Forward Induction as Confusion over the Equilibrium Being Played Out 26 January 1991/11 September 2007 Eric Rasmusen Abstract The Nash equilibrium of a game depends on it being common knowledge among the players which particular Nash equilibrium is being played out. This common knowledge arises as the result of some unspecified background process. If there are multiple equilibria, it is important that all players agree upon which one is being played out. This paper models a situation where there is noise in the background process, so that players sometimes are unknowingly at odds in their opinions on which equilibrium is being played out. Incorporating this possibility can reduce the number of equilibria in a way similar but not identical to forward induction and the intuitive criterion. Eric Rasmusen, Dan R. and Catherine M. Dalton Professor, Department of Business Economics and Public Policy, Kelley School of Business, Indiana University. Visitor (07/08), Nuffield College, Oxford University. Office: 011-44-1865 554-163 or (01865) 554-163. Nuffield College, Room C3, New Road, Oxford, England, OX1 1NF.
[email protected]. http://www.rasmusen.org. Copies of this paper can be found at: http://www.rasmusen.org/papers/rasmusen-subgame.pdf. I would like to thank Emmanuel Petrakis and participants in the University of Chicago Theory Workshop and the University of Toronto for helpful comments. 1. Introduction The idea here will be: if players observe actions by player Smith that are compatible with Nash equilibrium E1 but not with Nash equilibrium E2, they should believe that Smith will continue to play according to equilibrium E1, even if they themselves were earlier intending to play according to equilibrium E2.