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GAME THEORY & APPLICATIONS

J. Ajith Kumar, TAPMI, Manipal
Extensive Games with Perfect Information

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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THE ULTIMATUM GAME

Two players A and B have to share Rs. 100 between

themselves. The game is played as follows. Player A offers a
share of the Rs. 100 to Player B say Rs. X. Player B can
choose to accept or decline the offer. If Player B accepts the
offer, then she gets the Rs. X, while Player A gets Rs. 100X. If
Player B declines the offer, both players get nothing.
For example, assume that Player A offers Rs. 27 to Player B. If
Player B accepts it, then Player A gets Rs. 73 and Player B, Rs.
27. If Player B declines, then both players get Rs. 0.
Lets play this game between ourselves!

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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ENTRY GAME
Read Problem 1 of Exercise Set D.
Challenger
Out

In
Incumbent
Acquiesce
2, 1

Fight

1, 2

0, 0

Set of Players
(Challenger, Incumbent)
Decision node: A node where a player chooses an action
Terminal node: A terminal point at the end of a sequence of actions.
Terminal history: a sequence of actions that leads to a terminal node.
(In, Acquiesce), (In, Fight), (Out)
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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ENTRY GAME
Player function: a function that assigns a player to every node in the game.
A node can be represented by the sub-history of the game that precedes it.
P() = Challenger, P(In) = Incumbent.
Action sets available
This is specified node-wise, not player-wise
A() = {In, Out}, A(In) = {Acquiesce, Fight}
Preferences of the players

Represents for each player, his payoff for each terminal history in the game.
If A denotes the Challenger and B, the Incumbent, then,
uA(In, Acquiesce) = 2; uA(In, Fight) = 0; uA(Out) = 1
uB(In, Acquiesce) = 1; uB(In, Fight) = 0; uB(Out) = 2

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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EXERCISE Problem 2 of Exercise Set D.

C
2
E

2
F

2, 1

3, 4

4, 3

1, 2
1

EXERCISE Problem 3 of Exercise Set D.

C

Players: 1, 2.

2, 0

Terminal histories: (C, E, G), (C, E, H), (C, F), (D). 1

Player functions:
P() = 1, P(C) = 2, P(C, E) = 1

G
1, 2

3, 1

H
0, 0

Player preferences:
u1(CG, E) = 1, u1(C, E, H) = 0, u1(C, F) = 3, u1(D) = 2.
u2(C, E, G) = 2, u1(C, E, H) = 0, u1(C, F) = 1, u1(D) = 0.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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EXERCISE Problem 4 of Exercise Set D.

Karl
E

R
Rosa
B

Ernesto
H

Ernesto

Ernesto
H

B
2, 3, 2

1, 1, 1

B
1, 1, 1

H
3, 2, 3

B
Rosa
B
2, 3, 2

H
H
1, 1, 1

Rosa

B
1, 1, 1

H
3, 2, 3

Players: Karl, Rosa, Ernesto (the utilities are listed in this order).
Terminal histories:
(R, B, B), (R, B, H), (R, H, B), (R, H, H), (E, B, B), (E, B, H), (E, H, B), (E, H, H).
Player functions:
P() = Karl, P(R) = Rosa, P(E) = Ernesto, P(R, B) = Ernesto, P(R, H) = Ernesto.
Player preferences:
Write them.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Strategies and Outcomes

in extensive games with perfect information

A players strategy specifies the action the player chooses

for every history after which it is her turn to move.
In other words, a players strategy reveals the action she
takes at each of the nodes at which it is her turn to move.

Strategies of Player 1
{C, D}
Strategies of Player 2
{EG, EH, FG, FH}

1
2
E
2, 1

Strategy profiles in the game

(C, EG), (C, EH), (C, FG), (C, FH),
(D, EG), (D, EH), (D, FG), (D, FH)
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

2
F
4, 3

G
3, 4

H
1, 2

Here, strategy does

not mean plan of
action.

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Strategies and Outcomes

in extensive games with perfect information

A strategy profile is as if each player has

decided before hand the action that she
would take if the game reaches each node
where she has to make a move.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Strategies and Outcomes

in extensive games with perfect information
1

The terminal history of a

strategy profile is called
the outcome of that
strategy profile.

C
2
E
2, 1

2
F
4, 3

G
3, 4

H
1, 2

For strategy profile s, outcome O(s) is the terminal

history of s.
O(C, EG) = (C, E).
O(D, EH) = (D, H).
O(C, FH) = (C, F).
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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EXERCISE
Problem 6, 7 of Exercise Set D.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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0

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Finding NE by converting to strategic form

Problem 8 of Exercise Set D.

Challenger

Acquiesce

Out

In

Fight

In

Incumbent

Out

CHALLENGER

INCUMBENT

2, 1

1, 2

0, 0

1, 2

Acquiesce
2, 1

Fight

1, 2

0, 0

How do we interpret (Out, Fight) as a NE?

o (out, fight) is not a robust steady state. Why?
o fight is not a credible threat to the challenger, since the
challenger knows that if it enters, the incumbent is better off
choosing acquiesce.
o (In, Acquiesce) is a robust steady state and can be expected.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Nash Equilibrium of an Extensive Game

A strategy profile s* in an extensive game with perfect information

is a Nash Equilibrium iff for every player i, his payoff is at least
good as those in another profile (ri, s-i*) where ri is any strategy of
player i and s-i* is the set of strategies of other players in s*.
i.e. ui[ O(s*) ] ui[ O(ri, s-i*) ] for all i.

EXERCISE Problem 9 of Exercise Set D.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Question
Is it practical to always convert an extensive game
to its strategic form and solve for Nash
Equilibrium?

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Voting By Alternating Veto Problem 10 in Exercise Set D.

1
X

2
Y
1, 3

2
2

2, 2

1, 3

X
2, 2

3, 1

3, 1

YXX

YXY

YZX

YZY

ZXX

ZXY

ZZX

ZZY

1, 3

1, 3

1, 3

1, 3

2, 2

2, 2

2, 2

2, 2

1, 3

1, 3

3, 1

3, 1

1, 3

1, 3

3, 1

3, 1

2, 2

3, 1

2, 2

3, 1

2, 2

3, 1

2, 2

3, 1

There are two Nash equilibria: (Z, YXX) and (Z, ZXX).
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Subgame Perfect Equilibrium

Problem 11b in Exercise Set D.
This game has 4
subgames. The full
game (with subhistory ) is a subgame. The other
three subgames are:

1
2

1, 3

2, 2

1, 3

2, 2

1, 3

X
Z

3, 1

1, 3

2, 2

Y
3, 1

2
Z

Y
Z

2
Y

X
3, 1

2, 2

Y
3, 1

There are two Nash equilibria of the full game: (Z, YXX) and (Z, ZXX).
Which of these is subgame perfect?
First ask: What are the NEs of each of the subgames?
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Subgame Perfect Equilibrium (SPE)

Problem 11b in Exercise Set D.

A subgame perfect equilibrium is a strategy profile s* of the full

game such that for each player i, who plays ri* in s*, the payoff
obtained from the corresponding portion of s* in any subgame of
the full game, is at least as good as what he would obtain by
choosing an alternative strategy ri, given that all other players
collectively play s -i*.
Each subgame perfect equilibrium is a Nash Equilibrium.
However, each Nash Equilibrium need not be subgame perfect.
A subgame perfect equilibrium is a strategy profile
that induces a Nash equilibrium in every subgame.
In the above game, (Z, YXX) is a subgame perfect equilibrium,
whereas (Z, ZXX) is not.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Subgame Perfect Equilibrium (SPE)

Problem 12 in Exercise Set D.
Which NE of this game are SPE? Why?

E
CG

1, 2

3, 1

2, 0

E
1

CH

0, 0

3, 1

DG

2, 0

2, 0

DH

2, 0

2, 0

G
1, 2

3, 1

H
0, 0

There are three NE in the game: (CH, F), (DG, E), (DH, E).
Of these, only (DG, E) is Subgame perfect.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Subgame Perfect Equilibrium (SPE)

Interpretations
C

q As the outcome of the

players rational calculations
about each others strategies.

2, 0

E
1
G
1, 2

3, 1

H
0, 0

There may be parts of a players strategy that are inconsistent with

other parts however these can thought of as that players belief
about what other players think the focal player will do, if the
history preceding that action is played out.
E.g. (DG, E) is the SPE of the above game. If D is actually played by Player 1,
then Player 2 will not play E, nor will Player 1 ever play G However, the SPE can
be thought of as reflecting Player 1s belief that if he plays C, then Player 2 will
play E after reasoning that Player 1 will play G if the history CE is played out.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Subgame Perfect Equilibrium (SPE)

Interpretations

1
C

2, 0

E
1
G
1, 2

3, 1

H
0, 0

q A slightly perturbed steady state in which all players, on rare

occasions, take non-equilibrium actions, so that after long
experience each player forms correct beliefs about entire
players other strategies. Thus, each player knows how the
other players will behave in every subgame. Given these
beliefs, no player wishes to deviate from her strategy either at
the start of the game or after any history.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Backward Induction
A procedure to locate Subgame Perfect Equilibria
1

C
2

E
2, 1

3, 0

0, 2

H
1, 3

1 2, 1
2

E
2, 1

2, 1

1, 3

G
3, 0

0, 2

H
1, 3

Subgame perfect equilibrium : (C, EH)

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Backward Induction
A procedure to locate Subgame Perfect Equilibria

Length of a subgame: length of the longest history in the subgame

q Find optimal actions of players who move in subgames of length
1.
q Moving back: Take these actions as given and then find the
optimal actions of players in subgames of length 2. In general,
first find optimal actions in subgame of length k and then in that
of length k+1.
q If there are multiple optimal actions for a given subgame, then
retain all of them.
q Repeat the procedure until we complete the full game.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Backward Induction

Identify the subgame perfect

equilibria in this game using
backward induction

E
2, 1

1, 1

2, 0

H
1, 0

There are 4 combinations of player 2s

optimal actions: EG, EH, FG, FH
For each combination, what is Player
1s optimal action?

C
2

E
2, 1

F
1, 1

2, 0

1, 0

For EG, it is both C and D. For EH, it is only C. For FG, it is only D. For FH, it is
both C and D.
The subgame perfect equilibria are:(C, EG), (D, EG), (C, EH), (D, FG), (C, FH) and (D, FH).
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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Backward Induction
Two important realizations
Backward induction identifies only the subgame
perfect equilibria of the game. It cannot find Nash
Equilibria that are not subgame perfect.
Possible only in games of finite horizon. Games of
infinite horizon cannot provide a definite starting
point that backward induction needs.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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How Burning Bridges poses a credible threat

Problem 14 of Exercise Set D

The enemy knows that you have no option but to fight

and hence you will certainly fight. This means that
attacking would lead to a worse outcome for the
enemy than not attacking.
Assignment
Model as a simple entry game in which the incumbent
signals the new entrant that he will increase the
industry capacity or decrease the selling price and tries
to create a credible threat.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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More challenging exercises

q Entry game- multiple periods (Prob 15 of Ex Set D)
q Firm-union Bargaining (Prob 16 of Ex Set D)
q Synergistic Relationship (Prob 17 of Ex Set D)

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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STRATEGIC THINKING & GAME THEORY

Three ways one can be cheated in a partnership

q Adverse Selection: When the partner makes false claims

about his skills, abilities and resources, while entering into the
partnership.
q Moral Hazard: When the partnership is underway, the partner
offers less than what he promised at the beginning.
q Hold-up: When the partner misuses the power he has gained
after one (but not the partner) has made a transaction-specific
investment into the partnership.

Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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THE ULTIMATUM GAME

Two players A and B have to share Rs. 100 between themselves. The game is played as
follows. Player A offers a share of the Rs. 100 to Player B say Rs. X. Player B can
choose to accept or decline the offer. If Player B accepts the offer, then she gets the Rs.
X, while Player A gets Rs. 100X. If Player B declines the offer, both players get nothing.

Assume that player 1 can make only discrete offers, in multiples of

p, with the highest offer possible being 100, and the lowest, 0.

What are the NE and SPE of this game?

There are many NEs in the game given by the family Player 1 plays x
and Player 2 plays accept x, reject offers below x, either accept or reject
offers above x i.e. ...ARRRRR. Yet another NE is: Player 1 plays 0
and Player 2 plays reject all offers, i.e. (0, RRRRRR).

Only 2 of these are SPEs:

Player 1 plays the strategy 0 and Player 2, accept whatever
player 1 offers, i.e. AAAAA AA.
Player 1 plays the strategy p (lowest offer above 0) and
Player 2, accept whatever player 1 offers, except 0, i.e.
AAAAA
AR.
Prof. J. Ajith Kumar, TAPMI, Manipal
GAME THEORY NOTES

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THE ULTIMATUM GAME

Assume that Plr 1 can make continuous offers
with the highest offer possible being 100, and
the lowest, 0. Plr 2 can do A or R.

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1
X
2
Y
100-X, X

N
0, 0

Plr 1s actions are continuous, while Plr 2s are discrete.

What are the NE and SPE of this game?

Again many NEs in the game given by:
Player 1 plays x and Player 2 plays accept x, reject everything
below x and accept or reject offers above x and
Player 1 plays 0 and Player 2 plays reject all offers.

But, there is only 1 SPE:

Player 1 plays the strategy 0 and Player 2, accept whatever
player 1 offers, i.e. AAAAA AA.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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THE ULTIMATUM GAME

What it demonstrates

Aims to model peoples thinking in situations where they need to

work with each other in alliances and/or teams and sharing of
efforts and payoffs is involved.
Models relationships where one partner has a stronger say in the
how the pie is divided between the two, while the other only has
a power to nullify the pie. Can be relationships between people,
communities, social classes, organizations, countries.
q In a stable equilibrium, one partner completely dominates the
other and exploits him to the extreme.
q The equilibrium will not be reached if both partners perceive
each other to be equally powerful, and/or if either or both
partners have a sense of fear of rejection, sense fairness or
sense of equity.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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The Hold-up Game

Problem 5 of Exercise Set E

1
X

2
A
X-H, CH-X

2
R
-H, 0

A
X-L, CL-X

R
-L, 0

Subgame Perfect Equilibrium

(L AAAAAAAAA A, 0) leading to the payoffs (L, CL)
Person 2 exerts effort L resulting in the smaller sized pie of size
CL. Person 1 offers 0 amount to Person 2 and takes the small
pie all for himself.
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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The Hold-up Game

Problem 5 of Exercise Set E

1
X

2
A
X-H, CH-X

2
R
-H, 0

A
X-L, CL-X

R
-L, 0

Lessons: When human beings act perfectly rational in the Homo Economicus
sense, it can lead to an outcomes that are sub-optimal for all. Here, Person 2
knows that Person 1 will try to grab the entire pie produced for himself, hence
Person 2 is not motivated to produce a large pie.

If Person 1 (manager) is an exploiter and Person 2

(worker) knows so, then both become losers.
Prof. J. Ajith Kumar, TAPMI, Manipal

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The Hold-up Game

Problem 5 of Exercise Set E

q Workers in a factory, who know that if they work hard, their owners will
make a large profit. From past experience, they also know that the owners
will appropriate most of it and give very little to the workers. The workers
ask why should we work so hard? and compromise on their work,
leading to lesser productivity and lower quality. As a result, owners will
make lesser profit, and will share even less with workers. Everyone loses.
Who should take the first step?
q Corrupt politicians, IAS officers and leaders vs. staff working under them in
government offices. Smaller pie means that the whole country suffers.
Who should take the first step?
q Two companies A and B entering into a strategic alliance. Suppose B has to
invest irreversibly in a large fixed asset as part of the alliance, A can do a
hold-up on B after the investment is made. Suspecting this, B will be very
cautious in entering into an alliance with A. As a result, the likelihood of
alliance formation decreases and potential benefit is lost.
Who should take the first step?
Prof. J. Ajith Kumar, TAPMI, Manipal

GAME THEORY NOTES

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The Centipede Game

Problem 6 in Exercise Set E.
C

2, 0

1, 3

4, 2

3, 5

6, 4

5, 7

8, 6

7, 9

10, 8

What is the SPE?

If players are made to play this game, will they
actually play the SPE? Explain.

Prof. J. Ajith Kumar, TAPMI, Manipal

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The Centipede Game

Problem 6 in Exercise Set E.

Demonstrates how people reason about others application of

rationality in real-life situations. Each person can potentially
think what are other people more likely to do? Stop or
Continue? If they are likely to continue, then I need not stop
here too. But if they are highly likely to continue in the next
round, let me continue too!
Shows how people trade-off between short-term rational
outcomes, and larger long-term not-rational outcomes.
Individual greed and mistrust between people can hamper larger
outcomes for everyone that can accrue if there is long-term
cooperation and understanding.

Prof. J. Ajith Kumar, TAPMI, Manipal

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