8.1 - Noncooperative Game Theory

Chapter 8
Noncooperative Game Theory

General Equilibrium and Welfare Economics
Outline of the chapter
Introduction to Noncooperative Game Theory

Simultaneous-move games
Dynamic games
Complete information
Incomplete information
Incomplete/imperfect information
Repeated games
Introduction
Economic agents take strategic decisions in an

environment with conflicting interests
and in environments in which information and
knowledge are diffuse.
In this case, even simple cooperation proves
difficult.
Noncooperative means: each agent decides
unilaterally, maximizing only his own utility (not
taking into account the others).
The agents may still try to reach common goal
though.
3
Introduction
Firms decisions on prices, quantities, advertising, or

capacity influence other firms decisions on these
same variables, as well as firms welfare.
Similarly, people take strategic decisions in an
environment with conflicting interests.
Game Theory allows us to formally analyze
interdependence, and predict the final outcome
Introduction
Description (ingredients) of a game:
Players
Rules
Actions/Strategies
Outcomes
Each players payoff in each outcome
Introduction
Formal definition of a game:

Set of player: I = {1, , n} with typcial element i
Strategy space S = xi Si, where Si is player is
strategy set (this is also called action space/set)
Payoff function u that maps S into Rn, where u = (u1,
, un) specifies a payoff for every player i given any
strategy profile s in S.
Introduction
We will typically assume:
Rationality
Perfect recall
(Im)Perfect Information. Imperfect information is related
with probabilities.
(In)Complete Information. Don't know if something exist or
not or something can happen.
Common knowledge. Everybody knows the description of
the game. (I know that you know everything in reiterative
ways). (This reiterations usually take 3 steps, but we are
going to consider infinitive).
Introduction
Example: matching pennies
Two players
Rules: Player 1 chooses H or T, simultaneously player 2
chooses H or T. If pennies match, player 1 gets both
pennies, otherwise, player 2 gets them.
Actions/strategies: choose H or T
Outcomes: (H,H), (H,T), (T,H), (T,T)
Payoffs: (1,-1), (-1,1), (-1,1), (1,-1)
Introduction
Depicting matching pennies graphically:
Player 1 has two strategies:
H
T
H
T
Introduction
Making use of the payoff matrix (normal form of the

game).
Simultaneous-move version of matching pennies:
Player 2
H
Player 1
H 1,-1
T
T
-1,1
-1,1 1,-1
P1 P2
10
Introduction
We will classify games into:
Looking at the type of information:
Simultaneous-move games vs. Dynamic games

Normal form games vs. Extensive form games (game tree to
analyze sequences.
Perfect information
Imperfect information
and of the knowledge each player has when

taking a decision:
11
Introduction
Definition of a strategy for player i: function from the

set of information sets to the set of
actions/strategies that determines what player i
does at each possible information set.
Notice that a strategy says what to do at each
possible information set. It is a complete contingent
plan or description of what the players do in any
possible state of the world. Even if knowing or not
the result of the event, take a strategy in advance.
12
Introduction
Pure strategies: those played with probability one

Mixed strategies: the player plays two or more
strategies with positive probability. Ex: flip a coin for
deciding.
Pure strategies are a particular case of mixed strategies
13
Introduction
The games normal form is the set of players, a set

of strategies for each player, and utility functions for
each player:
Strategies
N I, S , u
Players
I
i i 1
I
i i1
utilities
14
Introduction
and it is graphically depcited in a payoff matrix.

For the matching pennies we saw it already:
Player 2
H
Player 1
H 1,-1
-1,1
1,-1
-1,1
15

Dynamic games
Repeated games
16
All players choose strategies at the same time:

players do not know what other players have
chosen when selecting their own strategies
Complete information: players know other players
relevant characteristics and the complete description
of the game
Incomplete information: players lack some
information on other players characteristics and/or
the description of the game
Example: auction
17
The Prisoners Dilemma

Dominant and dominated strategies
Prisoner 2
Prisoner 1
DC
DC
-2,-2
-10,-1
-1,-10 -5,-5
18
Here Dont Confess is strictly dominated for both

players, since it yields a lower payoff regardless of
the other players strategy
For the same reason, Confess is striclty dominant,
and we expect both players to play Confess
There is an equilibrium in dominant strategies.
Notice that we only require rationality. Players do
not need to know that the other player is rational
19
What if there is no dominant strategy?

Players will not choose dominated strategies, so
we may just remove them from their choice sets
As we delete strategies, maybe some strategies
become dominated, and we may erase them
Notice that this requires knowing that the other
player is rational
20
Example: consider the following game

Player 2
Player 1
Left
Center
Right
Up
1,1
2,0
1,1
Middle
0,0
0,1
0,0
Down
2,1
1,0
2,2
21
There are no dominant strategies, but M is

dominated:
Player 2
Player 1
Left
Center
Right
Up
1,1
2,0
1,1
Middle
0,0
0,1
0,0
Down
2,1
1,0
2,2
22
And then, C becomes dominated

Player 2
Player 1
Left
Center
Right
Up
1,1
2,0
1,1
Middle
0,0
0,1
0,0
Down
2,1
1,0
2,2
23
Now U is dominated by D:
Player 2
Player 1
Left
Center
Right
Up
1,1
2,0
1,1
Middle
0,0
0,1
0,0
Down
2,1
1,0
2,2
24
And hence, player 2 will not choose L:

Player 2
Player 1
Left
Center
Right
Up
1,1
2,0
1,1
Middle
0,0
0,1
0,0
Down
2,1
1,0
2,2
25
However, sometimes iterated deletion can not be

started:
Player 2
Player 1
Left
Center
Right
Up
2,1
2,2
0,3
Middle
1,1
1,1
1,1
Down
0,1
0,0
2,2
26
Strategy si is a best response for player i to his

rivals playing strategies s-i if:
ui(si, si ) ui(s'i , si )
s'i Si
i.e. si maximizes player is utility, given that the

remaining players choose s-i
27
A strategy profile s=(s1,,sI) constitutes a Nash

equilibrium of game N I, Si iI1 , ui iI1 if for
every player i=1,,I:
ui(si, si ) ui(s'i , si )
s'i Si
i.e. no player has any profitable deviation,

conditional on the remaining players playing the
equilibrium strategies
28
The players unilaterally choose an action. This

either leads to a Nash equilibrium or not. In a Nash
equilibrium, the players dont have an incentive to
change their behavior. Otherwise, they do.
If there is only one Nash equilibrium, then it is focal
for the players to choose it. Otherwise,
miscoordination can occur.
Common knowledge of rationality is required.
A dominant strategy is always part of a Nash
equilibrium. Dominated or never best response
strategies are never part of a Nash equilibrium.
29
For instance, in the following game:
Player 2
Player 1
b1
b2
b3
b4
a1
0,7
2,5
7,0
0,1
a2
5,2
3,3
5,2
0,1
a3
7,0
2,5
0,7
0,1
a4
0,0
0,-2
0,0
10,-1
30
Since a Nash equilibrium is the intersection of the

two players best response functions, it is useful to
characterize these best responses
Identify player 1s best response to each of player
2s strategies. Do the same for player 2, and search
for intersections.
31
For instance, player 1s best response function
would be given by:
Player 2
Player 1
b1
b2
b3
b4
a1
0,7
2,5
7,0
0,1
a2
5,2
3,3
5,2
0,1
a3
7,0
2,5
0,7
0,1
a4
0,0
0,-2
0,0
10,-1
32
And player 2s:
Player 2
Player 1
b1
b2
b3
b4
a1
0,7
2,5
7,0
0,1
a2
5,2
3,3
5,2
0,1
a3
7,0
2,5
0,7
0,1
a4
0,0
0,-2
0,0
10,-1
33
This way, the unique Nash equilibrium is a2,b2:
Player 2
Player 1
b1
b2
b3
b4
a1
0,7
2,5
7,0
0,1
a2
5,2
3,3
5,2
0,1
a3
7,0
2,5
0,7
0,1
a4
0,0
0,-2
0,0
10,-1
34
Coordination Games
The Nash equilibrium need not be unique. For
instance:
Player 2
Player 1
Left
Right
Left
100,100
0,0
Right
0,0
100,100
35
This game has two Nash equilibria:

Player 2
Player 1
Left
Right
Left
100,100
0,0
Right
0,0
100,100
36
These would be the equilibria even if payoffs were:

Player 2
Player 1
Left
Right
Left
100,100
0,0
Right
0,0
1,1
37
Another coordination game

2
Plaza
Metro
3,
0,
3
Plaza
0,
Metro
0
1,
Coordination Games
There are two

2
NE in pure actions:
Plaza
1
when both players
3,
choose the same
action (therefore
Plaza
coordination games).
There is also one
0,
NE in mixed strategies.
Metro
Probability
distribution of two
choices
Metro
0,
3
0
1,
Calculate NE in mixed actions
Idea: make the other player indifferent between

2
choosing Plaza and
Plaza
Metro
1
Metro.
Only then is he willing
3,
0,
to play a mixed strategy.
Plaza
3
If he were not indifferent,
then hed be better off
1,
to play one pure strategy. 0,
Metro

p
2
choosing Plaza and
1-p
Plaza
Metro
1
Metro.
Only then is he willing
3,
0,
Plaza
3
1,
Metro

p
2
choosing Plaza and
1-p
Plaza
Metro
1
Metro.
Only then is he willing q
3,
0,
Plaza
3
1,
Metro
1-q
Coordination Games with Conflicting

Interests: The battle of sexes
2
Opera
Football
3,
0,
1
Opera
0,
Football
0
1,

Player 1 is the woman and player 2 the man.

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


2
Opera
What are the NE?
Football
1
3,
0,
1
Opera
0,
Football
0
1,


2
Opera
What are the NE?
Football
1
and in mixed
3,
0,
strategies?
0,
Football
Opera
1,
0
Anti-Coordination Game: Chicken

Game
2
Swerve
1
0,
-1,
0
Swerve
+1,
Straight
Straight
+1
-10,
-1
-10

Game
Two cars are driving towards each other.

2
Swerve
1
0,
-1,
0
Swerve
+1,
Straight
Straight
+1
-10,
-1
-10

Game

2
Who swerves?
Swerve
1
0,
-1,
0
Swerve
+1,
Straight
Straight
+1
-10,
-1
-10

Game

2
Who swerves?
Swerve
Straight
and the loser is a 1
0,
-1,
chicken.
Swerve
+1,
Straight
+1
-10,
-1
-10

Game

2
Who swerves?
Swerve
Straight
and the loser is a 1
0,
-1,
chicken.
Motivation: there is a Swerve
0
+1
resource that is rivalrous
but non-excludable and
+1,
-10,
sharing comes at Straight
-1
-10
a cost: negative externality

Game
NE: There are two in pure strategies and one in

2
mixed strategies.
Swerve
0,
-1,
0
Swerve
Straight
Straight
+1,
+1
-10,
-1
-10
Zero-sum games: e.g. Matching Pennies

2
Left
Right
+1,
-1
Left
Right
-1,
-1,
+1
+1,
+1
-1
Note that the sum of the two players payoffs is

2
always zero:
Left
Right
So what one player, 1
gains, the other loses
+1,
-1,
and vice versa.
Left
-1
Right
-1,
+1
+1,
+1
-1
Note that the sum of the two players payoffs is

2
always zero:
Left
Right
So what one player, 1
gains, the other loses
+1,
-1,
and vice versa.
Left
-1
+1
A resource is rivalrous
and excludable.
Right
-1,
+1,
+1
-1
What is the NE?

2
Left
Right
How many NE are there?
+1,
-1
Left
Right
-1,
-1,
+1
+1,
+1
-1
There is no intersection of the best response

functions, and thus, there is no Nash equilibrium in
pure strategies
However, both players choosing H and T with
probability 0.5 is a Nash equilibrium in mixed
strategies
57
We conclude that sometimes the Nash equilibrium

in pure strategies does not exist; such as in the
simultaneous-move version of the matching pennies
game, in which there is only a Nash equilibrium in
mixed strategies
This is true in general for any zero sum game
58
On the Number of NE
Did you notice how many NE we found for the

different games we analyzed?
On the Number of NE
Did you notice how many NE we found for the

different games we analyzed?
The number of NE is always odd.

Intuition (picture): best-reply correspondences
always cut an odd number of times.
They cannot cut an even number of times.

Dynamic games
Repeated games
61
Dynamic games
Example: sequential matching pennies
Two players
Rules: Player 1 chooses H or T, then player 2 chooses H
or T knowing player 1s choice. If pennies match, player 1
gets both pennies, otherwise, player 2 gets them
Actions/strategies: choose H or T
Outcomes: (H,H), (H,T), (T,H), (T,T)
Payoffs: (1,-1), (-1,1), (-1,1), (1,-1)
Two important concepts: nodes and information sets
62
Dynamic games
The games extensive form is:

P1
H
P2
H
1 1

2 1
P2
T
1

1
1

1
1

1
63
Dynamic games
Strategies: matching pennies, dynamic version:
H
T
Player 2 has four strategies:
H if H, H if T
H if H, T if T
T if H, H if T
T if H, T if T
64
Dynamic games
Recall the normal form or Simultaneous-move

version of matching pennies:
Player 2
H
Player 1
H 1,-1
-1,1
1,-1
-1,1
65
Dynamic games
If both players choose simultaneously, the games

extensive form is:
P1
H
P2
H
1 1

2 1
P2
T
1

1
1

1
1

1
66
Dynamic games
Entry Game
Two players: entrant and incumbent

The entrant chooses to enter or not. The incumbent fights
or accommodates.
Outcomes: (Out, Fight), (Out, A.), (Enter, Fight), (Enter, A.)
Payoffs: (0,2), (0,2), (-3,-1), (2,1)
67
Dynamic games
In extensive form:
Entrant
Out
E 0

I 2
In
Incumbent
Fight
Accommodate
2

1
68
Dynamic games
There are two Nash equilibria:
(Out, Fight if in)

(In, Accommodate if in)
However, (Out, Fight if in) tells the incumbent to

choose a suboptimal action if the entrant enters
The principle of sequential rationality requires
players to choose optimal actions at every point
in the game tree (even those that are not
reached in equilibrium)
69
Dynamic games
Applying the principle of sequential rationality,

players may anticipate what other players will
do, and choose accordingly
The entrant anticipates that the incumbent will
accommodate if entry occurs, and thus, it
chooses to enter
The principle of sequential rationality allows us
to analyze these games by means of backward
induction
70
Dynamic games
Now consider this game:

Entrant
Out
In
Incumbent
E 0

I 2
Entrant
F
3

1
3

1
71
Dynamic games
If entry occurs, the entrant will play Accommodate

Entrant
Out
E 0

I 2
In
Incumbent
A
Entrant
A
1

2
3

1
72
Dynamic games
And the incumbent will also play Accommodate

Entrant
Out
E 0

I 2
In
Incumbent
A
Entrant
A
3

1
73
Dynamic games
Hence, it is as if the entrant played this game:

Entrant
Out
E 0

I 2
In
3

1
and, of course, it will choose to enter.
74
Dynamic games
Thus, the entrant enters, anticipating that both

the incumbent and the entrant will play
Accommodate
Hence, (In, Accommodate; Accommodate) is a
Nash equilibrium. However, (Out,
Accommodate; Fight) is also a Nash equilibrium
The difference is that only the former satisfies
the principle of sequential rationality
75
Dynamic games: some definitions
A subgame is a subset of the game that begins

at a singleton information set. It is a game within
the game
A strategy profile s1 (.),..., s I (.) is a Subgame
Perfect (Nash) Equilibrium if it induces a Nash
Equilibrium in every possible subgame.
A SPE is always a NE. It adds the requirement
of satisfying the principle of sequential rationality
76
Dynamic games
Recall the game:

Entrant
Out
In
Incumbent
E 0

I 2
Entrant
F
3

1
77
Dynamic games
In the post-entry subgame, the unique Nash

Equilibrium is (Accommodate, Accommodate)
Any SPE must specify both players accommodating
if entry occurs
Hence, the unique SPE is (In, Accommodate;
Accommodate)
78

8.1 - Noncooperative Game Theory

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8.1 - Noncooperative Game Theory

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Chapter 8

Noncooperative Game Theory

Outline of the chapter

Introduction to Noncooperative Game Theory

Economic agents take strategic decisions in an

Firms decisions on prices, quantities, advertising, or

Description (ingredients) of a game:

Formal definition of a game:

We will typically assume:

Example: matching pennies

Depicting matching pennies graphically:

Player 1 has two strategies:

Player 2 has two strategies:

Making use of the payoff matrix (normal form of the

We will classify games into:

Looking at the type of information:

Simultaneous-move games vs. Dynamic games

and of the knowledge each player has when

Definition of a strategy for player i: function from the

Pure strategies: those played with probability one

The games normal form is the set of players, a set

and it is graphically depcited in a payoff matrix.

Outline of the chapter

Introduction to Noncooperative Game Theory

All players choose strategies at the same time:

The Prisoners Dilemma

Here Dont Confess is strictly dominated for both

What if there is no dominant strategy?

Example: consider the following game

There are no dominant strategies, but M is

And then, C becomes dominated

And hence, player 2 will not choose L:

However, sometimes iterated deletion can not be

Strategy si is a best response for player i to his

i.e. si maximizes player is utility, given that the

A strategy profile s=(s1,,sI) constitutes a Nash

i.e. no player has any profitable deviation,

The players unilaterally choose an action. This

Since a Nash equilibrium is the intersection of the

This game has two Nash equilibria:

These would be the equilibria even if payoffs were:

Another coordination game

There are two

Calculate NE in mixed actions

Idea: make the other player indifferent between

Calculate NE in mixed actions

Idea: make the other player indifferent between

Calculate NE in mixed actions

Idea: make the other player indifferent between

Coordination Games with Conflicting

Coordination Games with Conflicting

Player 1 is the woman and player 2 the man.

Coordination Games with Conflicting

Player 1 is the woman and player 2 the man.

Coordination Games with Conflicting

Player 1 is the woman and player 2 the man.

Anti-Coordination Game: Chicken

Anti-Coordination Game: Chicken

Two cars are driving towards each other.

Anti-Coordination Game: Chicken

Two cars are driving towards each other.

Anti-Coordination Game: Chicken

Two cars are driving towards each other.