An introduction to game

theory

Today: The fundamentals of

game theory, including Nash
equilibrium
Today
Introduction to game theory
We can look at market situations with
two players (typically firms)
Although we will look at situations
where each player can make only one
of two decisions, theory easily
extends to three or more decisions
Who is this?
John Nash, the person
portrayed in A Beautiful
Mind
John Nash
One of the early
researchers in
game theory
His work resulted
in a form of
equilibrium
named after him
Three elements in every
game
Players
Two or more for most games that are
interesting
Strategies available to each player
Payoffs
Based on your decision(s) and the
decision(s) of other(s)
 Game theory: Payoff
matrix
Person 2
A payoff
Action C Action D matrix
shows the
payout to
Action 10, 2 8, 3 each
Person
1
A player,
given the
Action 12, 4 10, 1 decision
B of each
player
 How do we interpret this
box?
Person 2
The first number in
each box
Actio Actio determines the
nC nD payout for Person 1
Perso
n1 Actio 10, 2 8, 3 The second
nA number
Actio 12, 4 10, 1 determines the
payout for Person 2
nB
 How do we interpret this
box?
Person 2
Example
If Person 1
Actio Actio chooses Action A
nC nD and Person 2
Perso chooses Action D,
n1 Actio 10, 2 8, 3 then Person 1
nA receives a payout
Actio 12, 4 10, 1 of 8 and Person 2
nB receives a payout
of 3
Back to a Core Principle:
Equilibrium
The type of equilibrium we are
looking for here is called Nash
equilibrium
Nash equilibrium: Any combination of
strategies in which each players
strategy is his or her best choice, given
the other players choices (F/B p. 322)
Exactly one person deviating from a NE
strategy would result in the same
payout or lower payout for that person
How do we find Nash
equilibrium (NE)?
Step 1: Pretend you are one of the players
Step 2: Assume that your opponent picks a
particular action
Step 3: Determine your best strategy (strategies),
given your opponents action
Underline any best choice in the payoff matrix
Step 4: Repeat Steps 2 & 3 for any other opponent
strategies
Step 5: Repeat Steps 1 through 4 for the other
player
Step 6: Any entry with all numbers underlined is
NE
 Steps 1 and 2
Person 2
Assume
Action Action D that you are
C Person 1
Given that
Perso Person 2
n1 Action 10, 2 8, 3
chooses
A
Action C,
what is
Action 12, 4 10, 1 Person 1s
B best
choice?
 Step 3:
Person 2 Underline
Action Action D best payout,
given the
C choice of the
other player
Perso
n1 Action 10, 2 8, 3 Choose
Action B,
A since
12 > 10
Action 12, 4 10, 1 underline 12
B
 Step 4
Person 2
Now
Action C Action assume
D that Person
2 chooses
Perso Action D
n1 Action 10, 2 8, 3
A
Here,
10 > 8
Choose
Action 12, 4 10, 1 and
B underline
10
 Step 5
Person 2 Now,
Action C Action D assume you
are Person 2
If Person 1
chooses A
Perso
n1 Action 10, 2 8, 3 3>2
underline 3
A If Person 1
chooses B
Action 12, 4 10, 1 4>1
underline 4
B
 Step 6
Person 2
Which
Action C Action D box(es)
have
underlines
Perso
under both
n1 Action 10, 2 8, 3 numbers?
A Person 1
chooses B
and Person
Action 12, 4 10, 1 2 chooses
C
B This is the
only NE
 Double check our NE
Person 2
What if
Action C Action D Person 1
deviates
from NE?
Perso
Could
n1 Action 10, 2 8, 3 choose A
A and get 10
Person 1s
payout is
Action 12, 4 10, 1 lower by
deviating
B
 Double check our NE
Person 2
What if
Action C Action D Person 2
deviates
from NE?
Perso
Could
n1 Action 10, 2 8, 3 choose D
A and get 1
Person 2s
payout is
Action 12, 4 10, 1 lower by
deviating
B
 Dominant strategy
Person 2 A strategy is
Action C Action D dominant if
that choice is
definitely made
no matter what
Perso
n1 Action 10, 2 8, 3 the other
A person chooses
Example:
Person 1 has a
dominant
Action 12, 4 10, 1 strategy of
B choosing B
 New example
Person 2
Suppose in
Yes No this example
that two
people are
simultaneou
Perso
n1 Yes 20, 20 5, 10 sly going to
decide on
this game

No 10, 5 10, 10
 New example
Person 2
We will go
Yes No through the
same steps
to
Perso
n1 Yes 20, 20 5, 10 determine
NE

No 10, 5 10, 10
 Two NE possible
Person 2
(Yes, Yes) and
Yes No (No, No) are
both NE
Although (Yes,
Perso
Yes) is the
n1 Yes 20, 20 5, 10 more efficient
outcome, we
have no way
to predict
No 10, 5 10, 10 which
outcome will
actually occur
Two NE possible
When there are multiple NE that
are possible, economic theory tells
us little about which outcome
occurs with certainty
Two NE possible
Additional information or actions
may help to determine outcome
If people could act sequentially
instead of simultaneously, we could
see that 20, 20 would occur in
equilibrium
Sequential decisions
Suppose that decisions can be made
sequentially
We can work backwards to determine
how people will behave
We will examine the last decision first
and then work toward the first decision
To do this, we will use a decision tree
Decision tree in a
sequential game: Person
1 chooses first 20, 20
Person 2
chooses
yes
Person B
Person 2 5, 10
1
chooses
choose
no
A s yes
Person 2
Person C chooses 10, 5
1 yes
choose
s no
Person 2
chooses
no 10, 10
 Decision tree in a
sequential game: Person
1 chooses first
20, 20
Person 2 Given point B,
chooses
yes Person 2 will
Person B
1 Person 2 5, 10 choose yes
choose chooses
no
(20 > 10)
A s yes
Person 2
Person C chooses 10, 5
1 yes
Given point C,
choose
s no Person 2 will
Person 2
chooses
choose no
no 10, 10 (10 > 5)
 Decision tree in a
sequential game: Person
1 chooses first
20, 20 If Person 1 is
Person 2
chooses rational, she will
yes
Person B ignore potential
Person 2 5, 10
1
chooses
choices that
choose
s yes
no Person 2 will not
A
Person 2 make
Person C chooses
1 yes
10, 5 Example: Person
choose 2 will not choose
s no yes after Person
Person 2
chooses 1 chooses no
no 10, 10
 Decision tree in a
sequential game: Person
1 chooses first
20, 20 If Person 1 knows

Person 2
chooses that Person 2 is
yes
Person B rational, then she
5, 10
1 Person 2 will choose yes,
chooses
choose since 20 > 10
no
A s yes
Person 2
Person 2 makes a
Person C chooses decision from
10, 5
1 yes
choose point B, and he
s no will choose yes
Person 2 also
chooses
no 10, 10 Payout: (20, 20)
Summary
Game theory
Simultaneous decisions NE
Sequential decisions Some NE may
not occur if people are rational
Can you think of ways game
theory can be used in these
games?