The Game Theory

Microeconomics - 2.
1 Strategic form games
Description idsds Nash Rationalisability Correlated eq
Microeconomics
2. Game Theory
Alex Gershkov
http://www.econ2.uni-bonn.de/gershkov/gershkov.htm
21. November 2007
1 / 41
Microeconomics - 2.1 Strategic form games
Strategic form games
1.a Describing a game in strategic form

1.b Iterated deletion of strictly dominated strategies
1.c Nash equilibrium and examples
1.d Mixed strategies
1.e Existence of Nash equilibria
1.f Rationilazability
1.g Correlated equilibrium
2 / 41
Example: Entry game

1. 2 ice cream vendors decide whether or not to open an ice
cream stand in a particular street
2. the decision is taken without observing the other vendors
action
3. if only one stand is opened, this vendor earns $ 3 (the other
vendor earns zero)
4. if both stands open, they share profits and earn $ 1.5 each
3 / 41

Lets use a matrix to organise this information
entry no entry
entry 1.5,1.5 3,0
no entry 0,3 0,0
we use the following conventions

1. rows contain vendor 1s decisions, columns contain vendor 2s
decisions
2. each outcome of the game is located in one cell of the matrix
3. outcomes (payoffs, profits) are given in expected utility in the
form (u1 , u2 ).
4 / 41

This way of describing simultaneous move games is called
strategic form (sfg). Formally, a sfg consists of
1. a (not necessarily finite) set of players N: in the example
N = {1, 2}, generally N = {1, . . . , n}
2. a (not necessarily finite) set of pure strategies S = S1 S2 : in
the example Si = {entry , no entry }, S = Si2 , i {1, 2},
generally S = {S1 . . . Sn } = Sin
3. a set of payoff fns u(S): given as discrete values by the
payoffs in the sample matrix, generally by a vector of expected
utility fns u(S) = u1 (S), . . . , un (S)
Thus a game in strategic form is fully described by {N, S, u}. A sfg
is used to describe a game with no time dimension.
5 / 41
Predicting the agents (=vendors) actions is easy provided that

1. payoffs (=profits) are the only thing agents care about
2. agents are rational
3. agents maximise their profits
Then the predicted actions are (entry,entry) leading to an outcome
of (1.5,1.5).
Notice that in this example an agent does not need to know the
other agents choice in order to determine his optimal choice.
6 / 41
1.b Equilibria (idsds)
Example:
l c r
t 0,0 4,-1 1,-1
m -1,4 5,3 3,2
b -1,2 0,1 4,1
7 / 41
Definition: Given player i s pure strategy set Si , a mixed strategy

for player i , i : Si [0, 1] is a probability distribution over pure
strategies. (Denote by i the space of player i mixed strategies
and = 1 . . . n )
Another example:
l r
t 2,0 -1,1
m 0,1 0,0
b -1,0 2,2
8 / 41
Definition: Pure strategy si is strictly dominated for player i if

there exists i i such that
ui (i , si ) > ui (si , si ) for all si Si (1)

where Si = S1 . . . Si 1 Si +1 . . . Sn
The strategy si is weakly dominated if there exists a i i such

that inequality (1) holds weakly, that is, if the inequality is strict
for at least one si and equality holds for at least one si .
Definition: A rational player should never play a strictly

dominated strategy.
9 / 41
1.b Equilibria (idsds) & Rationality
Definition: X is called common knowledge (ck) between players A

and B if for any i {A, B}, i 6= j, k = 1, 2, 3, . . . Ki Kj Ki . . . X
| {z }
k
Idsds requires the following assumptions

1. players are rational
2. common knowledge of rationality
3. players know their payoffs
4. common knowledge of the structure of the game.
10 / 41

Definition
The process of idsds proceeds as follows: Set Si0 = Si and
0i = i . Define Sik recursively by
Sik = {si Sik1 | there is no i k1

i
k1
s.t. ui (i , si ) > ui (si , si ) for all si Si }
and define
ki = {i i |i (si ) > 0 only if Si Sik }
The set Si (
i ) is the set of Pi s pure (mixed) strategies that
survive idsd.
11 / 41
1.c Nash equilibrium

Game (Battle of the sexes)
f o
f 1,2 0,0
o 0,0 2,1
Here idsds does not workwe need a sharper tool: NEqm.
NEqm puts an additional restriction on the knowledge of players

compared to idsds: It assumes that players have a
correct expectation of which prediction is played and subsequently
have no incentive to deviate from this prediction!
12 / 41
Definition: A strategy profile s is a vector of dimension n

containing a single strategy choice for each player.
Notation: s = (s1 , . . . , sn ) = (si , si )
Definition: Player i s best response Bi is the set of own strategies

giving the highest payoff when the opponents play si . Formally
Bi (si ) = {si Si |ui (si , si ) ui (si , si ), si Si }
13 / 41
Definition: A Nash equilibrium is a strategy profile s which

prescribes a best response si for each player i given that the
. Hence for every i N
opponents play si
ui (si , si

) ui (si , si

), si Si
or equivalently
si Bi (si

), i N.
Notice that according to this definition, the players expected

prediction of play is correct in equilibrium.
14 / 41

Consider the following game
l r
u 3,2 2,0
d 0,0 1,1
Observe that
B1 (l ) = {u}, B1 (r ) = {u}
while
B2 (u) = {l }, B2 (d) = {r }.
Hence the unique NEqm is (u,l).

15 / 41
1.d NEqm & mixed strategies

What about this game, known as matching pennies?
h t
h 1,-1 -1,1
t -1,1 1,-1
THIS GAME HAS NO PURE STRATEGY NEQM!

Rem: A mixed strategy i is a probability distribution over player
i s set of pure strategies Si denoted by i .
Assumption
We assume that i randomises independently from the other
players randomisations.
Remark P
i is an |Si |-dimensional simplex i = {p [0, 1]|Si | : ph = 1}.
16 / 41

Definition: The mixed extension of the sfg {N, S, u} is the sfg
{N, , u} where i s payoff fn ui : jN j R assigns to each
jN j the expected utility of the lottery over S induced by .
Definition: A mixed strategy NEqm of a sfg is a NEqm of its
mixed extension such that for every i N
i argmax ui (i , i ).
i i
Lemma
If is a mixed strategy NEqm then for every i N every pure
action si Si to which i attaches positive probability is a best
response to i .
17 / 41
It is sufficient to check that no player has a profitable pure-strategy

deviation.
Alternative definition: A mixed strategy profile is a NEqm if

for all players i
ui (i , i

) ui (si , i ) for all si Si .
18 / 41
Theorem
(Nash 1950) Every finite sfg {N, S, u} has a mixed strategy Nash
equilibrium.
ui (i , i

) ui (i , i ), i i .
Proof: The proof consists of showing that our setting satisfies all
of Kakutanis assumptions and then concluding that there exists a
which is contained in the set of best responses B( ).
19 / 41
1.e Existence of NEqm
The existence question boils down to asking when the set of

intersections of best response correspondences
Bi (i ) = {i i |ui (i , i ) ui (i , i ), i i }
is non-empty. The way Nash answered this question was to set up

a mapping B : where
B() = (B1 (1 ), . . . , Bn (n )).

| {z } | {z }
1 n
20 / 41
Definition
Given X Rn , a correspondence F between the sets X and
Y Rk , written F : X Y , is a mapping that assigns a set F (x)
to every x X .
Definition
The graph of a correspondence F : X Y is the set
(F ) = {(x, y ) X Y | y F (x)}.
Hence the graph (F ) is a set which can be checked for open or

closedness just like any other set.
21 / 41
Theorem
(Kakutani 1941)
A correspondence F : X X satisfying
1. X is a convex, closed, and bounded subset of Rn ,
2. F () is non-empty and convex-valued, and
3. F () has a closed graph
has a fixed point x F (x ) for x X .
22 / 41
1. i is a convex, closed, and bounded subset of Rn :

0.1 i is convex because if i , i i then any mixture
i + (1 )i i for all [0, 1].
0.2 i is closed because its boundary points (assigning probability
0 and 1 to some pure strategy) are included in the set.
0.3 i is bounded because all probabilities are bounded between
[0, 1].
23 / 41
2. Bi (i ) is non-empty and convex-valued:

0.1 There is a finite number of pure strategies (by assumption),
therefore there exists at least one best reply to a given profile.
Thus the best response correspondence cannot be empty.
0.2 Let i , i i be best replies, then the mixture is a best reply
as well because it will yield the same amount. Hence, Bi (i )
is convex valued.
24 / 41

3. B() has a closed graph; thus any boundary point of the graph
is included.
Assume the condition is violated, so there is a sequence
( k ,
bk ) (, b) with bk B( k ), but b/ B(). Then,
bi
/ Bi (i ) for some player i . Thus, there is an > 0 and a
i such that ui (i , i ) > ui (b
i , i ) + 3. Since ui is
continuous and ( k , bk ) (, b), for k sufficiently large we
have
ui (i , i
k
) > ui (i , i ) > ui (b ik , i
i , i )+2 > ui (b k
)+.
Therefore, i does strictly better against i

k than
bik does,
bk B( k ).
contradiction to
25 / 41
1.f Rationalisability
Bernheims (1984) and Pearces (1984) concept of Rationalisability
stems from the desire to base an equilibrium concept on purely
behavioural assumptions (rationality)
agents view their opponents choice as an uncertain events
every agent optimizes s.t. some probabilistic assessment of
uncertain event
this assessment is consistent with all of his information
the previous points are commonly known
The starting point is: What are all the strategies that a rational
player could play? A rational player will use only those strategies
that are a best response to some belief he might have about the
strategies of his opponents.
Definition
A players belief i (j ) is the conditional probability he attaches to
opponent j playing a particular strategy j . 26 / 41
Consider the following game due to Bernheim (1984)
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
1. (a2 , b2 ) is the only Nash equilibrium (and hence both a2 and

b2 are rationalizable)
2. strategies a1 , a3 , b1 and b3 are rationalizable as well
3. a4 and b4 are not rationalizable
27 / 41
Definition
e 0 i and for each i recursively
Set i
e k {i
e k1 |i j6=i
e k1
i i j
e k1 }
s.t. ui (i , i ) ui (i , i ) for all i i
T e k
The strategy i of i is rationalizable if i k=0 i .
A strategy profile is rationalizable if i is rationalizable for each

player i .
28 / 41
1.f Rationalisability and idsd
Clearly, with any number of players, a strictly dominated strategy

is never a best response: If i strictly dominates i relative to i ,
then i is a strictly better response than i to every i in i .
Thus, the set of rationalizable strategies is contained in the set

that survives iterated strict dominance.
Theorem
(Pearce 1984) The set of rationalizable strategies and the set that
survives idsds coincide in two-players games.
29 / 41
Proof: (Second direction) X - the set of strategies that survive
idsd.
We show that for every player every member of Xj is rationalizable.

By definition, no action in Xj is strictly dominated in the game
with the set of actions for each player i is Xi . every action in Xj
is a BR among Xj to some beliefs on Xj .
We have to show that every action in Xj is a BR among Sj to

some beliefs on Xj . If sj Xj is not a BR among Sj then there is
k s.t. sj is a BR among Xjk to a belief j on Xj , but is not a BR
among Xjk1 . Then, bj Xjk1 \Xjk that is a BR among Xjk1 to
j , contradiction, since bj was eliminated at n.
30 / 41
1.h Correlated equilibrium

NEqm assumes that players use independent randomisation in
order to arrive at their mutual actions. Given these, NEqm is the
minimal necessary condition for reasonable predictions (in general
games). What if we dispense with this independence?
Consider that players can engage in (unmodelled)

pre-play communication. Then they could conceivably decide to
choose their actions based on this communication or, more
generally, on any other public (or private) event.
In order to capture this idea, lets assume that the players can
construct (or have access to) a signalling device which sends
(public or private) signals on which the players can co-ordinate
their actions.
31 / 41

Consider the following example
Can the players do any better?
u1 ()
(5,1)
l r 5
u 5,1 0,0
d 4,4 1,5
(2.5,2.5)
2.5
This game has 2 pure
NEqa {(u, l ), (d, r )} plus
the mixed eqm
1
(( 1/2 )u, ( 1/2 )l ) leading to (1,5)
(2.5, 2.5).
u2 ()
1 2.5 5
32 / 41

Suppose players can agree on constructing a public randomisation
device with 2 equally likely outcomes {H, T }.
Assume that the publicly observable outcomes of the

randomisations of this device are interpreted as the following plan
c:
if H (happening with pr(H) = 1/2 ), then play (u, l )
if T (happening with pr(T ) = 1/2 ), then play (d, r )
Then the expected payoffs from this plan c are

1 1 1 1
u1 (c) = u1 (u, l ) + u1 (d, r ) = 5 + 1 = 3 > 2.5!
2 2 2 2
(P2s u2 () is symmetric.)
33 / 41
1.g Correlated equilibrium

u1 ()
(5,1)
5
In the same fashion, by

using their public
randomisation device to (3,3)
co-ordinate their actions,

2.5
the players can do better (2.5,2.5)
than Nash by attaining

any point in the convex
hull of NEqa! 1
(1,5)
u2 ()
1 2.5 5
34 / 41

Can we do still better?
Suppose that players can agree on establishing a device which

sends correlated but private signals to each player.
Consider a device with 3 equally likely outcomes {A, B, C} and

assume the following information partitions:
P1s partition P1 = {{A}, {B, C}}
P2s partition P2 = {{A, B}, {C}}
Lets look at the following plan d:

P1 plays u if told {A} and plays d if told {B, C}
P2 plays l if told {A, B} and plays r if told {C}
35 / 41
Assumption
Players are Bayesian rational, ie. they use Bayes rule to update
their beliefs.
Claim: No player has an incentive to deviate from d.
Now P1s overall payoff from using the plan d is

1 1 1
u1 (d) = u1 (u, l ) + u1 (d, l ) + u1 (d, r ) =
3 3 3
1 1 1 10
5+ 4+ 1= > 3!
3 3 3 3
(Again the case for P2 is symmetric.)
36 / 41

u1 ()
(5,1)
5
By using a private ( 10 10
3 , 3 )
(3,3)
randomisation device,
even payoffs outside the 2.5
(2.5,2.5)
convex hull of NEqa are
attainable!
1
(1,5)
u2 ()
1 2.5 5
37 / 41

Definition
Communication device is a triple (, Hi , p) where
is a state space (set of possible outcomes of the device)
p is a probability measure on
Hi is information partition for i , if the true state is , Pi is
told that the state lies in hi (), Pi s posterior about is
given by Bayes rule p(|hi ) = p()/p(hi ) for hi and 0
for / hi
Definition
A pure strategy for the expended game is i : Hi Si
Alternatively,
A pure strategy is i : Si , such that i () = i ( ) whenever
, hi for some hi Hi
38 / 41
Definition
A CEqm relative to information structure (, Hi , p) is a Nash
equilibrium in strategies that are adapted to this information
structure. That is. (1 , ..., N ) is a correlated equilibrium if, for
every i and every adapted strategy bi
X X
p()ui (i (), i ()) p()ui (b
i (), i ()).

39 / 41

Theorem
(Aumann 1974) For every finite game, the set of CEqa is
non-empty.
Proof: Let the recommendation be an independent randomisation
for every player. Than the CEqm is an independently mixed
NEqm which we know to exist. Hence the set of CEqa contains
the set of NEqa.
Theorem
(Aumann 1974) The set of CEqm payoffs of a sfg is convex.
Proof: One can always obtain a new CEqm from publicly
randomising between two other CEqa.
40 / 41

u1 ()
(5,1)
5
Since players have

access to a public ( 10 10
3 , 3 )
(3,3)
randomisation device,
2.5
the set of CEqa is (2.5,2.5)
convex (and contains
the set of NEqa)!
1
(1,5)
u2 ()
1 2.5 5
41 / 41

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Microeconomics - 2.

1 Strategic form games

Description idsds Nash Rationalisability Correlated eq

21. November 2007

Description idsds Nash Rationalisability Correlated eq

Strategic form games

1.a Describing a game in strategic form

Description idsds Nash Rationalisability Correlated eq

1.a Describing a game in strategic form

Example: Entry game

Description idsds Nash Rationalisability Correlated eq

1.a Describing a game in strategic form

we use the following conventions

Description idsds Nash Rationalisability Correlated eq

1.a Describing a game in strategic form

Description idsds Nash Rationalisability Correlated eq

1.a Describing a game in strategic form

Predicting the agents (=vendors) actions is easy provided that

Description idsds Nash Rationalisability Correlated eq

1.b Equilibria (idsds)

Description idsds Nash Rationalisability Correlated eq

1.b Equilibria (idsds)

Definition: Given player i s pure strategy set Si , a mixed strategy

Description idsds Nash Rationalisability Correlated eq

1.b Equilibria (idsds)

Definition: Pure strategy si is strictly dominated for player i if

ui (i , si ) > ui (si , si ) for all si Si (1)

The strategy si is weakly dominated if there exists a i i such

Definition: A rational player should never play a strictly

Description idsds Nash Rationalisability Correlated eq

1.b Equilibria (idsds) & Rationality

Definition: X is called common knowledge (ck) between players A

Idsds requires the following assumptions

Description idsds Nash Rationalisability Correlated eq

1.b Equilibria (idsds)

Sik = {si Sik1 | there is no i k1

ki = {i i |i (si ) > 0 only if Si Sik }

Description idsds Nash Rationalisability Correlated eq

1.c Nash equilibrium

Here idsds does not workwe need a sharper tool: NEqm.

NEqm puts an additional restriction on the knowledge of players

Description idsds Nash Rationalisability Correlated eq

1.c Nash equilibrium

Definition: A strategy profile s is a vector of dimension n

Notation: s = (s1 , . . . , sn ) = (si , si )

Definition: Player i s best response Bi is the set of own strategies

Bi (si ) = {si Si |ui (si , si ) ui (si , si ), si Si }

Description idsds Nash Rationalisability Correlated eq

1.c Nash equilibrium

Definition: A Nash equilibrium is a strategy profile s which

Notice that according to this definition, the players expected

Description idsds Nash Rationalisability Correlated eq

1.c Nash equilibrium

Hence the unique NEqm is (u,l).

Description idsds Nash Rationalisability Correlated eq

1.d NEqm & mixed strategies

THIS GAME HAS NO PURE STRATEGY NEQM!

Description idsds Nash Rationalisability Correlated eq

1.d NEqm & mixed strategies

Description idsds Nash Rationalisability Correlated eq

1.d NEqm & mixed strategies

It is sufficient to check that no player has a profitable pure-strategy

Alternative definition: A mixed strategy profile is a NEqm if