GAME THEORY

Non-cooperative game theory is a set of tools that is used to model the behaviour or choices of players (individuals, firms, etc.) when the payoff (profit) of a choice depends on the choice of other players. Recognized payoff interdependency gives rise to interdependent decision making or strategic interaction. The optimal choice of a player will depend on her expectation of the choices of others playing the same game. How expectations of every player are formed? Game-theoretic analysis is built on two fundamental assumptions. 1. Rationality. We assume that a players preferences can be represented by a utility function or payoff function. Game theory assumes that players are interested in maximizing their payoffs. A utility function simply assigns an index number to each outcome with the property that higher index numbers are assigned to outcomes that are more preferred. In game theory it is common to refer to a players utility function as her payoff function. Payoffs for firms are simply profits or expected profits. 2. Common Knowledge. Common knowledge means that all players know the structure of the game and that their opponents are rational, that all players know that all players know the structure of the game and that their opponents are rational, and so on.

STATIC GAMES OF COMPLETE INFORMATION

NORMAL-FORM REPRESENTATION OF GAMES
The normal form specification of a game specifies: 1. the number (n) of the players in the game 2. the set of (pure) strategies (Si) available to each player; a strategy is identified by si Si (i = 1 n). Actions and strategies coincide only in static games of complete information 3. a payoff function (ui = ui(s)) for each player. Such function assigns each player i a level of utility for each profile/combination of strategies s, s S1 x S2 x x Sn The normal form representation of a game is consequently

G = {S1,..,Sn; u1,..,un}
In a static game players choose their strategies simultaneously. Simultaneously means that none of the players can benefit of the information concerning the choice of the rivals (logical vs. chronological simultaneity) An equilibrium concept is a function that associates to a game a specific combination of strategies The combination selected by the function is the one which is composed by strategies that make the correspondent player satisfied. What is satisfaction ?

G {s1,..,sn}

EQUILIBRIUM CONCEPTS
ELIMINATION OF STRICTLY DOMINATED STRATEGIES The prisoners dilemma
P2 Mum P1 Mum Fink -1,-1 0,-9 -9,0 -6,-6 Fink

Dominated strategy : si is dominated if si | ui(si,s-i) > ui(si,s-i)

Strict and weak dominance Mum is dominated by Fink: the combination of strategies {Fink; Fink} solves the game.

s-i

P2 Mum P1 Mum Fink C,C D,S

Fink S,D P,P

Solving a game means to provide a forecast of the outcome (of the equilibrium)
In general, we have a prisoners dilemma game when: D(efection) > C(ooperation) > P(unishment) > S(uckers payoff)

The free-riding problem can be interpreted as a prisoners dilemma

EQUILIBRIUM CONCEPTS
ITERATED ELIMINATION OF STRICTLY DOMINATED STRATEGIES
G2 G1 Up Down 1,0 0,3 1,2 0,1 0,1 2,0 Left Center Right

In this game, several combinations of strategies are all composed by non-dominated strategies

Only {Up, Center}, however, survives to an iterative process of elimination of dominated strategies Is that procedure a good representation of a rational choice? A rational player never plays strictly dominated strategies. This equilibrium concept need adequate assumptions concerning the rationality of the opponent (common knowledge) Despite the fact that iterated elimination of dominated strategies is a less demanding concept, the largest part of conceivable games still cannot be solved G2 G1 Up Center Down 0,4 4,0 3,5 9,0 4,4 2,5 5,3 5,3 6,6 Left Center Right

NASH EQUILIBRIUM
A strategically stable (self-enforcing) outcome is obtained when no player has anything to gain by changing her own strategy unilaterally In the game G, the strategy combination sN = {sN1,..,sNn} is said to be a Nash equilibrium if ui(sNi,sN-i) ui(si,sN-i) si, i P1 U C D 0,4 4,0 3,5 9,0 4,4 2,5 5,3 5,3 6,6 P2 L C R

This happens when sNi solves the problem : max si [ui(si,sN-i)]

A reaction function is defined in the strategy space as R*i = Ri(s-i) Ri(s-i) = argmax si [ui(si,s-i)] A best response s is a strategy which is a specific value of the reaction function, s = R (s ) i i i i Proposition A In the normal form game G, if iterated elimination of strictly dominated strategies eliminates all but one strategy for every player, then the survived strategy combination is the unique Nash equilibrium of the game. Proposition B In the normal form game G, every strategy combination which is a Nash equilibrium survives iterated elimination of strictly dominated strategies

THE TRAGEDY OF THE COMMONS [Hume, 1739]

This is a problem of public goods exploitation n farmers own gi (i=1..n) animals which are grazed on the village green The cost per head of livestock is c. The payoff per head of livestock is v(gi), v < 0 e v < 0. The strategic variable of the players is the number of animals they (simultaneously) decide to breed.

The individual farmers payoff , consequently is: ui(gi,g-i) = gi v(gi+g-i) c gi The Nash equilibrium is defined by: i FOCs are: or, equivalently: The social optimum needs: Whose FOC is g*i = argmaxgi [gi v(gi+g*-i) c gi] v(gi+g*-i) + gi v(gi+g*-i) c = 0 v(G*) + 1/n G* v(G*) c = 0 G = argmaxG [G v(G) c G] v(G) + G v(G) c = 0

It can be easily obtained that G* > G. This effect exemplifies the so called free riding behaviour, which emerges in presence of negative externalities (as is the exploitation of public goods)

MULTIPLE NASH EQUILIBRIA AND MIXED STRATEGIES

The battle of the sexes Pat Opera Chris Opera Fight Matching pennies Diff Heads Tails -1,1 1,-1 1,-1 -1,1 2,1 0,0 Fight 0,0 1,2 Tails

Eq Heads

In both games the payoffs depend on the coordination of the actions of the players. As they disagree about the preferred outcome, this type of games are not characterized by unique equilibria. The behavior of the rival is consequently uncertain We extend the analysis by admitting the possibility that the player randomize their actions A mixed strategy is a probability distribution {pi1,..,piK, k=1..K pik=1 }, over the strategies in Si = {si1,..,siK}

The basic idea in this slide is that the concept of dominance has to be redefined once we admit mixed strategies If we exclude mixed strategies, when si is dominated, then no one (pure) strategy of the opponents s-i (and consequently no one belief) can make si a best response. It can be easily demonstrated that if si is dominated, then not even a mixed strategy of the opponents can make si a best response. The opposite is false if we consider only pure strategies, but the opposite becomes true if we admit mixed strategies. In particular: if there is no belief that player i could hold about s-i such that it would be optimal to play si, then there exists a strategy si (possibly mixed) that strictly dominates si
2 L 1 R 3,_ 0,_ 1,_ 0,_ 3,_ 1,_

In this game, B is never a best response for every pure strategy played by 2, but neither T nor M dominate B. However, a mixed strategy with pT = e pM = , strictly dominates B

T M B

The Nash equilibrium concept can be obviously extended when mixed strategies are allowed. A pure strategy is only a particular mixed strategy

In a two players game with two symmetric actions {a, b}, if player 1 expects form player 2 a strategy {q,1 q}, her payoff becomes E(u(a)) = q u(a, a)+(1 q) u(a, b) and E(u(b)) = q u(b, a)+(1 q) u(b, b)

Depending on q (the probability of a), the best response for player 1 could be a or b. In particular, the threshold q, q = [u(b, b) u(a, b)] / [u(b, b) + u(a, a) u(a, b) u(b, a)] determines when the best response is a (q q) or the opposite. When q=q, player 1 is indifferent between a and b. In the case of a matching pennies game, for example, q= In a similar way player 2 can calculate her threshold r
r r*=RDIFF(q) q q*=RUG(r) r= q q= 1 r= 1 r q= 1 q r

More in general, in a two-player game, if p1 and p2 are the probability distributions over the two set of actions of the players composed of J and K elements:
v1 (p1 , p 2 ) = E(u1 (p1 , p 2 )) = p1 jp2 k u 1 s1 j , s 2 k
j=1 k =1 J K J K

) )

v 2 (p1 , p2 ) = E(u 2 (p1 , p2 )) = p1 jp 2 k u 2 s1 j , s 2 k

j=1 k =1

and the definition of Nash equilibrium becomes:

v1 (p *1 , p * 2 ) v1 (p1 , p * 2 ) v 2 (p *1 , p * 2 ) v 2 (p *1 , p2 ) p1 , p 2

The condition for a mixed strategy p1 to be the best response to the mixed strategy p2, is that (from the FOC) p1j > 0 iif the pure strategy s1j is also best response to p2:

k =1

p2 k u1 s1 j , s 2 k p2 k u1 s1 j' , s 2 k
k =1

j'

At the equilibrium, each player is indifferent between the equilibrium mixed strategy and every pure strategy played with positive probability (Fundamental Lemma)

MIXED STRATEGIES INTERPRETATION

An attempt to make ones behaviour unpredictable The representation of the opponents believes concerning the pure strategy each player will adopt The information available to each player concerning the outcome of previous realizations of such game Just before deciding how to move, each player privately obtains an unexpected signal concerning her own payoff (Harsanyis purification)

11

NASH THEOREM (1950)

Four cases:
x > z x < z x > z x < z y>w y<w y<w y>w DOMINANCE DOMINANCE
P1 U D

P2

L x,_ z,_

R y,_ w,_

If {r,1-r} and {q,1-q} are the generic strategies of player 1 and 2 respectively, in the first and in the second case r*=r(q) is constant (0 or 1); in the third and in the fourth cases the threshold q=(w-y)/(x-z+w-y) is the value where r* = 0 becomes r* = 1. In the equality cases (x=z and/or y=w), one of the strategies weakly dominates the other one, so that the reaction function is L-shaped (q = 0 or q = 1) Every couple of reaction function of the type illustrated above certainly intersect in the r/q space within the square 0/1 In the sixteen possible cases, we can then obtain: 1) a unique NE in pure strategies; 2) a unique NE in mixed strategies; 3) two pure-strategy NE and one NE in mixed strategies The Nash theorem generalizes such result when the number of players and the number of strategy combinations are finite: if n and Si are finite i, G(S1,..,Sn;u1,..,un), then there exists at least one NE, possibly involving mixed strategies Demonstration is based on the fixed point th.: if f(x) is continuous in [0,1] x*f(x*)=x*