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Lecturenotesongametheory Lecture Notes on Game Theory Theory and Examples Xiang Sun November 2, 2017 ii Contents Acknowledgement vii 1 Introduction 1 1.1 Timeline of the main evolution of game theory ................................ 1 1.2 Nobel prize laureates .............................................. 16 1.3 Potential Nobel prize winners ......................................... 19 1.4 Rational behavior ................................................ 20 1.5 Common knowledge .............................................. 20 2 Strategic games with complete information 23 2.1 Strategic games ................................................. 23 2.2 Nash equilibrium ................................................ 24 2.3 Examples .................................................... 25 2.4 Existence of a Nash equilibrium ........................................ 42 2.5 Symmetric games ................................................ 43 2.6 Strictly competitive games (zero-sum games) ................................. 44 2.7 Contest ..................................................... 45 2.8 Strategic games with discontinuous payoff functions ............................. 47 3 Bayesian games 49 3.1 Bayes’ rule (Bayes’ theorem) .......................................... 49 3.2 Bayesian games ................................................. 50 3.3 Examples .................................................... 54 3.4 Bilateral trading (Double auction) ....................................... 66 3.5 Providing a public good under incomplete information ........................... 71 i Contents ii 3.6 Comments on Bayesian games ......................................... 71 4 Auction 75 4.1 Preliminary ................................................... 75 4.2 The symmetric model ............................................. 77 4.3 Second-price sealed-bid auction ........................................ 77 4.4 First-price sealed-bid auction ......................................... 78 4.5 Revenue comparison .............................................. 86 4.6 Reserve prices ................................................. 88 4.7 The revenue equivalence principle ....................................... 91 4.8 All-pay auction ................................................. 92 4.9 Third-price auction ............................................... 93 4.10 Uncertain number of bidders ......................................... 95 5 Mixed-strategy Nash equilibrium 97 5.1 Mixed-strategy Nash equilibrium ....................................... 97 5.2 Examples .................................................... 99 5.3 Interpretation of mixed-strategy Nash equilibrium .............................. 102 5.3.1 Purification .............................................. 103 6 Correlated equilibrium 109 6.1 Motivation ................................................... 109 6.2 Correlated equilibrium ............................................. 110 6.3 Examples .................................................... 113 7 Rationalizability 117 7.1 Rationalizability ................................................ 117 7.2 Iterated elimination of never-best response .................................. 121 7.3 Iterated elimination of strictly dominated actions .............................. 122 7.4 Examples .................................................... 125 7.5 Iterated elimination of weakly dominated actions .............................. 128 8 Knowledge model 131 8.1 A model of knowledge ............................................. 131 8.2 Common knowledge .............................................. 136 8.3 Common prior ................................................. 137 Contents iii 8.4 “Agree to disagree” is impossible ........................................ 138 8.5 No-trade theorem ............................................... 140 8.6 Speculation ................................................... 141 8.7 Characterization of the common prior assumption .............................. 143 8.8 Unawareness .................................................. 145 9 Interactive epistemology 147 9.1 Epistemic conditions for Nash equilibrium .................................. 147 9.2 Epistemic foundation of rationalizability ................................... 150 9.3 Epistemic foundation of correlated equilibrium ............................... 151 9.4 The electronic mail game ............................................ 151 10 Extensive games with perfect information 155 10.1 Extensive games with perfect information .................................. 155 10.2 Subgame perfect equilibrium ......................................... 157 10.3 Examples .................................................... 160 10.4 Three notable games .............................................. 167 10.5 Iterated elimination of weakly dominated strategies ............................. 169 10.6 Forward induction ............................................... 170 11 Bargaining games 173 11.1 A bargaining game of alternating offers .................................... 173 11.2 Bargaining games with finite horizon ..................................... 174 11.3 Bargaining games with infinite horizon .................................... 175 11.4 Properties of subgame perfect equilibria in Rubinstein bargaining games .................. 178 11.5 Bargaining games with cost .......................................... 179 11.6 n-person bargaining games .......................................... 179 12 Repeated games 183 12.1 Infinitely repeated games ............................................ 183 12.2 Trigger strategy equilibrium .......................................... 188 12.3 Tit-for-tat strategy equilibrium ........................................ 193 12.4 Folk theorem .................................................. 194 12.5 Nash-threats folk theorem ........................................... 195 12.6 Perfect folk theorem .............................................. 196 12.7 Finitely repeated games ............................................ 199 Contents iv 13 Extensive games with imperfect information 201 13.1 Extensive games with imperfect information ................................. 201 13.2 Mixed and behavioral strategies ........................................ 203 13.3 Subgame perfect equilibrium ......................................... 206 13.4 Perfect Bayesian equilibrium .......................................... 212 13.5 Sequential equilibrium ............................................. 217 13.6 Trembling hand perfect equilibrium ...................................... 221 14 Information economics 1: signaling 223 14.1 Adverse selection ................................................ 223 14.2 Signaling .................................................... 226 14.3 Job-market signaling .............................................. 238 14.4 Cheap talk ................................................... 240 14.4.1 The model with two types ....................................... 242 14.4.2 The model with three types ...................................... 244 14.4.3 The model with a continuum of types ................................ 244 14.4.4 Optimal communication mechanism (the commitment case) .................... 248 14.5 Bayesian persuasion .............................................. 252 14.5.1 Example ................................................ 252 14.5.2 A model of Bayesian persuasion ................................... 254 14.5.3 Simplified problem .......................................... 256 14.5.4 Optimal information structure .................................... 257 14.6 Optimal information disclosure ........................................ 260 15 Information economics 2: screening 261 15.1 The principal-agent model ........................................... 261 15.1.1 Complete information ......................................... 262 15.1.2 Incomplete information ........................................ 265 15.1.3 The revelation principle ........................................ 269 15.1.4 General utility function for the agent ................................. 270 15.1.5 Nonresponsiveness .......................................... 271 15.2 Pricing a single indivisible good ........................................ 272 15.3 Nonlinear pricing ............................................... 275 15.3.1 The model with two types ....................................... 276 15.3.2 The model with a continuum of types ................................ 280 Contents v 15.4 Insurance .................................................... 282 15.5 Sequential screening .............................................. 282 15.5.1 A motivating example ......................................... 283 15.5.2 Optimal menu of refund contracts: two-type case .......................... 283 15.5.3 Sequential screening: general type case ................................ 287 15.5.4 Optimal selling mechanism ...................................... 290 16 Information economics 3: moral hazard 291 16.1 The principle-agent problem .......................................... 291 16.2 Complete information ............................................. 293 16.3 Incomplete information with risk-neutral agent ............................... 294 16.4 Incomplete information with limited liability ................................. 295 16.5 Incomplete information with risk-averse agent ................................ 296 16.6 n levels of performance ...........................................
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