Game theory Analysis of Conflict

3.11 Auctions 133 However, by the definition of an equilibrium, the optimal bid for i with value v, should be 13(4 So the derivative of this expected payoff with respect to w, should equal 0 when w, equals v,. That is, 0 = (v, — 13(v,))F(vi)(n — 1)F(vi)n-2 — 13'(v,)F(v,)' 1. This differential equation implies that, for any x in [0,M] 13(x)F(x)n-1 = f y(n — 1)F(y)n- 2F i(y)dy. This and other related results have been derived by Vickrey (1961) and Ortega-Reichert (1968). In the case where the types are uniformly dis- tributed, so that F(y) = y/M for any y in [0,M], this formula implies r3(v,) = (1 — 1/n)v„ Vv, E [0,M]. Notice that the margin of profit that each player allows himself in his bid decreases as the number of bidders increases. This game is an example of an auction with independent private values, in the sense that each bidder knows privately the actual value of the object to himself and considers the others' values to be independent random variables. In many auctions, however, the value of the object would be the same to all bidders, although the bidders may have dif- ferent estimates of this value, because they may have different private information about its quality. Such auctions are called common value auctions. For example, auctions for oil drilling rights on a given tract of land may be common value auctions, where the common value is the value of the oil under the land, about which the bidders may have different information and different estimates. Consider now a simple example of a two-bidder auction for a single object with an unknown common value. This object has a monetary value that depends on three independent random variables, go, g,, and x2, each of which is drawn from a uniform distribution on the interval from 0 to 1. The bidder who gets the object will ultimately derive benefits from owning it that are worth Aogo + A,x1 + A2g2, where Ao, A1, and A2 are given nonnegative constants that are commonly known by the bidders. At the time of the auction, player 1 has observed go and gi, but does not know g2; and player 2 has observed go and g2, but does not know g,. So player l's type is (go,g,), and 2's type is (go,g2). In the auction, the players simultaneously submit sealed bids c1 and c2 that are nonnegative numbers. The high bidder wins the object and

134 3 Equilibria of Strategic-Form Games pays the amount of his bid, and the low bidder pays nothing. In case of a tie, each player has a .5 probability of getting the object at the price of his bid. We assume that both players have risk-neutral utility for money. Thus, the utility payoff function for player i is (let j denote the player other than i) Ci Ui(CI,C2,(go,g1),(go,g2)) = Aogo Algi A2g2 if c. > c. p = (A0 X-0 + A I R, + A2g2 ci)/2 if ci = c3, = 0 if ci < cf. There is a unique linear Bayesian equilibrium of this game, in which player l's bid is Aogo + 0.5(A, + A2)'Z1 and player 2's bid is Aogo + 0.5(A, + A2)x2• To prove that this strategy profile is an equilibrium, suppose that player 1 expects 2 to use this strategy, but 1 is considering some other bid b, given the values go = x0 and g, = x, that he has observed. Such a bid would win the object for 1 if b > Aoxo + 0.5(A, + A2)g2, that is, if 2(b — A0R0)/(A, + A2) > g2. So, given l's information, a bid of b will win him the object with prob- ability Y(b), where Y(b) = 2(b — A0x0)/(A, + A2), when this number Y(b) is between 0 and 1. Player 1 should not use any bid b that makes Y(b) greater than 1, because such a bid would be larger than necessary to win the object for sure; and he should not use any bid that makes Y(b) less than 0, because such a bid would be sure to lose. Then, given l's type (go,g,), the conditionally expected payoff for player 1, when 1 submits a bid of b and 2 implements her equilibrium strategy, is

3.11 Auctions 135 Y(b) (Aoxo + Ai x, + A 2y2 0642 f O = Y(b)(Aoxo + Aix, + A2Y(b)12 — b). To interpret this formula, notice that Aoxo + A,x, + A2Y(b)/2 would be the conditionally expected value of the object, given both that player l's type is (xo,x,) and that player 1 could win the object by bidding b. Substituting the definition of Y(b) into this formula and choosing b to maximize this expected payoff for 1, we get b = Aoxo + 0.5(A, + A2)x, Substituting this value of b into the definition of Y(b), we get Y(b) = x1 ; so this bid satisfies our requirement that 0 Y(b) 1, for every xo and x1 between 0 and 1. A similar argument shows that player 2's optimal bid is as specified by her equilibrium strategy, given that player 1 is expected to follow his equilibrium strategy. Suppose, for example, that Ao = A, = A2 = 100, and go = 0 and = 0.01. Then l's equilibrium strategy tells him to submit a bid of 1. This bid may seem surprisingly low. After all, the expected value of g2 is 0.5, so the expected monetary value of the object in the auction given l's current information is 100 x 0 + 100 x 0.01 + 100 x 0.5 = 51. Why is player 1 submitting a bid that is less than 2% of the expected value of the object to him? To understand why player 1 must bid so conservatively, notice what would happen if he submitted a bid of 50 instead. It might seem that this bid would give player 1 a positive expected profit, because his bid is lower than the expected value of the object to him and is high enough to have a substantial probability of winning. But according to our formulas above, l's expected utility pay- off from this bid is —12 (because Y(50) = .5). Bidder 1 would expect such serious losses from a bid of 50 because, if l's bid of 50 were to win the auction, then 2's equilibrium bid of 100g2 would be not greater than 50; so x2 would have to be between 0 and 0.50. Thus, the conditionally expected value of the object, given l's information at the time of the auction and the additional information that a bid of 50 would win the auction, is 100 x 0.01 + 100 x 0.5/2 = 26. So a bid of 50 would give player 1 a probability .5 of buying an object for 50 that would have an expected value of 26 when he gets to buy it at this price, so that l's expected profit is indeed 0.5(26 — 50) = —12 < 0.

136 3 • Equilibria of Strategic-Form Games Thus, when computing the expected profit from a particular bid in an auction, it is important that the bidder estimate the value of the object by its conditionally expected value given his current information and the additional information that could be inferred if this bid won the auction. This conditionally expected value is often significantly less than the expected value of the object given the bidder's information at the time that he submits the bid. This fact is called the winner's curse. Now consider the case in which Ao = A, = E and A2 = 100 - E, where E is some very small positive number. In this case, player l's equilibrium strategy is to bid e 0 + 50i,, and player 2's equilibrium strategy is to bid ao + 50x-2. Thus, even though go and g, have the same small effect on the value of the object, g, has a much greater effect on player l's optimal bid, because g, is information that he knows privately, indepen- dently of anything that player 2 knows, whereas go is public information. As E goes to 0, this game converges to one in which player 2 knows the value of the object, and player 1 only knows that this value was drawn from a uniform distribution over the interval from 0 to 100. The limit of the Bayesian equilibria (in the sense of Milgrom and Weber, 1985), as e goes to 0, is a randomized equilibrium in which the informed player 2 bids one-half of the value of the object and player 1 submits a bid drawn from a uniform distribution over the interval from 0 to 50 and based on minor factors that are independent of anything 2 can observe at the time of the auction. 3.12 Proof of Existence of Equilibrium The Kakutani (1941) fixed-point theorem is a useful mathematical tool for proving existence of many solution concepts in game theory includ- ing Nash equilibrium. To state the Kakutani fixed-point theorem, we must first develop some terminology. (For a more thorough introduction to these mathematical concepts, see Debreu, 1959, pp. 1-27.) For any finite set M, RM is the set of all vectors of the form x = (x„,),„,,,, such that, for each m in M, the m-component xm is a real number in R. When it is more convenient, we can also interpret RM equivalently as the set of all functions from M into the real numbers R, in which case the m-component of x in RM can be written x(m) instead of xm. RM is a finite-dimensional vector space. Let S be a subset of the finite-dimensional vector space Rm. S is convex iff, for every two vectors x and y and every number X such that 0 X

3.12 • Proof of Existence of Equilibrium 137 1, if x E S and y E S, then Xx + (1 — X)y E S. (Here x = (x„,)„,, y = (y,„)„,,,, and Xx + (1 — X)y = (Xx„z + (1 — X)y„)„,04.) S is closed iff, for every convergent sequence of vectors (x( j));:i, if x(j) E S for every j, then limi_cox( j) E S. (A subset of RM is open iff its complement is closed.) S is bounded iff there exists some positive number K such that, for every vector x in S, EmEmixml K. A point-to-set correspondence G:X —>—> Y is any mapping that specifies, for every point x in X, a set G(x) that is a subset of Y. Suppose that X and Y are any metric spaces, so the concepts of convergence and limit have been defined for sequences of points in X and in Y. A correspon- dence G:X -->--> Y is upper-hemicontinuous iff, for every sequence (x(j),y(j));i, if x(j) E X and y(j) E G(x(j)) for every j, and the sequence (x(j)); converges to some point x, and the sequence (y( j))7=, converges to some point y, then y E G(x). Thus, G:X -->--> Y is upper-hemicontin- uous iff the set {(x,y) x E X, y E G(x)} is a closed subset of X x Y. Notice that most of the length of the definition of upper-hemicontin- uity comes from the three hypotheses, which have the effect of limiting the cases in which the conclusion E G(x)) is required to hold. Thus, this definition is really rather weak. In particular, if g:X —> Y is a continuous function from X to Y and G(x) = {g(x)} for every x in X, then G:X —>—> Y is an upper-hemicontinuous point-to-set correspondence. So upper-hemicontinuous correspondences can be viewed as a generaliza- tion of continuous functions. A fixed point of a correspondence F:S S is any x in S such that x E F(x). KAKUTANI FIXED-POINT THEOREM. Let S be any nonempty, con vex, bounded, and closed subset of a finite-dimensional vector space. Let F:S —>--> S be any upper-hemicontinuous point-to-set correspondence such that, for every x in S, F(x) is a nonempty convex subset of S. Then there exists some 5- c in S such that x E F(x). Proofs of the Kakutani fixed-point theorem and other related theo- rems can be found in Burger (1963), Franklin (1980), and Border (1985). Scarf (1973) provides a constructive proof by developing an algorithm for computing the fixed point whose existence is implied by the theorem. (For a generalization of the Kakutani fixed-point theorem, see Glicksberg, 1952.)

138 3 • Equilibria of Strategic-Form Games To understand the role of the various assumptions in the Kakutani fixed-point theorem, let S = [0,1] = fx E RIO 5 X 5 1}, and let F1:S -->—> S be F,(x) = {1} if 0 x 0.5, = {0} if 0.5 < x 1. Then F1 has no fixed points, and it satisfies all of the assumptions of the Kakutani fixed-point theorem except for upper-hemicontinuity, be- cause the set {(x,y)lx E S, y E F1(x)} is not a closed set at (0.5, 0). To satisfy upper-hemicontinuity, we must extend this correspondence to F2:S —>--> S, where x < 0.5, F2(x) = {1} if 0 =- {O,1} if x = 0.5, = {0} if 0.5 < x 1. F2 also has no fixed points, and it satisfies all of the assumptions of the Kakutani fixed-point theorem except convex-valuedness, because F2(0.5) is not a convex set. To satisfy convex-valuedness, we must extend the correspondence to F3:S --->--> S, where F3(x) = {1} if 0 x < 0.5, = [0,1] if x = 0.5, = {0} if 0.5 < x 1. This correspondence F3 satisfies all the assumptions of the Kakutani fixed-point theorem and has a fixed point, because 0.5 E F3(0.5). We can now prove the general existence theorem for Nash equilibria of finite games. Proof of Theorem 3.1. Let F be any finite game in strategic form, where /Let , F = (N (CAEN, The set of randomized-strategy profiles X EisA(Ci) is a nonempty, con- vex, closed, and bounded subset of a finite-dimensional vector space.

3.12 • Proof of Existence of Equilibrium 139 (This set satisfies the above definition of boundedness with K = INS, and it is a subset of RM, where M = U C - ?EN -?•) For any u in X iEN A(C) and any player j in N, let R,(o-_,) = argmax u,(cr„,T„). ,-JEA(c.,) That is, R,(a_,) is the set of j's best responses in A(C,) to the combination of independently randomized strategies cr_, for the other players. By Lemma 3.1 in Section 3.2, RJ(cr _j) is the set of all probability distributions p, over C, such that p,(c„) = 0 for every c3 such that c„ argmax u,(cr,,[d,]). d, E c, Thus, Ri(o-__,) is convex, because it is a subset of A(C3) that is defined by a collection of linear equalities. Furthermore, R,(o-_,) is nonempty, be- cause it includes [c3] for every c, in argmaxvc u,(o-_,,[c/„]), which is nonempty. Let R: X zE N z(C,) ---- X ?EN A(C) be the point-to-set correspondence such that R(o) = X Vo E X A(C,). JEN iEN That is, T E R(r) iff T, E R,(o-_,) for every j in N. For each o, R(r) is nonempty and convex, because it is the Cartesian product of nonempty convex sets. To show that R is upper-hemicontinuous, suppose that (o-k)/7_ and (Tk )k-1 are convergent sequences, o-k E X Vk E {1,2,3, . . . }, iEN Tk E R(rk), Vk E {1,2,3, . . . }, Tr = lim o-k, and k-z= = lim Tk. To prove upper-hemicontinuity, we need to show that these conditions imply that T- is in R(rr). These conditions imply that, for every player j in N and every p, in A(C,),

140 3 • Equilibria of Strategic-Form Games k k Vk E {1,2,3, . . . u (cr T U (0- p ) ' - J - 1' 1' this in By continuity of the expected utility function on X iEN turn implies that, for every j in N and p; in A(C;), u3(cTr_3,p)). So 7r.; E RO -_; ) for every j in N, and so T E R(U). Thus, R: X JEN A(C1) —>—> X zEN A(Ci) is an upper-hemicontinuous correspondence. By the Kakutani fixed-point theorem, there exists some randomized- strategy profile o- in X 2EN (Ci) such that if E R(cr). That is, o.; E R;(cr_;) for every j in N, and so G. is a Nash equilibrium of F. n 3.13 Infinite Strategy Sets We have mainly emphasized finite games, to minimize mathematical difficulties as we explore the fundamental principles of game-theoretic analysis. In this section, however, we broaden our scope to consider a more general class of games, in which players may have infinitely many strategies. In particular, we want to include the possibility that the set of pure strategies for a player may be a bounded interval on the real number line, such as [0,1]. (This set includes all rational and irrational numbers between 0 and 1, so it is an uncountably infinite set.) To state results in greater generality, all results in this section are based only on the assumption that, for each player i, the strategy set C, is a compact metric space. A compact metric space is a general mathematical structure for representing infinite sets that can be well approximated by large finite sets. One important fact is that, in a compact metric space, any infinite sequence has a convergent subsequence. The reader who is unfamiliar with metric spaces is referred to any mathematics text on real analysis, for example Royden (1968) or Kolmogorov and Fomin (1970). Any closed and bounded subset of a finite-dimensional vector space is an example of a compact metric space. More specifically, any closed and bounded interval of real numbers is an example of a compact metric space, where the distance between two points x and y is Ix — 3' I We will not need to refer to any examples more complicated than these. (For completeness, we summarize the basic definitions here. A metric space is a set M together with a function 8:M x M --> R, which defines the distance 6(x,y) between any two points x and y in the set and which satisfies the following properties, for every x, y, and z in M:

3.13 Infinite Strategy Sets 141 8(x,y) = 8(y,x) > 0, 8(x,y) = 0 iff x = y, 8(x,y) + 8(y,z) 8(x,z). In a metric space, a point y is the limit of a sequence of points (x(k))/%1 iff the distance 8(x(k),y) goes to 0 as k goes to infinity. An open ball of radius e around a point x, denoted B(x,e), is the set of all points in the metric space that have a distance less than e from x; that is, B(x,e)-- ly18(x,y) < E}. A set S is an open subset of a metric space M iff, for every x in S, there is some positive number e such that B(x,e) C S. A metric space M is compact iff every collection of open sets that covers M, in the sense that their union includes all of M, has a finite subcollection that also covers M.) Let N denote the finite set of players, N = {1,2, ,n}. For each player i in N, let C, be a compact metric space that denotes the set of all pure strategies available to player i. As usual, let C = X ,EN C, = C1 X • • • X C,,. As a finite Cartesian product of compact metric spaces, C is also a compact metric space (with 8(c, 'e) = /,EN 8(coei)). When there are infinitely many actions in the set C„ a randomized strategy for player i can no longer be described by just listing the probability of each individual action. For example, suppose that C, is the interval [0,1]. If player i selected his action from a uniform distri- bution over the interval [0,1], then each individual action in [0,1] would have zero probability; but the same would be true if he selected his action from a uniform distribution over the interval from 0.5 to 1. To describe a probability distribution over Ci, we must list the probabilities of subsets of C,. Unfortunately, for technical reasons, it may be math- ematically impossible to consistently assign probabilities to all subsets of an infinite set, so some weak restriction is needed on the class of subsets whose probabilities can be meaningfully defined. These are called the measurable sets. Here, we let the measurable subsets of C and of each set C, be the smallest class of subsets that includes all open subsets, all closed subsets, and al! finite or countably infinite unions and intersections of sets in the class. These are the Borel subsets (and they include virtually

142 3 • Equilibria of Strategic-Form Games all subsets that could be defined without the use of very sophisticated mathematics). Let @, denote the set of such measurable or Borel subsets of C,. Let A(C1) denote the set of probability distributions over C,. That is, o E A(C,) iff a is a function that assigns a nonnegative number cr(Q) to each Q that is a Borel subset of C, aa(C,) = 1, and, for any countable collection (Qk)k-_, of pairwise-disjoint Borel subsets of C,, Qk 1 = Cr z(Qk). k=1 k=1 We define convergence for randomized strategies by assigning the weak topology to A(C,). This topology is such that a sequence (a,k)k-_, of probability distributions in A(C,) converges to a probability distribution cr, iff, for every bounded continuous function f:C,—> R, lim f(c)clo-,(c) = f(ci)dcr,(c). f c,E C, c,EC, This equation asserts that, if el,' is a random strategy drawn from C, according to the r distribution, and e, is a random strategy drawn according to the r distribution, then the expected value of f(e',') must converge to the expected value of f(e) as k goes to infinity. With this topology, the set of probability distributions in A(C,) is itself a compact metric space (with a suitably defined distance function, called the Prohorov metric; see Billingsley, 1968). A function g:C --> R is (Borel) measurable iff, for every number x in R, the set {c E CI g(c) x} is a Borel subset of C. A function g:C —> R is bounded iff there exists some number K such that I g(c)I K for every c in C. To be able to define expected utilities, we must require that players' utility functions are measurable and bounded in this sense. Let u = (u1, . . . ,u„) and u = (21, . . . ,U„) be any two profiles of utility functions defined on C, such that, for each i in N, ui:C ---> R and —> R are bounded measurable functions, to be interpreted as pos- sible payoff functions for player i. We may define the distance between the utility-function profiles u and is to be max sup I u,(c) — ii,(c) I . LEN cEC (The supremum, or sup, of a set of numbers or values of a function is the least upper bound of the set. If a maximum exists in the set, then

3.13 Infinite Strategy Sets 143 the supremum and the maximum are the same.) As usual, we may extend any utility function to the set of all randomized-strategy profiles XJEN so u,(u) = f • • • u,(c)dcri(c,) . . . do-,,(c„), HQ E X A(C,), cn EC,, JEN ci ECi where if = (cr,, . . . ,cr,,) and c = (c,, . . . ,c,,). The utility-function profiles u and u each complete the definition of a game in strategic form, denoted by F and F respectively. That is, (Ci)Krsr, (1 F = (N, (Ci)iEN, (u0K/s/), i = 0K/sr). If a = (cr,),EN is an equilibrium of F, then if is, of course, not neces- sarily an equilibrium of F. Even if u and ft are very close, the equilibria of F and F may be very far apart. For example, if there is only one player, C, [0,1], ul(c,) = Eci, and il,(c,) = —eci, where E is any small positive number, then the unique equilibrium of F is 1 and the unique equilibrium of F is 0, even though the distance between u and is is only 2E. However, if u and it are very close, there is a sense in which the equilibria of F are \"almost\" equilibria of F. For any nonnegative number E, Radner (1980) defined an e-equilibrium (or an e-approximate equi- librium) of any strategic-form game to be a combination of randomized strategies such that no player could expect to gain more than e by switching to any of his feasible strategies, instead of following the ran- domized strategy specified for him. That is, a is an E-equilibrium of F iff Ui(Cf_i,{Ci]) ) E, Vi E N, Vci E Ci. Obviously, when E = 0, an E-equilibrium is just a Nash equilibrium in the usual sense. The following result, due to Fudenberg and Levine (1986), shows that such E-equilibria have a kind of continuity across games. THEOREM 3.3. Let F and 1\" be as above. Let a be the distance between the utility function profiles u and it, and suppose that a is an c-equilibrium of F. Then a is an (E 2a)-equilibrium of F.

144 3 • Equilibria of Strategic-Form Games Proof For any player i and any action ci, ui(cr_i,[ci]) — ui(o) = (ui(o-_,[cd) — + (Ui(o_i,[ci]) — iii(cr)) + (iii(cr) — ui(r)) Lca+e+a=- - 2a+ E. n For any game with continuous utility functions, the 6-equilibrium con- cept also satisfies a related form of continuity, as stated by the following theorem. R is continuous, for every player i THEOREM 3.4. Suppose that u,:C in N. Let (a-k)k—_, be a convergent sequence of randomized-strategy profiles in X iEN LUC), and let (Ek)k- _, be a convergent sequence of nonnegative numbers such that, for every k, ak is an Ek-equilibrium of F. Let (Tr =limy, ak and let e = Ek. Then (Ti- is an T-equilibrium of F. In particular, if F equals 0, then \"ci. is an equilibrium of F. Proof. For any player i and any ci in Ci, ui(off_,,[c,]) — N(Y) = lim (u,(o-k_i,[c,]) — Iii(Crk)) lim ek = T. n It is important to be able to relate infinite games to the conceptually simpler class of finite games. A function f from C, into a finite set Dt is (Borel) measurable iff, for every b, in Di, {c, E C,I f,(c,) = b,} is a Borel- measurable set. We may say that the game F is essentially finite iff there exists some finite strategic-form game F* = (N, (D,),,N, (v,),,N) and measurable functions (f,:C,—> D-)IEN such that, CIAO = v,(fi(c1), . . . ,f,z(cn)), Vi E N, Vc E C. The following finite-approximation theorem can be easily proved, using the fact that the sets of strategies are compact. THEOREM 3.5. Let a be any strictly positive real number. Suppose that, for every player i, the utility function u,:C --0 R is continuous on the compact

3.13 • Infinite Strategy Sets 145 domain C. Then there exists an essentially finite game I- = (N,(ui)iE N) such that the distance between u and u is less than a. These results enable us to prove that there exists an equilibrium of F in randomized strategies, if the utility functions (u,),\" are continuous. The existence theorem for finite games immediately implies that a randomized equilibrium exists for any essentially finite game. Then Theorems 3.5 and 3.3 imply that there exists a 2a-equilibrium of F, for any positive number a. By compactness of X ,„ z(C,), any sequence of randomized-strategy profiles has a convergent subsequence. Thus, let- ting a = 8,/2 and letting e, -+ 0, we can construct a convergent sequence of randomized-strategy profiles that satisfies the hypotheses of Theorem 3.4, with -8- = 0. Then the limit (Tr is a Nash equilibrium of F in random- ized strategies. Simon and Zame (1990) have applied a similar line of argument to prove a more general equilibrium existence theorem for games in which the utility functions may be discontinuous (see also Dasgupta and Mas- kin, 1986). However, Simon and Zame's formulation uses a weaker concept of a game, in which a range of possible payoff allocations may be allowed for some combinations of actions. Such a modification of the concept of a game is needed because, for strategic-form games as con- ventionally defined, equilibria need not exist when payoff functions are discontinuous. For a simple example, let N = {1}, C, = [0,1], ul(c,) = c1 if cl < 0.5, iii(c,) = 0 if c, 0.5. Then player 1 wants to choose the highest number that is strictly less than 0.5, but no such number exists. In a sense, the problem is that we chose the wrong way to define the payoff at the point of discontinuity. If we just changed the payoff there and let u1(0.5) = 0.5, then an equilibrium would exist. Following Simon and Zame (1990), a game with an endogenous-sharing rule, or an endogenous-sharing game is any U), rs = (N, where N and (C,),„ are as above, and U:C RN is a correspondence that specifies a set of utility payoff allocations in RN for every combi- nation of players' strategies. That is, for any c in C, if w E U(c) then w = (w,),\" is one possible allocation of utility to the players that could occur if they chose the strategy profile c. Suppose that N is finite and each C, is a compact subset of a metric space, and U is bounded (that is, there exists some number K such that, for every c in C, every w in

146 3 • Equilibria of Strategic-Form Games U(c), and every i in N, lw,i K). Suppose also that U:C --->—* RN is upper-hemicontinuous and, for each c in C, U(c) is a nonempty convex subset of RN. Using these assumptions, Simon and Zame (1990) have proved the following general existence theorem. FS THEOREM 3 . 6 . Let be an endogenous-sharing game as defined above. Then there exists some profile of utility functions (ili)iEN such that each —> R is a measurable function, ,(c), . . . , ii,„(c)) E U(c) for every c in C, and the resulting strategic form game (N, (Ci)i EN , (1.i)zEN) has at least one Nash equilib- rium in X ,EN A(C,). If each function u,:C --> R is continuous, then letting U(c) = {(u,(c), . . . Vc E C, defines a correspondence U(•) that satisfies all of the properties that we have assumed. More generally, for any profile of bounded utility functions u = (u,),E N, where some u,:C R may be discontinuous, there exists a unique minimal correspondence U:C RN such that U is upper-hemicontin- uous and, for every c in C, U(c) is a convex set that includes the vector (u,(c)),,,,. When U is this minimal correspondence, U(c) is the set of all limits of expected utility allocations that can be achieved by randomizing over strategy profiles that are arbitrarily close to c. To be more precise, let B(c,E) denote the set of all strategy profiles e such that, for every player i, the distance between e, and c, is less than E. Then, for any c in C, a payoff vector w is in U(c) iff, for every positive number E, there exists some probability distributionµ over the set B(c,e) such that, for every player i, w, —ui(e)dix(e) c E. f.EB( r,e) Applying Theorem 3.6 to this minimal correspondence U, we find that, for any profile of discontinuous utility functions u, there exists some profile of utility functions ft such that u differs from u only at points of discontinuity and an equilibrium of the resulting game F exists. For example, consider a two-player game where C, = [0,1], C2 = [0,1/4],

3.13 • Infinite Strategy Sets 147 u 1 (ci,c2) = 1 — u2(c 1 ,c2 ) = (c, + c2)/2 if c1 < C2 , = 1/2 = c2, if c1 = 1 — (c1 + c2)/2 if c1 > c2. (This game is a modified version of a classic example of Hotelling, 1929.) Following Simon and Zame, we can interpret this game by sup- posing that the players are two psychiatrists choosing where to locate their offices on a long road, represented by the interval from 0 to 1. The portion of the road represented by the interval from 0 to 1/4 is in Oregon, and the portion represented by the interval from 1/4 to 1 is in California. Player 1 is licensed to practice in both California and Oregon, but player 2 is licensed to practice only in Oregon. Patients are distrib- uted uniformly along this road, each patient will go to the psychiatrist whose office is closer. The payoff to each psychiatrist is the fraction of the patients that go to him. The payoff function for this game is discontinuous when the players choose the same point in the interval [0,1/4] (that is, when they locate across the road from each other in Oregon). We have, quite naturally, assumed that they share the patients equally in this case. However, there is no equilibrium of this game when we define payoffs at the disconti- nuity in this way. To see why, notice that player 1 can guarantee himself a payoff arbitrarily close to 3/4 by choosing c1 slightly larger than 1/4, and player 2 can guarantee herself a payoff of at least 1/4 by choosing c2 equal to 1/4. However, when c, and c2 both equal 1/4, player l's payoff drops to '/2 in this model. The smallest upper-hemicontinuous convex-valued endogenous-shar- ing rule U that contains the given profile of utility functions u is U(c,,c2) = {((c1 + c2)/2, 1 — (c, + c2)12)} if c1 < c2, U(c,,c2) = {(a, 1 — a) c1 Ls a :5_ 1 — c1} if c1 = c2, U(c1,c2) = {(1 — (c1 + c2)/2, (c1 + c2)/2)} if c1 > c2. To get an equilibrium, we may use any selection u such that 26,('/4,1/4) = 3/4, 2 ( 1/4, 1/4) = 1/4. The resulting game has an equilibrium (in pure strategies) at (c1,c2) = (1/4,1/4), with payoffs (3 /4,1/4). That is, to get an equilibrium, we must adjust the payoff functions at the points of discontinuity so that, when both players locate at the California—Oregon border, player 1 gets all the California patients and player 2 gets all the Oregon patients.

148 3 • Equilibria of Strategic-Form Games If we approximated the original game by a finite game in which ci and c2 are required to be integer multiples of 1/K, where K is any large positive integer that is divisible by 4, then there would be an equilibrium in pure strategies at (1/4 + 1/K, 1/4), with payoffs (3/4 — 1/(2K), 1/4 + 1/(2K)). As K goes to infinity, this equilibrium and payoff allocation converge to the equilibrium and payoff allocation that we got for F. Exercises Exercise 3.1. Suppose that ri is derived from F by eliminating pure strategies that are strongly dominated in F. Show that a is an equilibrium of F if and only if a is an equilibrium of F'. (NOTE: If Ci is a subset of C„ then any probability distribution pi in A(Ci) may be identified with the probability distribution in ii(Ci) that gives the same probabilities as p, to the pure strategies in Ci, and gives probability 0 to the pure strategies that are in Ci but not in C,.) Exercise 3.2. Suppose that F2 is derived from F by eliminating pure strategies that are weakly dominated in F. Show that, if a is an equilib- rium of F2, then a- is an equilibrium of F. Exercise 3.3. For each of the following two-player games, find all equi- libria. As usual, player 1 chooses the row and player 2 chooses the column. (HINT: Each game here has an odd number of equilibria.) a. Y2 X2 x, 2,1 1,2 1,5 2,1 b. Y2 X2 6,6 x, 3,7 y, 2,2 7,3 c. Y2 X2 x, 7,3 6,6 2,2 3,7 d. Y2 X2 Z2 x, 0,4 5,6 8,7 2,9 6,5 5,1 Y1

Exercises 149 e. Y2 z2 X2 0,0 5,4 4,5 x1 y1 4,5 0,0 5,4 z1 5,4 4,5 0,0 Exercise 3.4. Find all equilibria of the three-player game (due to B. O'Neill) shown in Table 3.15, where C, = {x„y,} for each i in {1,2,3}. That is, each player gets 0 unless exactly one player i chooses y„ in which case this player i gets 5, the player before i in the 1—>2—>3—÷1 cycle gets 6, and the player after i in this cycle gets 4. (HINTS: Notice the cyclical symmetry of this game. The number of equilibria is even, which is rather unusual.) Exercise 3.5. a. Consider a Bayesian game with incomplete information in which player 1 may be either type a or type 13, where type a has probability .9 and type 13 has probability .1 (as assessed by player 2). Player 2 has no private information. Depending on player l's types, the payoffs to the two players depend on their actions in C, = {x,,y,} and C2 = {x2,y2} as shown in Table 3.16. Show that there exists a Bayesian equilibrium in which player 2 chooses x2. b. (A version of the electronic mail game of Rubinstein, 1989.) Now suppose that the information structure is altered by the following pre- play communication process. If player 1 is type 13, then he sends no letter to player 2. Otherwise, player 1 sends to player 2 a letter saying, \"I am not type p.\" Thereafter, each time either player receives a message from the other, he sends back a letter saying, \"This is to confirm the receipt of your most recent letter.\" Suppose that every letter has a probability VI o of being lost in the mail, and the players continue exchanging letters until one is lost. Thus, when player 1 chooses his Table 3.15 A three-player game in strategic form C2 and C3 x3 y3 Cl X2 Y2 x2 Y2 xl 0,0,0 6,5,4 4,6,5 0,0,0 yl 5,4,6 0,0,0 0,0,0 0,0,0

150 3 Equilibria of Strategic-Form Games Table 3.16 Expected payoffs for all types and action profiles in a Bayesian game t, = a C2 C1 X2 Y2 2,2 xi —2,0 0,-2 0,0 t, = p C2 C1 X2 Y2 x, 1,0 0,2 Yi 2,0 1,-2 action in fx,,y11, he knows whether he is 13 or a; and if he is a, then he also knows how many letters he got from player 2. When player 2 chooses her action in {x2,y2}, she knows how many letters she got from player 1. After the players have stopped sending letters, what probability would player 2 assign to the event that a letter sent by player 1 was lost in the mail (so the total number of letters sent by 1 and 2 together is odd)? If player 1 is not type p, then what probability would player 1 assign to the event that a letter sent by player 1 was lost in the mail? Show that there is no Bayesian equilibrium of this game in which player 2 ever chooses x2. Exercise 3.6. Consider the perturbed version of the Battle of the Sexes game shown in Table 3.17. Here 0 < e < 1, and t, and 12 are indepen- dent random variables drawn from a uniform distribution over the interval [0,1]. Each player i observes only t, before choosing his action in C, = { f , , .s,}. Find three Bayesian equilibria of this game. (HINT: There is an equilibrium in which each player i has some types that choose s, and some other types that choose f,.) Exercise 3.7. Consider a first-price sealed-bid auction between two bid- ders with independent private values for the object being sold. Before

Exercises 151 Table 3.17 A perturbed version of the Battle of the Sexes game C2 Cl S2 f2 et1, Et2 3 + E t , 1 fl si 1, 3 + et2 0, 0 this auction, each bidder i (for i = 1,2) observes a random variable t, that is independently drawn from a uniform distribution over the in- terval [0,1]. Then the value of the object to bidder i is v, = t, + 0.5. Each bidder i submits a sealed bid b, that can be any nonnegative number, and his payoff is ui(b1,b241,t2) = (ti + 0.5) — bi if b, > b_1, if bi < b_i, = 0 = ((ti + 0.5) — 012 if b1 = b2. Find an equilibrium in which each bidder uses a strategy of the form bi = at, + 13. In this equilibrium, what is the conditionally expected payoff to bidder i, given his type t,? Exercise 3.8. Now consider a first-price sealed-bid auction between two bidders with a common value for the object being sold. As in Exercise 3.7, before this auction, each bidder i (for i = 1,2) observes a random variable t, that is independently drawn from a uniform distribution over the interval from 0 to 1, but in this situation the actual value of the object to each bidder i is v, = t1 + t2. Thus, given only his own infor- mation t„ the expected value of the object to bidder i is t, + 0.5, as in Exercise 3.7. In the auction, each bidder i submits a sealed bid b, that can be any nonnegative number, and his payoff is if b, > b_i, ui(b 1 ,b2,t 1 ,t2) = (ti + t2) — bi if bi = 0 < b_i, 0/2 if b1 = b2. = ((t1 + t2) Find an equilibrium in which each bidder uses a strategy of the form b, = at, + 13. In this equilibrium, what is the conditionally expected payoff to bidder i, given his type 4? Show that, for each value of t„ the

152 3 Equilibria of Strategic-Form Games equilibrium bid in this auction is lower than the equilibrium bid in the private-values example in Exercise 3.7. Exercise 3.9. a. Verify the equilibrium of the perturbed game described in Section 3.6. b. How would the equilibrium change if it were common knowledge that player 1 is an intelligent rational decision-maker but that there is still a probability .1 that player 2 may be replaced by a naive agent who would choose a bid according to the uniform distribution on the interval [0,1]? Exercise 3.10. Let N = {1, . . . ,n} be a fixed set of players, and let C1, . . . ,Cn be fixed finite strategy sets for the n players. For any sequence of games (Fk)k-_ 1 , where each Fk = (N, (C,),,N, (4,,N), and for any F = (N, (C,),EN, (u,),\"), we may say that lime a Fk = F iff, for every i in N and every c in C, 74(c) = u,(c). For any such game F, let E(F) denote the set of all Nash equilibria of F, and let D(F) denote the set of all Nash equilibria of F that assign zero probability to all weakly domi- nated pure strategies. a. Is E(.) upper-hemicontinuous? Justify your answer by a proof or a counterexample. b. Is upper-hemicontinuous? Justify your answer by a proof or a counterexample. Exercise 3.11. Let F be a two-person zero-sum game in strategic form. Show that {a, I o. is an equilibrium of F} is a convex subset of the set of randomized strategies for player 1. Exercise 3.12. Suppose that Y and Z are nonempty compact (closed and bounded) convex subsets of finite-dimensional vector spaces. Let g:Y X Z --> R be a continuous function such that, for every z in Z, g(•,z) is an affine function on Y. That is, for any z in Z, and any x and y in Y, and any X between 0 and 1, g(Xx + (1 - X)y,z) Xg(x,z) + (1 - X)g(y,z). For any z in Z, let F(z) = argmaxy,y g(y,z). Prove that F:Z -->—> Y is upper-hemicontinuous and nonempty-convex-valued. (HINT: The image of a compact set under a continuous function is a compact set; and a compact subset of the real number line is closed and bounded.)

Exercises 153 Exercise 3.13. Let F be the two-person game in which the pure strategy sets are C1 = C2 = [0,1], and the utility function of each player i is ui(c1,c2) = c1c2 — 0.1(c,)2. For any number E such that 0 < e < 1/2, let be the game in which the strategy sets are the same as in r, but the utility function of each player i is iii(c1,c2) = ui(maxle,c11, max{e,c2}). (In effect, all strategies between 0 and e are rounded up to e.) a. Show that (0,0) and (1,1) are the only equilibria of F. b. Show that (1,1) is the unique equilibrium of rE. c. Show that (0,0) is an 8-equilibrium of PE. d. Show that the distance between the utility-function profiles (u1,u2) and (u,022), as defined in Section 3.13, is less than E. Exercise 3.14. A strong Nash equilibrium is a Nash equilibrium such that there is no nonempty set of players who could all gain by deviating together to some other combination of strategies that is jointly feasible for them, when the other players who are not in this set are expected to stay with their equilibrium strategies. (See Aumann, 1959, and Bern- heim, Peleg, and Whinston, 1987.) Here, to formalize this definition, we can say that a randomized strategy profile cr is a strong Nash equi- librium iff, for each randomized strategy profile T that is different from cr, there exists some player i such that T, a and u,(T) ui(cr). a. Show an example of a game that has strong Nash equilibria and show another example of a game that does not have any strong Nash equilibria. (HINT: It suffices to consider some of the examples in Sec- tion 3.2.) b. Recall the game in Exercise 3.4. Show that, for each equilibrium of this game, there exists a set of two or three players who could all do better by changing their strategies in such a way that the new strategy profile (including the original equilibrium strategy of the player who is outside this set, if it contains only two players) is still an equilibrium.

4 Sequential Equilibria of Extensive-Form Games 4.1 Mixed Strategies and Behavioral Strategies Since the work of Selten (1975) and Kreps and Wilson (1982), there has been an increasing appreciation of the importance of studying equilibria of games in extensive form, not just in strategic form. Analysis of equilibria in behavioral strategies and of sequential equilibria of an extensive- form game can provide insights beyond those generated by analysis of equilibria of any one representation of the game in strategic form. Before we can define these two solution concepts for extensive-form games, however, we need to formulate the more basic concepts of ran- domized strategies for extensive-form games. We begin by recalling some notation developed in Chapter 2. Throughout this chapter, we let re denote an extensive-form game as defined in Section 2.1. The set of players in re is N. For any player i in N, we let S, denote the set of all possible information states for player i in re. We assume that players' information states are labeled such that S, and S, are disjoint sets whenever i 0 j, and we let S* denote the union of all these sets; that is s* = U si. iEN For any player i and any information state s in Si, we let Y, denote the set of nodes belonging to player i with information state s, and we let Ds denote the set of all moves available to i at information state s. That is, Ds is the set of all move-labels of alternative branches following any node in Y.,. A (pure) strategy for a player in Fe is a function that specifies a move for the player at each of his possible information states in the

4.1 • Mixed and Behavioral Strategies 155 game. We let Ci denote the set of such pure strategies for any player i in Fe, so Ci = X D5. sES; In Chapter 3 we defined randomized-strategy profiles and equilibria for strategic-form games. In Chapter 2 we defined two different ways of representing an extensive-form game by a strategic-form game: the normal representation and the multiagent representation. These two representations give us two different ways to define randomized-strat- F. egy profiles for any given extensive-form game A mixed-strategy profile of re is defined to be any randomized-strategy profile for the normal representation of Fe. That is, the set of mixed-strategy profiles of Fe is X A(C). iEN A behavioral-strategy profile of Fe is defined to be any randomized-strategy profile for the multiagent representation of F. Thus, the set of behav- ioral-strategy profiles of re is X A(/),) = X X 0(D5). sES* iEN sES; In the language of Section 2.1, a mixed-strategy profile specifies, for each player, a probability distribution over his set of overall strategies for playing Fe, whereas a behavioral-strategy profile specifies a proba- bility distribution over the set of possible moves for each possible infor- mation state of each player. A behavioral-strategy profile can also be called a scenario for the game, because it specifies a probability for every alternative branch at every decision node in the game tree. In general, if cr is a behavioral-strategy profile in X JEN X sES, A(Ds), then we can write ( Cji)iEN = (Cri.$)sES,,iEN

156 4 • Sequential Equilibria E X A(D) where ai = sES, and ai, = (cri s(ds))d,ED, E A(DS). Here the number o-,..,(c/s) can be called a move probability because it denotes the conditional probability (under scenario a) that player i would choose move 4, if the path of play reached a node that is controlled by player i with information state s. Any a, in X ,Es,A (Ds ), which specifies a prob- ability for every possible move at every possible information state of player i, is called a behavioral strategy for player i. On the other hand, a mixed strategy for player i is any Ti in A(C,) that specifies a probability Ti(c,) for every (nonrandomized) plan ci that player i could use to determine his moves at every information state. To appreciate the distinction between mixed strategies and behavioral strategies, consider the extensive-form game in Figure 4.1. The normal representation of this game (which is also the reduced normal repre- sentation, because there are no redundant strategies) is shown in Table 4.1 For any numbers a and 13 between 0 and 1/2, the mixed-strategy profile (a[wCi] + (.5 — 01.)[wiz1] + (.5 — ot)PelYil, P[x2z2] + (.5 — P)[lv2z2i (.5 P)Lx2Y21) P[w2Y2] is an equilibrium of this normal representation in strategic form. How- ever, all of these mixed-strategy profiles should be considered equivalent in the context of the original extensive-form game. In all of them, each player plans at each of his information states to use each of his two possible moves with probability 0.5. The only differences among these equilibria arise from the different ways that a player can correlate his planned moves at different information states. Because each player will actually move at only one of his two information states when the game is played, the correlation between the move that he chooses at one information state and the move that he would have chosen at any other information state has no significance. All that matters are the marginal distributions over moves that the randomized strategies generate at the various information states. Furthermore, these marginal distributions are all that are needed to describe a behavioral-strategy profile for the extensive-form game. That is, all of these mixed-strategy profiles cor- respond to the behavioral-strategy profile

4.1 • Mixed and Behavioral Strategies 157 2,0 2.3 X 2 •0,2 2.3 0,2 2,0 Y2 4,2 2 4 2,4 2,4 4,2 Figure 4.1 Table 4.1 A game in strategic form, the normal representation of Figure 4.1 C2 Cl W2 Y2 x2 y2 X2 22 W2Z2 wiYi 3,1 2,2 2,2 1,3 3,1 wiz' 2,2 1,3 2,2 1,3 xiyi 2,2 3,1 2,2 xiz, 1,3 2,2 3,1 2,2 (.5[w1 ] + .5 [x1], .5[yi] + 0.5k1l, .5[w2] + .5 [x2], •5[Y2] + .5 [z2]). Formally defining equivalence relationships between mixed-strategy profiles and behavioral-strategy profiles requires some technical care. For example, consider the game in Figure 4.2, and consider the mixed strategy .5[a1y1] + .5[bizi] for player 1. It might at first seem that this mixed strategy should correspond to the behavioral strategy (.5[a1] + .5[b1], .5[y1] + .5[z1]) for player 1, but this would be wrong. The only way that player 1 would plan to use z, at a 1.3 node under the mixed

158 4 • Sequential Equilibria 3,2 2.2 0,5 2.2 3,2 Figure 4.2 strategy .5[a,yi] + .5[b,zi] is if he chooses the pure strategy biz', in which case the path of play could not possibly reach a 1.3 node. In fact, under the mixed strategy .5[a,y i] + .5[bizi], player 1 would choose y, with conditional probability 1 if the path of play reached a 1.3 node, because al)), is the only strategy that has positive probability and is compatible with information state 3 of player 1. So the behavioral strategy for player 1 that corresponds to .5[aiy 1] + .5[bizi] is (.5[a1] + .5[bi], [y1]). In general, for any player i, any pure strategy ci in Ci, and any information state s in Si, we say that s and ci are compatible iff there exists at least one combination of pure strategies for the other players such that a node at which player i moves with information state s could occur with positive probability when i implements strategy ci. That is, s and ci are compatible iff there exists some c_z = MEN-i in C-i = XjEN-i Cj such that E p(xk) > 0, where c = (c_i,ci) and P(•I •) is as defined in Section 2.2. We let C:1'(s) denote the set of all pure strategies in C, that are compatible with i's information state s. For any Ti in 0(C,) and any s in Si, we say that s is compatible with Ti iff there exists some ci in C',K(s) such that TAO > 0. For any s in Si and any cl, in Ds, let CP*(d„s) denote the set of pure strategies that are compatible with s and designate cl, as i's move at information state s. That is, Cnds,$) = {ci. E CNs)lci(s) = ds}.

4.1 • Mixed and Behavioral Strategies 159 For example, in the game in Figure 4.2, Cr(3) = faih, aizil and Cr*(YD3) = {a1y1}. A behavioral strategy cr, =i.s,1 sE S, for player i is a behavioral repre- sentation of a mixed strategy Ti in A(C,) iff, for every s in Si and every d, in D,, (4.1) E Ti(e)) = E Tz(C,) • e,ECf(s) c,ECT*(4s) That is, a, is a behavioral representation of Ti iff, for every move d, at every information state s in Si that is compatible with Ti, cr,.,(d„) is the conditional probability that i would plan to choose d, at s given that he chose a pure strategy that is compatible with s. It is straightforward to check that any randomized strategy'r, in A(C,) has at least one behavioral representation in X sEs, A(Ds)• If some information state s in Si is not compatible with Ti, then any probability distribution cri.J.) in 0(D5) would satisfy condition (4.1), because both sides are 0. Thus, Ti can have more than one behavioral representation. A behavioral-strategy profile a = (cr,),,N is a behavioral representation of a mixed-strategy profile T in X iEN A(C,) iff, for every player i, cr, is a behavioral representation of Ti. Given any behavioral strategy o-, = (az.$)sEs, in X sES, A(Ds), the mixed representation of cr, is defined to be Ti in A(C,) such that Ti(c,) = 11 cri.s(c,(s)), vc, E sES, That is, the mixed representation of a behavioral strategy cr, is the mixed strategy in A(C,) in which i's planned move at each information state s has the marginal probability distribution cr, s and is determined inde- pendently of his moves at all other information states. The mixed representation of a behavioral-strategy profile a = (cr,),,, is the mixed- strategy profile T such that, for every player i, Ti is the mixed represen- tation of u,. It is straightforward to show that, if Ti is the mixed repre- sentation of a behavioral strategy a, for player i, then a, is a behavioral representation of Ti. Two mixed strategies in A(C,) are behaviorally equivalent iff they share a common behavioral representation. Thus, in the example in Figure 4.1, player l's mixed strategies .5[zv1y1] + .5[x,z1] and .5[w1z1] + are behaviorally equivalent, because both have the behavioral represen- tation (.5[w1] + .5[x1], .5[h] + .5[z1]), for which the mixed representa- tion is .25[w1y1] + .25[x1z1] + .25[1v1zi] + .25[x1y1]. Similarly, in the game

160 4 Sequential Equilibria + .5[biz1] and .5[a in Figure 4.2, .5[a 1y1] + .5[b1y1] are behaviorally equivalent, because both have the behavioral representation (.5[w1] + .5[x1], [YI]), for which .5[a iY 1] + .5[b1Y1] is the mixed representation. Two mixed strategy profiles 'T and T in X IEN A(Cz) are behaviorally equivalent iff, for every player i, T, and 7, are behaviorally equivalent. We say that two mixed strategies 7, and p, in 41(C,) are payoff equivalent iff, for every player j and every 7_, in X 1EN -z 0 (C1), where isfs utility function in the normal representation of Fe. That is, T, and p, are payoff equivalent if no player's expected utility depends on which of these two randomized strategies is used by player i. The following theorem, due to Kuhn (1953), is proved in Section 4.11. THEOREM 4.1. If Fe is a game with perfect recall (see Section 2.1), then any two mixed strategies in A(C,) that are behaviorally equivalent are also payoff equivalent. Figure 4.3 shows that the technical assumption of perfect recall is needed to prove Kuhn's Theorem. This game does not have perfect recall, because player 1 at information state 3 cannot recall whether he chose x1 or yi at his information state 1. Player l's mixed strategies 2.2 1.3 Figure 4.3

4.2 • Equilibria in Behavioral Strategies 161 .5[x,x3] + .5[y,y3] and .5[x,y3] + .5[y,x3] are behaviorally equivalent, because they have the same behavioral representation (.5[x1] + .5[y,], .5[x3] + .5[y3]). However, .5[xix3] + .5[3,03] and .5[x,y3] + .5[y,x3] are not payoff equivalent; against [x2], for example, .5[x,x3] + .5[y03] gives player 1 an expected payoff of 0, but .5[x,y3] + .5[y,x3] gives player 1 an expected payoff of —1. 4.2 Equilibria in Behavioral Strategies If we defined an equilibrium of an extensive-form game to be an equi- librium of its normal representation in strategic form, then games like Figure 4.1 would have an enormous multiplicity of equilibria that are all behaviorally equivalent. To avoid this problem, we might consider defining an equilibrium of an extensive-form game to be an equilibrium of its multiagent repre- sentation, but such a definition could create a more serious problem of nonsensical equilibria in which a player fails to coordinate his moves across different information states. For example, ([6.,],[w2],[zi]) is an equilibrium of the multiagent representation of Figure 4.2. In this equilibrium, given that player 2 is expected to choose w2, the agent for l's first information state anticipates that switching from b, to a, would reduce his payoff from 2 to 0, because the agent for l's last information state is planning to do z1. Furthermore, given the expectation that l's first agent will choose b1, l's last agent figures that his planned move would never be carried out and so planning to choose z, is as good as planning to choose y,. However, if player 1 really expected player 2 to choose w2, then player l's actual best response would be to choose a, at his first information state and y, at his last information state. The nonsensical equilibria arise in the multiagent representation because the possibility of a coordinated change that involves more than one infor- mation state is not considered. To avoid both of these problems, a (Nash) equilibrium of an extensive- form game, or an equilibrium in behavioral strategies, is defined to be any equilibrium cr of the multiagent representation such that the mixed representation of o- is also an equilibrium of the normal representation. That is, an equilibrium of Fe is defined to be a behavioral strategy profile that both is an equilibrium of the multiagent representation and corresponds to an equilibrium of the normal representation. Thus, for

162 4 • Sequential Equilibria example, the unique equilibrium in behavioral strategies of the game in Figure 4.1 is (.5[w1] + [Y I] + .5[z11, .5[w2] + . 5[x2], .5[Y2] .5 [z2]), .5 and the unique equilibrium of the extensive-form game in Figure 4.2 is (.5[a + .5[b1l, .5[w2] + .5[x21, [Y ID. Let Fe be an extensive-form game with perfect recall, and let F be its normal representation in strategic form. By Kuhn's Theorem, if T is a Nash equilibrium of F, and 7 is any other mixed-strategy profile that is behaviorally equivalent to T, then t is also a Nash equilibrium of F (because switching any player's strategy in an equilibrium to a payoff- equivalent strategy will not violate the property of being an equilibrium). So for any behavioral-strategy profile a, the mixed representation of a is an equilibrium of F if and only if every mixed-strategy profile that has a as a behavioral representation is an equilibrium of F. The following theorem tells us that, to find an equilibrium of Fe, it suffices to find an equilibrium of the normal representation of Fe, because any equilibrium of the normal representation corresponds to an equilibrium of the multiagent representation. The proof is in Section 4.11. THEOREM 4.2. If Fe is an extensive-form game with perfect recall and T is an equilibrium of the normal representation of Fe, then any behavioral rep- resentation of T is an equilibrium of the multiagent representation of re. Theorem 4.2, together with the existence theorem for strategic-form games (Theorem 3.1), immediately implies the following general exis- tence theorem for extensive-form games. THEOREM 4.3. For any extensive-form game Fe with perfect recall, a Nash equilibrium in behavioral strategies exists. The perfect recall assumption is needed for this existence theorem. For example, the game without perfect recall in Figure 4.3 does not have any equilibrium in behavioral strategies. The unique equilibrium of the normal representation in strategic form is (.5[x,x3] + .5[y03], .5[x2] + .5[y2]), which gives each player an expected payoff of 0, but

4.3 Sequential Rationality 163 this is not the mixed representation of any equilibrium of the multiagent representation. The behavioral representation of this mixed-strategy profile is (.5[xj + .5[y1], .5[x2] + .5[y2], .5[x3] + .5[y3]), which happens to be an equilibrium of the multiagent representation, but it gives player 1 an expected payoff of — 1/2, instead of 0. Such games without perfect recall are highly counterintuitive and have few (if any) real applications, so the nonexistence of equilibria in behavioral strategies for such games is not problematic. This example is discussed here mainly to illustrate the importance of the perfect recall assumption. 4.3 Sequential Rationality at Information States with Positive Probability We say that a strategy for player i is sequentially rational for player i at information state s in S, if i would actually want to do what this strategy specifies for him at s when information state s actually occurred. In Section 2.2, we justified the procedure of studying an extensive- form game through its normal representation in strategic form, by assuming that at the beginning of the game each player chooses an expected-utility-maximizing strategy that tells him what to do at every possible information state and thereafter he mechanically applies this strategy throughout the game. This prior-planning assumption was the- oretically convenient, but it is artificial and unrealistic in most circum- stances. So let us now drop the prior-planning assumption and ask whether equilibrium strategies are sequentially rational. For any extensive-form game re, the given structure of the game specifies a chance probability for every branch immediately following a chance node. A behavioral-strategy profile a specifies a move probability for every branch immediately following a decision node, where o,..,(m) is the move probability of a branch with move label m immediately following a node controlled by player i with information state s. For any behavioral-strategy profile cr and any two nodes x and y, if y follows x then let P(y o-,x) denote the multiplicative product of all the chance probabilities and move probabilities specified by cr for the branches on the path from x to y. If y does not follow x, then let 13(ylcr,x) = 0. So P(y I o.,x) is the conditional probability that the path of play would go through y after x if all players chose their moves according to scenario a- and if the play of the game started at x. Let f denote the set of all terminal nodes in the game Fe, and let

164 4 • Sequential Equilibria Uz(cr Ix) = T 3(y I cr,x)wi(y), yE0 where zuz(y) denotes the payoff to player i at terminal node y. That is, Uz(o- Ix) is the expected utility payoff to player i if the play of the game began in node x (instead of the root) and all players thereafter chose their moves as specified by a. Notice that Uz(crlx) depends only on the components of cr that are applied at nodes that follow the node x in the tree. Suppose that player i has an information state s that occurs at only one node x, so Y5 = {x}. Then the behavioral-strategy profile a is se- quentially rational for i at s iff a;., E argmax Ui(o-_ ) s.x,. ps E (DO (Here (a_,,p,) is the behavioral strategy that differs from a only in that player i would behave according to ps at state s.) That is, a is sequentially rational for i at state s iff cri., would maximize player i's expected utility when the node x occurred in the game, if player i anticipated that all moves after x would be determined according to a. Sequential rationality is somewhat more subtle to define at informa- tion states that occur at more than one node. At such an information state, a player's expected utility would depend on his beliefs about which of the possible nodes had actually occurred in the path of play. So these beliefs may have an important role in our analysis. For any information state s of any player i, a belief-probability distri- bution for i at s is a probability distribution over Y„ the set of nodes labeled \"i.s.\" That is, for any s in Si, a belief-probability distribution for i at s is a vector irz., in 0(Y5). If we assert that iris is player i's belief- probability distribution at state s, then we mean that, for each node x in Y„ Trz.,(x) would be the conditional probability that i would assign to the event that he was making a move at node x, when he knew that he was making a move at some node in Ys. A beliefs vector is any vector 'Tr = (Tr 1 z.$)z(N.,Es, in the set X iEN X sES, A(I') = X „s. A(Ys). That is, a beliefs vector specifies a belief-probability distribution for each information state of each player. Given a beliefs vector Tr, which specifies IT, as player i's belief-prob- ability distribution at an information state s in Si, a behavioral-strategy profile a is sequentially rational for i at s with beliefs IT iff

4.3 • Sequential Rationality 165 o E argmax E (4.2) .s,P51x)• ps E A(Ds) x E Y, That is, a is sequentially rational for player i at state s iff cr, s would maximize player i's expected payoff when a node in Y, occurred in the path of play, given the belief probabilities that i would assign to the various nodes in Ys when he learned that one of them had occurred, and assuming that all moves after this node would be determined ac- cording to Cr. Equivalently (by Lemma 3.1), Cr is sequentially rational for player i at his information state s with beliefs IT iff, for any move ds in Ds, if o- s(ds) > 0, then ds E argmax E Tr, s(x)U,(o- „[e s]lx). es EDs xEYs For any move es in Ds, where s E Si, player i's conditionally expected payoff E Tri s(x)Ui(o-_ i.„ [es] I x) xEY, is the sequential value of the move es for player i at state s, relative to the scenario if and beliefs Tr. Thus, if Q is not sequentially rational for i at s with 7, then there must exist some move bs in Ds such that the move probability o-,s(bs) is strictly positive but the sequential value of bs for i at s (relative to Q and Tr) is strictly less than the sequential value of some other move that is also available to i at s. Any such move bs is an irrational move in the scenario o-, with beliefs Tr. The above definition of sequential rationality begs the question (first addressed by Kreps and Wilson, 1982) of how should a rational intel- ligent player determine his belief probabilities? Belief probabilities are conditional probabilities given information that may become available to a player during the play of the game. Thus, these belief probabilities must be related by Bayes's formula to what this player would believe at the beginning of the game. For any node y and any behavioral-strategy profile cr, we let P(y I cr) denote the probability that the path of play, starting at the root, will reach node y when all players choose their moves according to the scenario Cr. That is, P(y I 0') = I cr,x °), where x° denotes the root or initial node of the tree, so P(y I Cr) is the multiplicative product of all the chance probabilities and move probabilities specified by a for the

166 4 • Sequential Equilibria branches on the path from the root to y. We refer to P(y I a) as the prior probability of node y under the scenario a. Now suppose that a is a behavioral-strategy profile that describes the behavior that an intelligent individual would anticipate in the play of Fe. Then, by Bayes's formula, for any player i and any information state s in Si, player i's belief-probability distribution iri.s at state s should satisfy the following equation, for every node x in Y5: (4.3) 1T,s(x) E P (Yiu) = TAxl Cr). yEY, That is, the conditional probability of node x given state s multiplied by the total prior probability of the i.s nodes must equal the prior proba- bility of node x, under the scenario a. We say that a beliefs vector 'rr is weakly consistent with a scenario o- iff IT satisfies condition (4.3), for every player i, every information state s in S„ and every node x in Ys. If the probability of the path of play going through a node in Y5 is strictly positive, so that E P(y I cr) > 0, (4.4) yE Y, then equation (4.3) completely characterizes i's belief probabilities at s, because it is equivalent to •Trz s(x) — (4.5) P(x16) V x E Y. PO iff) yE On the other hand, if condition (4.4) is violated, then state s has zero probability under a, or s is said to be off the path of a. Unfortunately, equation (4.3) cannot be used to compute the belief probabilities at an information state s that has zero probability in the scenario a, because both sides of the equation would be 0 no matter what Tr,s(x) may be. At information states that can occur with positive probability in an equilibrium, the equilibrium strategies are always sequentially rational. THEOREM 4.4. Suppose that a is an equilibrium in behavioral strategies of an extensive-form game with perfect recall. Let s be an information state in Si that occurs with positive probability under a, so condition (4.4) is satisfied. Let IT be a beliefs vector that is weakly consistent with a. Then a is sequential rational for player i at state s with beliefs IT.

4.3 • Sequential Rationality 167 The proof of Theorem 4.4 is given in Section 4.11. This theorem should not be surprising because, as we saw in Chapter 1, Bayes's formula itself can be derived using an axiom that optimal decisions after observing an event should be consistent with optimal contingent plans that a decision-maker would formulate before observing this event. Thus, without the prior planning assumption, equilibrium strategies are still rational to implement at all information states that have positive probability. To illustrate these ideas, consider again the simple card game dis- cussed in Section 2.1. In Section 3.2, we showed that the unique equi- librium of this game is (TI,T2) (1/2[Rd + 2/3[Rf], 2/3[M] + 1/2[P]). In behavioral strategies, this equilibrium is (Q, cr 1 b, Q2.0) = + 2/3[f], 2/3[M] + 1/2{PD. That is, player 1 should raise for sure at 1.a, when he has a red card; player 1 should raise with probability 1/3 and fold with probability 2/3 at 1.b, when he has a black card; and player 2 should meet with probability 2/3 and pass with probability 1/3, when she has seen player 1 raise. To verify sequential rationality, we must check whether each player would actually be willing to implement these equilibrium strategies when his moves are not planned in advance. It is easy to see that player 1 should raise when he holds a winning red card, since he has nothing to gain by folding. When player 1 raises with a black card, he gets +1 if player 2 passes, and he gets —2 if player 2 meets. Thus, under the assumption that player 2 would implement her equilibrium strategy and meet with probability 2/3, the sequential value of raising for player 1 at 1.b is —2 X 2/3 + 1 x 1/3 = —1. On the other hand, when player 1 folds with a black card, he gets a payoff of —1 also, so player 1 should be willing to randomize between raising and folding when he has a black card, as his equilibrium strategy specifies. The decision problem for player 2 is a bit more subtle at the two nodes labeled 2.0. If she passes, then she gets —1 at either node. If she raises, then she gets —2 at her upper node (where player 1 has a red card), but she gets +2 at her lower node (where player 1 has a black card). So her optimal move depends on her belief probabilities for these two nodes. To compute these probabilities, we apply Bayes's formula. Let ac, denote her upper node and let bo denote her lower node. Under

168 4 • Sequential Equilibria the behavioral equilibrium r, the probability of reaching the upper node is P(ao I = .5 x cri a(R) = .5 x 1 = .5, and the probability of her lower node is b = 1/6. P(b° kr) = .5 x cri (r) = .5 X Thus, the conditional probabilities of the two nodes given that player 1 has raised are .5 0 Ir2.o(ao) = .5 + y6 = 0.75, , 1 /6 + 1/6) = 0.25. 1 r2.o(bo) = (.5 With these belief probabilities, the sequential value of meeting for player 2 at her state 0, after player 1 raises, is .75 x (-2) + .25 x 2 = —1. On the other hand, if player 2 passes after a raise, then her sequential value is —1, which would be her payoff for sure. So the beliefs Tr2.0 do indeed make player 2 willing to randomize between meeting and passing, as her equilibrium strategy specifies. When we exhibit an equilibrium diagrammatically on an extensive- form game, we should show both the move probabilities of the behav- ioral-strategy profile and the belief probabilities of a beliefs vector that is consistent with the equilibrium. To facilitate reading, let us follow the convention of writing move probabilities in parentheses and belief prob- abilities in angle brackets (\"<.>\"). In Figure 4.4, we show the equilib- rium and consistent beliefs of our simple card game in extensive form. At each branch that immediately follows a player's decision node, we show the move probability (a component of the behavioral-strategy profile o) in parentheses. At each decision node, we show the belief probability (a component of the beliefs vector IT) in angle brackets. 4.4 Consistent Beliefs and Sequential Rationality at All Information States Theorem 4.4 looks like a complete resolution of the question of se- quential rationality, but in fact it is not. It says nothing about behavior at information states that have zero probability in equilibrium. To guar-

4.4 • Consistent Beliefs 169 i.a R (1) <1>J 1/2 (0) 1/2 (1/3) 2.0 M (2/3) • 2,2 <.25> (1/3) (2/3) Figure 4.4 antee sequential rationality at all information states, including states with zero probability, we must refine our concept of equilibrium in a substantial and important way. At first, it might seem that rational behavior at states of zero proba- bility might be a minor technical issue of little interest. After all, if something will almost surely not occur, why worry about it? The prob- lem is that the probability of an information state is determined endog- enously by the equilibrium itself. If we allow that players might behave irrationally in an event that endogenously gets zero probability, then we might find that such an event gets zero probability only because players are taking pains to ensure they never create a situation in which some- one would behave so irrationally. That is, such a possibility of irrational behavior can have a major impact on players' behavior at states that occur with positive probability. Thus, if we want to study the behavior of rational intelligent players who do not make binding prior plans, we must be careful to apply the criterion of sequential rationality to behav- ior at all information states, not just at the states of positive probability. Notice that a player's expected payoff, as evaluated at the beginning of the game, is not affected at all by the move that he plans to use at an information state that is supposed to occur in equilibrium with zero probability. Thus, in formulating a strategy that maximizes his expected payoff given only what he knows at the beginning of the game, there is no restriction at all on what moves a player might plan to use at information states that are supposed to have zero probability. For ex-

170 4 • Sequential Equilibria ample, in the game in Figure 4.5, suppose that player 1 is expected to choose yi. Then player 2 would expect a payoff of 9 no matter what strategy she planned to use. Thus, the strategy to choose y2 if she gets a chance to move would be as good as any other strategy for player 2, by the criterion of maximizing 2's expected utility given her information at the beginning of the game. Because 1 prefers to choose yi if 2 is planning to choose y2, 1],[y2]) is a Nash equilibrium of this game. However, it would be irrational for player 2 to choose y2 if she actually got the opportunity to move, because it gives her a payoff of 2 when she could get 3 by choosing x2. Thus, ffyi],[y2]) is not sequentially rational at player 2's node, even though it satisfies the definition of a Nash equilibrium for this game. (The other equilibrium of this game ax1],[x2]) is sequentially rational, however.) The unreasonable equilibrium in Figure 4.5 involves a weakly domi- nated strategy (y2), but it is easy to construct similar examples in which no strategies are weakly dominated. For example, consider Figure 4.6. No pure strategies are weakly dominated in this game, and ([yi], [y2], .5[x3] + .5[y3], [y4]) is an equilibrium in behavioral strategies, but there is no consistent beliefs vector that would make this equilibrium sequen- tially rational for player 3. The move x3 is irrational for player 3 in this scenario, because player 4 would be expected to choose y, after player 3 moves, so the sequential value of x3 would be less than the sequential value of y3 for player 3 (0 < 2). In general, a weak sequential equilibrium of Fe is any (cr,7r) such that cr is a behavioral-strategy profile in X „s.A(Ds), IT is a beliefs vector in X scs.A(Y5), o- is sequentially rational for every player at every infor- mation state with beliefs 7r, and it is weakly consistent with r. (This term has been used by Hillas, 1987.) That is, (o-,71-) is a weak sequential equilibrium iff it satisfies conditions (4.2) and (4.3) for every player i 2,3 0,2 1,9 Figure 4.5

4.4 • Consistent Beliefs 171 0,0,2,0 0,5,0,2 0,1,0,2 0,2,2,0 Figure 4.6 2,3,0,0 X2 x3 0,0,2,0 (0) 12.2 s ‘ (1/2) 3.3 Y3 Y2 X4 0,1,0,2 1.1 (0) (1) 4.4 , (0) <1/2> (1/2) Y4 <1> <1> ; X3 (1) 3.3 0,5,0,2 (1) (1/2) 1,9,0,0 <1/2> y3 ) (1/2) 0,2,2,0 Figure 4.7 and every information state s. We say that a behavioral-strategy profile is a weak sequential-equilibrium scenario iff there exists some beliefs vector 'r such that (o-,ir) is a weak sequential equilibrium. So the concept of weak sequential equilibrium can exclude some unreasonable equilibria. As we have seen, [y2], .5[x3] + .5[y3], [y4]) is an equilibrium of the game in Figure 4.6, but it is not a weak sequen- tial-equilibrium scenario. However, it is easy to construct other games in which equally unreasonable equilibria are not excluded by the concept of weak sequential equilibrium. For example, consider Figure 4.7, which is derived from Figure 4.6 by just switching the order in which players 3 and 4 make their moves. Because neither player observes the other's move, the order should not

172 4 • Sequential Equilibria matter, and indeed these two extensive-form games have the same representations (normal or multiagent) in strategic form. The behav- ioral-strategy profile ([y1], [y2], .5[x3] + .5[h], [y4]) is a weak sequential- equilibrium scenario of the game in Figure 4.7. To make this scenario a weak sequential equilibrium, we let the belief probabilities for the two decision nodes of player 3 both equal 1/2, as shown in the figure. Such beliefs are weakly consistent with this scenario because both of the 3.3 nodes have prior probabilities equal to 0 under this scenario (because both 3.3 nodes follow the x1 branch, which has move probability 0); so Bayes's formula (4.3) cannot be used to determine the belief probabili- ties ir3.3(x). When player 3 thinks that his two decision nodes are equally likely, he is willing to randomize between x3 and y3, each of which would give him a conditionally expected payoff of 1/2 x 2 + 1/2 x 0 = 1, when he knows only that some 3.3 node has been reached by the path of play. So (working backward through Figure 4.7), player 4 would be willing to choose y4 at her 4.4 node if she expected player 3 to randomly choose x3 and y3 with equal probability; player 2 would be willing to choose y2 at her 2.2 node if she expected players 3 and 4 to follow this scenario thereafter (because 1/2 x 5 + 1/2 x 2 > 3); and player 1 would prefer to choose y, if he expected player 2 to choose y2. The problem with this weak sequential equilibrium is that the belief probabilities specified for player 3 are unreasonable. If player 3 intel- ligently understood the given scenario ([y,], [y2], .5[x3] + .5[y3], [y4]), then he would expect player 4 to choose y4 if the path of play reached the 4.4 node; so he would believe that the path of play would have to be at the lower 3.3 node, with belief probability 1, if a 3.3 decision node were reached by the path of play. (With such beliefs, .5[x3] + .5[y3] would not be sequentially rational for player 3, because x3 would be an irrational move.) To develop a more sophisticated equilibrium concept that excludes such scenarios, we need some stronger concept of consis- tency for determining belief probabilities when all nodes with an infor- mation state have zero probability under a given scenario. It is not enough to simply say that any belief probabilities is are \"consistent\" when zero prior probabilities make both sides of equation (4.3) equal to O. To formulate a stronger definition of consistency of beliefs, let us try to think more systematically about the problem of how beliefs should be defined for all information states. We begin by making one simpli- fying assumption about the game Fe (to be relaxed in Section 4.8). Let

4.4 • Consistent Beliefs 173 us assume that every branch that immediately follows a chance node is assigned a chance probability in re that is strictly positive. With this assumption, any behavioral-strategy profile o that assigns a strictly positive move probability to every move at every information state will generate a strictly positive prior probability P(y I 0 \") for every node y in the tree. The set of all behavioral-strategy profiles in which all move probabilities are positive is X,,s*A°(Ds). (Recall the definition of A° in equation 1.6.) So if a E X sEs*A°(D,), then P(y cr) > 0 for every node y, and there is a unique beliefs vector 'rr that satisfies Bayes's formula (4.3) or (4.5). Let lf° denote the set of all pairs (a,7) such that E X sEs-A° (Ds) and Tr satisfies Bayes's formula (4.5) for every player i and every information state s in Si. Given the extensive-form game re, any stronger definition of \"con- sistent\" beliefs can be characterized mathematically by a set IP such that c X A(Ds)) x ( X A(Y5)), sES* ( sES* where qi denotes the set of all pairs (crjr) such that the beliefs vector 'rr is consistent with the scenario a. If consistency is supposed to be about satisfying all the implications of Bayes's formula, then ‘It° should be a subset of this set IP. That is, if (crjr) is in ke, then the beliefs vector IT should be considered consistent with if in any stronger sense, because Bayes's formula would allow no other beliefs vector with the scenario a in X scs.Y(Ds). For natural technical reasons, we can also suppose that x this set IP should be a closed subset of ( X sEs*A(D)) ( X sEs*A(Y$)), so that scenario-belief pairs that can be arbitrarily closely approximated by consistent pairs are themselves consistent. (For example, the set of pairs (crjr) such that IT is weakly consistent with a is a closed set, and it contains II/0 as a subset.) Thus, the strongest reasonable definition of consistency that we can consider is to let IP be the smallest closed set that contains ‘11°. So, following Kreps and Wilson (1982), we say that a beliefs vector Tr is fully consistent with a behavioral-strategy profile a in the game re iff there exists some sequence (6-k)/7=1 such that Qk E X A°(Ds (4.6) ), Vk E {1,2,3, . . . }, sES* o-is(cls) = lim es(ds), Vi E (4.7) N, Vs E S,, Vds E Ds,

174 4 • Sequential Equilibria . P(x I erk) (4.8) s(x) = , Vs E S*, Vx E Ys. Polak) k-'`' yE That is, ir is fully consistent with o- iff there exist behavioral-strategy profiles that are arbitrarily close to a and that assign strictly positive probability to every move, such that the beliefs vectors that satisfy Bayes's formula for these strictly positive behavioral-strategy profiles are arbitrarily close to it With this definition of full consistency, if we let II/ denote the set of all pairs (cror) such that 71- is fully consistent with then the set IP is exactly the smallest closed subset of ( X,Es.A(Ds)) x ( X sEs.A( 15)) that contains 111°. It is easy to show that full consistency implies weak consistency; that is, if it is fully consistent with Q, then it is also weakly consistent with cr. Hereafter, when we refer to beliefs being consistent with a scenario, we always mean that they are fully consistent, unless indicated otherwise. Recall from Section 1.6 that, when the number of possible states is finite, all Bayesian conditional-probability systems can be characterized as limits of conditional-probability systems that are generated by se- quences of probability distributions in which all events have positive probability, just as conditions (4.6)—(4.8) require. The only additional feature in (4.6)—(4.8) is that the sequences of probability distributions are required to treat the moves at different information states as sto- chastically independent random variables, to express the assumption that players choose their strategies without communication. It can be shown that, for any behavioral-strategy profile a- in X $Es.A(Ds), there exists at least one beliefs vector that is fully consistent with cr, although there may exist more than one fully consistent beliefs vector when Q is not in X sEs.Y(D5). To illustrate the implications of full consistency, consider the game in Figure 4.8, and consider the scenario ([z ],[y2],[y3]), which is an equi- 1 librium of this game. If we perturb this scenario slightly so that all move probabilities are positive, then we get a scenario EI)[z11, E2[X2] (60[X1] + 61[y1] + (1 (1 E0 E2)[Y2], 63[X3] + (1 E3)b)31) as shown in parentheses in Figure 4.8, where ro, ci, 82, and Es are very small positive numbers. Then Bayes's formula (4.5) implies that the belief probabilities shown in Figure 4.8 must satisfy

4.4 • Consistent Beliefs 175 • • x 4,2,2 3.3 (63) 2 < 0 > 0,0,0 i 2.2 (62) (1-6 3) Y2 3.3 • 0,0,3 x3 (63) <a > ' 0-62) x, <1> Ii3 (1-E3) 0,1,1 (Es) 2,2,2 3.3 x2 1.1 I 2.2 Yi (6 3) (E2) <8> y3 (El) ) <1> < 1-a > (1-6 3) 2,3,0 Y2 '--___-- (1-62) 3. x3 (1-6,3-Ei ) •2,0,0 (63) < c > 1,4,4 ) )13 (1-63) 0,1,1 Figure 4.8 Eo Ot = Eo + E1 60E2 P = 0 0 0 _,_ „ + .0.2 + '0 \ ' - 62) + 6162 6 1 E2) 82 60 = = 62a, 60 + 61 60(1 — 62) 1' — 6 062 + 80(1 — 62) + 61 62 + 61(1 — 62) = (1 — 62)a, 6162 8 = 6062 + 60( 1 - 62) + 6162 + 61(1 - 62) 62 6 1 = = 62(1 — a), 60 4- 61 Ei(1 - 62) = 6062 + 60( 1 - 62) + 61 62 + 61(1 - 62) a). = (1 - 62)(1 - As these positive numbers E0, E 1, 6 2 , and 63 go to 0, these consistent beliefs must satisfy

176 4 • Sequential Equilibria 0 = o, ,y = a, 8 = 0, t = 1 — a, where a may be any number in the interval [0,1]. So there is a one- parameter family of beliefs vectors that are fully consistent with the scenario az,],[y2],[y3])• The belief probability a, which is the conditional probability that player 2 would assign to the event that player 1 chose x, if the path of play reached a decision node controlled by player 2 (which is a zero-probability event under this scenario), can be any num- ber between 0 and 1. However, full consistency implies that the sum of belief probabilities 13 + y, which is the conditional probability that player 3 would assign to the event that player 1 chose x1 if the path of play reached a decision node controlled by player 3, must be equal to this same number a. That is, players 2 and 3 must agree about the condi- tional probability of x1, conditional on z1 not being chosen. Also, the sum of belief probabilities 13 + 8, which is the conditional probability that player 3 would assign to the event that player 2 chose x2 if the path of play reached a decision node controlled by player 3, must equal 0, because the move probability of x2 is 0 in this scenario. As defined by Kreps and Wilson (1982), a sequential equilibrium (or a full sequential equilibrium) of Fe is any (cr,Tr) in ( X scs• A(DS)) x ( X,Es. A(Y5)) such that the beliefs vector Tr is fully consistent with a and, with beliefs IT, the scenario a is sequentially rational for every player at every information state. We can say that a behavioral-strategy profile a is a sequential-equilibrium scenario, or that a can be extended to a sequential equilibrium, iff there exists some IT such that (cr,Tr) is a sequential equilibrium. The unique sequential equilibrium of our simple card game is shown in Figure 4.4. For the game in Figure 4.5, the unique sequential-equi- librium scenario is ax,],[x2]). For the games in Figures 4.6 and 4.7, the unique sequential-equilibrium scenario is ([x1], [x2], .5[x3] + .5[y3], .5[x4] + .5[y4]); to extend this scenario to a sequential equilibrium, we assign belief probabilities 1/2 to each of player 4's nodes in Figure 4.6, or to each of player 3's nodes in Figure 4.7. For the game in Figure 4.8, the unique sequential-equilibrium scenario is qx1],[x2],[x3]). To see why the equilibrium az1],[y2],[y3]) cannot be extended to a sequential equilibrium of Figure 4.8, recall that full consistency with this scenario would require that the belief probabilities shown in the figure must satisfy 13 = 8 = 0, y = a, and C = 1 — a. Given that player 3 would choose y3 at information state 3, player 2's expected payoff at

4.5 Computing Sequential Equilibria 177 information state 2 (with these belief probabilities) would be Oa + 3(1 — a) if she chose x2, or would be la + 1(1 — a) = 1 if she chose y2. So choosing y2 would be sequentially rational for player 2 at infor- mation state 2 iff Oa + 3(1 — a) < 1, so a 2/3. On the other hand, with these belief probabilities, player 3's expected payoff at information state 3 would be 213 + 3y + 28 + = 3a if he chose x3, or would be 013 + ly + 08 + 1 = 1 if he chose y3. So choosing y3 would be sequentially rational for player 3 at information state 3 iff 1 3a, so a 1/3. Thus (because a cannot be both less than 1/3 and greater than 2/3), there is no way to assign belief probabilities that are fully consistent with azi],[y2],[y3]) and make qz,],[y2],[y3]) sequentially rational for both play- ers 2 and 3. We can now state two basic theorems that are necessary to confirm that this definition of sequential equilibrium is a reasonable one. THEOREM 4.5. If (a,'rr) is a sequential equilibrium of an extensive-form game with perfect recall, then v is an equilibrium in behavioral strategies. THEOREM 4.6. For any finite extensive-form game, the set of sequential equilibria is nonempty. The proof of Theorem 4.5 is deferred to Section 4.11. The proof of Theorem 4.6 is given in Chapter 5, after our development of the con- cept of perfect equilibrium. To illustrate Theorem 4.5, recall the example in Figure 4.2. The scenario qb,],[w2],[z,]) is an equilibrium of the multiagent representation of this game, but it is not an equilibrium in behavioral strategies. With this scenario, fully consistent beliefs must assign belief probability 1 to the upper 1.3 node that follows w2. With such beliefs, however, z, would be an irrational move for player 1 at information state 3. Thus, ab1],[w2],[z ID is not a sequential-equilibrium scenario, so Theorem 4.5 is satisfied. (Notice that this argument requires full consistency. In fact, abl],[w2],[zi]) is a weak sequential-equilibrium scenario.) 4.5 Computing Sequential Equilibria Consider the game shown in Figure 4.9, adapted from Rosenthal (1981). This game can be interpreted as follows. After the upper chance event, which occurs with probability .95, the players alternate choosing be-

178 4 • Sequential Equilibria 1.1 2.2 92 1.3 2.4 93 94 • 8,8 (Y) <8> (E) (c) <1> <a> <1> 95 f2 (1-c) (1-y) (1-0 3,9 4,4 0,0 -1,5) 05 1.1 / 1.3 91 93 • 8,8 (E) (13) fi (1-p) (1-E) 0,0 4,4 Figure 4.9 tween generous (gk, for k = 1,2,3,4) and selfish ( fk) actions until someone is selfish or until both have been generous twice. Each player loses $1 each time he is generous, but gains $5 each time the other player is generous. Everything is the same after the lower chance event, which occurs with probability .05, except that 2 is then incapable of being selfish (perhaps because she is the kind of person whose natural integrity would compel her to reciprocate any act of generosity). Player 1 does not directly observe the chance outcome. The move probabilities and belief probabilities that make up a se- quential equilibrium are shown in Figure 4.9 in parentheses and angle brackets. To characterize the beliefs, let a denote the probability that player 1 would assign to the event that player 2 is capable of selfishness at the beginning of the game, and let 8 denote the probability that 1 would assign to the event that 2 is capable of selfishness if he had observed her being generous once. To characterize the behavioral strat- egies, let 13 be the probability that 1 would be generous in his first move; let -y be the probability that 2 would be generous in her first move, if she is capable of selfishness; let e be the probability that 1 would be generous in his second move; and let t be the probability that 2 would be generous at her second move, if she is capable of selfishness. We now show how to solve for these variables, to find a sequential equilib- rium of this game. Two of these variables are easy to determine. Obviously, a = .95, because that is the probability of the upper alternative at the chance

4.5 • Computing Sequential Equilibria 179 node, the outcome of which is unobservable to player 1. Also, it is easy to see that = 0, because player 2 would have no incentive to be generous at the last move of the game, if she is capable of selfishness. To organize the task of solving for the other components of the sequential equilibrium, we use the concept of support, introduced in Section 3.3. At any information state, the support of a sequential equi- librium is the set of moves that are used with positive probability at this information state, according to the behavioral-strategy profile in the sequential equilibrium. We select any information state and try to guess what might be the support of the sequential equilibrium at this state. Working with this guess, we can either construct a sequential equilib- rium or show that none exists with this support and so go on to try another guess. It is often best to work through games like this backward. We already know what player 2 would do at information state 4, so let us consider now player l's information state 3, where he makes his second move. There are three possible supports to consider: {g3}, {f3}, and {g3,f3}. Because 4 = 0, player 1's expected payoff (or sequential value) from choosing g3 at state 3 is 38 + 8(1-8); whereas player l's expected payoff from choosing f3 at state 3 is 48 + 4(1-8) = 4. By Bayes's formula (4.5), .9513y 19y 8 — .9513y + .0513 19y +1 Even if 13 = 0, full consistency requires that 8 = 19y/(19y + 1), because this equation would hold for any perturbed behavioral strategies in which 13 was strictly positive. Let us try first the hypothesis that the support of the sequential equilibrium at l's state 3 is {g3}; so E = 1. Then sequential rationality for player 1 at state 3 requires that 38 + 8(1-8) 4. This inequality implies that 0.8 8 = 19.y/(19y + 1); so y 5_ 4/19. But € = 1 implies that player 2's expected payoff from choosing g2 at state 2 (her first move) would be 9, whereas her expected payoff from choosing f2 at state 2 would be 5. Thus, sequential rationality for player 2 at state 2 requires that y = 1, when s = 1. Since y = 1 and y 5_ 4/19 cannot both be satisfied, there can be no sequential equilibrium in which the support at l's state 3 is {g3}. Let us try next the hypothesis that the support of the sequential equilibrium at 1's state 3 is {f3}; so r = 0. Then sequential rationality for player 1 at state 3 requires that 38 + 8(1-8) 4. This inequality

180 4 • Sequential Equilibria 8 = 19-y/(19.y + 1); so y a 4/19. But E = 0 implies implies that 0.8 that player 2's expected payoff from choosing g2 at state 2 would be 4, whereas her expected payoff from choosing f2 at state 2 would be 5. Thus, sequential rationality for player 2 at state 2 requires that y = 0 when E = 0. Because y = 0 and -y a 4/19 cannot both be satisfied, there can be no sequential equilibrium in which the support at l's state 3 is {f3}. The only remaining possibility is that the support of the sequential equilibrium at state 3 is {g3,f3}; so 0 < E < 1. Then sequential rationality for player 1 at state 3 requires that 38 + 8(1 — 8) = 4, or else player 1 would not be willing to randomize between g3 and f3. With consistent beliefs, this implies that 0.8 = 8 = 19-y/(19-y + 1); so -y = 4/19. Thus, player 2 must be expected to randomize between g2 and f2 at state 2 (her first move). Player 2's expected payoff from choosing g2 at state 2 is 9E + 4(1—E), whereas her expected payoff from choosing f2 at state 2 is 5. Thus, sequential rationality for player 2 at state 2 requires that 5 = 9E + 4(1—E); so E = 0.2. It only remains now to determine l's move at state 1. If he chooses s1, then he gets 0; but if he chooses gl, then his expected payoff is .95 x (4/19) x .2 x 3 + .95 x(4/19) x .8 x 4 + .95 x (15/19) x (-1) + .05 x .2 x 8 + .05 x .8 x 4 = 0.25, when a = .95, -y = 4/19, E = .2, and = 0. Because 0.25 > 0, sequential rationality for player 1 at state 1 requires that 13 = 1. That is, in the unique sequential equilibrium of this game, player 1 should be generous at his first move. Consider now the scenario afii,[f2],[L],[f4]), in which each player would always be selfish at any information state; so [3 = y = E = t = 0. If the chance node and the nodes and branches following the lower .05-probability branch were eliminated from this game, then this would be the unique sequential-equilibrium scenario. That is, if it were com- mon knowledge that player 2 would choose between selfishness and generosity only on the basis of her own expected payoffs, then no player would ever be generous in a sequential equilibrium. Furthermore, ([fl ],[f2],[f3],[f 4 ]) is an equilibrium in behavioral strategies of the actual game given in Figure 4.9 and can even be extended to a weak sequential equilibrium of this game, but it cannot be extended to a full sequential equilibrium of this game. For example, we could make this scenario a

4.5 • Computing Sequential Equilibria 181 weak sequential equilibrium, satisfying sequential rationality at all in- formation states, by letting the belief probabilities a and 8 both equal .95. However, the belief probability 8 = .95 would not be consistent (in the full sense) with this scenario because, if player 2 would be expected to be selfish at state 2 (y = 0), then player 1 would infer at state 3, after he chose generosity and did not get a selfish response from player 2, that player 2 must be incapable of selfishness, so 8 must equal 0. But with 8 = 0, selfishness (f3) would be an irrational move for player 1 at state 3, because he would expect generosity (g3) to get him a payoff of 8, with probability 1 — 8 = 1. This example illustrates the fact that small initial doubts may have a major impact on rational players' behavior in multistage games. If player 1 had no doubt about player 2's capacity for selfishness, then perpetual selfishness would be the unique sequential equilibrium. But when it is common knowledge at the beginning of the game that player 1 assigns even a small positive probability of .05 to the event that player 2 may be the kind of person whose natural integrity would compel her to reciprocate any act of generosity, then player 1 must be generous at least once with probability 1 in the unique sequential equilibrium. The essential idea is that, even if player 2 does not have such natural integ- rity, she still might reciprocate generosity so as to encourage player 1 to assign a higher probability to the event that she may continue to be generous in the future. Her incentive to do so, however, depends on the assumption that player 1 may have at least some initial uncertainty about player 2's type in this regard. The crucial role of such small initial uncertainties in long-term relationships has been studied in other ex- amples of economic importance (see Kreps, Milgrom, Roberts, and Wilson, 1982). For a second example, consider the game in Figure 4.10. To char- acterize the sequential equilibria of this game, let a denote the belief probability that player 2 would assign in information state 3 to the upper 2.3 node, which follows player l's x1 move. With these beliefs at information state 3, player 2's conditionally expected payoff would be 8a + 0(1 — a) if she chose e3, 7a + 7(1 — a) = 7 if she chose f3, or 6a + 9(1 — a) = 9 — 3a if she chose g3. So move e3 would be optimal for player 2 at state 3 when both 8a > 7 and 8a 9 — 3a, that is, when a 7 /s. Move f3 would be optimal for 2 when both 7 8a and 7 9 — 3a, that is, when 2/3 7/8. Move g3 would be optimal for 2 when both 9 — 3a > 8a and 9 —3a 7, that is, when a 2A. Notice that

182 4 • Sequential Equilibria Figure 4.10 there is no value of a for which e3 and g3 both would be optimal for player 2 at state 3, so the only possible supports at information state 3 for a sequential equilibrium are {e3}, {f3}, {g3}, {e3,f3}, and {f3,g3}. We consider these possibilities in this order. If player 2 were to use e3 for sure at state 3, then player 1 would want to choose x1 at state 1 and x2 at state 2. Then consistency with ax,],[x2]) would require that a = 1/2, but e3 would be irrational for 2 at state 3 if a = 1/2 (because g3 would be better for her). So there is no sequential equilibrium with support {e3} at state 3. If player 2 were to use f3 for sure at state 3, then player 1 would want to choose y, at state 1 and y2 at state 2. Then consistency with ay,],[y2]) would impose no restriction on the belief probability a, because 2.3 nodes would have prior probability 0. However, sequential rationality for player 2 at information state 3 would require 2/3 Vs, or else player 2 would not be willing to choose f3. So the behavioral-strategy profile ay,],[y2],[f3]) with any beliefs vector such that 2/3 s a 7/8 together form a sequential equilibrium. If player 2 were to use g3 for sure at state 3, then player 1 would want to choose x, at state 1 and y2 at state 2. Then consistency with ([x1],[y2]) would require that a = 1, in which case g3 would be an irrational move for player 2 at state 3 (e3 would be better for her). So there is no sequential equilibrium with support {g3} at state 3. For a randomization between e3 and f3 to be sequentially rational for player 2 at state 3, the belief probability a must equal 7/8 (so that 8a = 7). There are two ways to construct a sequentially rational scenario, in