Introduction to Applied Game

Theory
Lecture 6

Applied Game Theory 1

Sequential/ Extensive-form Games
 There is a clear order of play or there is
possibility of moving first.

 Look forward and reason backward

(Backward induction)

Applied Game Theory 2

Strategies
 Strategy – independent of other’s choices
– specify actions at all possible nodes –
prevent off-equilibrium play
1

A B

2
2
C D
C D

 Nodes; Subgames

Applied Game Theory 3

Strategies
 S1={A, B}

 S2={C if A, C if B;
C if A, D if B;
D if A, C if B;
D if A, D if B}

={CC; CD; DC; DD}

Applied Game Theory 4

Example
 Backward induction solution: (B; DD)
 Backward induction solution: (A; CD)

A B

2
2
C D
C D

3, 1 -1, 2 1, 0 2, 1
3, 3

Applied Game Theory 5

Theorem
 Every extensive-form game of perfect
information maps into a normal-form
game.

Applied Game Theory 6

Predation Game
Entrant

Out
 Backward
In
induction
0, 3 Incumbent solution:
(In; A)
Fight Accommodate

-3, -1 2, 1

Incumbent
Fight Accommodate NE: (Out; F)
Out 0, 3 0, 3
Entrant
In -3, -1 2, 1
(In; A)

Applied Game Theory 7

Subgame Perfect Nash equilibrium
 A pair (or set) of strategies is SPNE if it
induces a Nash equilibrium in every
subgame of the original game.

 Only SPNE: (In; A)

 Theorem: In an extensive game of perfect

information, set of SPNE = set of
backward induction solutions
Applied Game Theory 8
Acting crazy…

 If rival does not enter, the incumbent is

free to do whatever it likes

 In particular, it can threaten to fight

 In which case, the rival is better off staying

out

Applied Game Theory 9

Equilibria…
1. Rival enters, neither firm fights
2. Rival doesn’t enter, incumbent threatens to
fight if it did enter
 Now entry deterrence depends crucially on
the rival’s beliefs about the incumbent’s
response
 If the rival is convinced that the incumbent
will be aggressive, it should not enter
 Since the rival chooses not to enter,
choosing to actually be aggressive is a best
response by incumbent

Applied Game Theory 10

Equilibria…
 Even though it is a dominant strategy for
incumbent to not fight, it can deter entry
by threatening.
 Since in the event of successful
deterrence, the threat is not tested this is
a best response for the incumbent
 If the incumbent can affect the rival’s
beliefs, it is possible to deter entry even
in this framework
Applied Game Theory 11
Equilibria… which one?
 The prospect that a threat (which is
costly to carry out) might succeed in a
situation like this posed a problem for
game theory

 Is there some rational means to choose

between the equilibria?

Applied Game Theory 12

Subgame Perfect Nash Equilibrium
 When presented with any history of the
game (even an unexpected one), players
should choose best responses to future
beliefs

 Formally, we require that players choose

optimizing strategies everywhere in the
game (every subgame)

Applied Game Theory 13

Subgame Perfect Equilibrium
 Nash equilibrium in every subgame
 Not fighting is a dominant strategy for the
incumbent if the rival enters
 Therefore, despite incumbent’s threats to
the contrary
◦ Rival should anticipate that its entry will not
lead to fighting
◦ Therefore, it pays to enter.
 Entry deterrence is not credible
Applied Game Theory 14
Extensive-form games of complete
but imperfect information
1 (Ravi) Stadium Play

Play Stadium Stadium 4, 2 0, 0

Play 0, 0 2, 4

2 (Shalini)

Play Stadium Play Stadium

 You don’t know previous actions chosen

when you move.
 Example – prices/quantities of your rival

Applied Game Theory 15

Looking ahead – extensive-form
games of incomplete information
Nature
[½] [½]
S W
1 1

R R
L L
2

 You know actions chosen, but not who has played it.
 You know price/quantity but not if the firm is low-cost
or high-cost type; you know education chosen but not
worker type
Applied Game Theory 16