Basic information

Education background：
2008.09-2012.06, Guangxi University, Bachelor
2012.09-2015.06, Northwest A&F University, Master
2015.09-2019.12, Northwest A&F University, Ph.D

Working experience：
2018.11-2020.10, Wageningen University & Research, Postdoc
2020.11 until now, Northwest A&F University, Associate professor
Wang Qian
E-mail: [email protected]
Tel: 15249210684

Research Interests:
Agricultural economic management, Land resource management

1
 Course requirements
• Compulsory course

• Class hours: 12 hours

• Attendance: sign in every time

• Exercise: Take your exercise book

• Take some notes and listen carefully

2
 Questions
• What did you learn in the last six weeks?
• Profit maximization

• Cost minimization

• Consumer theory

• Perfect competitive markets

• Imperfect competitive markets

• Which section do you like best?

• How much could you get from the lesson?

3
 Contents

• The teaching contents:

• Game theory

• Public goods

• Externalities

• Behavioral economics

4
Chapter 15 Game Theory

Qian Wang
E-mail: [email protected]
Telephone: 15249210684

5
 Contents
• 15.1 Introduction

• 15.2 Solution
• Solution concepts
• Nash equilibrium

• 15.3 Repeated game

• 15.4 Sequential games

• 15.5 Repeated games and subgame perfection

• 15.6 Games with incomplete information

6
• 15.1 Introduction

7
 15.1 Introduction
Questions
a) How much do you know about game theory?

b) How to get the game solution?

Rock-paper-scissors
Tian Ji, a general of Qi State, had a penchant for racing
horses. Once he made a deal with Duke Wei of Qi
State to have a horse race. They categorized their
horses into three classes: top, middle and low. This
time, both of them sent in the top, middle and low
classes of horses in order. As the horses of Duke were
better than those of Tian in every class, Tian lost8 all
Horse racing
three races.
 15.1 Introduction
More examples:
War
Marriage
Gambling
College admission
……

9
 15.1 Introduction
• Game theory was originally developed by the
Hungarian-born American mathematician John von
Neumann and his Princeton University colleague
Oskar Morgenstern, a German-born American
economist, to solve problems in economics.
• Game theory was further developed in the 1950s by
American mathematician John Nash, who
established the mathematical principles of game
theory, a branch of mathematics that examines the
rivalries between competitors with mixed interests.

Game theory emphasizes a study of cold-blooded "rational" decision-making,

since this is felt to be the most appropriate model for most economic behavior.
10
 15.1 Introduction
• Game theory is the study of interacting
decision makers. A game is a multi-person decision
situation, in which a person’s outcome is influenced
by other people’s decisions as well as his own.

Two leading frameworks for analyzing games:

Cooperative game theory assumes rational strategic behavior, unlimited communication,
and unlimited ability to make agreements. Its goal is to characterize the limits of the set of
possible agreements that might emerge from rational (possibly implicit) bargaining.

Noncooperative game theory replaces cooperative game theory’s assumptions of

unlimited communication and ability to make agreements with a detailed model of the
situation and of how rational players will behave in it. Its goal is to use rationality,
augmented by the “rational expectations” notion of Nash equilibrium, to predict or explain
outcomes in a situation. 11
 15.1 Introduction
Classification
• One person game
• One-person games are also known as games against nature. A person
deciding whether to carry an umbrella weighs the costs and benefits of
carrying or not carrying it.
• Two-person game
• Games of perfect information(Chess)
• Games of imperfect information(Poker)
• N-person game (Mixed strategies and the minimax theorem)

Most economic behavior can be viewed as special cases of game theory,

and a sound understanding of game theory is a necessary component of
any economist's set of analytical tools. 12
 15.1 Introduction
• Two ways for description: Extensive forms VS. Strategic form.

• Strategic form of the game is defined by exhibiting a set of players, a

set of strategies, the choices that each player can make, and a set of
payoffs that indicate the utility that each player receives if a particular
combination of strategies is chosen.
• Game matrix

13
 15.1 Introduction

• Game matrix

For purposes of exposition, we will treat two-person games in this

chapter. Each player knows his own payoffs and strategies, and the
other player's payoffs and strategies.

14
 15.1 Introduction
Example 1：Matching Pennies

Each player has a coin which he can arrange so Game matrix

that either the head side or the tail side is face-up.

We suppose that if both players show heads or

both show tails, then Row wins a dollar and
Column loses a dollar.

Constant sum game(Zero-sum game)

Zero-sum games, whose players have perfectly conflicting goals,

played a leading role in the development of the theory.

15
 15.1 Introduction
Example 2：The Prisoners’ Dilemma
• There were two prisoners who jointly
participated in a crime. They could
cooperate with each other and refuse to
give evidence, or one could defect and
implicate the other.

• The players can discuss the game in

advance but the actual decisions must be
independent.

• Variable-sum game(Non-zero-sum game)

16
 15.1 Introduction
Example 3：Cournot Duopoly
• We suppose that there are two firms who produce an identical good at zero
cost. Each firm must decide how much output to produce without knowing
the production decision of the other duopolist.

• If the firms produce a total of x units of the good, the market price will be
p(x); that is, p(x) is the inverse demand curve facing these two producers.

• If 𝑥𝑖 is the production level of firm i, the market price will then be 𝑝(𝑥1 +
𝑥2 ), and the profits of firm i are given by 𝑛𝑖 = 𝑝 𝑥1 + 𝑥2 𝑥𝑖 . In this game the
strategy of firm i is its choice of production level and the payoff to firm i is
its profits.

17
 15.1 Introduction
Example 4：Bertrand Duopoly
• Suppose that the strategy of each player is to announce the price at which
he would be willing to supply an arbitrary amount of the good in question.
• It is plausible to suppose that the consumers will only purchase from the
firm with the lowest price, and that they will split evenly between the two
firms if they charge the same price.

This game has a similar structure to that of the Prisoner's Dilemma. If both
players cooperate, they can charge the monopoly price and each reap half
of the monopoly profits. But the temptation is always there for one player to
cut its price slightly and thereby capture the entire market for itself. But if
both players cut price, then they are both worse off.
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 15.1 Introduction
Economic modeling of strategic choices
• In the Cournot game, the payoff to each firm is a continuous function of its
strategic choice;
• In the Bertrand game, the payoffs are discontinuous functions of the strategies.

• Which model is right?

It is probably more fruitful to ask what considerations are

relevant in modeling the set of strategies used by the agents.

✓ Strategies should be something that can be committed to or that are

difficult to change once the opponent's behavior is observed.

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• 15.2 Solution

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 15.2 Solution
Solution concepts
• Neither player wants the other player to be able to predict his choice
accurately.

• A solution to a game describes the optimal decisions of the players, who

may have similar, opposed, or mixed interests, and the outcomes that may
result from these decisions.

• Random strategy: Matching pennis

• Pure strategy: Strategies in which some choice is made with probability 1.
• Mixed strategy: is a probability distribution over all possible pure strategies.

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 15.2 Solution

• Exercise:

• Figure out the pure strategy for both players

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 15.2 Solution

• Exercise:

• Figure out the pure strategy for both players

23
 15.2 Solution
Solution concepts

• Pure strategy
• If R is the set of pure strategies available to Row, the set of mixed
strategies open to Row will be the set of all probability distributions over R,
where the probability of playing strategy r in R is 𝑝𝑟 . Similarly, 𝑝𝑐 , will be
the probability that Column plays some strategy c.

• In order to solve the game, we want to find a set of mixed strategies (𝑝𝑟 , 𝑝𝑐 )
that are in equilibrium. It may be that some of the equilibrium mixed
strategies assign probability 1 to some choices, in which case they are
interpreted as pure strategies.
24
 15.2 Solution
Solution concepts
• Each wants to maximize his or her expected utility given his or her beliefs.
Given my beliefs about what the other player might do, I choose the
strategy that maximizes my expected utility.

• Each player in the game knows that the other player is out to maximize his
own payoff, and each should use that information in determining what are
reasonable beliefs to have about the other player's behavior.

• The nature starting point in a search for a solution concept is standard

decision theory: Each player has some probability beliefs about the
strategies that the other player might choose and that each player choose
the strategy that maximized his expected payoff.
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 15.2 Solution
A standard decision-theoretic model
• The payoff to Row is 𝑢𝑟 (𝑟, 𝑐) if row plays r and Column plays c.
• Assume that Row has a subjective probability distribution over Column's
choices, 𝜋𝑐 , is supposed to indicate the probability, as envisioned by Row,
that Column will make the choice c. Column has some beliefs about Row's
behavior that we can denote by 𝜋𝑟 .
• Each player to play a mixed strategy and denote Row's actual mixed
strategy by (𝑝𝑟 ) and Column's actual mixed strategy by (𝑝𝑐 ).

• Row's probability that a particular outcome (r, c) will occur is 𝑝𝑟 𝜋𝑐 .

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 15.2 Solution
• One of the fundamental principles of game theory, the idea of
equilibrium strategies was developed by John F. Nash.

• Nash equilibrium, in game theory, an outcome in a

noncooperative game for two or more players in which no
player’s expected outcome can be improved by changing one’s
own strategy.

• A Nash equilibrium is a certain kind of rational expectations

equilibrium.

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 15.2 Solution
Nash equilibrium
• A Nash equilibrium consists of probability beliefs, (𝜋𝑟 , 𝜋𝑐 ) over strategies, and
probability of choosing strategies (𝑝𝑟 , 𝑝𝑐 ), such that:
• I) the beliefs are correct: 𝑝𝑟 = 𝜋𝑟 and 𝑝𝑐 = 𝜋𝑐 , for all r and c; and,
• 2) each player is choosing (𝑝𝑟 ) and (𝑝𝑐 ) so as to maximize his expected utility given
his beliefs.

• In equilibrium each player correctly foresees how likely the other player is to
make various choices, and the beliefs of the two players are mutually consistent.

• It is a pair of mixed strategies (𝑝𝑟 , 𝑝𝑐 ) such that each agent's choice maximizes
his expected utility, given the strategy of the other agent.

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 15.2 Solution
Nash equilibrium
• Pure strategy Nash equilibrium

• Mixed strategy Nash equilibrium

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 15.2 Solution
Nash equilibrium

• Pure strategies. A Nash equilibrium in pure strategies is a pair 𝑢𝑟 (𝑟 ∗, 𝑐 ∗

) such that 𝑢𝑟 (r*, c*) > 𝑢𝑟 (r, c*) for all Row strategies r, and 𝑢𝑐 (r*,c *) > 𝑢𝑐 (r*,c )
for all Column strategies c.

• If Row believes that Column will play c*, then Row’s best reply is r* and
similarly for Column. No player would find it in his or her interest to deviate
unilaterally from a Nash equilibrium strategy.
• If a set of strategies is not a Nash equilibrium then at least one player is not
consistently thinking through the behavior of the other player. That is, one of
the players must expect the other player not to act in his own self-interest——
ontradicting the original hypothesis of the analysis.

Note: There is no pure strategy Nash equilibrium in zero-sum game.

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 15.2 Solution
Nash equilibrium
• Pure strategies
• An equilibrium concept is often thought of as a "rest point" of some adjustment
process. One interpretation of Nash equilibrium is that it is the adjustment
process of "thinking through" the incentives of the other player.

• Row might think: "If I think that Column is going to play some strategy 𝑐1 then
the best response for me is to play 𝑟1 . But if Column thinks that I will play 𝑟1 ,
then the best thing for him to do is to play some other strategy 𝑐2 . But if Column
is going to play 𝑐2 , then my best response is to play 𝑟2 . . ." and so on.

• A Nash equilibrium is then a set of beliefs and strategies in which each player's
beliefs about what the other player will do are consistent with the other player's
actual choice.
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 15.2 Solution
Nash equilibrium
• Example: Battle of the Sexes

• Rhonda Row and Calvin

Column are discussing whether
to take microeconomics or
macroeconomics this semester. Find the pure strategy equilibria?
• Rhonda gets utility 2 and Calvin
gets utility 1 if they both take
micro; the payoffs are reversed
if they both take macro. If they
take different courses, they both
get utility 0.

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 15.2 Solution
Nash equilibrium
• Exercise1(5 minutes):
• Two California teenagers Bill and
Ted are playing Chicken. Bill
drives his hot rod south down a
one-lane road, and Ted drives his
hot rod north along the same Questions:
road. Each has two strategies: (a) Find all pure strategy equilibria.
Stay or Swerve. If one player
chooses Swerve he looses face; if
both Swerve, they both lose face.
However, if both choose Stay,
they are both killed. The payoff
matrix for Chicken looks like this:
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 15.2 Solution
Nash equilibrium
• Mixed strategy Nash equilibrium for battle of sexes
• Let (𝑝𝑡 , 𝑝𝑏 ) be the probabilities with which Row plays Top and Bottom, and
define (𝑝𝑙 , 𝑝𝑟 ) in a similar manner. Then Row's problem is

Let A, 𝑝𝑡 , and 𝑝𝑏 be the Kuhn-Tucker multipliers on the constraints, so

that the Lagrangian takes the form:
First-order condition

34
 15.2 Solution

• Since we already know the pure strategy solutions, we only consider the
case where 𝑝𝑡 > 0 and 𝑝𝑏 > 0. The complementary slackness conditions
then imply that 𝑝𝑡 = 𝑝𝑏 = 0. Using the fact that 𝑝𝑙 + 𝑝𝑟 = 1, we easily see
that Row will find it optimal to play a mixed strategy when 𝑝𝑙 =
1Τ 𝑎𝑛𝑑 𝑝 = 2Τ .
3 𝑟 3

• Following the same procedure for Column, we find that 𝑝𝑡 = 2Τ3 and 𝑝𝑏 =
1Τ .
3

35
 15.2 Solution
Nash equilibrium
• Exercise1(10 minutes)
• Two California teenagers Bill and
Ted are playing Chicken. Bill drives
his hot rod south down a one-lane
road, and Ted drives his hot rod Questions:
north along the same road. Each (b) Find all mixed strategy equilibria.
has two strategies: Stay or Swerve. (c) What is the probability that both teenagers
If one player chooses Swerve he will survive.
looses face; if both Swerve, they
both lose face. However, if both
choose Stay, they are both killed.
The payoff matrix for Chicken
looks like this:
36
 15.2 Solution
• 1) Will a Nash equilibrium generally exist;

Nash (1950) showed that with a finite number of agents and a finite number
of pure strategies, an equilibrium will always exist.

It may, of course, be an equilibrium involving mixed strategies.

2) Will the Nash equilibrium be unique?

Uniqueness, however, is very unlikely to occur in general.

37
 15.2 Solution
• Dominant strategy
• Let 𝑟1 and 𝑟2 be two of Row‘s strategies. We say that 𝑟1 strictly dominates 𝑟2 for
Row if the payoff from strategy 𝑟1 is strictly larger than the payoff for 𝑟2 no matter
what choice Column makes.

• The strategy 𝑟1 weakly dominates 𝑟2 if the payoff from 𝑟1 is at least as large for
all choices Column might make and strictly larger for some choice.

• A dominant strategy equilibrium is a choice of strategies by each player such

that each strategy (weakly) dominates every other strategy available to that
player.

• Note: A dominant strategy equilibrium is a Nash equilibrium, but not all Nash equilibria
are dominant strategy equilibria. 38
 15.2 Solution
• Elimination of dominated strategies
• When there is no dominant strategy equilibrium, we have to resort to the
idea of a Nash equilibrium. But typically there will be more than one Nash
equilibrium. Our problem then is to try to eliminate some of the Nash
equilibria as being "unreasonable."

When given a game, we should first eliminate all strategies that are
dominated and then calculate the Nash equilibria of the remaining game.
This procedure is called elimination of dominated strategies; it can
sometimes result in a significant reduction in the number of Nash equilibria.

39
 15.2 Solution
• Example: Elimination of dominated strategies

Note that there are two pure strategy Nash

equilibria, (Top, Left) and (Bottom, Right).
However, the strategy Right weakly dominates
the strategy Left for the Column player.

Elimination of strictly dominated strategies is generally agreed to be an

acceptable procedure to simplify the analysis of a game. Elimination of weakly
dominated strategies is more problematic; there are examples in which
eliminating weakly dominated strategies appears to change the strategic nature of
the game in a significant way.
40
 15.2 Solution
• Exercise
• Find out the dominated strategy.
• What are the Nash equilibria of the following game after one eliminates
dominated strategies

41
• 15.3 Repeated game

42
 15.3 Repeated games
• Give me one more time, I will……
• Next time, I will……

• It was not appropriate to expect that the outcome of a repeated game with
the same players as simply being a repetition of the one-shot game.

• Each player can determine his or her choice at some point as a function of
the entire history of the game up until that point.

• My opponent can modify his behavior based on my history of choices, I must

take this influence into account when making my own choices.
43
 15.3 Repeated games
• The situation is quite different in a repeated game with an infinite number of
repetitions. In this case, at each stage it is known that the game will be
repeated at least one more time and therefore there will be some (potential)
benefits to cooperation.

• The payoffs in the repeated game are the discounted sums of the payoffs at
each stage. If a player gets a payoff at time t of 𝑢𝑡 , his payoff in the repeated
game is taken to be σ∞ 𝑡
𝑡=0 𝑢𝑡 (1 + 𝑟) ,where r is the discount rate.

• As long as the discount rate is not too high there exists a Nash equilibrium pair
of strategies such that each player finds it in his interest to cooperate at each
stage.

44
 15.3 Repeated games

Cooperate on the current move unless the other player defected on the last
move. If the other player defected on the last move, then Defect forever.

• Punishment strategy
• In a repeated Prisoner’s Dilemma any payoff larger than the payoff received if
both parties consistently defect can be supported as a Nash equilibrium.

• Maintaining a cartel
45
• 15.4 Sequential games

46
 15.4 Sequential games
In many situations at least some of the choices are made
sequentially, and one player may know the other player's choice
before he has to make his own choice.

Example: A monopolist gets to observe consumer demand behavior

before it produces output, or a duopolist may observe his opponent's
capital investment before making its own output decisions, etc.

47
 15.4 Sequential games
Game tree: This is simply a diagram that indicates the choices that each
player can make at each point in time. The payoffs to each player are
indicated at the "leaves" of the tree.

This illustrates the payoffs when Row gets to move first.

48
 15.4 Sequential games
Once a choice has been made, the players are in a subgame consisting of the
strategies and payoffs available to them from then on.

Only one of the two Nash equilibria satisfies the condition that it is not only an
overall equilibrium, but also an equilibrium in each of the subgames. A Nash
equilibrium with this property is known as a subgame perfect equilibrium.

49
 15.4 Sequential games
The extensive form of the game is also capable of modeling situations where
some of the moves are sequential and some are simultaneous.

The information set of an

agent is the set of all nodes of
the tree that cannot be
differentiated by the agent.

The extensive form of a game can be used

to model everything in the strategic form
The shaded area indicates that
plus information about the sequence of
Column cannot differentiate which
choices and information sets.
of these decisions Row made at the
time when Column must make his
50
own decision.
 15.4 Sequential games
• Example: A simple bargaining model
Two players, A and B, have $1
𝛼=𝛽<1
to divide between them. They
agree to spend at most three
days negotiating over the
division.

Rule: The first day, A will make

an offer, B either accepts or
comes back with a counteroffer
the next day, and on the third
day A gets to make one final
offer. If they cannot reach an
agreement in three days, both
players get zero.
51
 15.4 Sequential games
• Example: A simple bargaining model
𝛼=𝛽<1

The heavy line connects together the 15.3

equilibrium outcomes in the subgames. The
point on the outermost line is the subgame-
perfect equilibrium.
52
 15.4 Sequential games
• Example: A simple bargaining model
𝛼=𝛽<1
What happens in the infinite game?
The final equilibria

Note: If a = 1 and ,b <1, then player A

receives the entire payoff.
The heavy line connects together the 15.3
equilibrium outcomes in the subgames. The
point on the outermost line is the subgame-
perfect equilibrium. 53
• 15.5 Repeated games and subgame perfection

54
 15.5 Repeated games and subgame perfection
• A somewhat less harsh strategy is known as Tit-for-Tat: start out
cooperating on the first play and on subsequent plays do whatever your
opponent did on the previous play. In this strategy, a player is punished for
defection, but he is only punished once. In this sense Tit-for-Tat is a
"forgiving“ strategy.

• A natural criterion is to eliminate strategies that are "too complex." Although

some progress has been made in this direction, the idea of complexity is an
elusive one, and it has been hard to come up with an entirely satisfactory
definition.

55
• 15.6 Games with incomplete information

56
 15.6 Games with incomplete information
• If one agent doesn't know the payoffs of the other agent, then the Nash
equilibrium doesn't make much sense.
• One approach is to subsume all of the uncertainty that one agent may have about
another into a variable known as the agent’s type.
• For example, one agent may be uncertain about another agent’s valuation of some good,
about his or her risk aversion and so on. Each type of player is regarded as a different player
and each agent has some prior probability distribution defined over the different types of
agents.

• A Bayes-Nash equilibrium of this game is a set of strategies for each type of

player that maximizes the expected value of each type of player, given the
strategies pursued by the other players.
• In a simultaneous-move game, this definition of equilibrium is adequate. In a
sequential game it is reasonable to allow the players to update their beliefs about
the types of the other players based on the actions they have observed
57
 Exercise
• Consider the following coordination game

(a) Calculate all the pure strategy equilibria of this game.

(b) Do any of the pure strategy equilibria dominate any of the others?
(c) Suppose that Row moves first and commits to either Top or Bottom.
(d) What are the subgame perfect equilibria of this game?

58