ECON10004

Introductory Microeconomics
Semester 1, 2018

Department of Economics
University of Melbourne
Game theory: sequential games

• The concepts that we have learnt so far can also be applied to

games with sequential moves
• Recall: strategies in sequential games must specify a complete
set of decisions i.e. a decision for every possible previous move
in the game
• The equilibrium should still comprise best-response strategies
of all players

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Game theory: sequential games

• Lets start with a simple coordination game:

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Game theory: sequential games

• Suppose that instead of it being a simultaneous game, player

1 gets to choose her phone carrier first.
• For P1, then, a strategy is simply choosing Telstra or Virgin
• For P2, however, we need to specify an action at each
potential decision point.
• Strategies here will be a pair of actions that are conditional on
whether Player 1 has chosen Telstra or Virgin.
• We are thus specifying an action for each potential history.
• T,V means that P2 chooses Telstra if P1 chooses Telstra. P2
chooses Vodaphone if P1 chooses Vodaphone
• V,T means that P2 chooses Vodaphone if P1 Chooses Telstra.
P2 chooses Telstra if P1 chooses Vodaphone

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Game theory: sequential games

• We could specify a new Normal Form to find all the NE:

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Game theory: sequential games

• The Normal Form approach has some issues:

• The normal form doesn’t give us any sense of timing. We have
a hard time reconstructing the original game.
• A bigger issue is that some of the NE of the game are strange.
• If P1 chooses T , P2 using strategy {V , V } will be getting 0.
• She could do better if she changed her strategy after P1’s
initial choice and switched to T,V
• Thus, the Nash Equilibrium V , {V , V } exists in part because
P2 is not switching strategies when it is in his interest.
• We can this type of equilibrium “non-credible” because the
equilibrium is based on a strategy profile that the individual
would like to change when they arrive at a future decision.

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Game theory: sequential games

• To address these issues we typically use game trees to

analyse sequential games.
• Game trees are often referred to as extensive form games

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Game theory: sequential games

• The decision tree for the coordination game is as follows:

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Game theory: sequential games

• To find equilibrium that are credible we want to make sure no

one wants to change their mind later int he game. We do this
through backward induction.
• A subgame is a game comprising a portion of a longer game,
starting from a non-initial node of the larger game.
• Backward induction starts at the final subgames, and finds the
Nash equilibrium for these subgames.
• It then moves up the tree using these choices as the predicted
actions of the later subgames.

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Game theory: sequential games

• We first solve the lowest subgames from the perspective of

player 2 (the person making the move).

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Game theory: sequential games

• We first solve the lowest subgames from the perspective of

player 2 (the person making the move).

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Game theory: sequential games

• We then solve the next layer of the game using the payoffs
that are predicted from the lower subgames.

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Game theory: sequential games

• An equilibrium found through backward induction is called a

Subgame Perfect Nash Equilibirum or SPNE.
• Such an equilibrium is a set of strategies that is a Nash
equilibrium at every single subgame of the game. This
includes subgames that are off the equilibrium path of play.
• The solution predicts stable outcomes, as no player wants to
deviate from her equilibrium strategies.

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Game theory: sequential games

• Summing up
• Sequential games occur when individuals can condition their
play on events that happen in the past.
• Strategies get more complicated in sequential games since we
must specify an action for every potential history.
• We often use a refinement of Nash Equilibrium that eliminates
equilibria that are based on non-credible threats.
• Subgame-Perfect Nash Equilbrium satisfy this refinement by
requiring that the strategy profile is a Nash equilibrium in
every subgame.

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Game theory: sequential games

Airbus versus Boeing

• CEOs of Airbus and Boeing are in a strategic situation

involving whether to respectively introduce a new passenger
jet
• Table below represents their available choices and payoffs
Boeing
Introduce Not
Introduce 100,50 50,100
Airbus
Not 25,150 150,25

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Game theory: sequential games

• In a simultaneous game, there is no pure strategy equilibrium

• Now, suppose Airbus moves first, then Boeing
• We can use a game tree to represent this sequential setting

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Game theory: sequential games

Payoff to the first mover

100, 50
Introduce Payoff to the second mover

Boeing • Branches represent

Introduce actions available to each
Not introduce player
50, 100
Airbus
• Decisions nodes are
25, 150 points where a player
Introduce
Not introduce makes a choice of
Boeing action

Not introduce
150, 25

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Game theory: sequential games

• By “backward induction”, we can infer that Airbus’s strategy

is {Introduce} and Boeing’s strategy is {Not Introduce,
Introduce}.
• In this SPNE, therefore, the payoffs are {50, 100}
• Note: even decision nodes that are never reached are
important for understanding player’s observable actions.

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Game theory: sequential games

• What if Boeing moves first?

• Again, using “backward induction”, we can infer that Boing’s
strategy is {Introduce} and Airbus’s strategy is {Introduce,
Not Introduce}
• The payoff is 50,100
• Notice how the SPNE and payoffs change when the ordering
of moves changes.

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Game theory: sequential games

Payoff to the first mover

50, 100
Introduce Payoff to the second mover

Airbus • Branches represent

Introduce action available to each
Not introduce player
150, 25
Boeing
• Decisions nodes are
100, 50 points where a player
Introduce
Not introduce makes a choice of
Airbus action.

Not introduce
25, 150

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Game theory: sequential games

Penalty kicks

• Kicker and Goalie play penalty kicks

• Kicker chooses to aim “L,C,R” and goalie prepares to stop the
shot with one of “L,C,R”
• Table of choices and probability of scoring and the
corresponding payouts of the two players
Goalie
L C R
L 0.6,-0.6 0.8,-0.8 0.9,-0.9
Kicker C 1.0,-1.0 0.0,0.0 1.0,-1.0
R 0.9,-0.9 0.9,-0.9 0.4,-0.4

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Game theory: sequential games

• Again, there are no pure strategy equilibria if players move

simultaneously
• Now, suppose Kicker moves first, then Goalie
• We can use a game tree to represent the sequential setting
• What is the NE (and resulting payoffs)?

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Game theory: sequential games

Key lessons for sequential games:

1. Backward induction

• Look ahead to anticipate what other players would do, and

use that information to work out a best-response strategy
• Use these best-response strategies to find the SPNE

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Game theory: sequential games

2. Ordering matters

• Moving first allows a player to commit to a strategy, which

can be valuable in terms of forcing other players to change
their decisions
• Moving second allows a player to discover information about
the other players’ strategies, which can be valuable for
working out own best-response

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Game theory: sequential games

3. Strategy revelation

• In some games, it is optimal to let other players know one’s

strategy (i.e. coordinate to obtain higher payoffs)
• In other games, it is optimal to prevent other players from
knowing one’s strategy (zero-sum payoffs)

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Game theory: oligopoly

Why are oligopolistic markets ideal for studying strategic

behaviour?

• Recall: oligopolistic markets comprise just a few firms

• Oligopolists are best off collectively when they cooperate and
act like a monopolist
• In the absence of a binding agreement, however, firms face
incentives to deviate from cooperation

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Game theory: oligopoly

Quantity competition (simultaneous game):

Airbus versus Boeing

• Suppose Airbus and Boeing are the only two firms (duopoly)
in the passenger jet industry i.e. QS = QA + QB
• Both firms have FC = 0 and MC = $100 million
• Inverse demand is P = 800 − QD
• What is the monopoly outcome?
• Cartel: what quantities would firms choose if they choose to
collude?

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Game theory: oligopoly

• Suppose Boeing behaves according to the cartel’s agreement:

Airbus will then be tempted to increase its production to
increase profits
• Knowing this, Boeing will also have an incentive to deviate
from the agreement
• Any change in production will impact market prices (and thus
firm profit), so each firm must optimally react to the other
firm’s production
• Derive Airbus’ best-response function to Boeing’s production
• Set MRA = MCA to obtain QA as a function of QB

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Game theory: oligopoly

• Since Airbus and Boeing face identical costs, Boeing will have
an identical best-response function (i.e. QB as a function of
QA )
• The game is symmetric so we expect QA = QB in equilibrium:
this is in fact the Nash equilibrium of the duopoly game
• Note: the (cooperative) cartel outcome cannot be achieved
unless there is some form of enforcement mechanism e.g.
infinitely-repeated game

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Game theory: oligopoly
Game theory: oligopoly
• What would the outcome be if the industry was perfectly
• What would the outcome be if the industry was perfectly
competitive?
competitive?
• What prevents the duopoly from achieving the competitive
• What prevents the duopoly from achieving the competitive
outcome?
outcome?
• •Indeed,
Indeed, if we have
if we havea alarge
large number
number of firms,
of firms, thewill
the NE NE will
converge towardsthe
converge towards the competitive
competitive outcome
outcome

QA

B’s best-response function

A’s best-response function

QB 29
Game theory: oligopoly

Quantity competition (sequential game):

• Suppose again that Airbus and Boeing operate as a duopoly,

but one firm gets to move first
• Is it better to go first or second?
• Recall: moving first allows a player to commit to a strategy
and thus force the other players to react accordingly, while
moving second allows a player to learn about other players’
strategies from earlier moves

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Game theory: oligopoly

• In this example, best-response functions are negatively-sloped

(i.e. if Airbus chooses a large QA , Boeing’s best response is a
small QB )
• In other words, firm production choices are “strategic
substitutes”
• From the perspective of Airbus, a larger QA and a smaller QB
both enhances its profit, so there is clearly a first-mover
advantage

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