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# 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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 3 / 43
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 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.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 4 / 43
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
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 5 / 43
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.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 6 / 43
Static Bayesian Games: Player 2s Strategies

## To be able to determine player 2 best reply however strategies

and payos are not enough.

game is played.

that:

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

game given her beliefs on which game is played.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 7 / 43
Static Bayesian Games: Player 1s Best Reply
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
The best reply is therefore R.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 8 / 43
Static Bayesian Games: Player 1s Best Reply
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
The best reply is therefore R.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 9 / 43
Static Bayesian Games: Bayesian Nash Equilibrium
Recall that player 1s best reply is:

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.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 10 / 43
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)
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 11 / 43
Bayesian Game Example
Consider the Bayesian game we solved before:

1
= {A, B}

2
= {C}

## 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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 12 / 43
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 13 / 43
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
)
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 14 / 43
Extra: Beliefs about other Players Types [Take 2]
Also in the general case with interdependence players form beliefs
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
)
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 15 / 43
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
.

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
))
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 16 / 43
Bayesian Game Example (contd)
Consider the Bayesian game we solved before:

1
= {A, B}, T
2
= {C}

## 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
)

2
{L, R}

## Player 2 cannot act upon player 1s private information

Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 17 / 43
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 18 / 43
Interim Expected Utility

The interim stage occurs just after a player knows his type
T
i
= t
i

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
)
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 19 / 43

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 .
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 20 / 43
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 21 / 43
Bayesian Game Example (contd)
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 22 / 43
Bayesian Game Example (contd)
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!!!
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 23 / 43
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 24 / 43
DSE Example: Exchange

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

T
S
= {L, H}. The buyer does not observe this.

## Seller decides whether or not to sell.

Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 25 / 43
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
.

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.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 26 / 43
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;
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 27 / 43
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
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 28 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 29 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
_
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 30 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
) .
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 31 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
_
_
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 32 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
_
_
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 33 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 34 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 35 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
_
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
_
.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 36 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 37 / 43
Static Bayesian Games: Cournot Duopoly (contd)
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 38 / 43
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
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 39 / 43
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.
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 40 / 43
Computing Bayes Nash Equilibria
Testing for BNE behavior:

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

## 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)

Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 41 / 43
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)
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 42 / 43
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)
Leonardo Felli (LSE) EC202 Microeconomic Principles II 30 January 2014 43 / 43