Module 1: Introduction to Game Theory

Syllabus:
1.1 Introduction, The theory of rational choice, Games with Perfect Information, Nash
Equilibrium: Theory, Prisoner’s Dilemma, Stag Hunt, Matching pennies, BOS, Multi NE,
Cooperative and Competitive Games, Strict and Non Strict NE, Best response functions for
NE.
1.2 Nash Equilibrium: Illustrations, Cournot’s model of oligopoly, Bertrand’s model of
oligopoly, Electoral competition, The War of Attrition, Auctions, Mixed Strategy
Equilibrium, Strategic games in which players may randomize, Dominated actions, Extensive
Games with Perfect Information
 Introduction to Game Theory
 Definition: Game theory is the formal study of strategic interactions among rational
decision-makers (players).

 Key Elements: A game is defined by players, their possible actions (strategies), the potential
outcomes, and the payoffs each player receives from each outcome.

 Origins: The field was formalized by John von Neumann and Oskar Morgenstern in their
1944 book,

Theory of Games and Economic Behavior

. John Nash later introduced the key concept of the Nash Equilibrium.

The Theory of Rational Choice

 Assumption: Game theory assumes that players are rational agents, meaning they aim to
maximize their own expected payoff (utility) given the available information and the actions
of others.

 Common Knowledge: It is generally assumed that each player knows the other players are
rational, and this is common knowledge among all players.

Games with Perfect Information

 Definition: A game has perfect information if every player, at each point where they make a
decision, is perfectly informed of all the events that have previously occurred, including the
"initialization event" of the game.

 Examples: Chess is a game with perfect information. Poker is a game with imperfect
information because players do not know all the cards held by opponents.

 Representation: These games are often represented in extensive form (using a decision
tree).

Nash Equilibrium (NE): Theory

 Definition: A Nash Equilibrium is a set of strategies (one for each player) such that no
player can increase their payoff by unilaterally changing their own strategy, assuming the
other players' strategies remain fixed.

 Stability: It represents a stable outcome where each player is making their best possible
decision given what everyone else is doing; no one has an incentive to deviate.
 Pure vs. Mixed Strategy NE: A pure strategy NE involves players choosing a specific action
with certainty. A mixed strategy NE involves players choosing a random strategy (e.g.,
flipping a coin).

Classic Game Examples and NE

 Prisoner's Dilemma:

o Scenario: Two suspects are arrested and offered a deal: betray the other for a lighter
sentence, or remain silent.

o NE: The single Nash Equilibrium is for both players to defect (confess/betray), even though
both would be better off if they both cooperated (remained silent).

 Stag Hunt:

o Scenario: Two hunters can hunt a stag (requires cooperation) or a hare (can hunt alone). A
stag provides much more food.

o NE: There are two Nash Equilibria in pure strategies: (Stag, Stag) and (Hare, Hare). It
illustrates the conflict between safety and social cooperation.

 Matching Pennies:

o Scenario: Two players choose "Heads" or "Tails" simultaneously. Player 1 wins if they
match, Player 2 wins if they don't.

o NE: This game has no pure strategy NE but has a mixed strategy NE. It is a purely
conflictual, zero-sum game.

 BOS (Battle of the Sexes):

o Scenario: A couple wants to go to an event (e.g., Ballet or Sports), but prefer to go together.

o NE: There are two pure strategy Nash Equilibria (e.g., both go to the Ballet, or both go to
Sports).

Cooperative and Competitive Games

 Cooperative Games: Players can make binding agreements and form coalitions to
coordinate strategies and maximize collective outcomes.

 Competitive/Non-Cooperative Games: Binding agreements are not allowed. Players act

independently to maximize their own self-interest. The analysis of NE primarily falls under
non-cooperative game theory. Games like Matching Pennies are strictly competitive.
 Strict and Non-Strict NE
 Strict Nash Equilibrium: A NE is strict if a player's chosen strategy is the only best
response to the other players' strategies. Any deviation would lead to a strictly worse payoff.

 Non-Strict (Weak) Nash Equilibrium: An NE is non-strict if a player has at least one other
alternative strategy that yields the same payoff as their equilibrium strategy (but no better
payoff).

Best Response Functions for NE

 Best Response: A player's best response is the strategy that yields the highest payoff, given
the strategies chosen by all other players.

 Finding NE: A Nash Equilibrium occurs at an action profile where every player's chosen
strategy is a best response to the strategies of all the other players. Plotting best response
functions can graphically show where they intersect, indicating the NE.
 Cournot’s Model of Oligopoly
 Strategic Variable: Firms compete by simultaneously choosing the quantity of
homogeneous goods to produce.

 Market Outcome: The market price is determined by the total quantity produced by all firms
through the inverse demand function.

 Nash Equilibrium: The Cournot-Nash equilibrium is the intersection of the firms' best-
response functions (reaction curves), where each firm's output is its profit-maximizing
quantity given the other firms' outputs.

 Outcome: The equilibrium price is typically above the perfect competition level (marginal
cost) but below the monopoly price.

Bertrand’s Model of Oligopoly

 Strategic Variable: Firms compete by simultaneously choosing the price for a homogeneous
product.

 Market Outcome: Consumers buy from the firm with the lowest price. If prices are equal,
firms share the demand.

 Nash Equilibrium: The unique Nash equilibrium is for all firms to set their price equal to
their marginal cost (p = MC).

 Outcome: This results in the same outcome as perfect competition (the "Bertrand paradox"),
even with only two firms, because firms undercut each other until price equals cost.

Electoral Competition
 Concept: Game theory models can illustrate how political candidates choose platforms to
maximize their votes.

 Nash Equilibrium: The Median Voter Theorem is a key result, suggesting that in a one-
dimensional policy space, the only Nash equilibrium is for both candidates to choose the
policy position of the median voter to capture the most votes.

The War of Attrition

 Concept: A dynamic game where players expend resources (attrition) over time to win a
prize, and the player who "holds out" the longest wins.

 Nash Equilibrium: This game often features mixed-strategy equilibria or multiple equilibria,
depending on the specific payoffs and time horizons. The key is that a player's optimal
 strategy depends heavily on their valuation of the prize and their belief about the opponent's
staying power.

Auctions
 Concept: Various auction formats (e.g., first-price, second-price) can be analyzed using Nash
equilibrium.

 Nash Equilibrium: Bidding strategies in auctions constitute a Nash equilibrium if each

bidder's bid maximizes their expected payoff, given the bids of the others. For example, in a
second-price (Vickrey) auction, bidding one's true valuation is a dominant strategy, which is
a stronger condition than Nash equilibrium.

Mixed Strategy Equilibrium

 Concept: In some games, no pure strategy Nash equilibrium exists (e.g., Matching Pennies).
A mixed strategy allows players to choose a probability distribution over their available
actions.

 Nash Equilibrium: A mixed strategy Nash equilibrium is a profile of mixed strategies where
each player is indifferent between their pure strategies and no player can improve their
expected payoff by changing their probabilities.

Strategic Games in which Players May Randomize

 Concept: This formalizes the idea of mixed strategies. Players use randomization to make
their behavior unpredictable, which can be optimal when their opponent's best response
depends on knowing their action ahead of time (as in zero-sum games).

Dominated Actions
 Concept: A dominated action is a strategy that always yields a lower payoff than another
available strategy, regardless of what the other players do.

 Use in Nash Equilibrium: Rational players will never choose a strictly dominated action.
Identifying and eliminating dominated actions can simplify a game and help find the Nash
equilibrium(s).

Extensive Games with Perfect Information

 Concept: These are dynamic games (played over time) where every player, when making a
decision, is fully informed of all events that have previously occurred. The game is typically
represented by a game tree.
 Solution Concept: The primary solution concept for these games is subgame perfect Nash
equilibrium (SPNE), which uses backward induction to find a Nash equilibrium that is also a
Nash equilibrium in every subgame.