Microeconomic Theory II FDPE Spring 2014 Pauli Murto / Juuso välimäki
Microeconomic Theory II focuses on strategic interactions and informational asymmetries. The main methodology is game theory. The emphasis is on analytical techniques and modelling issues. Together with Microeconomic Theory I, this course will offer the basic analytical framework for other more specialized courses.
Lectures and study material:
The course consists of 42 lecture hours. The first half is taught by Murto, and focuses on game theory. The second half is taught by Välimäki, and focuses on information economics.
The main text is:
 MasColell, Whinston and Green: “Microeconomic Theory”, Oxford University Press (MWG).
This book covers much of the material of the lectures. However, there are many more specialized books that can be helpful as supplementary material.
The first half of the course focuses on game theory. There are at least three well established graduate level text books on game theory:
 Fudenberg and Tirole: “Game Theory”, MIT Press.
 Osborne and Rubinstein: “A Course in Game Theory”, MIT Press.
 Myerson: “Game Theory. Analysis of Conflict”, Harvard University Press.
In addition, a new, comprehensive game theory book is now available:
 Maschler, Solan, and Zamir: “Game Theory”, Cambridge University Press.
The second half of the course focuses on information economics. The following books are useful for that:
 Salanie: “The Economics of Contracts. A primer”, MIT Press.
 Bolton and Dewatripont: “Contract Theory”, MIT Press.
We will post lecture notes on the course website as the course proceeds. These will give a good idea about the contents of the lectures, but they will not be selfcontained: proofs, illustrations, further discussions, etc. will be done in the class. Some further readings are also pointed out in the lecture notes.
Exercises:
Working on exercises should be an essential part of your studying. There will be 8 exercise sessions, each with a problem set that will be posted on the course page well in advance.
FDPE microeconomic theory, spring 2014 Lecture notes I: Basic concepts of game theory Pauli Murto
1 Introduction
1.1 Background
In Part I of the course, the focus was on individual decision making
Collective decisions appeared only in the context of general equilibrium:
ñ Every agent optimizes against the prices
ñ Prices equate supply and demand
ñ No need for the agents to understand where prices come from
In Part II, we will be explicitly concerned about strategic interaction be tween the agents
This requires more sophisticated reasoning from agents: how are the other players expected to behave?
The Örst half of the course studies the methodology of modeling interactive decision making: game theory
1.2 Some classiÖcations of game theory
Noncooperative vs. cooperative game theory
ñ In noncooperative games, individual players and their optimal ac tions are the primitives
ñ In cooperative games, coalitions of players and their joint actions are the primitives
ñ In this course, we concentrate on noncooperative games
Static vs. dynamic games
ñ We start with static games but move then to dynamic games
Games with complete vs. incomplete information
ñ We start with games with complete information but then move to incomplete information
1
1.3 From decision theory to game theory
We maintain the decision theoretic framework familiar from Part I of the course
In particular, the decision maker is rational :
ñ Let A denote the set of available actions
ñ An exhaustive set of possible consequences C .
ñ A consequence function g : A ! C specifying which actions lead to which consequences.
ñ Complete and transitive preference relation % on C:
Preference relation can be represented by a real valued utility function u on C
To model decision making under uncertainty, we assume that the prefer ences also satisfy von Neumann Morgenstern axioms.
This leads to expected utility maximization:
ñ Let the consequence depend not only decision makerís action but also a state in some set :
ñ If the decision maker takes action a; and state ! 2 materializes, then the decision makerís payo§ is u (g (a; ! )):
ñ If the uncertainty is captured by a probability distribution p on ; the decision maker maximizes his expected payo§
X p (! )u (g (a; ! )):
! 2
In decision theory uncertainty in the parameters of environment or events that take place during the decision making process
In strategic situations, consequence g not only depends on the DMís own action, but also on the actions of the other DMs
Hence, uncertainty may stem from random actions of other players or from reasoning of other players
2 Basic concepts
2.1 A strategic form game
A game in strategic (or normal) form consists of:
1. Set I = f 1; :::; I g of players
2
2. Pure strategy space S _{i} for each i 2 I
3. A von NeumannMorgenstern utility u _{i} for each i 2 I :
where S :=
I i =1 ^{S} i ^{.}
u _{i} : S ! R ,
That is, u _{i} (s) gives the utility of i for strategy proÖle s := ( s _{1} ; :::; s _{I} ).

We 
write u := 
( u _{1} ; :::; u _{I} ) 

We also write s = (s _{i} ; s _{} _{i} ), where s _{} _{i} 2 S _{} _{i} := _{j} _{6}_{=}_{i} S _{j} 
We often (but not always) assume that S _{i} are Önite sets.
The game is hence deÖned by ^{} I ; f S _{i} g _{i} _{2}_{I} ; f u _{i} g _{i} _{2}_{I} ^{}
In standard table presentation, player 1 chooses row and player 2 chooses column. Each cell corresponds to payo§s so that player 1 payo§ is given Örst.
Some classic 2x2 games that highlight di§erent stratecic aspects:
Prisonerís dilemma:
Cooperate Defect
Cooperate 
3; 3 
0; 4 
Defect 
4; 0 
1; 1 
Coordination game ("stag hunt"):
^{B}^{a}^{t}^{t}^{l}^{e} ^{o}^{f} ^{s}^{e}^{x}^{e}^{s}^{:}
HawkDove:
Matching pennies:
Ballet F ootball
Ballet
F ootball
Dove
Hawk
Head
T ail
3
2.1.1 Mixed strategies
The players may also randomize their actions, i.e. use mixed strategies
Suppose that strategy sets S _{i} are Önite
DeÖnition 1 A mixed strategy for player i, _{i} : S _{i} ! [0; 1] assigns to each pure strategy s _{i} 2 S _{i} a probability _{i} (s _{i} ) 0 that it will be player, such that
X _{i} (s _{i} ) = 1 .
s _{i} 2S _{i}
The mixed strategy space for i is a simplex over the pure strategies
_{i} := ( ( _{i} (s _{1} ) ; :::; _{i} (s _{n} )) 2 R ^{n} : _{i} (s _{i}_{k} ) > 0
8k ,
n
X
k
=1
_{i} (s _{i}_{k} ) = 1 ) ;
where n is the number of pure strategies.
(We alternatively use notation (S _{i} ) to denote the space of probability distributions over S _{i} )
:= ( _{1} ; :::; _{I} ) is a mixed strategy proÖle
If the players choose their strategies simultaneously and independently of each other, a given pure strategy proÖle (s _{1} ; :::; s _{I} ) is chosen with proba bility
I
Y
i =1
_{i} (s _{i} ) .
Player iís payo§ to proÖle is
u _{i} ( ) = ^{X}
s
2S
I
Y
i
=1
_{i} (s _{i} ) ! u _{i} (s) .
Note that here we utilize the von Neumann  Morgenstern utility repre sentation
Mixed strategies over continuous pure strategy spaces are deÖned analo gously
The game ^{} I ; f _{i} g _{i} _{2}_{I} ; f u _{i} g _{i} _{2}_{I} ^{} is sometimes called the mixed extension of the game ^{} I ; fS _{i} g _{i} _{2}_{I} ; fu _{i} g _{i} _{2}_{I} ^{}
4
2.2 Extensive form
Strategic form seems to miss some essential features of strategic situations:
dynamics and information
Consider a simple card game example:
ñ Players 1 and 2 put one dollar each in a pot
ñ Player 1 draws a card from a stack and observes it privately
ñ Player 1 decides wheter to raise or fold
ñ If fold, then game ends, and player 1 takes the money if the card is red, while player 2 takes the money if black
ñ If raise, then player 1 adds another dollar in the pot, and player 2 must decide whether to meet or pass
ñ If player 2 passes, the game ends and player 1 takes the money in the pot
ñ If player 2 meets, he adds another dollar in the pot. Then player 1 shows the card, and the game ends. Again, player 1 takes the money in the pot if the card is red, while player 2 takes the money if black
To formalize this game, we must specify:
ñ Who moves when?
ñ What do players know when they move?
ñ What are payo§s under all contingencies?
Formally, a Önite game in extensive form consists of the following elements:
1. 
The set of players, I = f1 ; :::; I g. 

2. 
A directed graph i.e. a set nodes X and arrows connecting the nodes. This must form a tree which means: 

(a) 
There is a single initial node x ^{0} , i.e. a node with no arrows pointing towards it. 

(b) 
For each node, there is a uniquely determined path of arrows con necting it to the initial node. (This is called the path to the node). 

1. 
The nodes are divided into: 

(a) 
Terminal nodes Z , i.e. with no outward pointing arrows. 

(b) 
Decision nodes X n Z , i.e. nodes with outward pointing arrows. 

4. 
Each decision node is labeled as belonging to a player in the game (the player to take the decision). This labeling is given by a function : X nZ ! I . 
5
5. 
Each arrow represents an action available to the player at the decision node at the origin of the arrow. Actions available at node x is A (x). If there is a path of arrows from x to x ^{0} , then we say that x ^{0} is a successor of x, and we write x ^{0} 2 s(x). 

2. 
Payo§s assign a utility number to each terminal payo§ (and thus also to each path through the game tree). Each player i has a payo§ function u _{i} : Z ! R : 

7. 
A 
partition H of decision nodes (I.e. H = ^{} h ^{1} ; :::; h ^{K} ^{} such that h ^{k} X nZ 
for all k and h ^{k} \ h ^{l} = ? for k 6= l and [ _{k} h ^{k} = X nZ ) into information sets h ^{k} . These are collections of nodes such that: 

(a) The same player acts at each node within the information set. (I.e. (x) = (x ^{0} ) if 9k such that x; x ^{0} 2 h ^{k} ). 

(b) The same actions must be available at all nodes within the informa tion set. (I.e. A (x) = A (x ^{0} ) if 9k such that x; x ^{0} 2 h ^{k} ). 

8. 
If 
Nature moves, the probability that she takes each available action must 
be speciÖed. 

2.2.1 
Remarks: 
Simultaneous actions can be modeled by an extensive form, where one
player moves Örst, but so that all nodes resulting from her actions are in
a single information set for the other player
Asymmetric information can be modeled by moves by nature and ap propriately chosen information sets (in particular, Bayesian games, to be considered later)
2.2.2 ClassiÖcations:
Games with perfect information
ñ If all information sets are singletons, then a game has perfect infor mation.
ñ Otherwise the game has imperfect information.
ñ Note that since only one player moves in each node, games of perfect information do not allow simultaenous actions
Multistage games with observed actions
ñ There are "stages" k = 1; 2 ; ::: such that
1. In each stage k every player knows all the actions taken in pre vious stages (including actions taken by Nature)
2. Each player moves at most once within a given stage
6
3. No information set contained in stage k provides information about play in that stage
ñ In these games, all actions taken before stage k can be summarized in public history h ^{k}
Bayesian games, or games of incomplete information
ñ Nature chooses a "type" for each player according to a common prior
ñ Each player observes her own type but not that of others
Games of perfect recall
ñ A game is of perfect recall, when no player forgets information that he once knew
ñ A formal deÖnition involves some restrictions on information sets
ñ All the games that we will consider are of perfect recall
2.2.3 Strategies of extensive form games
Let H _{i} be the set of player iís information sets, and let A (h _{i} ) be the set of actions available at h _{i} 2 H _{i}
The set of all actions for i is then A _{i} := [ _{h} _{i} _{2}_{H} _{i} A (h _{i} )
DeÖnition 2 A pure strategy for i is a map
s _{i} : H _{i} ! A _{i}
with s _{i} (h _{i} ) 2 A (h _{i} ) for all h _{i} 2 H _{i} .
Important: a strategy must deÖne the action for i at all contingencies deÖned in the game
The set of pure strategies for i is
S _{i} =
A (h _{i} ) :
h _{i} 2H _{i}
In a Önite game, this is a Önite set.
2.2.4 Mixed strategies
Having deÖned pure strategies, we can deÖne mixed strategies just as in the case of strategic form:
DeÖnition 3 A mixed strategy for player i, _{i} : S _{i} ! [0; 1] assigns to each pure strategy s _{i} 2 S _{i} a probability _{i} (s _{i} ) 0 that it will be played, such that
X _{i} (s _{i} ) = 1 .
s _{i} 2S _{i}
7
There is another more convenient way to deÖne mixed strategies, called behavior strategies.
With those strategies, mixing takes place independently at each decision node:
DeÖnition 4 A behavior strategy for player i speciÖes for each h _{i} 2 H _{i} a prob ability distribution on the set of available actions A (h _{i} ). That is,
b _{i} 2
(A (h _{i} )) ;
h _{i} 2H _{i}
where (A (h _{i} )) is a simplex over A (h _{i} ).
Every mixed stratey generates a unique behavior strategy (see e.g. Fudenberg Tirole for the construction)
In games of perfect recall (all relevant games for our purpose), it makes no di§erence whether we use mixed or behavior strategies:
Theorem 5 (Kuhn 1953) In a game of perfect recall, mixed and behavior strategies are equivalent.
More precisely: every mixed strategy is equivalent to the unique behavior strategy it generates, and each behavior strategy is equivalent to every mixed strategy that generates is.
Therefore, there is no loss in using behavior strategies
2.2.5 From extensive form to strategic form
Recall that extensive form deÖnes payo§ u _{i} : Z ! R for each terminal node.
Since each strategy proÖle leads to a probability distribution over terminal nodes Z , we may directly associate payo§s for strategy proÖles (utilizing expected utility formulation):
where S :=
I i =1 ^{S} i ^{.}
u _{i} : S ! R ,
Now ^{} I ; fS _{i} g _{i} _{2}_{I} ; fu _{i} g _{i} _{2}_{I} ^{} meets our deÖnition of a strategic form game
This is the strategicform representation of our extensive form game
To see how this works, take any 2x2 game, formulate its extensive form assuming sequential moves, and then move back to strategic form (and you get a 2x4 game)
Every extensive form game may be represented in strategic form
However, as will be made clear later, we will need extensive form to reÖne solution concpets suitable for dynamic situations
8
3 Basic solution concepts in strategic form games
We now develop the basic solution concepts for the strategic form games
This is the simple game form normally used for analysing static interac tions
But any extensive form game may be represented in strategic form, so the concepts that we develop here apply to those as well
3.1 Implications of rationality
Rationality means that each of the players chooses s _{i} in order to maximize her expectation of u _{i}
But what should players expect of other playerís actions?
Standard game theory is built on the assumption that the rationality of the players is common knowledge.
This means that all the players are rational, all the players know that all the players are rational, all the players know that all the players know that all the players are rational, and so on
We start by asking what implication common knowledge of rationality has on the playersíbehavior
This will lead us to the concept of rationalizable strategies
3.1.1 Dominant strategies
Let us start with the most straightforward concepts:
DeÖnition 6 A strategy s _{i} is a dominant strategy for i if for all s _{} _{i} 2 S _{} _{i} and for all s _{i} 6= s _{i} ,
u _{i} (s _{i} ; s _{} _{i} ) > u (s _{i} ; s _{} _{i} ) .
0
0
0
DeÖnition 7 A strategy s _{i} is a weakly dominant strategy for i if for all s _{i} 6= s _{i} ,
u _{i} (s _{i} ; s _{} _{i} ) u _{i} (s _{i} ; s _{} _{i} ) >
0
u (s _{i} ; s _{} _{i} ) for u (s _{i} ; s _{} _{i} ) for
0
all s _{} _{i} 2 S _{} _{i} and some s _{} _{i} 2 S _{} _{i} :
In a few cases, this is all we need.
9
Example: Prisonerís dilemma
Let I = f1; 2 g; A _{i} = fC; D g for all i; and let payo§s be determined as follows:
Whatever strategy the other player chooses, it is strictly optimal for i to choose D and not C: Thus (D; D ) is the dominant strategy equilibrium of this game.
Thus, rational players should always play D (even if (C; C ) would be better for both)
Example: Secondprice auction
A seller has one indivisible object for sale
There are I potential buyers with valuations 0 v _{1} ::: v _{I} , and these valuations are common knowledge
The bidders simultaneously submit bids s _{i} 0.
The highest bidder wins the object and pays the second highest bid (if several bidders bid the highest price, then the good is allocated randomly among them)
Excercise: show that for each player i bidding s _{i} = v _{i} weakly dominates all other strategies
Thus, s _{i} = v _{i} for all i is a weakly dominant strategy equilibrium
Bidder I wins and has payo§ v _{I} v _{I} _{} _{1} .
Note that these strategies would remain dominant even if the players would not know each otherís valuations
3.1.2 Dominated strategies
However, very few games have dominant strategies for all players
Consider the following game:
U
M
D
10
There are no dominant strategies, but M is dominated by R , thus a ra tional player 2 should not play M
But if player 2 will not to play M , then player 1 should play U
But if player 1 will play U , player 2 should play L
This process of elimination is called iterated strict dominance
We say that a game is solvable by iterated strict dominance when the elimination process leaves each player with only a single strategy
Note that a pure strategy may be strictly dominated by a mixed strategy even if not dominated by a pure strategy. Below, M is not dominated by U or D , but it is dominated by playing U with prob. 1/2 and D with prob. 1/2:
U
M
D
DeÖnition 8 Pure strategy s _{i} is strictly dominated for player i if there exists _{i} 2 _{i} such that
u _{i} ( _{i} ; s _{} _{i} ) > u _{i} (s _{i} ; s _{} _{i} ) for all s _{} _{i} 2 S _{} _{i}
DeÖnition 9 The process of iterated deletion of strictly dominated strategies proceeds as follows: Set S = S _{i} and = _{i} . DeÖne S recursively by
0
i
0
i
n
i
S
n
i
= ^{} s _{i} 2 S
n
i
1
^{} @ _{i} 2 ^{n} ^{} ^{1} s.t. u _{i} ( _{i} ; s _{} _{i} ) > u _{i} (s _{i} ; s _{} _{i} ) , 8s _{} _{i} 2 S
i
1
n
i
^{} :
and
Set
Let
^{n} = f _{i} 2 _{i} j _{i} (s _{i} ) > 0 only if s _{i} 2 S g .
i
n
i
S
1
i
=
1
\
n =0
S
n
i
:
1
i
= ^{} _{i} 2 _{i} ^{} _{i} 2 _{i} s.t. u _{i} ( _{i} ; s _{} _{i} ) > u _{i} ( _{i} ; s _{} _{i} ) , 8s _{} _{i} 2 S
^{} @
0
0
i ^{} .
1
S
i
1 is the set of player iís pure strategies that survive iterated deletion of
1 i is the set of mixed strategies that survive
strictly dominated strategies, and iterated strict dominance.
The game is solvable by iterated (strict) dominance if, for each player i,
S
1
i
is a singleton.
Strict dominance is attractive since it is directly implied by rationality :
Common knowledge of rationality means that players would only use strategies in S
1
i
^{:}
11
In process deÖned here, one deletes simulatenously all dominated strate gies for both players in each round. One can show that the details of elimination process do not matter.
One can also apply iterative deletion to weakly dominated strategies, but then the order of deletion matters
Note that dominated mixed strategies are eliminated only at the end of the process. One would get the same result by eliminating all dominated mixed strategies at each round of the process.
Example: Cournot model with linear demand
Let us model the twoÖrm Cournot model as a game hf1; 2g; (u _{i} ); (S _{i} )i ; where S _{i} = R _{+} and, for any (s _{1} ; s _{2} ) 2 S _{1} S _{2} ;
u _{1} (s _{1} ; s _{2} ) = s _{1} (1 (s _{1} + s _{2} )) ;
u _{2} (s _{1} ; s _{2} ) = s _{2} (1 (s _{1} + s _{2} )) :
Here s _{i} is to be interpreted as quantity produced, and 1 (s _{1} + s _{2} ) is the inverse demand function
Taking the derivative gives the e§ect of a marginal increase in s _{i} on iís ^{p}^{a}^{y}^{o}^{§}^{:}
(1)
@u _{i} (s _{i} ; s _{j} )
@s _{i}
= 1 s _{j} 2s _{i} :
If (1) is positive (negative) under (s _{i} ; s _{j} ), then marginally increasing (de creasing) s _{i} increases iís payo§. If this holds continuously in the interval [a; b ] of iís choices under s _{j} , then increasing s _{i} from a to b increases iís payo§.
By (1), s _{i} = 1= 2 strictly dominates any s _{i} > 1 =2; given that s _{j} 0: Thus
S
1
i
= s _{i} : 0 s _{i} _{2} , i = 1; 2 .
1
By (1), s _{i} = 1 = 2 (1= 2) ^{2} strictly dominates any s _{i} < 1 =2 (1=2) ^{2} ; given that 0 s _{j} 1 =2: Thus
S
2
i
= ( a _{i} :
1 2 a _{i} _{2} ) , i = 1; 2 .
^{}
1
2 2
1
By (1), a _{i} = 1= 2 (1= 2) ^{2} + (1=2) ^{3} strictly dominates any a _{i} > 1=2 (1=2) ^{2} + (1= 2) ^{3} ; given that 1= 2 (1=2) ^{2} a _{j} 1 =2: Thus
S
3
i
= ( a _{j} :
1
2
^{} 2 2
1
a _{j}
12
1
2 ^{}
2 _{2} +
1
1
_{2} 3 ) , i = 1; 2.
Continuing this way for k (odd) steps, we get
S
k
i =
8
>
<
>
:
a _{i} :
1
2 ^{}
2 _{2} +
1
_{2} ^{} ^{3} ::: ^{}
1
2 ^{} k 1
1
1
2 ^{}
a _{i}
2 _{2} +
1
_{2} ^{} ^{3} ::: + ^{}
1
1
2 k
9
>
=
>
;
:
Letting k go to inÖnity, both the end points of the interval converge to
Thus
1 (1= 2) ^{2} ^{} 1 (1=2) ^{2} ^{=} 3 1 ^{:}
1= 2
(1=2) ^{2}
_{}
1
3 ^{;} 3
1
is the unique strategy pair that survives the iterated elimination of strictly dominated strategies.
3.1.3 Rationalizability
Iterated strict dominance eliminates all the strategies that are dominated
Perhaps we could be even more selective: eliminate all the strategies that are not best responses to a reasonable belief about the opponents strategy
This leads to the concept of rationalizability
But it turns out that this concept is (almost) equivalent to the concept of iterated strict dominance
We say that a strategy of player i is rationalizable when it is a best response to a "reasonable" belief of i concerning the other playersíactions
By a "belief" of i, we mean a probability distribution over the other play ersípure strategies:
where
_{i} 2 (S _{} _{i} ) ;
^{S} i ^{=} ^{} j 2I i ^{S} j ^{:}
There are two notions of rationality in the literature: either _{i} is a joint probability distribution allowing other playersíactions to be correlated, or more restrictively, other playerís actions are required to be independent
Unlike MWG, we allow here correlation (this is sometimes called correlated rationalizability ).
What is a "reasonable" belief of i regarding other playersíactions?
13
Building on the notion of "common knowledge of rationality", beliefs should put positive weight only on those other playersístrategies, which in turn can be rationalized
Formally, this leads to a following deÖnition (assume Önite strategy sets).
DeÖnition 10 The set of rationalizable strategies is the largest set _{i} _{2}_{I} Z _{i} , where Z _{i} S _{i} , and each s _{i} 2 Z _{i} is a bestresponse to some belief _{i} 2 (Z _{} _{i} ).
To make the link to iterated strict dominance, deÖne:
DeÖnition 11 A strategy s _{i} is a neverbest response if it is not a best reso ponse to any belief _{i} 2 (S _{} _{i} ).
We have:
Proposition 12 A strategy s _{i} is a neverbest response if and only if it is strictly dominated.
Proof. It is clear that a strictly dominated strategy is never a best response. The challenge is to prove the converse, that a neverbest response is strictly dominated. By contrapositive, we need to show that if strategy s _{i} is not strictly dominated, then it is a bestresponse given some belief _{i} 2 (S _{} _{i} ).
Let u _{i} ( _{i} ) := fu _{i} ( _{i} ; s _{} _{i} )g _{s} _{} _{i} _{2}_{S} _{} _{i} denote a vector, where each component is iís payo§ with mixed strategy _{i} , given a particular pure strategy proÖle s _{} _{i} for the other players. This vector contains iís value for all possible combinations of pure strategies possible for the other players. Let N denote the number of elements of that vector so that u _{i} ( _{i} ) 2 R ^{N} . Given an arbitrary belief _{i} 2 (S _{} _{i} ), we can then write the payo§ for strategy _{i} as:
u ( _{i} ; _{i} ) := _{i} u _{i} ( _{i} ) :
Consider the set of such vectors over all _{i} :
U _{i} := f u _{i} ( _{i} )g _{} _{i} _{2} _{} _{i} .
It is clear that U _{i} is a convex set. Assume that s _{i} is not strictly dominated. Let U ^{+} (s _{i} ) denote the set of
payo§ vectors that strictly dominate u _{i} (s _{i} ):
U ^{+} (s _{i} ) := ^{} u 2 R ^{N} : (u ) _{k} (u _{i} (s _{i} )) _{k} for all k = 1 ; :::; N and (u ) _{k} > (u _{i} (s _{i} )) _{k} for some k = 1; :::; N ^{} ;
where ( ) _{k} denotes the k ^{t}^{h} component of a vector. U ^{+} (s _{i} ) is a convex set, and since s _{i} is not strictly dominated, we have U _{i} \ U ^{+} (s _{i} ) = ; . By the separating hyperplane theorem, there exists some vector _{i} 2 R ^{N} , _{i} 6= 0 , such that
_{i} (u _{i} ( _{i} ) u _{i} (s _{i} )) 

0 for all _{i} 2 _{i} and 
(2) 
_{i} (u _{i} u _{i} (s _{i} )) 

0 for all u _{i} 2 U ^{+} (s _{i} ) . 
(3) 
14 
By (3), each component of _{i} must be positive. We can also normalize _{i} so that its components sum to one (without violating (2) or (3)), so that
_{i} 2 (S _{} _{i} ) .
Equation (2) can now be written as
or
_{i} u _{i} (s _{i} ) _{i} u _{i} ( _{i} ) for all _{i} 2 _{i} ;
u (s _{i} ; _{i} ) u ( _{i} ; _{i} ) for all _{i} 2 _{i} ,
so that s _{i} is a best response to belief _{i} 2 (S _{} _{i} ).
Given this result, the process of iteratively deleting those strategies that are not best responses to any belief on the other playersíremaining strate gies is equivalent to the process of deleting strictly dominated strategies. Therefore, we have the following result:
Proposition 13 The set of pure strategies that survive the elimination of strictly dominated strategies is the same as the set of rationalizable strategies.
Note: our deÖnition of "neverbest response" considers arbitrary belief _{i} 2 (S _{} _{i} ) that allows i to believe that other playersíactions are corre lated
If correlation not allowed, then the equivalence between "neverbest re sponse" and "strictly dominated" breaks down with more than two play ers: there are strategies that are never best responses to independent ran domizations of the other players, yet they are not strictly dominated
Hence, the alternative notion of "rationalizability" (that rules out corre lation) is somewhat stronger than iterated strict dominance
But this di§erenece is not relevant in twoplayer games (because correla tion between other players strategies is not relevant)
3.1.4 Discussion
Rationalizability is the ultimate implication of common knowledge of ra tionality in games
But it makes generally weak predictions. In many intersting games it does not imply anything. For example, consider the "Battle of sexes" game:
Ballet F ootball
Ballet 
2; 1 
0; 0 
F ootball 
0; 0 
1; 2 
15
Rationalizability allows all outcomes. For example, players could choose (F; B ): F is optimal to player 1 who expects 2 to play F , and B is optimal to player 2 who expects 1 to play B .
A way forward: require expectations to be mutually correct  > Nash equi librium
3.2 Nash equilibrium
Rationalizability requires that each playerís strategy is a best response to a reasonable conjecture on other playerís play
Nash equilibrium is a more stringent condition on strategic behavior.
It requires that players play a best response against a correct belief of each otherís play.
For pure strategies, Nash equilibrium is deÖned as:
DeÖnition 14 A pure strategy proÖle s = (s _{1} ; :::; s _{I} ) constitutes a Nash equi librium if for every i 2 I ,
0
for all s _{i} 2 S _{i} .
0
u _{i} (s _{i} ; s _{} _{i} ) u _{i} (s _{i} ; s _{} _{i} )
Equivalently, s constitutes a Nash equilibrium if s _{i} is a best response against s _{} _{i} for all i.
3.2.1 Nonexistence of pure strategy Nash equilibrium
Consider the game of Matching Pennies (or think about familiar Rock PaperScissors game):
1
H
T
2
Clearly, whenever player i chooses best response to j , j wants to change. There is no rest point for the bestresponse dynamics.
Hence, there is no pure strategy Nash equilibrium
16
3.2.2 Nash equilibrium in mixed strategies
This nonexistence problem is avoided if we allow mixed strategies
DeÖnition 15 A mixed strategy proÖle 2 constitutes a Nash equilibrium if for every i 2 I ,
u _{i} ( _{i} ; _{} _{i} ) u _{i} (s _{i} ; _{} _{i} )
for all s _{i} 2 S _{i} .
It is easy to check that playing H and T with prob. 1/2 constitutes a Nash equilibrium of the matching pennies game
Whenever is a Nash equilibrium, each player i is indi§erent between all s _{i} for which (s _{i} ) > 0. This is the key to solving for mixed strategy equilibrium.
3.2.3 Discussion
A Nash equilibrium strategy is a best response, so it is rationalizable
Hence, if there is a unique rationalizable strategy proÖle, then this proÖle must be a Nash equilibrium
Obviously also: dominance solvability implies Nash
An attractive feature of Nash equilibrium is that if players agree on playing Nash, then no player has an incentive to deviate from agreement
Hence, Nash equilibrium can be seen as a potential outcome of preplay communication
Keep in mind that Nash equilibrium can be seriously ine¢ cient (Prisonerís dilemma)
3.2.4 Interpretations of mixed strategy equilibrium
Do people really "randomize" their actions? Or should we interpret the mixed strategy equilibrium in some "deeper" way?
There are various interpretations:
1. Mixed strategies as objects of choice
This is the straightforward interpretation: people just randomize
2. Mixed strategy equilibrium as a steady state
Players interact in an environment where similar situation repeats itself, without any strategic link between plays
17
Players know the frequences with which actions were taken in the past
3. Mixed strategies as pure strategies in a perturbed game
Playersípreferences are subject to small perturbations
Exact preferences are private information
Mixed strategy equilibrium as the limit of pure strategy equilibrium of the perturbed game as perturbation vanishes
This is the puriÖcation argument by Harsanyi (1973)
4. Mixed strategies as beliefs
Think of as a belief system such that _{i} is the common belief of all the players of iís actions
Each action in the support of _{i} is bestresponse to _{} _{i}
Each player chooses just one action
Equilibrium is a steady state in the playersíbelies, not in their actions
3.3 Existence of Nash equilibrium
There are many existence results that guarantee existence of Nash equi librium under varying conditions
The best known applies to Önite games, and was proved by Nash (1950):
Theorem 16 Finite games, i.e., games with I players and Önite strategy sets S _{i} , i = 1 ; :::; I , have a mixed strategy Nash equilibrium.
The proof relies on the upperhemicontinuity of the playersíbestresponse correspondences, and the utilization of Kakutaniís Öxed point theorem
See MWG Appendix of Ch. 8 for proof (and mathematical appendix for upperhemicontinuity)
In many applications, it is more natural to model strategy space as a continuum
Think about, e.g., Cournot oligopoly
There is then no general existence theorem (it is easy to construct games without Nash equilibria)
The simplest existence theorem assumes quasiconcave utilities:
Theorem 17 Assume that S _{i} are nonempty compact convex subsets of an Euclid ean space, u _{i} : S ! R is continuous for all i and quasiconcave in s _{i} for all i. Then the game has a Nash equilibrium in pure strategies.
18
Again, see MWG Appendix of Ch. 8 for the proof.
In fact, Nashís theorem (previous therem) is a special case of this
Many other theorems apply to various situations where continuity and/or quasiconcavity fail
3.4 Multiplicity of Nash equilibria
A more serious concern for game theory is the multiplicity of equilibria. Consider Battle of sexes
Ballet F ootball
Ballet 
2; 1 
0; 0 

F ootball 
0; 0 
1; 2 

or, HawkDove 

Dove Hawk 

Dove 
3; 3
1; 4
4; 1
0; 0


Hawk 
Both of these games have two pure strategy equilibria and one mixed strategy equilibrium (can you see this?)
There is no way to choose (especially between the two pure strategy equi libra)
Sometimes equilibria can be pareto ranked
Consider staghunt:
It can be argued that preplay communication helps to settle on pareto dominant equilibrium (A; A )
But even this might not be obvious. Consider:
Now playing A seems a bit shaky (what if the other player still chooses
B ?)
Morever, with preplay communication, players have an incentive to con vince the other player that A will be played, even if they plan to play B . Is preplay communication credible?
We conclude that generally there is no good answer for selecting among multiple equilibria
19
3.5 Correlated equilibrium
Consider once again Battle of Sexes example
There is a unique symmetric equilibrium in mixed strategies: each player takes her favourite action with a certain probability (compute this)
But suppose that the players have a public randomization device (a coin for example). Let both players take the following strategy: go to ballet if heads, and to football if tails.
Excercise: Show that this is an "equilbrium" and gives a better payo§ to both players than the symmetric mixed strategy equilibrium.
A generalization of this idea is called correlated equilibrium (see Osborne Rubinstein Ch. 3.3, FudenbergTirole Ch. 2.2, or Myerson Ch. 6 for more details)
Correlated equilibrium may be interpreted as a solution concept that im plicitly accounts for communication
4 Zerosum games
Let us end with a few words about a special class of games: zerosum games

A twoplayer game is a zero sum game if u _{1} (s) = u _{2} (s) for all s 2 S . 

This of course implies that u _{1} ( ) = u _{2} ( ) for all 2 . 
Matching pennies is a zerosum game
Zerosum games are the most "competitive" games: maximizing ones pay o§ is equivalent to minimizing "opponent"ís payo§. There is absolutely no room for cooperation (should tennis players cooperate in Wimbledon Önal?)
What is the largest payo§ that player 1 can guarantee herself? This is obtained by choosing
Similarly for player 2:
max min 2 u _{1} ( _{1} ; _{2} ) .
_{1} 2 _{1} _{2} 2
max min 1 u _{2} ( _{1} ; _{2} ) .
_{2} 2 _{2} _{1} 2
But, because u _{1} = u _{2} , this is equivalent to
min max 1 u _{1} ( _{1} ; _{2} ) :
_{2} 2 _{2} _{1} 2
20
Famous minmax theorem by von Neumann (1928) states that
max min 2 u _{1} ( _{1} ; _{2} ) = min max 1 u _{1} ( _{1} ; _{2} ) :
_{1} 2 _{1} _{2} 2
_{2} 2 _{2} _{1} 2
This means that maxmin value must give the payo§ of a player in any Nash equilibrium (can you see why?)
See e.g. Myerson Ch. 3.8 for more details.
21
FDPE microeconomic theory, spring 2014 Lecture notes 2: Sequential rationality in dynamic games Pauli Murto
1 Outline
We now move to dynamic games
We focus especially on Nash equilibrium reÖnements induced by sequential rationality: subgame perfect equilibrium and sequential equilibrium
Material: MWG Chapter 9
Other relevant sources: FudenbergTirole Ch. 34, 8.3, OsborneRubinstein Ch. 67, 12, Myerson Ch. 4
Some motivating examples:
1.1 Example: predation
An entrant considers entry into an industry with a current incumbent Örm
Entry costs 1 unit
Monopoly proÖt in the industry is 4
If entry takes place, the monopolist can either accomodate or Öght
Accommodation splits monopoly proÖts, whereas Öghting gives zero proÖt to both Örms
Will entrant enter, and if so, will incumbent Öght or accomodate?
Normal form representation of the game:
Fight if entry Accommodate if entry
Enter 
1; 0 
1 ; 2 
Stay out 
0 ; 4 
0 ; 4 
There are two Nash equilibria: (Enter, Accommodate) and (Stay out, Fight if entry)
Is one of the two equilibria more plausible?
1
1.2 Example: quality game
A producer can produce an indivisible good, and choose either high or low quality
Producing high quality costs 1 and bad quality 0
Buyers values high quality at 3 and bad quality at 1
For simplicity, suppose that good must be sold at Öxed price 2
Which quality will be produced and will the buyer buy?
Normal form representation of the game:
High quality Low quality
Buy Do not buy 
1; 1 
1; 2 
0; 1 
0; 0 
Only one Nash equilibrium (Do not buy, Low)
What if seller moves Örst?
What if buyer moves Örst?
What if seller moves Örst, but quality is unobservable?
1.3 Example: Stackelberg vs. Cournot
Consider the quantity setting duopoly with proÖt functions
_{i} (q _{i} ; q _{j} ) = q _{i} (1 q _{1} q _{2} ); for all i = 1; 2 :
Suppose the players set their quantities simultaneously (Cournot model). The unique Nash equilibrium is:
which gives payo§s
1
1
3 ^{;}
(q ; q ) =
1
2
1
3 ^{;} 3 ^{;}
1
_{3} 1 = _{2}
1
3 ^{;}
_{3} 1 = 1
2
3 3 ^{=} 9 1 ^{:}
1
What if player 1 moves Örst? (Stackelberg model)
After observing the quantity choice of player 1, player 2 chooses his quan tity.
2
Given the observed q _{1} ; Örm 2 chooses q _{2} . Optimal choice is
BR _{2} (q _{1} ) = ^{1} ^{} 2 ^{q} ^{1}
^{:}
Player 1 should then choose:
max u _{1} (q _{1} ; BR _{2} (q _{1} )) = 1 q _{1} ^{1} ^{} ^{q} ^{1}
q
1
2
^{} _{q} 1 _{=} (1 q _{1} )q _{1}
2
This leads to
with payo§s
q _{1} = _{2} ; q _{2} = BR _{2} (q _{1} ) = ^{1}
4
1
1 _{}
1
2 ^{;} 4 ^{=}
1
1
_{8} ; _{2}
1
2 ^{;} 4 ^{=} 16 1 ^{:}
1
^{:}
1.4 Example: matching pennies
Head
T ail
Nash equilibrium, where both players mix with 1/2 probabilities
What if player 1 moves Örst?
What if player 1 moves Örst, but choice is unobservable?
1.5 Discussion
These examples illustrate that the order of moves is crucial
Moving Örst may help (commitment to an action)
Moving Örst may also hurt (matching pennies)
The normal form representation misses the dynamic nature of events, so we need to utilize extensive form representation
The key principle is sequential rationality , which means that a player should always use a continuation strategy that is optimal given the current situation
For example, once entrant has entered, the incumbent should act optimally given this fact (accommodate)
This will lead us to reÖnements of Nash equilibrium, in particular subgame perfect equilibrium (SPE) and sequential equilibrium
3
2 Subgame perfect equilibrium
2.1 Subgame
Consider an extensive form game with perfect recall
A subgame is a subset of the original gametree that inherits information sets and payo§s from the original game, and which meets the following requirements:
1. There is a single node such that all the other nodes are successors of this node (that is, there is a single initial node to the subgame)
2. Whenever a node belongs to the subgame, then all of its successor nodes must also belong to the subgame.
3. Whenever a node belongs to the subgame, then all nodes in the same information set must also belong to the subgame.
2.2 Subgame perfect equilibrium
DeÖnition 1 A strategy proÖle of an extensive form game is a subgame per fect Nash equilibrium (SPE) if it induces a Nash equilibrium in every subgame of the original game.
Every subgame perfect equilibrium is a Nash equilibrium, but the con verse is not true. Thus, subgame perfection is a reÖnement of the Nash equilibrium concept.
The idea is to get rid of equilibria that violate sequential rationality prin ciple.
It is instructive to go through the examples that weíve done so far and identify subgame perfect equilibria.
2.3 Backward induction in games of perfect information
In Önite games with perfect information, subgame perfect equilibria are found by backward induction:
Consider the nodes, whose immediate successors are terminal nodes
Specify that the player who can move in those nodes chooses the action that leads to the best terminal payo§ for her (in case of tie, make an arbitrary selection)
Then move one step back to the preceding nodes, and specify that the players who move in those nodes choose the action that leads to the best terminal payo§  taking into account the actions speciÖed for the next nodes
4
Continue this process until all actions in the game tree have been deter mined
This process is a multiplayer generalization of backward induction prin ciple of dynamic programming
Theorem 2 A Önite game of perfect information has a subgame perfect Nash equilibrium in pure strategies.
The proof is the backward induction argument outlined above
If optimal actions are unique in every node, then there is a unique sub game perfect equilibrium
Note that the terminal nodes are needed to start backward induction. Does not work for inÖnite games.
How about chess?
2.4 Example: chain store paradox
Note that the entry game (predation) discussed at the beginning of the lecture is a perfect information game
Could a Örm build a reputation for Öghting if it faces a sequence of en trants?
Chain store paradox considers an incumbent Örm CS that has branches in cities 1 ; :::; K .
In each city there is a potential entrant.
In period k , entrant of city k enters or not. If it enters, incumbent may Öght or accomodate.
Payo§s for city k are as in original entry game:
Fight if entry Accommodate if entry
Enter 
1; 0 
1 ; 2 
Stay out 
0 ; 4 
0 ; 4 
Incumbent maximizes the sum of payo§s over all cities, while each entrant maximizes proÖts of that period.
An entrant only enters if it knows the CS does not Öght.
Would it pay for CS to build a reputation of toughness if K is very large?
The paradox is that in SPE, the CS can not build a reputation.
In the Önal stage, the optimal action of CS is Accomodate, if the entrant enters.
5
The entrant know this, and thus enters.
By backward induction, this happens in all stages.
We Önd that the unique SPE is that all entrants enter and CS always accomodates.
To bring reputation e§ects to life, we would need to introduce incomplete information (later in this course)
2.5 Example: centipede game
Centipede game is a striking example of backward induction
Two players take turns to choose Continute (C ) or stop ( S )
The game can continue at most K steps ( K can be arbitrarily large)
In stage 1, player 1 decides between C and S . If he chooses S , he gets 2 and player 2 gets 0. Otherwise game goes to stage 2.
In stage 2, player 2 decides between C and S . If he chooses S , he gets 3 and player 2 gets 1. Otherwise game goes to stage 3, and so on.
If no player ever stops, both players get K .
Draw extensive form and solve by backward induction. What is the unique SPE?
If i stops in stage k , he gets k + 1, while j gets k 1 .
3 Multistage games with observed actions
One restrictive feature of games of perfect information is that only one player moves at a time
A somewhat larger class of dynamic games is that of multistage games with observed actions
Many players may act simultaneously within each stage
We may summarize each node that begins stage t by history h ^{t} that con tains all actions taken in previous stages: h ^{t} := ^{} a ^{0} ; a ^{1} ; :::; a ^{t} ^{} ^{1} ^{} .
A pure strategy is a sequence of maps s ^{t} from histories to actions a ^{t} 2 A _{i} (h ^{t} ).
Payo§ u _{i} is a function of the terminal history h ^{T} ^{+}^{1} , where T is inÖnite in some applications.
i
i
6
3.1 Onestep deviation principle
Since many players may act simultaneously within a stage, backward in duction argument can not be applied as easily as with games of perfect information
However, the following principle that extends backward induction idea is useful:
Theorem 3 In a Önite multistage game with observed actions, strategy proÖle s is a subgame perfect equilibrium if and only if there is no player i and no strategy s _{i} that agrees with s _{i} except at a single t and h ^{t} , and such that s _{i} is a better response to s _{} _{i} than s _{i} conditional on history h ^{t} being reached.
0
0
That is: to check if s is a SPE, we only need to check if any player can improve payo§s by a onestep deviation
Note that the result of the previous slide requires a Önite horizon, just like backward induction
Importantly, the result carries over to inÖnite horizon games under an extra condition that essentially requires that distant events are relatively unimportant
In particular, if payo§s are discounted sums of per period payo§s, and payo§s per period are uniformly bounded, then this condition holds
The proof of the onestep deviation principle is essentially the principle of optimality for dynamic programming.
3.2 Example: repeated prisonerís dilemma
Consider prisonerís dilemma with payo§s:
Cooperate Defect
Cooperate 
1; 1 
1 ; 2 
Defect 
2 ; 1 
0; 0 
Suppose that two players play the game repeatedly for T periods, with total payo§
X
T 1
1
1 ^{T}
^{t} g _{i} ^{} a ^{t} ^{} ;
t=0
where g _{i} gives the perperiod payo§ of action proÖle a ^{t} as given in the table above
Players hence maximize their discounted sum of payo§s, where the term
1
1
_{T} is just a normalization factor to make payo§s of games with di§erent
horizons easily comparable
7
Suppose Örst that the game is played just once (T = 1). Then (De fect,Defect) is the unique Nash equilibrium (Defect is a dominant action)
Suppose next that T is Önite. Now, subgame perfection requires both players to defect in the last period, and backward induction implies that both players always defect.
Finally, suppose that T is inÖnite. Then backward induction cannot be applied but onestep deviation principle holds (discounting and bounded payo§s per period)
"Both defect every period" is still a SPE
However, provided that is high enough, there are now other SPEs too
By utilizing onestep deviation principle, show that the following is a SPE:
"cooperate in the Örst period and continue cooperating as long as no player has ever defected. Once one of the players defect, defect in every period for the rest of the game".
4 Sequential equilibrium
Recall that a subgame starts with an information set that consists of a single node
But in games of imperfect information, there may be few such nodes
For example, in Bayesian games, where nature chooses a type for each player, the only subgame is the whole game tree
In such situations the reÖnement of subgame perfect equilibrium has no bite
To evaluate sequential rationality in information sets with many nodes, we must consider the beliefs of the player that chooses her action
We deÖne a belief system as:
DeÖnition 4 A belief system
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