontation
Upon this latter choice (A = atomic confrontation), the two superpowers play
the following simultaneous move game:
1. They can either retreat (R) or choose doomsday (D), in which case the
world is destroyed (as far as they are concerned).
2. If both choose to retreat then they suffer a small loss, and payoffs are
(−1, −1).
3. If either one chooses doomsday, then the world is destroyed, and payoffs
are (−K , −K ), where K ≈ ∞ is a very large number.
Note: The two choice nodes joined by the dashed line are referred to as an information set of 2 and are to be
treated as a single choice node for 2, denoting that 2 does not know what 1 chose (as in a simultaneous game).
289 / 339
· The simultaneous move game starting at player’s 1 second node can be
written as follows:
1\2 D R
D ∗
−K , −K ∗ −K , −K ∗
R −K ∗ , −K −1∗ , −1∗
· It has two pure strategy Nash equilibria:
· (D, D ) and (R, R ) with payoffs (−K , −K ) and (−1, −1).
· Now we have two “reduced games” (one for each Nash equilibrium):
B 2,-2 B 2,-2
E 2 E 2
1 1 A -K,-K
A -1,-1
I 0, 0 I 0, 0
· We see there are two subgame perfect equilibria:
· ((I , R ), (A, R )) with payoffs (0, 0)
· ((E , D ), (B, D )) with payoffs (2, −2).

written as follows:
1\2 D R
D ∗
−K , −K ∗ −K , −K ∗
R −K ∗ , −K −1∗ , −1∗
B 2,-2 B 2,-2
E 2 E 2
1 1 A -K,-K
A -1,-1
I 0, 0 I 0, 0
· Are doomsday actions played?
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written as follows:
1\2 D R
D ∗
−K , −K ∗ −K , −K ∗
R −K ∗ , −K −1∗ , −1∗
B 2,-2 B 2,-2
E 2 E 2
1 1 A -K,-K
A -1,-1
I 0, 0 I 0, 0
· None of the equilibrium paths involve the doomsday action!

How large should K be?
· After leaving the White House, McGeorge Bundy [ex-security advisor to
presidents J.F. Kennedy and L.B. Johnson] wrote in Foreign Affairs:
“In the real world of real political leaders—whether here or in the Soviet
Union—a decision that would bring even one hydrogen bomb on one city
of one’s own country would be recognized as a catastrophic blunder; ten
bombs on ten cities would be a disaster beyond human history; and a
hundred bombs on a hundred cities unthinkable.”
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· In the last year of the Cold War, in a famous talk, Herbert York [nuclear
physicist] posed the question:
“How many nuclear weapons are needed to deter an adversary rational
enough to be deterred?”.
Concurring with Bundy’s own judgement he answered his question:

“Somewhere in the range of 1, 10, or 100... closer to 1 than to 100.”

· In the last year of the Cold War, in a famous talk, Herbert York [nuclear
physicist] posed the question:
“How many nuclear weapons are needed to deter an adversary rational
enough to be deterred?”.
Concurring with Bundy’s own judgement he answered his question:

· In 1986, the US had 23,317 nuclear warheads and Russia had 40,159, for
a total of 63,836 weapons.
from: Chapter 9, p. 144 in: The Doomsday Machine: Confessions of a Nuclear War
Planner, 2017, by Daniel Ellsberg.
292 / 339
Today’s nuclear arsenal:

How large should K be? “...in the range 1, 10, or 100... closer to 1 than to 100”
The New York Times, March 4, 2024, W.J. Hennigan,

Nuclear War Is Called Unimaginable. It’s Not Imagined Enough.
https://www.nytimes.com/interactive/2024/03/04/opinion/nuclear-war-prevention.html
293 / 339
How large should K be? “...in the range 1, 10, or 100... closer to 1 than to 100”
The New York Times, March 4, 2024, W.J. Hennigan,

Nuclear War Is Called Unimaginable. It’s Not Imagined Enough.
https://www.nytimes.com/interactive/2024/03/04/opinion/nuclear-war-prevention.html
Application: Liar’s Poker

· A deck of cards consists of 50% Aces and 50% Kings.
· Player 1 is dealt one card.
· Player 1 can either bet (A) stating that he has an Ace, or pass (K )
stating that he has a King.
· If player 1 bets (A), player 2 can either believe it (b) or object (o).
If player 2 believes it (b):
· the game is over and player 2 pays 10e to player 1.
If player 2 objects (o) player 1 turns over his card (the showdown) and:
· If player 1 has an Ace, player 2 pays 20e to player 1.
· If player 1 “lied” and is caught, then he pays 40e to player 2.
· If player 1 passes (K ), the game is over and player 1 pays 10e to player 2.
· Assume risk neutrality and selfishness.
· We will consider three different games depending on the information
available to the players.
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Liar’s Poker with Perfect Information – open card poker
Player 1 is dealt the card face up so that everybody can see it.
This gives the following perfect information game:
o (20,-20)
2
A (10,-10)
b
1
2
1/
=
K (-10, 10)
A)
P(
o (-40, 40)
2
P(
A
K)
b (10,-10)
=
1/
2
1
K (-10, 10)
Liar’s Poker with Imperfect Information – poker

Player 1 is dealt the card face down so that he can see it, but not player 2.
This gives the following imperfect information game:
o (20,-20)
2
A (10,-10)
b
1
2
1/
)=
K (-10, 10)
A
P(
o (-40, 40)
2
P(
A
K)
b (10,-10)
=
1/
2
1
K (-10, 10)
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Liar’s Poker with Imperfect Information – blind poker
Player 1 is dealt the card face down so that no player can see it.
This gives the following imperfect information game:
o (20,-20)
2
A (10,-10)
b
1
2
1/
=
K (-10, 10)
A)
P(
o (-40, 40)
2
P(
A
K
(10,-10)
)=
b
1/
2
1
K (-10, 10)
Solution to Open Card Poker

Can be solved by backward induction.
Player 2 will:
· believe (b) if an Ace is dealt, object (o) if a King is dealt.
Player 1 will:
· bet (A) if he gets an Ace, pass (K ) if he gets a King.
The backward induction equilibrium (BIE) is:
· ((A, K ), (b, o )) with (expected) payoffs: (0, 0).
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Solution to Blind Poker
Player 1 is dealt the card face down so that no player can see it. We cannot
solve it by backward induction since there are hidden actions.
o (20,-20)
2
A (10,-10)
b
1
2
1/
=
K (-10, 10)
A)
P(
o (-40, 40)
2
P(
A
K)
b (10,-10)
=
1/
2
1
K (-10, 10)
Convert it to normal form: 1\2 o b

A −10, 10 10, −10
K −10, 10 −10, 10
1\2 o b
A −10, 10 10, −10
K −10, 10 −10, 10
· Both players have a weakly dominated strategy:

· K is weakly dominated for Player 1 and b for Player 2.
· There are 2 pure strategy Nash equilibria: (A, o ) and (K , o ).
· The expected payoffs at both equilibria are (−10, 10).
· It is better to be Player 2 than Player 1.
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1\2 o b
A −10, 10 10, −10
K −10, 10 −10, 10
· Both players have a weakly dominated strategy:

· K is weakly dominated for Player 1 and b for Player 2.
· There are 2 pure strategy Nash equilibria: (A, o ) and (K , o ).
· The expected payoffs at both equilibria are (−10, 10).
· It is better to be Player 2 than Player 1.
Note: Here the Nash equilibria are also subgame perfect equilibria. But because the
game is zero-sum they are also part of the players’ security strategies. Hence −10 is
also the value of the game Blind Poker to player 1.
Solution to Poker
o (20,-20)
2
A (10,-10)
b
1
2
1/
=
K (-10, 10)
A)
P(
o (-40, 40)
2
P(
A
K)
b (10,-10)
=
1/
2
1
K (-10, 10)
Player 1 has two information sets and four possible strategies:

· (A, A) always bet;
· (A, K ) always tell the truth (play A with Ace, K with King);
· (K , A) always lie (play K with Ace, A with King);;
· (K , K ) always pass.
so S1 = {(A, A), (A, K ), (K , A), (K , K )}.
Player 2 has two strategies o and b, so S2 = {o, b }.

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Solution to Poker
Since the game is zero sum, it suffices to compute the payoff for one agent.
For example:
1 1
u1 ((A, A), o ) = 20 + (−40) = −10
2 2
1 1
u1 ((A, K ), o ) = 20 + (−10) = 5
2 2
1 1
u1 ((K , A), o ) = (−10) + (−40) = −25.
2 2
Solution to Poker
The game in normal form is:
1\2 o b
(A,A) −10, 10 10, −10
(A,K) 5, −5 0, 0
(K,A) −25, 25 0, 0
(K,K) −10, 10 −10, 10
Eliminate the strictly dominated strategies:
· (K , A) is strictly dominated by (A, A); and (K , K ) by (A, K ).
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Solution to Poker
1\2 o b
(A,A) −10, 10 10, −10
(A,K) 5, −5 0, 0
(K,A) −25, 25 0, 0
(K,K) −10, 10 −10, 10
We are left with the 2 × 2 subgame: 1\2 o b
(A,A) −10, 10 10, −10
(A,K) 5, −5 0, 0
Solution to Poker
1\2 o b
(A,A) −10, 10 10, −10
(A,K) 5, −5 0, 0
(K,A) −25, 25 0, 0
(K,K) −10, 10 −10, 10
(A,A) −10, 10 10, −10
(A,K) 5, −5 0, 0
The game has a unique Nash equilibrium in mixed strategies:

· ( ( 51 , 45 , 0, 0) , ( 52 , 35 ) ) with expected payoffs (2, −2).
It is better to be Player 1 in this case!
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Solution to Poker
1\2 o b
(A,A) −10, 10 10, −10
(A,K) 5, −5 0, 0
(K,A) −25, 25 0, 0
(K,K) −10, 10 −10, 10
(A,A) −10, 10 10, −10
(A,K) 5, −5 0, 0
The game has a unique Nash equilibrium in mixed strategies:

· ( ( 51 , 45 , 0, 0) , ( 52 , 35 ) ) with expected payoffs (2, −2).
It is better to be Player 1 in this case!
Note: Again, the Nash equilibrium is also subgame perfect (why?). And since the
game is zero-sum it also constitutes a security strategy profile. Hence 2 is the value of
the game Poker to player 1.
Important Lesson
The information structure of a game can make a significant

difference and can lead to different equilibrium outcomes.
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Commitment
Commitment and entry investments: Another entry game
· Consider a domestic firm (firm 1) and a foreign firm (firm 2) participating

in a simultaneous entry game.
· There are 10 millions of revenue to be made but there is a fixed cost of
entry of 7 million. There are no variable costs.
· The game in normal form is:
1\2 e n
e −2, −2 3, 0
n 0, 3 0, 0
· Now, suppose that there is an early phase during which the domestic
firm can make investments (such as unique types of equipment or
job-specific training) that once made cannot be recovered.
· The investment is part of the 7 million entry cost if you enter, but is
lost if you stay out.
· We consider investing 0, 1, or 3 millions in specific investments.
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The entry investment game in extensive form
e -2,-2
2
e
n 3, 0
1
e 0, 3
n
2
n 0, 0
In0
e -2,-2
2
e
In1 n 3, 0
1 1
e -1, 3
n
2
n -1, 0
In3
e -2,-2
2
e
n 3, 0
1
e -3, 3
n
2
n -3, 0
In0: The original entry game
1\2 e n
e −2, −2 3, 0
n 0, 3 0, 0
· There are two pure strategy Nash equilibria.

· If firm 1 believes firm 2 will enter, it will stay out;
· If firm 1 believes firm 2 will stay out, it will enter.
· And vice versa.
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In1: Involvement and the entry game
1\2 e n
e −2, −2 3, 0
n −1, 3 −1, 0
· There are still two pure strategy Nash equilibria.

· If firm 1 believes firm 2 will enter, it will stay out
· If firm 1 believes firm 2 will stay out, it will enter.
· And vice versa.
· The term “involvement” indicates that the domestic firm anticipates a
later situation (entering) and starts making choices (investment) now
that would be made later if the situation substantiates.
The only cost is that these choices will not be optimal if the anticipated
situation does not occur.
In3: Commitment and the entry game
1\2 e n
e 2, −2 3, 0
n −3, 3 −3, 0
· Now entering becomes a dominant strategy for firm 1.

· The strategy profile (e, n ) with payoffs (3, 0) is the unique Nash
equilibrium.
· Firm 1 now has successfully committed to enter.
· Commitment is more than anticipating later choices, it is about binding
one’s own choices. (The kind of commitment in the game is strategic as
the domestic firm could still decide to stay out– however, this would not
be optimal.)
Lesson
“The power to constrain an adversary depends upon the power to
bind oneself.” (Thomas Schelling)
304 / 339
Topic 8. Repeated Games
-- not exam relevant --
Fabrizio Germano
Winter 2024
Origin of Cooperation, Social Preferences, Norms ...

...and Morality
Recall from Topic 6:
Figure: From social anthropology book on the origin and history of inequality
Recommended book: Bowles and Gintis (2012) A Cooperative Species: Human
Reciprocity and its Evolution, Princeton University Press.
But see also: Jean-Jacques Rousseau, David Hume,..., Friedrich Nietzsche, ..., Michel
Foucault etc., etc.
305 / 339
Key Terms in Repeated Games
Some general terms:
· Reciprocity – Cooperation
· Punishment
· Penal code – optimal penal code
· Norm
· Reputation
Hammurabi Code (ca. 1792-1750 BCE)
Key Terms in Repeated Games

Some general terms:
· Reciprocity – Cooperation
· Punishment
· Penal code – optimal penal code
· Norm
· Reputation
Some technical terms:

· Stage game – Repeated game
· Continuation game
· Discount factor
· History dependent strategy
· Grim trigger – Tit for Tat
Hammurabi Code (ca. 1792-1750 BCE)
306 / 339
First Example
Suppose player 1 and 2 interact over two periods and play in both
periods the stage game:
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
Suppose the payoffs of the overall two-period game are the sums of
the stage game payoffs.
· For example, if players play (A, X ) in period 1 and (B, Y ) in
period 2, then payoffs are:
(4, 3) + (2, 1) = (6, 4).
First Example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
10
8
Payoff of player 2
0
0 2 4 6 8 10
Payoff of player 1
307 / 339
First Example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
10
Payoff of player 2
6
0
0 2 4 6 8 10
Payoff of player 1
The above graph shows all the possible payoffs that can be reached with pure
actions in the two-period game.
· The red points can be supported as Nash equilibria of the stage game in
both periods. Nash equilibria of G are (A, Z ), (B, Y ).
First Example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
10
8
Payoff of player 2
0
0 2 4 6 8 10
Payoff of player 1
The above graph shows all the possible payoffs that can be reached with pure
actions in the two-period game.
· The red points can be supported as Nash equilibria of the stage game in
both periods. Nash equilibria of G are (A, Z ), (B, Y ).
· The blue point does not involve playing a Nash equilibrium in both
periods but is nonetheless a subgame perfect equilibrium outcome.
308 / 339
First Example
Fix a finite stage game G that is repeated finitely many times.
Then any sequence of Nash equilibrium profiles of the stage game G can
be supported as the outcome of a Nash equilibrium and in fact of a
subgame perfect equilibrium of the repeated game.
· The red points of the example can be supported in this way, as
Nash equilibria of the stage game in both periods, thus forming a
subgame perfect equilibrium.
But are there Nash equilibria or even subgame perfect equilibria of the
repeated game that do not consist of playing Nash equilibrium profiles of
the stage game in each period?
· YES! This is true even with finite repetitions.
· The blue point (5, 7) in the previous figure is such an example.
· How can we support it as a subgame perfect equilibrium?
First Example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
Consider the following repeated game strategy profile for both players:
· Period 1: Play (A, X )
· Period 2:
Player 1: As long as player 2 did not deviate from X in period 1, play A;
otherwise, play B.
Player 2: As long as player 2 did not deviate from X in period 1, play Z ;
otherwise, play Y .
In equilibrium this leads to the following actions chosen: (A, X ) in period
1 and (A, Z ) in period 2 with payoffs of
(4, 3) + (1, 4) = (5, 7).
Is this a Nash equilibrium of the repeated game? Is it subgame perfect?

309 / 339
First Example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
Checking deviations: To see whether the above strategy is subgame
perfect, we check whether there is a player who wants to deviate.
We use backward induction and start from the last period.
· Period 2:
· The strategy profile implies that in the second period the
players play:
(A, Z ) if (A, X ) or (B, X ) was played in period 1

(B, Y ) if anything else occurred in period 1.
Both are Nash equilibria of the last period stage game and so no
player has an incentive to deviate from the period 2 action.
First Example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
Assuming players play according to the strategy in Period 2:

· Period 1:
· If player 1 plays B instead of A then his payoff is:
0+1 = 1 < 5
assuming player 2 plays the above strategy.
· If player 2 plays Y or Z instead of X his payoff is:
Y : 0+1 = 1 < 7 and Z : 4 + 1 = 5 < 7,
assuming player 1 plays the above strategy.
Thus no player has an incentive to deviate from the period 1 action.
The above strategy is not only a Nash equilibrium but also a a subgame
perfect equilibrium of the repeated game.
310 / 339
First Example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
Given the above strategy, the period 2 continuation strategies are given
by the following matrix (as a function of what was played in period 1):
1\2 X Y Z
A (A, Z ) (B, Y ) (B, Y )
B (A, Z ) (B, Y ) (B, Y )
from which we can compute the period 2 continuation payoffs (again as
a function of what was played in period 1):
1\2 X Y Z
A 5, 7 2, 1 3, 5
B 1, 4 4, 2 2, 1
Second Example: Finitely Repeated Prisoner’s Dilemma

Consider a repeated prisoner’s dilemma game with stage game:
1\2 C D
G = C 3, 3 0, 4
D 4, 0 1, 1
Suppose it is played T times with T finite, then it is easy to show that

the unique subgame perfect equilibrium has both players playing D in
every period.
· To see this, use “backward induction” and show that, in each
period, D is the unique best response.
· Alternatively, prove by induction on T .
· Show that the prisoner’s dilemma repeated T = 1 time has a
unique SPE; and then, if this is true for T = n, it must also be true
for T = n + 1.
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Second Example: Finitely Repeated Prisoner’s Dilemma
Consider a repeated prisoner’s dilemma game with stage game:
1\2 C D
G = C 3, 3 0, 4
D 4, 0 1, 1
Suppose it is played T times with T finite, then it is easy to show that

the unique subgame perfect equilibrium has both players playing D in
every period.
· To see this, use “backward induction” and show that, in each
period, D is the unique best response.
· Alternatively, prove by induction on T .
· Show that the prisoner’s dilemma repeated T = 1 time has a
unique SPE; and then, if this is true for T = n, it must also be true
for T = n + 1.
· Unlike the previous example, there is no scope for improving on the
stage game outcome (1, 1).
Finitely Repeated Games
More generally we can show:
Proposition
If the stage game of a finitely repeated game has a unique Nash
equilibrium, then the finitely repeated game has a unique subgame
perfect equilibrium where each player always plans to use the
unique Nash equilibrium action.
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Finitely Repeated Games
More generally we can show:
Proposition
If the stage game of a finitely repeated game has a unique Nash
equilibrium, then the finitely repeated game has a unique subgame
perfect equilibrium where each player always plans to use the
unique Nash equilibrium action.
What happens if the game is repeated infinitely often?

· We consider infinitely repeated games and show how
cooperation is possible in such cases.
· In particular, also in the infinitely repeated prisoner’s
dilemma.
Preliminaries
We consider repeated games defined by the list:
GT ,δ = (G , T , δ)
where:
· G is a the stage game defined by:
· N the set of players
· Ai the set of actions of player i
· ui the utility or utility function of player i.
· T * N is the number of consecutive repetitions of G .
· δ * (0, 1] is a common discount factor.
We assume N and each Ai are finite and players know G , T , δ.
When δ < 1 players maximize discounted payoffs: Ui = ∑T t 21 u (at ).
t =1 δ i
1
When δ = 1 players maximize average payoffs: Ui = T ∑T t
t = 1 ui ( a ) .
313 / 339
Preliminaries
As in extensive form games, pure strategies in repeated games
are contingent plans that specify, for each player, an action
ai,t * Ai , for every period of repetition, and for every possible
history of actions up to t 2 1, for every t = 1, 2, . . . , T .
Definition
A pure strategy of player i in the game GT ,δ , si = (si,t )T
t =1 , is
defined, for every t = 1, 2, . . . , T , by a map:
si,t : H t 21 ³ Ai ,
where
H t 21 = {ht 21 = (a1 , a2 , . . . , at 21 )|aτ * A, τ = 1, 2, . . . t 2 1}
is the set of possible histories up to t 2 1. Let Si denote the set

of pure strategies of i.
Notice that at = (a1t , a2t , . . . , ant ) * A is an action profile in
period t, and ht = (a1 , a2 , . . . , at ) is a history of action profiles,
specifying an action profile for each period τ = 1, 2, . . . , t.
Preliminaries
Let δ * (0, 1) and let v = 1 + δ + δ2 + . . .

Then we can write:
δ + δ2 + δ3 + . . . = δ(1 + δ + δ2 + . . .) = δv
1
ó v = 1 + δv ñó v = .
12δ
Hence, for any a * R:
a
a + a · δ + a · δ2 + . . . = a · v = .
12δ
We use this repeatedly when evaluating deviations and continuation
payoffs in infinitely repeated games.
314 / 339
Infinitely Repeated Prisoner’s Dilemma
We now consider the infinitely repeated prisoner’s dilemma G∞,δ with

stage game:
1\2 C D
G = C 3, 3 0, 4
D 4, 0 1, 1
and δ * (0, 1).

So consider the infinitely repeated prisoner’s dilemma G∞,δ with stage
game G as above.
In general, a player’s strategy is a full description of an action to take at
every information of the player.
In an infinitely repeated game there is an information set for every period
t and for every different history ht 21 = (a1 , a2 , . . . , at 21 ), for t ³ ∞.
Fortunately, many interesting equilibria can be described by a few types
of simple strategies.
· One example is a strategy that prescribes a Nash equilibrium action
of the stage game for each contingency.
· This also constitutes a subgame perfect equilibrium of the game.
· In the repeated prisoner’s dilemma it yields the profile (D, D ) being
played in each period.
315 / 339
So consider the infinitely repeated prisoner’s dilemma G∞,δ with stage
game G as above.
In general, a player’s strategy is a full description of an action to take at
every information of the player.
In an infinitely repeated game there is an information set for every period
t and for every different history ht 21 = (a1 , a2 , . . . , at 21 ), for t ³ ∞.
Fortunately, many interesting equilibria can be described by a few types
of simple strategies.
· One example is a strategy that prescribes a Nash equilibrium action
of the stage game for each contingency.
· This also constitutes a subgame perfect equilibrium of the game.
· In the repeated prisoner’s dilemma it yields the profile (D, D ) being
played in each period.
· But can the players do better?

Consider again G∞,δ with stage game:
1\2 C D
G = C 3, 3 0, 4
D 4, 0 1, 1
To show the emergence of cooperation we consider another type of

repeated game strategy, called grim trigger strategy.
In the prisoner’s dilemma game there are two natural profiles, the
cooperative profile (C , C ) and the punishment profile (D, D ).
As it turns out in G the punishment profile is a Nash equilibrium of the
stage game, while the cooperative profile is not.
In a grim trigger strategy of G∞,δ , players play the cooperative profile
each period and IF there is a deviation from that, then they play the
punishment profile forever after.
Is this a Nash equilibrium of G∞,δ ? Is it subgame perfect?

316 / 339
Let δ * (0, 1) be the common discount rate.
From each player’s point of view, we have the following continuation
payoffs of the above grim trigger strategy:
3
C : 3 + 3 · δ + 3 · δ2 + . . . =
12δ
δ
D: 4 + 1 · δ + 1 · δ2 + . . . = 4 +
12δ
Note: 4 is the period t deviation payoff of playing D instead of C .
Hence, to sustain players playing the cooperative profile (C , C ), we need
that:
3 δ 1
g 4+ ñó δ g .
12δ 12δ 3
Recall that when δ < 1 players maximize Ui = ∑T t 21 u (at ).

t =1 δ i
Therefore, if δ g 1 then the above grim trigger strategy:

3
· Play C at t = 1 and keep playing C in any t while the profile played
at t 2 1 is C ; if you observe something other than (C , C ), then play
D forever.
played by both players, constitutes a Nash equilibrium of G∞,δ .
Since (D, D ) is a Nash equilibrium of the stage game G , it is also
subgame perfect.
This shows that it is possible to obtain cooperation in the infinitely

repeated prisoner’s dilemma.
· At the constructed subgame perfect equilibrium players play (C , C )
in each period (along the equilibrium path).
317 / 339
Infinitely Repeated Prisoner’s Dilemma – automata
An automaton is an idealized computing machine. A finite automaton can
keep track of a finite number of states.
Two 2-state automata for the infinitely repeated prisoner’s dilemma.
Each circle represents a possible state of the machine. The letter inside
represents the action the machine will take in that state. The arrows represent
transitions pointing to the states or actions to be taken in the next period in
response to actions taken by the opponent in the current period. Each machine
has an arrow that comes from nowhere to indicate the machine’s initial state.
Machines that start with C are said to be nice, and nasty otherwise.

Some 1-state and 2-state automata for the infinitely repeated prisoner’s
dilemma.
· GRIM corresponds to our grim trigger strategy.
318 / 339
All 1-state and 2-state automata for the infinitely repeated prisoner’s dilemma.
· Some make more sense than others.

Note: Here d (= Dove) corresponds to C , and h (= Hawk) to D.

Some 1-state and 2-state automata for playing the infinitely repeated prisoner’s
dilemma.
· Can look at equilibria between automata and check which pairs of

automata constitute equilibria of G∞,δ .
319 / 339
To see this, consider the following version of the Prisoner’s Dilemma:
1\2 C D
G = C 2, 2 21, 3
D 3, 21 0, 0
And compute payoff histories of two automata playing agains each other.

Table: Tit-for-Tat vs. Tat-for-Tit
Period 1 2 3 4 5 6 7 8 9 ···
Payoff 21 0 3 21 0 3 21 0 3 ···
Tit-for-Tat C D D C D D C D D ···
Tat-for-Tit D D C D D C D D C ···
Payoff 3 0 21 3 0 21 3 0 21 ···
What are average (stage game) payoffs? Is it a Nash equilibrium?
320 / 339
Table: Tit-for-Tat vs. Tat-for-Tit
Period 1 2 3 4 5 6 7 8 9 ···
Payoff 21 0 3 21 0 3 21 0 3 ···
Tit-for-Tat C D D C D D C D D ···
Tat-for-Tit D D C D D C D D C ···
Payoff 3 0 21 3 0 21 3 0 21 ···

· (2/3, 2/3) and no, it’s not a Nash equilibrium.
21+0δ+3δ2 +··· (21+3δ2 )/(12δ) 21+3
· Note: limδ³1
1+δ+δ2 +···
= limδ³1 (1+ δ + δ2 ) / (12 δ )
= 3 = 23 .
Table: Tat-for-Tit vs. Tat-for-Tit
Period 1 2 3 4 5 6 7 8 9 ···
Payoff 0 2 2 2 2 2 2 2 2 ···
Tat-for-Tit D C C C C C C C C ···
Payoff 0 2 2 2 2 2 2 2 2 ···
321 / 339
Table: Tat-for-Tit vs. Tat-for-Tit
Period 1 2 3 4 5 6 7 8 9 ···
Payoff 0 2 2 2 2 2 2 2 2 ···
Payoff 0 2 2 2 2 2 2 2 2 ···

· (2, 2) and yes, it’s a Nash equilibrium.

Shaded cells are Nash equilibria between the corresponding automata.
Note: Here Dove corresponds to C and Hawk to D.
Recall the prisoner’s dilemma stage game:

1\2 C D
G = C 2, 2 21, 3
D 3, 21 0, 0
322 / 339
Shaded cells are Nash equilibria between the corresponding automata.
Note: Here Dove corresponds to C and Hawk to D.
Recall the prisoner’s dilemma stage game:

1\2 C D
G = C 2, 2 21, 3
D 3, 21 0, 0
Folk Theorems
What stage game payoffs can be sustained as equilibria of infinitely

repeated games when players are sufficiently patient (δ ³ 1)?
323 / 339
Folk Theorems

Note: Game theorists refer to these results as folk theorems because they were
thought to be part of the profession’s wisdom before various versions were
formally proved.
We will discuss a subgame perfect equilibrium version (Theorem A) and a Nash

equilibrium version (Theorem B). If time allows, we will strengthen the latter to
subgame perfect and also discuss a version with an optimal penal code.
Folk Theorem A
324 / 339
Folk Theorem A
Definition
A payoff profile u = (u1 , u2 , . . . , un ) * Rn is feasible for G if there
exist nonnegative weights:
(νa )a*A g 0 with ∑ νa = 1
a *A
such that for all i * N:

ui = ∑ νa ui (a).
a *A
That is, if they can be written as the convex combination of

payoffs of the stage game G .
Folk Theorem A

Theorem (Friedman, 1971)

Let G∞,δ be an infinitely repeated n-player game. Let v * Rn be a
payoff vector associated to a Nash equilibrium of the stage game
G . Let u * Rn be any feasible payoff of the stage game with:
ui > vi , for all i * N.
then, if δ is sufficiently close to 1, the vector u can be supported

arbitrarily closely by a subgame perfect equilibrium of G∞,δ .
325 / 339
Folk Theorem A – infinitely repeated prisoner’s dilemma
Consider again the infinitely repeated prisoner’s dilemma game G∞,δ with
stage game:
1\2 C D
G = C 3, 3 0, 4
D 4, 0 1, 1
What can be sustained in G∞,δ ? Anything in the blue-dashed polyhedron.

5
4
Payoff of player 2
0
0 1 2 3 4 5
Payoff of player 1
If δ ³ 1, then any feasible u1 , u2 > 1 can be sustained as a subgame

perfect equilibrium. The feasible payoffs are in the gray polyhedron.
Folk Theorem A – infinitely repeated introductory example

Consider the infinitely repeated game G∞,δ with the stage game of the
introductory example:
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0

5
4
Payoff of player 2
0
0 1 2 3 4 5
Payoff of player 1
If δ ³ 1, then any feasible u1 > 2, u2 > 1 can be sustained as a subgame

326 / 339
Folk Theorem A – infinitely repeated introductory example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0

5
Payoff of player 2 4
0
0 1 2 3 4 5
Payoff of player 1
If δ ³ 1, then any feasible u1 > 2, u2 > 1 can be sustained as a subgame

Folk Theorem A – infinitely repeated trust game

Consider the following version of the trust game:
1\2 Pay Not pay

G = Deliver 2, 2 0, 4
Not deliver 1, 0 1, 0
What are Nash equilibria? Subgame perfect equilibria?
327 / 339
1\2 Pay Not pay

G = Deliver 2, 2 0, 4

What can be sustained in G∞,δ ?

1\2 Pay Not pay

G = Deliver 2, 2 0, 4

What can be sustained in G∞,δ ?
3
Payoff of player 2
0
0.0 0.5 1.0 1.5 2.0
Payoff of player 1
If δ ³ 1, then anything in the blue-dashed triangle can be sustained as a SPE in G∞,δ .
328 / 339
Folk Theorem B

Recall: v i = min max ui (αi , α2i )(g max min ui (αi , α2i ) = v i ).
α 2i αi αi α 2i
Note: the minmax value (v i ) is the worst payoff the opponents can
force i to accept (that is, allowing i to react to the opponents’ actions.)
Definition
A payoff profile u = (u1 , u2 , . . . , un ) * Rn is enforceable (or
individually rational) for G if for all i * N:
ui g v i .
It is strictly enforceable if ui > v i for all i.
Folk Theorem B

Theorem (Fudenberg and Maskin, 1986)

Let G∞,δ be an infinitely repeated n-player game where the set of
feasible payoffs has full dimension |N |. Let u * Rn be any feasible
and strictly enforceable payoff vector of the stage game G , then if
δ is sufficiently close to 1, u can be supported as a subgame
perfect Nash equilibrium of G∞,δ .
Note: If punisher and deviator have same payoffs, it is impossible to incentivize

punishments. Full-dimensionality ensures that for each i, there exists a ui2 in the
feasible and enforceable set that satisfies v i < ui2 < ui . This is necessary to incentivize
players to carry out punishments.
329 / 339
Folk Theorem B – infinitely repeated prisoner’s dilemma
Consider again the infinitely repeated prisoner’s dilemma game G∞,δ with stage
game:
1\2 C D
G = C 3, 3 0, 4
D 4, 0 1, 1
What can be sustained in G∞,δ ? Anything in the green-dashed polyhedron.

5
Payoff of player 2
3
0
0 1 2 3 4 5
Payoff of player 1
If δ ³ 1, then any u with u1 , u2 > 1 can be sustained as a subgame perfect

equilibrium. The feasible payoffs are in the gray polyhedron. Notice that
v 1 = v 2 = 1. So same as Thm A!
Folk Theorem B – infinitely repeated introductory example

1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0
What else can be sustained in G∞,δ ? Anything in the green-dashed polyhedron.

5
4
Payoff of player 2
0
0 1 2 3 4 5
Payoff of player 1
If δ ³ 1, then any u with u1 > 23 = v 1 , u2 > 54 = v 2 can be sustained as a

subgame perfect Nash equilibrium. Feasible payoffs are in the gray polyhedron.
In particular, here player 2 can enforce the (1, 4) outcome.
330 / 339
Folk Theorem B – infinitely repeated introductory example
1\2 X Y Z
G = A 4, 3 0, 0 1, 4
B 0, 0 2, 1 0, 0

5
Payoff of player 2 3
0
0 1 2 3 4 5
Payoff of player 1

In particular, here player 2 can
enforce the (1, 4) outcome.
1 4
Player 1 can play σ1 = 5 , 5 and Player 2 can play σ2 = 0, 13 , 23 .

Recall Topic 1: Zero-Sum Games – maxminimization

1\2 X Y

B 2, 4 6, 0
W1 (σ1 ) = min{u1 ((σ11 , 1 2 σ11 ), X ), u1 ((σ11 , 1 2 σ11 ), Y )}
= min{4σ11 + 2(1 2 σ11 ), 0σ11 + 6(1 2 σ11 )}
1
2 + 2σ11 if σ11 f

= min{2 + 2σ11 , 6 2 6σ11 } = 2
6 2 6σ11 else
W2 (σ2 ) = min{u2 (A, (σ21 , 1 2 σ21 )), u2 (B, (σ21 , 1 2 σ21 ))}
= min{2σ21 + 6(1 2 σ21 ), 4σ21 + 0(1 2 σ21 )}
3
4σ21 if σ21 f

1 1 4
= min{6 2 4σ2 , 4σ2 } =
6 2 4σ21 else
· What is the best guaranteed payoff player i can obtain?
v i = max Wi (σi ) = max min ui (σi , sj ) = max min ui (σi , σj ).
σi *Σi σi *Σi sj *Sj σi *Σi σj *Σj
331 / 339
Recall Topic 1: Zero-Sum Games – maxminimization
u1 u2
6 6
5 5
4 u1(Ã1,X) 4 u2(A,Ã2)
3
u1(Ã1,Y) 3
u2(B,Ã2)
W1(Ã1) W2(Ã2)
2 2
1 1
Ã1A Ã2X
0.2 0.4 0.6 0.8 1.0 0.2 0.4 0.6 0.8 1.0
Figure: Game G : The functions W1 (left) and W2 (right) (these are the
minimum of the red and blue lines) and player 1 and 2’s security strategies
(achieved at the maximum of W1 at σ11 = 21 at which player 1’s payoff is
v 1 = 3 for player 1 and achieved at the maximum of W2 at σ12 = 34 at which
player 2’s payoff is v 2 = 3 for player 2.
So, what is the MinMax?
· It is the lowest payoff players can be forced to accept.
Recall Topic 1: Zero-Sum Games – minmaximization
· The minmax payoff level can be written as
v i = min Bi (σj ) = min max ui (si , σj ) = min max ui (σi , σj ),

where
Bi (σj ) = max ui (si , σj ).
si * Si
Note:
· v i is the lowest payoff player i can be forced to accept.

· v i is the highest payoff player i can secure.
· In zero-sum games: v i = v i = v ; in general: v i g v i .
332 / 339
1\2 X Y

B 2, 4 6, 0
B1 (σ2 ) = max{u1 (A, (σ21 , 1 2 σ21 )), u2 (B, (σ21 , 1 2 σ21 ))}
= max{4σ21 + 0(1 2 σ21 ), 2σ21 + 6(1 2 σ21 )}
3
6 2 4σ21 if σ21 f

= max{4σ21 , 6 2 4σ21 } = 4
4σ21 else
B2 (σ1 ) = max{u1 ((σ11 , 1 2 σ11 ), X ), u1 ((σ11 , 1 2 σ11 ), Y )}

= min{2σ11 + 4(1 2 σ11 ), 6σ11 + 0(1 2 σ11 )}
1
4 2 2σ11 if σ11 f

1 1 2
= min{4 2 2σ1 , 6σ1 } =
6σ11 else
u1 u2
6 6
5 5
4 u1(A,Ã2) 4 u2(Ã1,X)
3 u1(B,Ã2) 3 u2(Ã1,Y)
B1(Ã2) B2(Ã1)
2 2
1 1
Ã2X Ã1A
0.2 0.4 0.6 0.8 1.0 0.2 0.4 0.6 0.8 1.0
Figure: Game G : The functions B1 (left) and B2 (right) (these are the
maximum of the red and blue lines) and player 2 and 1’s strategies of forcing
the lowest acceptable payoffs (achieved at the minimum of B1 at σ12 = 43 at
which player 1’s payoff is v 1 = 3 for player 1 and achieved at the minimum of
B2 at σ11 = 21 at which player 2’s payoff is v 2 = 3 for player 2.
333 / 339
Theorem B – infinitely repeated entry game
Chain store paradox
1\2 X Y
A 2, 2 0, 0
B 1, 5 1, 5
· The best payoffs for players 1 and 2 are given by B1 (σ2 ) and B2 (σ1 ).

· Can compute that: v 1 = 1 and v 2 = 2

with σ1 = (1, 0) and σ2 = (x, 1 2 x ) for 0 f x f 1/2.

Chain store paradox
u1 u2
2.0 5
4
1.5
u1(A,Ã2) u2(Ã1,X)
3
u1(B,Ã2) u2(Ã1,Y)
1.0
B1(Ã2) 2 B2(Ã1)
0.5
1
Ã2X Ã1A
0.2 0.4 0.6 0.8 1.0 0.2 0.4 0.6 0.8 1.0
Figure: Entry game: The functions B1 (left) and B2 (right) (these are the maximum
of the red and blue lines) and player 2 and 1’s strategies of forcing the lowest
acceptable payoffs (achieved at the minimum of B1 at 0 f σ12 f 21 (maximum
probability on Acquiesce is 1/2) at which player 1’s payoff is v 1 = 1 for player 1 and
achieved at the minimum of B2 at σ11 = 1 (probability 1 on In) at which player 2’s
payoff is v 2 = 2 for player 2.
334 / 339
Chain store paradox
1\2 X Y
A 2, 2 0, 0
B 1, 5 1, 5
What else can be sustained in G∞,δ ?

Chain store paradox
1\2 X Y
A 2, 2 0, 0
B 1, 5 1, 5

5
Payoff of player 2 (Incumbent)
0
0.0 0.5 1.0 1.5 2.0
Payoff of player 1 (Entrant)

335 / 339
Reputation and infinitely repeated trust game(s)
Institutions, brand names, long-run and short-run players
1\2 Pay Not pay

G = Deliver 2, 2 0, 4
If δ g 21 , then the outcome (2, 2) can be sustained as a SPE in G∞,δ .
In particular, for player 2 we compute:

2
Pay : 2 + 2 · δ + 2 · δ2 + . . . =
12δ
2
Not pay : 4+0·δ+0·δ +... = 4
Can cooperation be sustained in other ways? How to model reputation?
How can institutions help enforce obligations? How may institutions come about?
Tadelis (2006, pp. 204-209); Milgrom, North, Weingast (1990) “law merchant”; Kreps (1990) “brand names”
Greif (2006) Institutions and the path to the modern economy: Lessons from medieval trade.

1. Trust game with existing legal institution that enforces payment (at cost to 2).
Consider the following variant of the trust game:
There is a SPE that yields the outcome (2, 2).

· The institution allows the exchange to take place in the one shot game.
· No need for repetition.
336 / 339
2. Trust game with a law merchant (player 3) who provides a service at fee 0.1 by
collecting a bond from player 2 and using it to pay player 1 if player 2 does not pay.
Variant with player 3

(the law merchant):
The SPE does not involve using the law merchant and yields the outcome (1, 0, 0).
· At the SPE, the law merchant keeps the bond (does not fulfil agreement).
· No exchange takes place in the one shot game.


(the law merchant):
337 / 339

(the law merchant):
The infinitely repeated version delivers (2, 1.9, 0.1) as a SPE outcome, provided the
law merchant’s discount rate satisfies δ3 > 0.96. (Why?)
· This works even if players 1 and 2 are short-run players (P1t , P2t ).
· Law merchant is long-run player (P3 ) who has incentive to build a reputation.


(the law merchant):
The infinitely repeated variant delivers (2, 1.9, 0.1) as a SPE outcome, provided the
law merchant’s discount rate satisfies δ3 > 0.96. (Why?) Compute 10.1 2δ3 > 2.5.
t t
· This works even if players 1 and 2 are short-run players (P1 , P2 ).
· Law merchant is long-run player (P3 ) who has incentive to build a reputation.
338 / 339
4. Trust game with brand names. Both players 1 and 2 are short-run players (P1t , P2t ).
At end of each period t, player P2t has option of selling a brand name to player P2t +1 .
The price of the brand name in t is 3 (any price > 2 works) and maintains its value as
long as the player P2t pays. Otherwise, the brand name is worth 0.
Variant with selling of a brand name:
Again, there is a SPE of the infinitely repeated variant that yields the outcome (2, 2).
· The possibility of selling the brand name allows the exchange to take place.
· The brand name allows to establish a reputation that payment will be made.
339 / 339

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INTRODUCTION TO

Ñ Solving the problem sets and participating in

Ñ Solving the problem sets and participating in

Course Information - Schedule

project presentations 10%

ÒGame theory is the study of strategic

ÒGame theory is the study of strategic

Game theory Ñ origins

Which of the following is false:

John von Neumann

Which of the following is false:

John von Neumann?

The essential ingredients

Example: Major entry in French Mobile telecom market.

See: ÒMarket entry,

(¬4.6bn ~ 7.7% of industry; 2012-14)

Application: The Tragedy of the Commons

Question: How many sheep do you expect there to be?

Application: The Tragedy of the Commons

This is the cooperative outcome.

This is the cooperative outcome.

Application: The Tragedy of the Commons

This is the cooperative outcome.

This is a non-cooperative outcome.

Application: The Tragedy of the Commons

This is a non-cooperative outcome.

This is a non-cooperative outcome.

Application: The Tragedy of the Commons

Ñ overfishing in common waters

From the article ÒA Global Deal for

COP15, UN Biodiversity Agreement

Edward O. WilsonÕs Half-Earth Project

The Guardian, March 5, 2023

So far 84 countries have signed:

Distinguishing types of games

A key aspect in game theory is learning to

Apparently small differences in payoffs within a

A social dilemma game.

Both players have a Òdominant strategyÓ to play

A social dilemma game.

Both players have a Òdominant strategyÓ to play

The social dilemma is resolvedÉ

Now both players have a Òdominant strategyÓ to play

A pure coordination game.

This a coordination and common payoff game.

Another coordination game.

Players have Òcommon interestsÓ and also some

A strictly competitive game.

Row player wants to match, while Column player

Another strictly competitive game.

Players still have Òopposite interestsÓ.

Nash equilibrium Ñ intuitively

A profile of actions is a Nash

Universitat Pompeu Fabra

UPF, Introduction to Game Theory, Winter 2024 Topic 1, Slide 1

· You want to open a shop in a touristic area for the summer.

Table: Actions, States, Consequences

UPF, Introduction to Game Theory, Winter 2024 Topic 1, Slide 3

· Suppose θ is the weather: if it’s sunny, you’ll sell a lot of

· The realizations of the random variable θ follow a probability

Fundamental problem of Decision Theory: how to use the

· Now suppose θ is the decision of a neighbor that may open a

· The neighbor won’t choose what to do randomly (following a