Forward induction in games with an outside option

Abstract

We provide eductive foundations for the concept of forward induction, in the class of games with an outside option. The formulation presented tries to capture in a static notion the rest point of an introspective process, achievable from some restricted preliminary beliefs. The former requisite is met by requiring the rest point to be a Nash equilibrium that yields a higher payoff than the outside option. With respect to the beliefs, we propose the Incentive Dominance Criterion. Players should consider one action more likely than another whenever the former is better than getting the outside option for more conjectures over his rival's actions. We apply this model to the case where the subgame is a coordination game with a conflict between payoff dominance and risk dominance. Our results provide support for dominance solvability, but not for Van Damme's notion of forward induction. We show how the forward induction logic helps to select the Pareto dominant equilibrium. This is the case whenever player 1's act of giving up the outside option reverses the incentive dominance relations among 1's pure actions in the subgame.