Lecture 24: Game Theory c 2009 Je¤rey A.

Miron

Outline

1. Introduction

2. The Payo¤ Matrix of a Game

3. Nash Equilibrium

4. Mixed Strategies

5. The Prisoner’s Dilemma

6. Repeated Games

7. Sequential Games

8. A Game of Entry Deterrence

1 Introduction

In the previous lecture we discussed oligopoly behavior, in particular, the fact that
cartel members have an incentive to cheat. This creates a demand for strategies the
cartel members could pursue that might discourage cheating and increase pro…ts on
average.

This is but one example of a more general phenomenon: strategic interaction

occurs in many aspects of life. By strategic interaction, we mean situations in which
my desired choice of behavior depends on what I think you will do, and your desired
choice depends on what you think I will do. This kind of situation is addressed by
the branch of economics known as game theory.

Note the key di¤erence between the strategic setting and most of those we have
considered so far. Both a pure competitor and a monopolist take market conditions
as given; they can then decide what actions are in their own best interest without

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worrying about how some other economic actor will respond. In all the models of
consumer behavior that we have considered, consumers took prices as given.

In many instances, however, what matters is how I think others will respond to
my actions, how they think I will respond to their actions, how I think they will
think that I will respond, and so on.

We now examine game theory as a method of modeling these kinds of environ-

ments. We are interested in applications of game theory to the theory of the …rm,
especially in the case of oligopoly, but also in the insights and techniques that come
from game theory more generally.

2 The Payo¤ Matrix of a Game

Game theory in principle can be applied in settings with many participants (e.g., an
industry with many competitors), but we limit our analysis to two-person games for
simplicity. This allows us to portray the key aspects of the game in a payo¤ matrix.

Consider a speci…c example with two players named A and B. Each player can
choose between two strategies.

Player A writes one of two words on a piece of paper, “Top”or “Bottom.”

Simultaneously, Player B writes “Left”or “Right.”

Each player does this independently, i.e., without knowledge of the other’s actions.

After the players do this, the pieces of paper are examined, and each player gets
the payo¤ depicted in the table.

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 Player B

Left Right

Top 1, 2 0, 1
Player A
Bottom 2, 1 1, 0

The payo¤ to A is the …rst entry in each pair; the payo¤ to B is the second entry.

Person A has two strategies: top or bottom. These could represent economic
choices like raise price or lower price, or they could represent other things like declare
war or make peace; go to the movies or not, etc. The strategies do not have to be
strategic per se; they are just choices the players might make.

Note that this approach forces the set of strategies to be discrete –raise price or
lower price –when in reality, the choices available to real economic actors might be
continuous – choose an amount by which to raise or lower price. Whether this is
a serious restriction depends on the setting. In some cases, it is reasonable (e.g., in
actual games that have speci…c rules about the possible actions) while in others, it
potentially assumes away economically relevant interactions (e.g., the adjustment of
price to achieve equilibrium).

What will be the outcome of this game?

In this case, a simple solution exists. For A, it always better to say Bottom
because the payo¤ is higher whether B chooses Left or Right. For B, it is always
better to choose Left because the payo¤ is higher whether A chooses Top or Bottom.

Thus equilibrium strategy is for A to play Bottom and for B to play Left.

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 Note that each player in this game has what is referred to as a dominant strat-
egy: a strategy that is better no matter what the other player does.

Whenever one player has a dominant strategy, we expect that player to adopt
that strategy.

If both players have a dominant strategy, we assume that the equilibrium outcome
of the game will be the one determined by those two dominant strategies, as in the
example above.

3 Nash Equilibrium

Many games, however, do not have dominant strategies. Consider the following:

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 Table: A Nash Equilibrium

Player B

Left Right

Top 2, 1 0, 0
Player A
Bottom 0, 0 1, 2

In this example, A’s best choice depends on what B does, and B’s best choice
depends on what A does, so no dominant strategy exists for either player.

Therefore, consider another criterion for predicting what outcome will occur:
Assume A makes the choice that is optimal for him assuming B makes the choice
that is optimal for him, and vice versa.

That is, we say that a pair of strategies is a Nash equilibrium if A’s choice is
optimal given B’s choice, and B’s choice is optimal given A’s choice.

Remember that neither player knows what the other will do at the time when a
strategy is chosen; the moves are simultaneous.

But each player can make an educated guess about what the other will do.

So, we can interpret Nash equilibrium as a pair of expectations about the other
player’s choice such that, when the other player’s choice is revealed, neither player
wants to change their choice of strategies.

In this example, (Top, Left) is a Nash equilibrium.

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 Note that the Cournot equilibrium we examined under oligopoly is an example
of a Nash Equilibrium.

The Nash equilibrium solution concept is appealing, but it has some problems as
a method of solving games.

First, some games have more than one Nash equilibrium. In the previous exam-
ple, (Bottom, Right) is also a NE.

Second, some games have no Nash equilibria. See the following example:

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 Table: A Game with No Nash Equilibria in Pure Strategies

Player B

Left Right

Top 0, 0 0, -1
Player A
Bottom 1, 0 -1, 3

The possibility of many NE or no NE might seem to suggest that game theory

is not so useful; it is presumably awkward to use a theory that either generates no
prediction about the equilibrium, or makes multiple, di¤erent predictions. In fact,
things are not quite so bleak.

4 Mixed Strategies

The second problem with Nash Equilibrium –the possibility that a game has no NE
–can be reduced by broadening our de…nition of strategies.

So far we have been thinking of choices about strategies as discrete choices: play
Top or Bottom, Left or Right. These approaches are called pure strategies.

Another possibility, however, is that each person randomizes their choice over a
range of strategies. That is, a player assigns a probability to each strategy, and then
chooses between the strategies randomly but according to the assigned probabilities.

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 For example, say Player A assigns a probability of .8 to Top and .2 to Bottom.
Assume Player A has a coin that comes up heads 80% of the time and tails 20% of
the time. Then, before choosing a move, Player A ‡ips this (unfair) coin; if it comes
up heads, Player A plays Top; if it comes up tails, Player A plays Bottom.

This is known as a mixed strategy.

Say A and B in the previous game each use 50% as the probability of each strategy.
Then the game ends up in each of the cells with a frequency of .25.

The average payo¤ to A will be 0, and the average payo¤ to B will be 1/2.

It turns out that if A does .75 / .25, and B does .5 / .5, this is a NE in mixed
strategies.

Each of the kinds of games we consider has at least one MSNE (Mixed Strategy
Nash Equilibrium).

This kind of equilibrium might seem odd. You probably think that people do
not actually behave this way; ‡ipping a coin before deciding what strategy to adopt
in a given situation.

Consider, however, a couple of initial examples that suggest this behavior is not
necessarily so odd.

The …rst is the game rock, paper, scissors.

Imagine adopting any non-random strategy for playing this game, e.g., always
play rock; or always play rock on round 1, then paper on round 2, then scissors on
round 3.

If you adopt one of these non-random strategies, and interact with any given
opponent repeatedly, and if this opponent is at all swift, then the opponent will
detect the pattern in your play and adopt a strategy that always wins. So, a
predictable pattern cannot be a NE.

But imagine instead that you ‡ip a mental, three-sided coin before each turn,
and randomly choose R, P, or S, each with probability 1/3.

Imagine that your opponent does the same.

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 Then you each win exactly half the time. Neither of you has any incentive to
change because, given the other’s behavior, no strategy does better than 50-50.

(Note also that a random pattern that assigns probabilities to each strategy other
than 1/3, 1/3, 1/3, would also allow your opponent to win more than half the time).

A similar situation arises in many sports examples. In each football play, the
o¤ense must decide whether to run or pass. The defense must decide whether to
defend against a run or a pass. If either side is predictable (e.g., if the o¤ense
adopts a rule like “always run if the yards necessary for a …rst-down are three or
less”), then the other side can anticipate and react accordingly. If instead each side
randomizes, the other side cannot gain any advantage by exploiting predictability.
Similar considerations arise in deciding whether to serve to your opponents backhand
or forehand in tennis, and whether to kick right or left when attempting penalty kicks
in soccer.

Note again that randomness by itself is not su¢ cient; the probabilities assigned
to each strategy must be the appropriate ones. Say your opponents backhand is
worse than his forehand, assuming he does not know whether the serve is coming to
his forehand or backhand. Then you probably want the fraction of serves going to
the backhand to exceed 50%. But if your opponents ability to return your serve also
depends on whether he expected forehand or backhand, then you want to serve to
the forehand some of the time to maintain the element of surprise. Thus, a strategy
like 75% to the backhand, 25% to the forehand, is likely to emerge as your strategy
in the NE, and the reverse strategy –expect 75% to the backhand, and 25% to the
forehand –is likely to emerge as your opponent’s NE strategy.

So, the introduction of mixed strategies means we can have NE even in games
that have no pure strategy NE. This expands dramatically the percentage of games
in which a NE exists.

5 The Prisoner’s Dilemma

A important feature of game theory is that many NE are not Pareto-e¢ cient out-
comes. The classic example is known as the prisoner’s dilemma:

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 Table: The Prisoner’s Dilemma

Player B

Confess Deny

Confess -3, -3 0, -6
Player A
Deny -6, 0 -1, -1

The scenario behind these payo¤s is as follows. Two people have been arrested for
allegedly committing a crime. The two prisoners have been separated by the police
and cannot communicate with one another. The police question them separately,
and each prisoner can either deny having participated in the crime or confess. If
a prisoner confesses and the other prisoner also confesses, each gets a moderate
sentence (3 years). If each denies participation, each gets one year only (the police
have some other evidence). If one confesses and the other denies, the confessor gets
a free pass from the police while the denier gets a sti¤ sentence (6 years).

Now put yourself in position of player A. If B hangs tough, you are better o¤
confessing since you get o¤ free. If B confesses, you are also better o¤ confessing,
since then you get 3 years of prison instead of 6. Thus, whatever B does, A is better
o¤ confessing. Confess is a dominant strategy.

Everything in the game is symmetric, so Confess is also a dominant strategy for

B.

So, it is a dominant strategy equilibrium for both prisoners to confess.

Yet, if both hang tough, both would be better o¤; they would each get one year
of prison instead of 3.

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 Thus, both players end up at a Pareto-ine¢ cient outcome even though a Pareto-
e¢ cient one exists.

The problem is that the prisoners need a way to coordinate (perhaps sharing the
same lawyer).

This same basic game structure applies, at least roughly, in many settings.

In the cartel setting, imagine that each …rm has two possible strategies: stick to
the agreement, or defect (cheat) by cutting price.

Both …rms are better o¤ if they both stick to the cartel, but the dominant strategy
equilibrium is for both to defect.

This result is unsatisfying. We would like to believe that people do not regularly
choose ine¢ cient outcomes.

So, is our analysis so far incomplete? Yes, partially.

6 Repeated Games

In the preceding example, players met only once and played the game only once.

The outcome of a game is potentially di¤erent, however, if the game is played

repeatedly by the same players.

For example, imagine that you are playing the Prisoner Dilemma game twice in
a row. Ignoring the lesson of the one-shot game, you decide to hang tough in the
…rst round, hoping your opponent will also hang tough.

Your opponent might or might not; but if he confesses, then you can confess in
the second round, in‡icting some punishment on him for bad behavior in the …rst
round.

A second issue is that, in a repeated game, each player has the opportunity to
establish a reputation for cooperation, and thereby encourage other players to do the
same.

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 So, having multiple plays of the game allows for the possibility of punishment
and the possibility of building a reputation. Does this necessarily eliminate “bad”
equilibria?

Consider a situation where a game repeats, but the number of rounds is …nite
and known.

Now think about the last round. Nothing happens afterwards, so no player has
any incentive to build a reputation or accept less than is optimal in this last round
in exchange for something in the future - no future occurs. Playing the last round
is just like playing the one-shot game. Thus, in the last round, we expect to get the
one-shot outcome. For example, in the Prisoner’s Dilemma game, we expect both
players to confess.

Now consider the second-to-last round. We know each player will defect in the
last round, no matter what happens in the second-to-last round.

So, both players might as well defect in the second-to-last round.

This logic extends backwards, all the way to the …rst round.

This means that with a …xed number of periods, the equilibrium in the multi-
period game is just the one-shot outcome multiple times. Players still have no
incentive for cooperation, so everything unravels. The factor that might potentially
generate cooperation in the current period is that cooperation now will help generate
cooperation in the future; but if there is no future, this mechanism is inoperative.

Thus, adding more periods, by itself, does not seem to change the fact that
Prisoner’s Dilemma type outcomes are NE.

The situation can be di¤erent, however, if the number of repetitions of the game
is in…nite.

Then you can potentially always in‡uence your opponent’s behavior: if he refuses
to cooperate, you can refuse to cooperate next time, and there is always a next time.

As long as both parties care enough about future payo¤s, the threat of non-
cooperation in the future may be su¢ cient to convince people to play the Pareto-
e¢ cient strategy in the present.

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 This has been demonstrated in a convincing way by a series of experiments run
by Robert Axelrod.

He asked dozens of experts on game theory to submit their favorite strategies

for the Prisoner’s Dilemma, and then ran a tournament on a computer to pit these
against each other.

Every strategy was played against every other on the computer, and the computer
kept track of the payo¤s.

The winning strategy was tit-for-tat, which works as follows.

In the …rst round, cooperate. On every round thereafter, if your opponent

cooperated, you cooperate. If your opponent defected, you defect. In other words,
do whatever the other player did in the last round.

This approach does well because it o¤ers an immediate punishment for defection.

This approach is also forgiving: it punishes the other player only once for each de-
fection. If he falls into line and starts to cooperate again, then you start cooperating
again too.

7 Sequential Games

So far, we have looked at simultaneous games.

In some settings, however, one player goes …rst and the other follows. The
Stackelberg model was an example.

To illustrate the implications, consider the following game.

In the …rst round, A chooses top or bottom; B gets to observe the choice and
then chooses Left or Right.

Assume the payo¤s are as follows:

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 Table: Payo¤ Matrix of a Sequential Game

Player B

Left Right

Top 1, 9 1, 9
Player A
Bottom 0, 0 2, 1

Note that when the game is presented in this form, it has two NE: (Top, Left)
and (Bottom, Right).

One of these, however, is not “reasonable.” The payo¤ matrix hides the fact that
one player gets to know the other player’s move before making his own choice.

To see this, consider the following diagram, which is known as the extensive form
of the game:

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 Figure: Extensive Form of a Game
y = 4 :5x

A,B
B L 1,9
chooses

T
A R 1,9
chooses

L 0,0
B

B
chooses R 2,1

To analyze, start at the end and work backwards.

From each possible node where B gets to make a choice, we can …gure out what
B will do given that the game has gotten to that node.

This shows that if A plays Top, B is indi¤erent between Left and Right, and A
would get 1 regardless. If A plays Bottom, B plays Right to get 1 instead of 0, and
A gets 2.

So, A will not want to give B the choice of going Left or Right from the Top
choice; A will play Bottom knowing that B will then play Right, so A gets 2 rather
than 1. B does not like this, since B gets 1 rather than 9, but given the rules of
the game, there is nothing B can do.

So, you might think that B should threaten to play Left if A plays Bottom; if B
carried out this threat, A would get 0 rather than 2.

This threat is not credible, however. Once A has played Bottom, B is better o¤
accepting this and playing Right rather than Left.

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 Of course, B might try to commit himself (or give someone else his decision) to
push A toward top.

This shows that B could be better o¤ by limiting his choices.

Thus, taking account of the sequential nature of this game eliminates one NE as
unreasonable. The only reasonable outcome is B,R.

Note also that the sum of the payo¤s at BR is strictly less than at TL. So, if
bribery were allowed, we would always get to the T row.

This suggests that game theory models can be somewhat arti…cial, especially if
the application is economic environments where the payo¤s are money that can be
transferred.

8 A Game of Entry Deterrence

In our analysis of oligopoly, we took the number of …rms as …xed.

Existing …rms would like to prevent entry. And, in some settings, they might be
able to act strategically to accomplish this.

Suppose we have a monopolist who is facing threat of entry by another …rm.

The entrant decides whether or not to enter the market; the incumbent then
decides whether or not to cut its price.

See the …gure:

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 Figure: Extensive Form for Entry Game

A,B
incumbent fight 1,9
chooses

stay out
Entrant don't fight 1,9
chooses

fight 0,0
enter

incumbent
chooses don't 2,1
fight

Note that this exactly the same as the previous structure, just with di¤erent
labels on the strategies.

The equilibrium is for the entrant to enter and the incumbent not to …ght.

The incumbent would of course like to commit himself to …ght, i.e., cut price; if
he could credibly commit, then the potential entrant would know that the payo¤s
would be (0,0), and so would not enter in the …rst place.

One possible commitment mechanism might be building extra capacity; this low-
ers the costs of production, and therefore the cost of …ghting.

This changes the payo¤s.

Now the threat of …ghting is credible.

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 Figure: Entry Game with Changed Payo¤

A,B
incumbent fight 1,9
chooses

stay out
Entrant don't fight 1,9
chooses

fight 0,2
enter

incumbent
chooses don't 2,1
fight

This is potentially interesting, but it is also important to note that it takes fairly
detailed and specialized assumptions to make this outcome (no entry, continued
monopoly) the equilibrium.

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