Introduction to Game Theory

Daniel Navarro Martínez

6. Sequential games of perfect
information
Sequential games of perfect information
 Sequential: Players choose their actions following a sequence
1) Player 1 chooses an action
2) Player 2 observes the action and chooses
3) Player 1 or 3 observes previous actions and chooses
4) …

 Perfect information: When choosing actions, players always

know what has happened before

 Imperfect information: When players lack some information

of previous actions of other players or of random events
 Example: The mayor race game

 Alice is running for mayor of a big city

 Bob is the only other candidate who could challenge her
 Alice has to decide whether to launch a preemptive advertising
campaign
 Bob, seeing Alice’s choice, has to decide whether to enter the
race or retire
 Representation of the game
 Tree or extensive form of the game
 In this example we use numbers 1 to 4 as utility indicators

 Parts of the tree: decision nodes, branches (possible actions),

terminal nodes (associated to payoffs)
 Solution
 Backward induction equilibrium

 Equilibrium strategies: (advertise; (retire, enter))

 Equilibrium path: (advertise, retire)
 Equilibrium payoffs: (3, 3)
 Subgame perfect NE
 With perfect information:
backward induction equilibrium = subgame perfect NE

 The subgame perfect NE is a refinement of the NE for

sequential games, defined as:
A NE of the full game that is also a NE for all the subgames

 Subgame: Any full subset of the game starting from any

decision node (including the first one)
 It’s the most used solution concept in sequential games
 Due to Reinhard Selten (1965): Proved that every finite-
horizon game that can be broken into subgames has one
Solution using the subgame perfect NE

 Normal form of the full game (subgame 1):

A B EE ER RE RR  NEs:
A 1, 1 1, 1 3, 3 3, 3
(A; (R, E)) with (3, 3)
NA 2, 4 4, 2 2, 4 4, 2
(NA; (E, E)) with (2, 4)
Solution using the subgame perfect NE

 Subgame 2:  Subgame 3:

A B E R A B E R
A 1, 1 3, 3 NA 2, 4 4, 2

 NE: (R) with (3, 3)  NE: (E) with (2, 4)

Solution using the subgame perfect NE

 So, the only SPNE is: (A; (R, E)) with (3, 3)
What if decisions were simultaneous?

A B E R
A 1, 1 3, 3
NA 2, 4 4, 2

 Solution of the game?

 Another example: Entry game

 Firm B is the only grocery store in a city and makes profits of 20

 Firm A can invest in something else and make profits of 5, but
it’s considering entering the market and sharing profits with B
 Entry costs are 3
 Firm B knows A’s intentions and threatens with a price war,
which would result in both companies making 0 profits
 A has to decide weather to enter or not; B has to decide
whether to start the price war or not, knowing A’s decision
 Solution

 Equilibrium strategies:
 Equilibrium path:
 Equilibrium payoffs:
 If decisions were simultaneous

A B W NW
E
NE

 Solution of the game?

Games we’ve seen: Battle of the sexes

1 2 Opera Football
Opera 3, 2 1, 1
Football 0, 0 2, 3

 Solution of the game?

 What if it is sequential and the woman decides first?
 BIE/SPNE?
 How many NEs are there in the full game?
 Solution

 Equilibrium strategies:
 Equilibrium path:
 Equilibrium payoffs:
 Solution

 NEs:
1 2 OO OF FO FF
O
F
 What if the man decides first?

 Equilibrium strategies:
 Equilibrium path:
 Equilibrium payoffs:
 Matching pennies

1 2 Heads Tails
Heads 1, -1 -1, 1
Tails -1, 1 1, -1

 Solution of the game?

 What if it is sequential and player 1 decides first?
 BIE/SPNE?
 How many NEs are there in the full game?
Solution
 Solution

1 2 HH HT TH TT  NEs:
H 1, -1 1, -1 -1, 1 -1, 1
T -1, 1 1, -1 -1, 1 1, -1
What if player 2 decides first?
Efficiency: The borrower-lender game

 Firm E asks bank B to borrow 100, promising to pay back 105 in

a year
 The bank can decide to give the loan or to reject it
 If the bank gives the loan, the firm can invest and earn 110
during the year
 The firm can then decide to pay back the loan or to default
 Solution

 Equilibrium strategies:
 Equilibrium path: Is it efficient?
 Equilibrium payoffs:
 Borrower-lender game 2
 It is possible to create legal institutions/arrangements to try
to facilitate efficient outcomes

 Imagine the lender can sue the debtor if he/she refuses to pay
back
 60% of the time, lenders win these cases, and the debtors have
to return the debt; 40% of the time, lenders lose
 The party that loses has to cover litigation costs of 75
 Solution

 Expected payoffs if B sues E:

B)
E)
 Solution

 Equilibrium strategies: ((give, sue); pay)

 Equilibrium path: (give, pay) Is it efficient?
 Equilibrium payoffs: (5, 5)
 Borrower-lender game 3

 Imagine that the bank is always the one who covers the
litigation costs (of 75)
 If the firm loses, it has to pay an extra penalty of 20
Solution
 Solution

 Equilibrium strategies:
 Equilibrium path: Is it efficient?
 Equilibrium payoffs:
Credibility: The burning ships game

 A famous story says that when Hernan Cortes arrived in

America in 1519 to fight the Aztec empire, he burned his ships
to make retreat impossible
 He used this as a commitment device and to make his fighting
intentions credible
 Shortly after, he defeated the Aztec empire
 Let’s analyze this from a game theory perspective
 Solution

 Equilibrium strategies:
 Equilibrium path:
 Equilibrium payoffs:
 Solution

 If H keeps the ships, is his intention to fight credible?

 In strategic situations, it is possible to make
intentions/threats credible by eliminating options
 Credibility and SPNE

 The credibility of intentions is a crucial part of the concept of

SPNE

 Requiring a strategy to be a NE of all the subgames

eliminates all non-credible strategies
 Another example: Previous game

 Equilibrium strategies: (advertise; (retire, enter))

 Equilibrium path: (advertise, retire)
 Equilibrium payoffs: (3, 3)
Sequential game analysis without trees

 Backward induction can be applied to any finite-horizon,

perfect information game, no matter how complicated

 But if the game is too complicated, tree analysis can become

inconvenient or even impossible
 For example, solving the game of chess with a tree is beyond
the ability of the most powerful computers

 So, backward induction analysis without a tree is very

common
 The theoretical idea is exactly the same
 The ultimatum game
 Player 1 has to decide how to divide an amount (for example
10€) between himself/herself and player 2
 Then player 2 sees the allocation proposed by player 1 and can
either accept it or reject it
 If player 2 accepts, the players get what player 1 has proposed;
if player 2 rejects, both of them get nothing
 More formally:
 Player 1 offers s€ to player 2
 If player 2 accepts, the outcome is (10-s, s)
 If player 2 rejects, the outcome is (0, 0)
 Solution: What is the BIE/SPNE?
 Starting with player 2:
 u2(s, accept) = s, u2(s, reject) = 0
 If s > 0, u2(s, accept) > u2(s, reject)
 As long as s > 0, player 2 will accept

 Player 1:
 u1(s, accept) = 10 - s, u1(s, reject) = 0
 max 10 - s, with s ϵ (0, 10]
 Player 1 will choose the minimum s above 0: 0.01€

 Solution:
 Equilibrium strategies:
 Equilibrium path:
 Equilibrium payoffs:
 The tree
 In the case of the ultimatum game it is possible to draw a tree
Actual behavior in the ultimatum game

 Is the equilibrium a good prediction of how people

perceive/play this game?

 This game has been used a lot to explore people’s actual

“social preferences” and social interactions

 Starting with Guth et al. (1982)

 Actual behavior in the ultimatum game
 Results from Roth et al. (1991)
 Ultimatum game with strategy space [0$, 10$] for player 1

N 0 1-10 11-20 21-30 31-40 41-50 51-60 61-100 Mean

Offers 27 - - 4% 11% 22% 56% 4% 4% 47%
Rejections 27 - - 0% 67% 17% 7% 0% 100% 19%

 What explains the behavior of player 2?

 Player 1?
 The dictator game

 Player 1 has to decide how to divide an amount (for example

10€) between himself/herself and player 2
 Player 2 just receives the allocation proposed by player 1 and
cannot do anything
 More formally:
 Player 1 allocates s€ to player 2
 The outcome is (10-s, s)

 Equilibrium?
 Behavior in the dictator game

 Results from Kahneman et al. (1986), Forsythe et al. (1994),

Hoffman et al. (1996)

N 0 1-10 11-20 21-30 31-40 41-50 51-60 61-100 Mean

Study 1 161 NA 24% NA NA NA 76% NA NA 40%
Study 2 24 21% 17% 13% 29% - 21% - - 24%
Study 3 36 64% 19% 6% 3% - 6% - 3% 10%
 The trust game
 Player 1 has a monetary endowment (for example 10€) and
has to decide how much of it to send over to player 2
 The amount that is sent over is multiplied by 3 and given to
player 2
 Then player 2 has to decide how much of the money he/she
receives is sent back to player 1
 More formally:
 Player 1 sends s€ to player 2
 Player 2 receives s€ x 3 and sends t€ back to player 1
 The outcome is ((10-s)+t, 3s-t)

 Equilibrium?
 Behavior in the trust game
 Berg et al. (1995)

 Behavior of player 2?

 Player 1?
 Related to “gift
exchange” in labor
markets
 Public good game and punishment
 There are 4 players and each one has a monetary endowment
(for example 20€)
 They have to simultaneously decide which amount x ϵ [0, 20]
they want to give to a common group project (public good)
 Payoff for each player: (20-x) + (total project·1.6)/4

PUNISHMENT STAGE
 Then the players see each other’s contributions and can reduce
the payoff of other players by an amount r
 Reducing payoffs has a cost of c=r·1/3
 Solution
 Starting with the punishment stage:
 Punishing can never increase payoffs and it always reduces them
 So, no player should punish (r=0)
 Contribution stage:
 Every € that a player gives to the group project is multiplied by
1.6 and divided by 4: 1€ to project = 0.4€
 So, for any actions of the other players, the best response of a
player is always to keep all the money.
 But notice that:
 If all players keep all the money: Payoff =
 If all players give all the money: Payoff =
 Behavior in the game
 Fehr and Gachter (2000)

 People played the game repeatedly (equilibrium?)

 4 different groups:
 Punishment, re-matching (6 times)
 No punishment, re-matching (6 times)
 Punishment, no re-matching (10 times)
 No punishment, no re-matching (10 times)
Behavior in the game: Punishment
Behavior in the game: Contribution
 Modelling social preferences

 Two main possibilities:

 Models of inequity aversion

 Models of reciprocity (intentions)

 These models operate by modifying preferences (utility

functions), keeping the usual solution concepts
 Modelling social preferences
 Inequity aversion, Fehr and Schmidt (1999):

 For 2 players with payoffs x1 and x2:

 Reciprocity, Rabin (1993):

 Utilities depend on: 1) Own payoffs, 2) perceived kindness, 3)

reciprocity
 “Fairness equilibrium”
 Example 1: The prisoner’s dilemma
with inequity aversion

1 2 Deny Confess
Deny -3, -3 -25, -1
Confess -1, -25 -10, -10

 With α1=β1=α2=β2=0.5:
 Example 1: The prisoner’s dilemma
with inequity aversion
 The game becomes:

1 2 Deny Confess
Deny -3, -3 -37, -13
Confess -13, -37 -10, -10

 Solution of the game?

 Example 2: The mini ultimatum game

 With α1=α2=0.4, β1 =β2=0.2

 Example 2: The mini ultimatum game

 Solution?
 Repeated p-beauty contest game
 Results first round (Nagel, 1995):
 With repetition: