APPLIED

MACROECONOMICS
AdaTeaches

GAME THEORY

Game theory is_____

1. the study of strategic decision making.
2. the study of mathematical models of conflict and
cooperation between intelligent rational decisionmakers.
3. the analysis of competitive situations (or situations of
conflict) using mathematical models

USES

1. economics
2. political science
3. psychology
4. logic
5. biology

ELEMENTS

1. Players participants, each may be an individual, a

group or organisation, a machine, and so on.
2. Moves where a move is an action carried out during
the game, including chance moves (when nature plays
a hand) as in the toss of a coin.
a.

Enter a bid in an auction?

b.

Decide whether to end a strike?

c.

When to sell a stock?

d.

Decide how to vote?

3. Outcomes where an outcome is the result of the

completion of one or more moves [e.g. game of chess may
end in checkmate or a draw]
4. Payoff an amount received for a given outcome.
a. Do they care about some profit?
b. Do they care about other players?
c. Do they want to minimize cost?
5. Rules-which specify the conditions for the players,
moves, outcomes and payoffs.

STRATEGIC FORM

In game theory, the strategic form (or normal form) is a way

of describing a game using a matrix. The game is defined by
exhibiting on each side of the matrix the different players
(here players 1 and 2), each strategy or choice they can
make (here strategies A and B) and sets of payoffs they will
each receive for a given strategy (p1A,p2A ; p1A,p2B ;
p1B,p2A ; p1B,p2B).

CONVENTIONS

1. Columns are the decisions (called strategies) taken by

player 1, rows are the strategies chosen by vendor 2.
2. Each possible result of the game (called outcome) is
situated in one cell of the matrix (identified by a unique
strategy combination or profile).
3. Outcomes are written as payoff-tuples (P1x, P2x) in
units of expected utility.
4. The first entry P1x of the outcome tuple is player 1s
payoff, the second P2x is player 2s payoff.

STRATEGIC FORM

The strategic form is usually the right description for

simultaneous games, where both players choose
simultaneously, as opposed to sequential games for which is
better to describe the game using the extensive form (or
tree form). Its worth mentioning that simultaneous games
imply there is complete and imperfect information, and the
rules of the game as well as each players payoffs are
common knowledge.

SIMULTANEOUS GAMES

Simultaneous games are those where decisions are

simultaneous: both we and the other player choose at the
same time. The simplest example of this is probably rock,
paper, scissors. Complete information means that we know
what we stand to win or lose: we know that rock beats
scissors and that this will give us some form of utility (we
might get to pick the plan for that evening or simply feel a
warm glow of superiority). We also know that our opponent
has this same information, this is, the rules of the game and
each players payoffs are common knowledge.

EQUILIBRIA

What this all means is that we only have one chance to get
it right, but that we can play smart by knowing what our
opponent will do and acting accordingly. An equilibrium is
reached when both players will rationally make a decision
that they have no reason to change: whatever else they do,
they will only be worse off. Our situation can only be
improved if our opponent chooses to do something else.
These equilibria are known as Nash equilibria after John
Nash, an economist from the early/mid 20th century. The
most famous example of this is the prisoners dilemma.

PRISONERS DILEMMA.

Two suspects are arrested and charged with a crime. The

police lack sufficient evidence to convict the suspects,
unless at least one confesses. The police hold the suspects
in separate cells and explain the consequences that will
follow from the actions they could take. If neither confesses
then both will be convicted of a minor offense and
sentenced to one month in jail. If both confess then both
will be sentenced to jail for six months. Finally, if one
confesses but the other does not, then the confessor will be
released immediately but the other will be sentenced to
nine months in jailsix for the crime and a further three for
obstructing justice.

PRISONERS DILENMA

STRATEGIES

In this game, each player has two strategies available:

confess and lie. The payoffs to the two players when a
particular pair of strategies is chosen are given in the
appropriate cell of the bi-matrix. By convention, the payoff
to the so-called row player (here, Prisoner 1) is the first
payoff given, followed by the payoff to the column player
(here. Prisoner 2). Thus, if Prisoner 1 chooses Confess and
Prisoner 2 chooses Lie, for example, then Prisoner 1
receives the payoff 0 (representing immediate release and
Prisoner 2 receives the payoff -9 (representing nine months
in jail) .

Although we stated that in a stragetic-form game the

players choose their strategies simultaneously, this does not
imply that the parties necessarily act simultaneously: it
suffices that each choose his or her action without
knowledge of the others' choices, as would be the case here
if the prisoners reached decisions at arbitrary times while
in their separate cells.

BUNKS INTERROGATION
TECHNIQUES

STRATEGIC-FORM
REPRESENTATION

The normal-form representation of a game specifies:

(1) the players in the game
(2) the strategies available to each player,
(3) the payoff received by each player for each combination
of strategies that could be chosen by the players.

STRATEGIC-FORM
REPRESENTATION

1) Players---We will often discuss an n-player game in

which the players are numbered from 1 to n and an
arbitrary player is called player i.
2) Strategies----Let Si denote the set of strategies available
to player i (called is strategy space), and let si, denote
an arbitrary member of this set .Strategy si, is a
member of the set of strategies Si.) Let (si , ... ,sn)
denote a combination of strategies, one for each player,
and
3) Payoff---- let ui denote player i's payoff function:
ui(si,...,sn) is the payoff to player i if the players choose
the strategies (si,... ,sn)

Players : N= {1,..n}
Strategies for player i Si

s=(s1,.,sn) S= S1 An
Payoff function of player i : ui : S R
u=(u1,.,un)

A GAME IN STRATEGIC FORM

The normal-form representation of an n-player game

specifies the players' strategy spaces S1,..., Sn and their
payoff functions u1. Un. We denote this game by G =
{S1,..., Sn; u1. Un}

Players: N= {1,,10000000}
Strategy set for player i Ai ={Revolt, Not }
Utility function for player i
ui(a)=1 if #{j: aj=Revolt}2000000}
ui(a)=-1 if #{j: aj=Revolt}<2000000} and ai= Revolt
ui(a)=0 if #{j: aj=Revolt}<2000000} and ai= Not

DOMINANT STRATEGIES

Dominant strategies are considered as better than other

strategies, no matter what other players might do. In game
theory, there are two kinds of strategic dominance:
-a strictly dominant strategy is that strategy that always
provides greater utility to a the player, no matter what the
other players strategy is;
-a weakly dominant strategy is that strategy that provides
at least the same utility for all the other players strategies,
and strictly greater for some strategy.

A dominant strategy equilibrium is reached when each

player chooses their own dominant strategy. In the
prisoners dilemma, the dominant strategy for both players
is to confess, which means that confess-confess is the
dominant strategy equilibrium.

In the battle of the sexes, a couple argues over what to do over

the weekend. Both know that they want to spend the weekend
together, but they cannot agree over what to do. The man
prefers to go watch a boxing match, whereas the woman wants
to go shopping. This is a classical example of a coordination
game, analysed in game theory for its applications in many
fields, such as business management or military operations.
Since the couple wants to spend time together, if they go
separate ways, they will receive no utility (set of payoffs will be
0,0). If they go either shopping or to a boxing match, both will
receive some utility form the fact that theyre together, but one
of them will actually enjoy the activity. The description of this
game in strategic form is therefore as follows: Battle of the
sexes

In this case, knowing your opponents strategy will not help

you decide on your own course of action, and there is a
chance an equilibrium may not be reached. This can be
easily seen by looking for a dominant strategy, eliminating
all dominated strategies. However, there will be two
dominant strategies, two Nash equilibria (underlined in
red). The way to solve this dilemma is through the use of
mixed strategies, in which we look at the probability of our
opponent choosing one or the other strategy and balance
our pay off against it.

Consider the following normal form: N={1, 2} Ai={Movie, Theater} Each

player chooses an action of either going to a movie or going to the theater.
Player 1 prefers to see a movie with Player 2 over going to the theater with
Player 2. Player 2 prefers to go to the theater with Player 1 over seeing a
movie with Player 1. Players get a payoff of 0 if they end up at a different
place than 1/2
the other player.
Movie
Theater

Movie

a,b

0,0

Theater

0,0

c,d

What restrictions should a,b,c and d satisfy?

a) a>c, b>d
b) a>d, b<c
c) a>c, b<d
d) a<c, b<d

Using the best-response method, best responses to each of the

opponent's strategies are in bold:

X
Y
A

10,10

15,5

5,15

12,12

What is the equilibrium of the above game?

a) A,X
b) B,X
c) A,Y
d) B,Y

0,0

0,1

2,0

0,0

What is/are the equilibrium/equilibria of the above game?

a) B,X only
b) A,Y and B,X
c) A,Y; B,X; and B,Y
d) none

Two firms are involved in developing a new technology that will allow consumers to
taste food over the Internet. This has potential, for example, in restaurant promotion.
Given the risks and the relatively small expected size of this market, compatibility of
the technologies is very important. Firm DigiTaste is far advanced in developing its
RemoteTaste technology. WebOdor has been expanding into the Internet taste arena
with its incompatible product, BitterWeb. The two companies agree that if they both
adopt the same technology, they each may gross $200M from the developing industry.
If they adopt different technologies, consumers will make fun of both companies, and
purchase neither product, leading to a gross of $0. Retooling one's factory to make
the competing (nonproprietary) technology would cost WebOdor $100M and DigiTaste
$250M. By the wave of an economist's wand, their production decisions must be made
simultaneously. Set up the above scenario as a normal form (simultaneous) game.
WEB ODOR
What is the equilibrium outcome? Here is the game:

DIGITASTE

REMOVE
TASTE

BITTERWEB

REMOVE TASTE

200,100

0,0

BITTERWEB

-250,-100

-50,200

a. Both adopt RemoteTaste

b. Both adopt Bitter
c. Web DigiTaste adopts RemoteTaste and WebOdor adopts BitterWeb
d.

WebOdor adopts RemoteTaste and DigiTaste adopts BitterWeb

SYMMETRY

A game is called symmetric if the payoffs resulting from a

particular strategy profile depend only on the strategies
employed, not on who is playing them. Thus, if one can
change the identities of the players without changing the
payoff to the strategies, then a game is symmetric. If a
game is symmetric, it is sufficient to determine the payoffs
for one player as all players payoffs are identical. This is
often useful for didactic purposes although real situations
are rarely perfectly symmetric

0,0

4,-1

1.-1

-1,4

5,3

3,2

-1,2

0,2

4,1

Note that whatever P1 plays, l gives a strictly higher payoff

to P2 than r. Hence, strategy r is strictly dominated. A
rational player P2 should never play r. (Hence, we eliminate
r.) 2. If P1 knows that P2 is rational, he knows that she will
never choose r. Given this, t is better than b, independently
of whether P2 plays l or c. (Eliminate b.)

0,0

4,-1

1.-1

-1,4

5,3

3,2

-1,2

0,2

4,1

3 Now c is strictly dominated. If P2 is rational and knows

that P1 is rational (and P2 knows that P1 knows that P2 is
rational), then P2 shouldnt play c. (Eliminate c.)
4 Now m is strictly dominated. If P1 is rational and knows
that P2 is rational (and P1 knows that P2 knows that P1 is
rational . . . ), then P1 shouldnt play m. (Eliminate m.)
Hence (t,l) is the only strategy-profile surviving IESDS
and thus the result of our analysis. (The sequence does
not matter.)

6,6

8,20

0,8

10,0

5,5

2,8

8,0

20,0

4,4

What is the unique equilibrium of the above game?

a. B,Y
b. C,Z
c. A,X
d. A,Y

Mixed strategies need to be analysed in game theory when

there are many possible equilibria, which is especially the
case for coordination games. The battle of the sexes is a
common example of a coordination game where two Nash
equilibria appear (underlined in red), meaning that no real
equilibrium can be reached.
In the battle of the sexes, a couple argues over what to do
over the weekend. Both know that they want to spend the
weekend together, but they cannot agree over what to do.
The woman prefers to go shopping for a new pair of shoes,
whereas the man wants to go a boxing match. The game
matrix is therefore as follows: Battle of the sexes

In this case, knowing your opponents strategy will not help you
decide on your own course of action, and there is a chance an
equilibrium may not be reached. The way to solve this dilemma is
through the use of mixed strategies, in which we look at the
probability of our opponent choosing one or the other strategy and
balance our pay off against it.
Lets suppose that the woman is likely to choose boxing with
probability q and shopping with probability (1-q). Likewise, the man
is likely to choose boxing with a probability of r and shopping with a
probability of (1-r). In that case, our outcomes are as follows:
Boxing-Boxing: qr

Shopping-boxing: (1-r) q

Boxing-shopping: r (1-q)

Shopping-shopping: (1-q) (1-r)

The mans chances of going to a boxing match, his expected

utility, will be 2r (payoff*probability) and, of shopping, 1-r
(because his utility from shopping is 1), therefore r= 1/3.
Analogously, for the woman, q= 2/3. Now she must balance
what q (the mans chances of valuing his own happiness
over hers) really is. If r>1/3, theyll go to a boxing match. If
r=1/3, either could happen, and if r<1/3, the woman will
get her own way and theyll go shopping. She must balance
this carefully, because if she makes a mistake in valuing his
probability (likewise for the man) then, as this is still a
simultaneous game and there are no second chances, they
could end up spending the weekend apart, which would
mean less utility for both.

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

Definition
A mixed strategy of player i is a probability distribution i over is
pure strategy space Si. We denote by i the space of is mixed
strategies and the full space by = 1 ... n.
Note that the space of mixed strategies contains all pure strategies.
Example:

t
m
b

l
2,0
0,1
-1,0

r
-1,1
0,0
2,2

Consider the mixed strategy 1 assigning1/2 to t and b each.

This strategy secures a payoff of 0.5 to P1, whatever P2 does.
Note that pure strategy m is strictly dominated by 1.
13 / 119

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

Notation: Given the n-dimensional vector x = x1, . . . , xn, the

notation xi denotes the n 1 dimensional vector
xi = x1,... ,xi1,xi+1,... ,xn
missing the element xi from x. I.e., xi = x \ xi.

Definition
A strategy si i is called strictly dominated for player i if there
is a i i suchthat
ui(i, si) > ui(si, si) for all si Si

()

where Si = S1 . . . Si1 Si+1 . . . Sn.

Definition
A strategy si i is called weakly dominated if there is a i i
such that () is strict for at least one si and holds with equality
for all others.

14 / 119

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

Definition
A rational player never plays a strictly dominated strategy.
If a game is dominance solvable, then the result of IESDS is often
a good prediction of how people choose in reality (or experiments).
If payoffs can take on extreme values, however, then this is not
always true.

t
b

l
2,100
1,50

r
,99
2,49

IESDS recommendation: (t, l).

P1 must be very sure of P2s rationality to follow this advice!
15 / 119

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

To get a clearer idea of the rationality requirements of IESDS,

consider the following example of Hotellings location game.
Two vendors A and B sell some homogenous good; they have
a discrete number of possible locations along some linear city
[0, 1]:{0,1,,...,}foreven(thus1/2 ispossible).
Vendors choose their location simultaneously.
Consumers populate the city uniformly [0, 1] and buy their
good from whoever is closer (transport cost).

1
1/

1/2

The usual example is again ice cream but this time on a beach.
16 / 119

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

Will vendor A choose location 0 vs.1/ (1 vs.1/, resp)?

Locations are described as pairs (A,B).
(0,1/) (1/,1/):
0

1/

2/

(0, 0) (1/, 0):

0
B

A@1/

(0,n/) (1/,n/):
0

B@n/

No! 0 1/ is always profitable & 0 is dominated!

17 / 119

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

Through repetition of the above elimination, IESDS eliminates all

grid points except for the middle point.
IESDS gives the unique recommendation to play (1/2,1/2).

1
1/2

If you know the concentration of electronics stores at Tottenham

Court Road, London, then youll appreciate that this may not be
too far from the truth!

18 / 119

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

Definitions
Lets be more formal and define for gsf G = {N, S, u}

Ri to mean that player i is (IESDS) rational, and

Ki X to mean, that player i knows X.

Then
1. {0, 1} are eliminated if KiG, Ri, i {A,
B}:e.g., if KBG, RB, then B will not play {0, 1}
2. {1/,1 1/} are eliminated if KiKjG, KjRi, i = j
{A,B}:
e.g., if KAKBG, KARB, then A knows that B will not play
{1/,1 1/}
}Ri.
h. {h1 ,1 h1} are eliminated if KiKj ... }G,|j
| {z
{z
h

h1

19 / 119

Applied Micro 2/20151. Applied Game Theory

Strategic form Nash Eqm Extensive form Subgame perfection Imperfect info Incomplete info

Assumptions on IESDS
Definition
X is called common knowledge among i {A,B} if KiKjKi ...
}X,
|
{z
i = j, n = 1,2,3,... for as many rounds as required.

IESDS requires the following assumptions

1. rationality of all players,
2. common knowledge of rationality, and
3. common knowledge of the game structure {N, S, u}.
What else do we need for Nash equilibrium (see slide #37)?

20 / 119