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Game Theory
 Game Theory

• Game theory helps to model strategic

behavior by agents who understand that
their actions affect the actions of other
agents.
Some Applications of Game Theory
• The study of oligopolies (industries
containing only a few firms)
• The study of cartels; e.g. OPEC
• The study of externalities; e.g. using a
common resource such as a fishery.
Some Applications of Game Theory
• The study of military strategies.
• Bargaining.
• How markets work.
 What is a Game?

• A game consists of
– a set of players
– a set of strategies for each player
– the payoffs to each player for every possible
choice of strategies by the players.
 Two-Player Games
• A game with just two players is a two-player
game.
• We will study only games in which there are
two players, each of whom can choose
between only two actions.
An Example of a Two-Player Game

• The players are called A and B.

• Player A has two actions, called “Up” and
“Down”.
An Example of a Two-Player Game

• Player B has two actions, called “Left” and

“Right”.
• The table showing the payoffs to both
players for each of the four possible action
combinations is the game’s payoff matrix.
An Example of a Two-Player Game

Player B
L R

U (3,9) (1,8) This is the

Player A game’s
D (0,0) (2,1) payoff matrix.

Player A’s payoff is shown first.

Player B’s payoff is shown second.
 An Example of a Two-Player Game

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

A play of the game is a pair such as (U,R) where

the 1st element is the action chosen by Player A
and the 2nd is the action chosen by Player B.
 An Example of a Two-Player Game

Player B
L R

U (3,9) (1,8) This is the

Player A game’s
D (0,0) (2,1) payoff matrix.

E.g. if A plays Up and B plays Right then A’s payoff

is 1 and B’s payoff is 8.
 An Example of a Two-Player Game

Player B
L R

U (3,9) (1,8) This is the

Player A game’s
D (0,0) (2,1) payoff matrix.

And if A plays Down and B plays Right then A’s

payoff is 2 and B’s payoff is 1.
An Example of a Two-Player Game

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

What plays are we likely to see for this game?

An Example of a Two-Player Game

Player B Is (U,R) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)
 An Example of a Two-Player Game

Player B Is (U,R) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)

If B plays Right then A’s best reply is Down since

this improves A’s payoff from 1 to 2. So (U,R) is
not a likely play.
An Example of a Two-Player Game

Player B Is (D,R) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)
 An Example of a Two-Player Game

Player B Is (D,R) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)

If B plays Right then A’s best reply is Down.

 An Example of a Two-Player Game

Player B Is (D,R) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)

If B plays Right then A’s best reply is Down.

If A plays Down then B’s best reply is Right.
So (D,R) is a likely play.
An Example of a Two-Player Game

Player B Is (D,L) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)
 An Example of a Two-Player Game

Player B Is (D,L) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)

If A plays Down then B’s best reply is Right,

so (D,L) is not a likely play.
An Example of a Two-Player Game

Player B Is (U,L) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)
An Example of a Two-Player Game

Player B Is (U,L) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)

If A plays Up then B’s best reply is Left.

An Example of a Two-Player Game

Player B Is (U,L) a likely

L R play?

U (3,9) (1,8)
Player A
D (0,0) (2,1)

If A plays Up then B’s best reply is Left.

If B plays Left then A’s best reply is Up.
So (U,L) is a likely play.
 Nash Equilibrium
• A play of the game where each strategy is a
best reply to the other is a
Nash equilibrium.
• Our example has two Nash equilibria; (U,L)
and (D,R).
An Example of a Two-Player Game

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

(U,L) and (D,R) are both Nash equilibria for

the game.
An Example of a Two-Player Game

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

(U,L) and (D,R) are both Nash equilibria for the

game. But which will we see? Notice that
(U,L) is preferred to (D,R) by both players.
Must we then see (U,L) only?
 The Prisoner’s Dilemma
• To see if Pareto-preferred outcomes must be
what we see in the play of a game, consider
the famous example called the Prisoner’s
Dilemma game.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

What plays are we likely to see for this game?

 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

If Bonnie plays Silence then Clyde’s best reply is

Confess.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

If Bonnie plays Silence then Clyde’s best reply is

Confess.
If Bonnie plays Confess then Clyde’s best reply is
Confess.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

So no matter what Bonnie plays, Clyde’s best

reply is always Confess. Confess is a dominant
strategy for Clyde.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

Similarly, no matter what Clyde plays, Bonnie’s

best reply is always Confess. Confess is a
dominant strategy for Bonnie also.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

So the only Nash equilibrium for this game is

(C,C), even though (S,S) gives both Bonnie and
Clyde better payoffs. The only Nash equilibrium
is inefficient.
 Who Plays When?
• In both examples the players chose their
strategies simultaneously.
• Such games are simultaneous play games.
 Who Plays When?
• But there are other games in which one player
plays before another player.
• Such games are sequential play games.
• The player who plays first is the leader. The
player who plays second is the follower.
 A Sequential Game Example
• Sometimes a game has more than one Nash
equilibrium and it is hard to say which is more
likely to occur.
• When a game is sequential it is sometimes
possible to argue that one of the Nash
equilibria is more likely to occur than the
other.
 A Sequential Game Example

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)

(U,L) and (D,R) are both NE when this game is

played simultaneously and we have no way of
deciding which equilibrium is more likely to occur.
 A Sequential Game Example

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)
Suppose instead that the game is played
sequentially, with A leading and B following. We
can rewrite the game in its extensive form.
 A Sequential Game Example

A
U D A plays first.
B B B plays second.

L R L R

(3,9) (1,8) (0,0) (2,1)

 A Sequential Game Example

A
U D A plays first.
B B B plays second.

L R L R

(3,9) (1,8) (0,0) (2,1)

(U,L) is a Nash equilibrium.
 A Sequential Game Example

A
U D A plays first.
B B B plays second.

L R L R

(3,9) (1,8) (0,0) (2,1)

(U,L) is a Nash equilibrium. So is (D,R).
Is one equilibrium more likely to occur?
 A Sequential Game Example

A
U D A plays first.
B B B plays second.

L R L R

(3,9) (1,8) (0,0) (2,1)

If A plays U then B follows with L; A gets 3.
 A Sequential Game Example

A
U D A plays first.
B B B plays second.

L R L R

(3,9) (1,8) (0,0) (2,1)

If A plays U then B follows with L; A gets 3.
If A plays D then B follows with R; A gets 2.
 A Sequential Game Example

A
U D A plays first.
B B B plays second.

L R L R So (U,L) is the
likely NE.
(3,9) (1,8) (0,0) (2,1)
If A plays U then B follows with L; A gets 3.
If A plays D then B follows with R; A gets 2.
 A Sequential Game Example

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)
This is our original example once more. Suppose
again that play is simultaneous. We discovered that
the game has two Nash equilibria; (U,L) and (D,R).
 A Sequential Game Example

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)
Player A has been thought of as choosing to play
either U or D, but no combination of both; i.e. as
playing purely U or D. U and D are Player A’s
pure strategies.
 A Sequential Game Example

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)
Similarly, L and R are Player B’s pure strategies.
 A Sequential Game Example

Player B
L R

U (3,9) (1,8)
Player A
D (0,0) (2,1)
Consequently, (U,L) and (D,R) are pure strategy
Nash equilibria. Must every game have at least
one pure strategy Nash equilibrium?
 Pure Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Here is a new game. Are there any pure strategy

Nash equilibria?
 Pure Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium?

 Pure Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium?
 Pure Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium? No.
Is (D,L) a Nash equilibrium?
 Pure Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium? No.
Is (D,L) a Nash equilibrium? No.
Is (D,R) a Nash equilibrium?
 Pure Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

Is (U,L) a Nash equilibrium? No.

Is (U,R) a Nash equilibrium? No.
Is (D,L) a Nash equilibrium? No.
Is (D,R) a Nash equilibrium? No.
 Pure Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

So the game has no Nash equilibria in pure strategies.

Even so, the game does have a Nash equilibrium, but
in mixed strategies.
 Mixed Strategies

• Instead of playing purely Up or Down, Player A

selects a probability distribution (pU,1-pU),
meaning that with probability pU Player A will
play Up and with probability 1-pU will play
Down.
• Player A is mixing over the pure strategies Up
and Down.
• The probability distribution (pU,1-pU) is a mixed
strategy for Player A.
 Mixed Strategies

• Similarly, Player B selects a probability

distribution (pL,1-pL), meaning that with
probability pL Player B will play Left and with
probability 1-pL will play Right.
• Player B is mixing over the pure strategies Left
and Right.
• The probability distribution (pL,1-pL) is a mixed
strategy for Player B.
 Mixed Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

This game has no Nash equilibrium in pure strategies,

but it does have a Nash equilibrium in mixed
strategies. How is it computed?
 Mixed Strategies

Player B
L, pL R, 1-pL
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
 Mixed Strategies

Player B
L, pL R, 1-pL
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
A’s expected value of choosing Up is ??
 Mixed Strategies

Player B
L, pL R, 1-pL
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
A’s expected value of choosing Up is pL.
A’s expected value of choosing Down is ??
 Mixed Strategies

Player B
L, pL R, 1-pL
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
A’s expected value of choosing Up is pL.
A’s expected value of choosing Down is 3(1 - pL).
 Mixed Strategies

Player B
L, pL R, 1-pL
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
A’s expected value of choosing Up is pL.
A’s expected value of choosing Down is 3(1 - pL).
If pL > 3(1 - pL) then A will choose only Up, but
there is no NE in which A plays only Up.
 Mixed Strategies

Player B
L, pL R, 1-pL
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
A’s expected value of choosing Up is pL.
A’s expected value of choosing Down is 3(1 - pL).
If pL < 3(1 - pL) then A will choose only Down, but
there is no NE in which A plays only Down.
 Mixed Strategies

Player B
L, pL R, 1-pL
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
If there is a NE necessarily pL = 3(1 - pL)  pL = 3/4;
i.e. the way B mixes over Left and Right must make A
indifferent between choosing Up or Down.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
If there is a NE necessarily pL = 3(1 - pL)  pL = 3/4;
i.e. the way B mixes over Left and Right must make A
indifferent between choosing Up or Down.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
B’s expected value of choosing Left is ??
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
B’s expected value of choosing Left is 2pU + 5(1 - pU).
B’s expected value of choosing Right is ??
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
B’s expected value of choosing Left is 2pU + 5(1 - pU).
B’s expected value of choosing Right is 4pU + 2(1 - pU).
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
B’s expected value of choosing Left is 2pU + 5(1 - pU).
B’s expected value of choosing Right is 4pU + 2(1 - pU).
If 2pU + 5(1 - pU) > 4pU + 2(1 - pU) then B will choose
only Left, but there is no NE in which B plays only Left.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, pU (1,2) (0,4)
Player A
D, 1-pU (0,5) (3,2)
B’s expected value of choosing Left is 2pU + 5(1 - pU).
B’s expected value of choosing Right is 4pU + 2(1 - pU).
If 2pU + 5(1 - pU) < 4pU + 2(1 - pU) then B plays only
Right, but there is no NE where B plays only Right.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
Player A
D, 2/5 (0,5) (3,2)
If there is a NE then necessarily
2pU + 5(1 - pU) = 4pU + 2(1 - pU)  pU = 3/5;
i.e. the way A mixes over Up and Down must make B
indifferent between choosing Left or Right.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
Player A
D, 2/5 (0,5) (3,2)
The game’s only Nash equilibrium consists of A
playing the mixed strategy (3/5, 2/5) and B playing
the mixed strategy (3/4, 1/4).
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
9/20
Player A
D, 2/5 (0,5) (3,2)
The payoff will be (1,2) with probability
3/5 × 3/4 = 9/20.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
9/20 3/20
Player A
D, 2/5 (0,5) (3,2)
The payoff will be (0,4) with probability
3/5 × 1/4 = 3/20.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
9/20 3/20
Player A
D, 2/5 (0,5)
(3,2)
6/20
The payoff will be (0,5) with probability
2/5 × 3/4 = 6/20.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
9/20 3/20
Player A
D, 2/5 (0,5) (3,2)
6/20 2/20
The payoff will be (3,2) with probability
2/5 × 1/4 = 2/20.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
9/20 3/20
Player A
D, 2/5 (0,5) (3,2)
6/20 2/20
A’s NE expected payoff is
1×9/20 + 3×2/20 = 3/4.
 Mixed Strategies

Player B
L, 3/4 R, 1/4
U, 3/5 (1,2) (0,4)
9/20 3/20
Player A
D, 2/5 (0,5) (3,2)
6/20 2/20
A’s NE expected payoff is
1×9/20 + 3×2/20 = 3/4.
B’s NE expected payoff is
2×9/20 + 4×3/20 + 5×6/20 + 2×2/20 = 16/5.
 How Many Nash Equilibria?
• A game with a finite number of players, each
with a finite number of pure strategies, has at
least one Nash equilibrium.
• So if the game has no pure strategy Nash
equilibrium then it must have at least one
mixed strategy Nash equilibrium.
 Repeated Games
• A strategic game that is repeated by being
played once in each of a number of periods.
• What strategies are sensible for the players
depends greatly on whether or not the game
– is repeated over only a finite number of periods
– is repeated over an infinite number of periods.
 Repeated Games

• An important example is the repeated

Prisoner’s Dilemma game. Here is the one-
period version of it that we considered
before.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

Suppose that this game will be played in each

of only 3 periods; t = 1, 2, 3. What is the likely
outcome?
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

Suppose the start of period t = 3 has been reached

(i.e. the game has already been played twice). What
should Clyde do? What should Bonnie do?
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

Suppose the start of period t = 3 has been reached

(i.e. the game has already been played twice). What
should Clyde do? What should Bonnie do? Both
should choose Confess.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

Now suppose the start of period t = 2 has been

reached. Clyde and Bonnie expect each will choose
Confess next period. What should Clyde do? What
should Bonnie do?
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

Now suppose the start of period t = 2 has been

reached. Clyde and Bonnie expect each will choose
Confess next period. What should Clyde do? What
should Bonnie do? Both should choose Confess.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

At the start of period t = 1 Clyde and Bonnie both

expect that each will choose Confess in each of the
next two periods. What should Clyde do? What
should Bonnie do?
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

At the start of period t = 1 Clyde and Bonnie both

expect that each will choose Confess in each of the
next two periods. What should Clyde do? What
should Bonnie do? Both should choose Confess.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

The only credible (subgame perfect) NE for this game

is where both Clyde and Bonnie choose Confess in
every period.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

The only credible (subgame perfect) NE for this game

is where both Clyde and Bonnie choose Confess in
every period. This is true even if the game is
repeated for a large, still finite, number of periods.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

However, if the game is repeated for an infinite

number of periods then the game has a huge number
of credible NE.
 The Prisoner’s Dilemma

Clyde
S C
S (-5,-5) (-30,-1)
Bonnie
C (-1,-30) (-10,-10)

(C,C) forever is one such NE. But (S,S) can also be a

NE because a player can punish the other for not
cooperating (i.e. for choosing Confess).