EC202 Slides Lecture 3

EC202 Microeconomic Principles II: Lecture 3
Leonardo Felli
CLM.G.02
30 January 2014
Static Bayesian Games
Consider the following simple normal form game:

1\2 L R
U 1, 1 0, 0
D 0, 0 6, 6
This game has two pure strategy Nash equilibria (U, L) and
(D, R) with payos respectively (1, 1) and (6, 6).
There also exists one mixed strategy Nash equilibrium

(6/7, 6/7) with payos (6/7, 6/7).
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 2 / 43
Static Bayesian Game: Example
Assume now that player 2 has some small uncertainty when

casting her choice of strategy in the game.
With probability
9
10
she thinks she is playing Game A:
1\2 L R
U
A
1, 1 0, 0
D
A
0, 0 6, 6
while with probability

1
10
she thinks she is playing Game B:
1\2 L R
U
B
1, 0 0, 10
D
B
0, 0 6, 6
Static Bayesian Games: Assumptions
We assume that:
Player 2 does not discover which game she is playing until

after she has decided her strategy.
Player 2 has to choose the same action in both games.
Player 1 has perfect information and knows exactly which

game he is playing.
Player 1 can choose a dierent action in each game.

This is a game of incomplete information or a Bayesian game.
Static Bayesian Games: Player 1s Strategies
This is a simultaneous move game hence Nash equilibrium

should be the basic tool to get a prediction.
We can than determine the strategy choice of player 1 as a

function of what he expects player 2 to do as best reply.
As argued above, a strategy choice for player 1 is a pair of

actions,
(a
A
, a
B
)
the rst element species the action player 1 will take if the
game is A: a
A
,
the second element species the action player 1 will take if the
game is B: a
B
.
Static Bayesian Games: Player 1s Best Reply
1\2.A L R 1\2.B L R
U
A
1,1 0,0 U
B
1,0 0,10
D
A
0,0 6,6 D
B
0,0 6,6
If the game played is A then player 1s best reply if he expects

player 2 to play L is U
A
, while his best reply if he expects
player 2 to play R is D
A
.
If the game played is B then player 1s best reply if he expects

player 2 to play L is U
B
, while his best reply if he expects
player 2 to play R is D
B
.
This is not a surprise since the payos to player 1 are the same in
both games.
Static Bayesian Games: Player 2s Strategies
To be able to determine player 2 best reply however strategies

and payos are not enough.
We need to take into account player 2s beliefs about which

game is played.
As mentioned in the description of the game player 2 believes

that:
with probability 9/10 the game played is A,
with probability 1/10 the game played is B.
We then need to compute player 2s expected payos in the

game given her beliefs on which game is played.
If player 2 expects player 1 to play U
A
or U
B
her expected payos
are:
2
(U
A
, U
B
; L) = 1
_
9
10
_
+ 0
_
1
10
_
=
9
10
2
(U
A
, U
B
; R) = 0
_
9
10
_
+ 10
_
1
10
_
= 1
The best reply is therefore R.
If player 2 expects player 1 to play D
A
or D
B
her expected payos
are:
2
(D
A
, D
B
, L) = 0
_
9
10
_
+ 0
_
1
10
_
= 0
2
(D
A
, D
B
, R) = 6
_
9
10
_
+ 6
_
1
10
_
= 6
If player 2 expects player 1 to play U
A
or D
B
her expected payos
are:
2
(U
A
, D
B
; L) = 1
_
9
10
_
+ 0
_
1
10
_
=
9
10
2
(U
A
, D
B
, R) = 0
_
9
10
_
+ 6
_
1
10
_
=
6
10
The best reply is therefore L.
Finally if player 2 expects player 1 to play D
A
or U
B
her expected
payos are:
2
(D
A
, U
B
; L) = 0
_
9
10
_
+ 0
_
1
10
_
= 0
2
(D
A
, U
B
, R) = 6
_
9
10
_
+ 10
_
1
10
_
=
64
10
Static Bayesian Games: Bayesian Nash Equilibrium
Recall that player 1s best reply is:
if player 2 chooses L to play U

A
and U
B
,
if player 2 chooses R to play D

A
and D
B
.
The unique Bayesian Nash equilibrium of the game is therefore:
player 2 chooses R and
player 1 chooses D
A
if the game is A and D
B
if the game is B.
The equilibrium payos for the two players are:
1
A
(D
A
, D
B
, R) = 6,
1
B
(D
A
, D
B
, R) = 6,
2
(D
A
, D
B
, R) = 6.
Incomplete Information (Strategic Form)
An incomplete information game consists of:
N the set of players in the game
A
i
player i s action set
T
i
player i s set of possible types
A prole of types t = (t
1
, ..., t
n
) is an element T =
j N
T
j
a distribution over the possible types
u
i
: A T R player i s utility function, u
i
(a|t)
Bayesian Game Example
Consider the Bayesian game we solved before:
Player 1s type takes two values: T

1
= {A, B}
Player 2s type takes only one values: T

2
= {C}
Probabilities are such that: (C, A) = 0.9
Payos and action sets are as described in the matrix:

1\2.A L R 1\2.B L R
U
A
1,1 0,0 U
B
1,0 0,10
D
A
0,0 6,6 D
B
0,0 6,6
Information Structure
Information structure:
T
i
denotes the type as a random variable
its realizations belong to the set of possible types T

i
t
i
denotes the realization of the random variable T
i
T
i
= (T
1
, ..., T
i 1
, T
i +1
, ..., T
n
) denotes a prole of types for
all players other than i
Player i observes only the realization of T

i
Player i ignores T
i
, but knows
i
Player i has beliefs regarding the realization of the types of the
other players t
i
Beliefs about other Players Types [Take 1]
In this course we consider models in which types are independent:
(t) =
j N
j
(t
j
)
This implies that the type T
i
of player i is independent of T
i
Beliefs are a probability distribution over the types of the other
players
Any player forms beliefs about the types of the other players by
using Bayes Rule
Independence implies that conditional on observing T
i
= t
i
the
beliefs of player i are:
i
(t
i
|t
i
) =
j N\i
j
(t
j
) =
i
(t
i
)
Extra: Beliefs about other Players Types [Take 2]
Also in the general case with interdependence players form beliefs
about the types received by the others by using Bayes Rule
Conditional observing T
i
= t
i
the beliefs of player i are:
i
(t
i
|t
i
) = Pr(T
i
= t
i
|T
i
= t
i
) =
=
Pr(T
i
= t
i
T
i
= t
i
)
Pr(T
i
= t
i
)
=
=
Pr(T
i
= t
i
T
i
= t
i
)
i
T
i
Pr(T
i
=
i
T
i
= t
i
)
=
=
(t
i
, t
i
)
i
T
i
(
i
, t
i
)
Strategies
Strategy Proles:
A strategy consists of a map from available information to

actions:
s
i
: T
i
A
i
s
i
(T
i
) species an action for every realization of the type T
i
.
A strategy prole consists of a strategy for every player:

s(T) = (s
1
(T
1
), ..., s
N
(T
N
))
We adopt the usual convention:

s
i
(T
i
) = (s
1
(T
1
), ..., s
i 1
(T
i 1
), s
i +1
(T
i +1
), ..., s
N
(T
N
))
Bayesian Game Example (contd)
Consider the Bayesian game we solved before:
Players types are: T

1
= {A, B}, T
2
= {C}
Probabilities are such that: (C, A) = 0.9
Payos and action sets are as described in the matrix:

1\2.A L R 1\2.B L R
U
A
1,1 0,0 U
B
1,0 0,10
D
A
0,0 6,6 D
B
0,0 6,6
A strategy for player 1 is a map s

1
: {A, B} {U, D}, it is a
pair (a
A
, a
B
)
A strategy for player 2 is an element of the set s

2
{L, R}
Player 2 cannot act upon player 1s private information

Dominant Strategy Equilibrium
Strategy s
i
weakly dominates s
i
if for any a
i
and t T:
u
i
(s
i
(t
i
), a
i
|t) u
i
(s
i
(t
i
), a
i
|t) with > for some a
i
Strategy s
i
is dominant if it dominates any other strategy s
Strategy s
i
is undominated if no strategy dominates it
Denitions (Dominant Strategy Equilibrium DSE)
A Dominant Strategy equilibrium of an incomplete information
game is a strategy prole s that for any i N, t T and
a
i
A
i
satises:
u
i
(s
i
(t
i
), a
i
|t) u
i
(s
i
(t
i
), a
i
|t) for any s
i
: T
i
A
i
I.e. s
i
is optimal independently of what others know and do
Interim Expected Utility
The interim stage occurs just after a player knows his type
T
i
= t
i
It is when strategies are chosen in a Bayesian game
The interim expected utility of a (pure) strategy prole s is

dened by:
U
i
(s|t
i
) =
T
i
u
i
(s(t)|t)(t
i
|t
i
) : T
i
R
With such notation in mind notice that:

U
i
(a
i
, s
i
|t
i
) =
T
i
u
i
(a
i
, s
i
(t
i
)|t)(t
i
|t
i
)
Best Reply
The best reply correspondence of player i is dened by:

b
i
(s
i
|t
i
) = arg max
a
i
A
i
U
i
(a
i
, s
i
|t
i
)
BR maps identify which actions are optimal given the type

observed by player i and the strategies followed by the other
players i .
Pure Strategy Bayes Nash Equilibrium
Denitions (Bayes Nash Equilibrium BNE)
A pure strategy Bayes Nash equilibrium of an incomplete
information game is a strategy prole s such that for any i N
and t
i
T
i
satises:
U
i
(s|t
i
) U
i
(a
i
, s
i
|t
i
) for any a
i
A
i
BNE requires interim optimality (i.e. do your best given what you
know)
BNE requires s
i
(t
i
) b
i
(s
i
|t
i
) for any i N and t
i
T
i
Consider the Bayesian game with (C, A) = 0.9:
1\2.A L R 1\2.B L R
U
A
1,1 0,0 U
B
1,0 0,10
D
A
0,0 6,6 D
B
0,0 6,6
As seen above the best reply maps for both player are:
b
1
(s
2
|A) =
_
U
A
if s
2
= L
D
A
if s
2
= R
b
1
(s
2
|B) =
_
U
B
if s
2
= L
D
B
if s
2
= R
while
b
2
(s
1
) =
_
L if s
1
= (U
A
, D
B
)
R otherwise
As seen above, this Bayesian game has a unique (pure strategy)
BNE in which:
s
1
(A) = D
A
, s
1
(B) = D
B
, s
2
= R
The payos associated with the BNE are:
U
1
(D
A
, D
B
, R|A) = 6,
U
1
(D
A
, D
B
, R|B) = 6,
U
2
(D
A
, D
B
, R) = 6.
DO NOT ANALYZE MATRICES SEPARATELY!!!
Relationships between Equilibrium Concepts
Theorem
If s is a DSE then it is a BNE.
In fact for any action a
i
and type t
i
:
u
i
(s
i
(t
i
), a
i
|t) u
i
(a
i
, a
i
|t) a
i
, t
i

u
i
(s
i
(t
i
), s
i
(t
i
)|t) u
i
(a
i
, s
i
(t
i
)|t) s
i
, t
i

T
i
u
i
(s(t)|t)
i
(t
i
|t
i
)
T
i
u
i
(a
i
, s
i
(t
i
)|t)
i
(t
i
|t
i
) s
i

U
i
(s|t
i
) U
i
(a
i
, s
i
|t
i
) s
i
DSE Example: Exchange
A buyer and a seller want to trade an object:
Buyers value for the object is 3
Sellers value is either 0 or 2 based on its type,

T
S
= {L, H}. The buyer does not observe this.
Buyer can oer either 1 or 3 to purchase the object
Seller decides whether or not to sell.

DSE Example: Exchange (contd)
The game is described by the following matrixes:
B\S.L sale no sale B\S.H sale no sale
3 0,3 0,0 3 0,1 0,2
1 2,1 0,0 1 2,-1 0,2
This game for any Bs beliefs 0 < < 1 has a DSE in which:
S
(L) = sale,
S
(H) = no sale,
B
= 1
where
i
(t
i
) is player i s strategy if the type is t
i
.
Oering 1 is a weakly dominant strategy for the buyer:

whatever
S
U
B
(1,
S
) U
B
(3,
S
) = 0
Once S expects B to oer 1 then it is optimal for S to

choose sale if t
S
= L and no sale if t
S
= H.
Static Bayesian Games: Cournot Duopoly
Consider now the following Cournot Duopoly game with imperfect
information.
Firm 1s cost function is:
c(q
1
) = c q
1
.
Firm 2 can be a high cost rm:
c
H
(q
2
) = c
H
q
2
where c
H
> c;
or it can be a low cost rm:
c
L
(q
2
) = c
L
q
2
where c
L
< c;
Static Bayesian Games: Cournot Duopoly (contd)
We assume that:
Firm 2 knows whether its variable cost is high c
H
or low c
L
,
Firm 1 does not know the variable cost of rm 2 but believes that:
with probability
1
2
the cost is high c
H
,
with probability
1
2
the cost is low c
L
.
The inverse demand function faced by both rms is:
P(q
1
+q
2
) = a (q
1
+q
2
)
where c
H
< a.
Notice that rm 1 will choose a unique quantity.
Notice that rm 2 will choose a dierent quantity depending on
whether its cost is high or low.
We label these quantities: q
H
2
or q
L
2
.
Depending on the value of the cost rm 2s prot functions are:
H
2
(q
1
, q
H
2
) = q
H
2
_
a (q
1
+q
H
2
) c
H
_
or
L
2
(q
1
, q
L
2
) = q
L
2
_
a (q
1
+q
L
2
) c
L
_
while rm 1s expected prot function is:
1
(q
1
, q
H
2
, q
L
2
) =
1
2
q
1
_
a (q
1
+q
H
2
) c
_
+
+
1
2
q
1
_
a (q
1
+q
L
2
) c
_
For any given quantity chosen by rm 1, q
1
, rm 2s best reply is,
depending on the value of the cost:
max
q
H
2
R
+
q
H
2
_
a (q
1
+q
H
2
) c
H
_
or
q
H
2
=
1
2
(a q
1
c
H
) ,
and
max
q
L
2
R
+
q
L
2
_
a (q
1
+q
L
2
) c
L
_
or
q
L
2
=
1
2
(a q
1
c
L
) .
For any given quantity chosen by the two types of rm 2 q
H
2
and
q
L
2
, rm 1s best reply is:
max
q
1
R
+
1
2
q
1
_
a (q
1
+q
H
2
) c
_
+
1
2
q
1
_
a (q
1
+q
L
2
) c
_
or
q
1
=
1
2
_
1
2
_
a q
H
2
c
_
+
1
2
_
a q
L
2
c
_
_
.
In other words the best reply of the two types of rm 2 and of rm
1 are:
q
H
2
=
1
2
(a q
1
c
H
) ,
q
L
2
=
1
2
(a q
1
c
L
) ,
q
1
=
1
2
_
1
2
_
a q
H
2
c
_
+
1
2
_
a q
L
2
c
_
_
.
The solution to this system of equations is:
q
1
=
(a 2c +
1
2
c
H
+
1
2
c
L
)
3
and
q
H
2
=
(a 2c
H
+c)
3
+
1
12
(c
H
c
L
)
and
q
L
2
=
(a 2c
L
+c)
3

1
12
(c
H
c
L
)
where q
L
2
> q
H
2
.
This is the unique Bayesian Nash equilibrium of this Cournot game
with asymmetric information.
Useful question is what is the dierence with the Cournot model
with perfect information.
Consider the same model in which everything is the same except
that rm 1 knows the costs of rm 2.
In this case rm 1 will choose two dierent quantities depending
on whether it is competing with the high cost rm 2, q
H
1
, or the
low cost rm 2, q
L
1
.
These quantities are the solution to the following two problems:
max
q
H
1
R
+
q
H
1
_
a ( q
H
1
+ q
H
2
) c
_
with best reply:
q
H
1
=
1
2
_
a q
H
2
c
_
,
and
max
q
L
1
R
+
q
L
1
_
a ( q
L
1
+ q
L
2
) c
L
_
or
q
L
1
=
1
2
_
a q
L
2
c
_
.
Firm 2s best reply are instead:
q
H
2
=
_
a q
H
1
c
H
_
2
, q
L
2
=
_
a q
L
1
c
L
_
2
.
The Nash equilibria of this two Perfect Information Cournot games
are then:
q
H
1
=
(a 2c +c
H
)
3
q
H
2
=
(a 2c
H
+c)
3
and
q
L
1
=
(a 2c +c
L
)
3
q
L
2
=
(a 2c
L
+c)
3
Compare now the quantities chosen by rm 2 in the presence of
complete vs. asymmetric information:
q
H
2
=
(a 2c
H
+c)
3
+
1
12
(c
H
c
L
) > q
H
2
and
q
L
2
=
(a 2c
L
+c)
3

1
12
(c
H
c
L
) < q
L
2
while for rm 1:
q
1
=
1
2
q
H
1
+
1
2
q
L
1
or
q
H
1
> q
1
> q
L
1
Mixed Strategies in Bayesian Games
Strategy Proles:
A mixed strategy is a map from information into a probability

distribution over actions
In particular
i
(a
i
|t
i
) denotes the probability that i chooses a
i
if his type is t
i
A mixed strategy prole consists of a strategy for every player:

(T) = (
1
(T
1
), ...,
N
(T
N
))
As usual
i
(T
i
) denotes the prole of strategies of all
players, but i
Mixed strategies are independent:

i
cannot depend on
j
Extra: Interim Payo & Bayes Nash Equilibrium
The interim expected payo of mixed strategy proles and
(a
i
,
i
) are:
U
i
(|t
i
) =
T
i
aA
u
i
(a|t)
j N
j
(a
j
|t
j
)(t
i
|t
i
)
U
i
(a
i
,
i
|t
i
) =
T
i
a
i
A
i
u
i
(a|t)
j =i
j
(a
j
|t
j
)(t
i
|t
i
)
Denitions (Bayes Nash Equilibrium BNE)
A Bayes Nash equilibrium of a game is a strategy prole such
that for any i N and t
i
T
i
satises:
U
i
(|t
i
) U
i
(a
i
,
i
|t
i
) for any a
i
A
i
Interim optimality: do your best given what you know.
Computing Bayes Nash Equilibria
Testing for BNE behavior:
is BNE if only if:

U
i
(|t
i
) = U
i
(a
i
,
i
|t
i
) for any a
i
s.t.
i
(a
i
|t
i
) > 0
U
i
(|t
i
) U
i
(a
i
,
i
|t
i
) for any a
i
s.t.
i
(a
i
|t
i
) = 0
Strictly dominated strategies are never chosen in a BNE
Weakly dominated strategies are chosen only if they are

dominated with probability zero in equilibrium
This conditions can be used to compute BNE (see examples)

Example I
Consider the following example for
1
(L) = 1/2:
1\2.L X Y 1\2.R W Z
T 1,0 0,1 T 0,0 1,1
D 0,1 1,0 D 1,1 0,0
All BNEs for this game satisfy:
1
(T) = 1/2 and
2
(X|L) =
2
(W|R)
Such games satisfy all BNE conditions since:
U
1
(T,
2
) = (1/2)
2
(X|L) + (1/2)(1
2
(W|R)) =
= (1/2)(1
2
(X|L)) + (1/2)
2
(W|R) = U
1
(D,
2
)
u
2
(X,
1
|L) =
1
(T) = 1
1
(T) = u
2
(Y,
1
|L)
u
2
(W,
1
|R) = (1
1
(T)) =
1
(T) = u
2
(Z,
1
|R)
Example II
Consider the following example for
1
(L) = q 2/3:
1\2.L X Y 1\2.R W Z
T 0,0 0,2 T 2,2 0,1
D 2,0 1,1 D 0,0 3,2
All BNEs for this game satisfy
1
(T) = 2/3 and:
2
(X|L) = 0 (dominance) and
2
(W|R) =
3 2q
5 5q
Such games satisfy all BNE conditions since:
U
1
(T,
2
) = 2(1 q)
2
(W|R) =
= q + 3(1 q)(1
2
(W|R)) = U
1
(D,
2
)
u
2
(X,
1
|L) = 0 < 2
1
(T) + (1
1
(T)) = u
2
(Y,
1
|L)
u
2
(W,
1
|R) = 2
1
(T) =
1
(T) + 2(1
1
(T)) = u
2
(Z,
1
|R)

EC202 Slides Lecture 3

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EC202 Slides Lecture 3

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EC202 Microeconomic Principles II: Lecture 3

Consider the following simple normal form game:

There also exists one mixed strategy Nash equilibrium

Assume now that player 2 has some small uncertainty when

while with probability

Player 2 does not discover which game she is playing until

Player 2 has to choose the same action in both games.

Player 1 has perfect information and knows exactly which

Player 1 can choose a dierent action in each game.

This is a simultaneous move game hence Nash equilibrium

We can than determine the strategy choice of player 1 as a

As argued above, a strategy choice for player 1 is a pair of

If the game played is A then player 1s best reply if he expects

If the game played is B then player 1s best reply if he expects

To be able to determine player 2 best reply however strategies

We need to take into account player 2s beliefs about which

As mentioned in the description of the game player 2 believes

with probability 9/10 the game played is A,

with probability 1/10 the game played is B.

We then need to compute player 2s expected payos in the

if player 2 chooses L to play U

if player 2 chooses R to play D

player 2 chooses R and

N the set of players in the game

a distribution over the possible types

Player 1s type takes two values: T

Player 2s type takes only one values: T

Probabilities are such that: (C, A) = 0.9

Payos and action sets are as described in the matrix:

its realizations belong to the set of possible types T

Player i observes only the realization of T

A strategy consists of a map from available information to

A strategy prole consists of a strategy for every player:

We adopt the usual convention:

Players types are: T

Probabilities are such that: (C, A) = 0.9

Payos and action sets are as described in the matrix:

A strategy for player 1 is a map s

A strategy for player 2 is an element of the set s

Player 2 cannot act upon player 1s private information

It is when strategies are chosen in a Bayesian game

The interim expected utility of a (pure) strategy prole s is

With such notation in mind notice that:

The best reply correspondence of player i is dened by:

BR maps identify which actions are optimal given the type

Buyers value for the object is 3

Sellers value is either 0 or 2 based on its type,

Buyer can oer either 1 or 3 to purchase the object

Seller decides whether or not to sell.

Oering 1 is a weakly dominant strategy for the buyer:

Once S expects B to oer 1 then it is optimal for S to

A mixed strategy is a map from information into a probability

A mixed strategy prole consists of a strategy for every player:

Mixed strategies are independent:

is BNE if only if:

Strictly dominated strategies are never chosen in a BNE

Weakly dominated strategies are chosen only if they are

This conditions can be used to compute BNE (see examples)

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