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EC319 Economic Theory and Its Applications,

Part II: Lecture 7

Leonardo Felli

NAB.2.14

27 February 2014
Signalling Games

Consider the following Bayesian game:

I Set of players: N = {N , S, R},

I Nature N strategy space: (1/2, 1/2)

I R’s beliefs: µ(S1 ) = 1/2.

I The game is known as a signaling game and it is described in


the following extensive form.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 2 / 39
Signalling Games: Example

(1, 3) r UL UR r (2, 1)
@
@ [p] L S1 R [q]
@..r r ..r
.. ..@
.. .. @
.. ... @r
r
(4, 0) DL ... .. DR (0, 0)
.. ( 12 ) ...
.. ..
.. ..
.. b N
.. R R ...
.. ..
.. ..
(2, 4) r UL .... ( 12 )
..
.. UR r (1, 0)
@ .. ..
@ ... ..
..r
@.r r
[1 − p] L S2 R [1 − q] @
@
(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 3 / 39
Signalling Games: Equilibria

I We can classify the Perfect Bayesian equilibria of the game


according to the beliefs of the receiver R at the information
set in which he is asked to play.

I In particular in this game there exist two categories of


equilibria.

I Pooling equilibria: these are equilibria in which the two types


of sender S1 and S2 send the same signal (in this game a
choice of action aSi ) either L or R.

I In this case only one information set of the receiver R is on


the equilibrium path.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 4 / 39
Signalling Games: Equilibria (cont’d)

I Bayes rule imposes that the beliefs at this information set are
the same as the probabilities with which nature takes its
choice ( 12 ) and ( 21 ).

I Separating equilibria: these are equilibria in which the two


types of sender S1 and S2 send the two different signals: L
and R.

I In this case both information sets of the receiver R are on the


equilibrium path.

I Bayes rule imposes that the beliefs at the two information sets
are degenerate: p ∈ {0, 1} and q ∈ {0, 1}.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 5 / 39
Pooling Equilibria

I Consider now a candidate pooling equilibrium in which both


S1 and S2 choose strategy L.

I In this case Bayes rule implies p = 12 .

I The expected payoff to R are then:


7 1
ΠR (L, L; UL ) = , ΠR (L, L; DL ) =
2 2

I It is therefore a best reply for R to choose UL .

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 6 / 39
Pooling Equilibria (cont’d)

(1, 3) r UL UR r (2, 1)
@
@ [p] L S1 R [q]
@..r r ..r
.. ..@
.. .. @
.. ... @r
r
(4, 0) DL ... .. DR (0, 0)
.. ( 12 ) ...
.. ..
.. ..
.. b N
.. R R ...
.. ..
.. ..
(2, 4) r UL .... ( 12 )
..
.. UR r (1, 0)
@ .. ..
@ ... ..
..r
@.r r
[1 − p] L S2 R [1 − q] @
@
(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 7 / 39
Pooling Equilibria (cont’d)

I We now need to specify the off-the-equilibrium-path beliefs q


that sustain this equilibrium.

I At this purpose notice that if R response to R is UR then it is


not a best reply for S1 to choose L: he can gain by deviating
and choosing R instead.

I It is however a best reply for S2 to choose L.

I If instead R response to R is DR then it is a best reply for


both S1 and S2 to choose L.

I Therefore for the pooling strategy (L, L) to be part of a


Perfect Bayesian equilibrium we need R to choose DR at the
information set off the equilibrium path.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 8 / 39
Pooling Equilibria (cont’d)

I The expected payoff to R at this information set is:

ΠR (UR ) = q, ΠR (DR ) = 2 (1 − q)

I Clearly ΠR (DR ) ≥ ΠR (UR ) if and only if

2
q≤
3

I A Pooling Perfect Bayesian Equilibrium of this game is:


 1 2
(L, L); (UL , DR ), p = , q ≤
2 3

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 9 / 39
Pooling Equilibria (cont’d)
In other words given the following Bayesian signaling game:

(1, 3) r UL UR r (2, 1)
@
@ [p] L S1 R [q]
@..r r ..r
.. ..@
.. .. @
.. ..
(4, 0) r DL ... 1
.. DR@r
.. (0, 0)
.. (2) ..
.. ..
.. ..
.. b N
.. R R ...
.. ..
.. ..
(2, 4) r UL .... 1
(2)
..
... UR
r (1, 0)
@ .. ..
@ ... ..
@.r r .r
[1 − p] L S2 R [1 − q] @
@
(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 10 / 39
Recipe:

We used the following recipe to find a solution:

I make an hypothesis on the sender equilibrium strategies;


I given these strategies, identify the receiver’s beliefs at every
information set that is on the equilibrium path;
I given these beliefs compute the receiver’s best reply at the
information set that are on the equilibrium path;
I verify that the sender’s equilibrium strategies you started from
are a best reply for the different types of sender;
I identify the restrictions that this last step imposes on the
receiver’s beliefs at information sets that are off the
equilibrium path (if there is any).

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 11 / 39
Pooling Equilibria (cont’d)

I We already found a Pooling Strong Perfect Bayesian


Equilibrium:
 1 2
(L, L); (UL , DR ), p = , q ≤
2 3

I Consider now the other Pooling equilibrium in which both S1


and S2 choose the action R.

1
I Clearly Bayes rule implies that q = .
2

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 12 / 39
Pooling Equilibria (cont’d)

I Given this beliefs R’s best response is DR :


1
ΠR (R, R; UR ) = < ΠR (R, R; DR ) = 1
2

I Given this the sender S1 will always find optimal to deviate


and choose L independently of whether R following L will
choose UL or DL .

I This implies that there there does not exist a Pooling Perfect
Bayesian Equilibrium where S1 and S2 both choose R.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 13 / 39
Pooling Equilibria (cont’d)

(1, 3) r UL UR r (2, 1)
@
@ [p] L S1 R [q]
@..r r ..r
.. ..@
.. .. @
.. ... @r
r
(4, 0) DL ... .. DR (0, 0)
.. ( 12 ) ...
.. ..
.. ..
.. b N
.. R R ...
.. ..
.. ..
(2, 4) r UL .... ( 12 )
..
.. UR r (1, 0)
@ .. ..
@ ... ..
..r
@.r r
[1 − p] L S2 R [1 − q] @
@
(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 14 / 39
Separating Equilibria

I Consider now the Separating equilibrium in which S1 chooses


L and S2 chooses R.

I Bayes rule in this case implies p = 1 and q = 0.

I Given these beliefs it is then a best reply for R to choose:

I UL following the observed choice of L.

I DR following the observed choice of R.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 15 / 39
Separating Equilibria (cont’d)

I Notice however that given R’s best reply S2 can gain a payoff
of 2 by deviating and choosing L instead of the payoff of 1 he
gets by choosing R.

I This implies that there does not exist a Separating Perfect


Bayesian Equilibrium where S1 chooses L and S2 chooses R.

I Finally consider the Separating equilibrium in which S1


chooses R and S2 chooses L.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 16 / 39
Separating Equilibria (cont’d)

(1, 3) r UL UR r (2, 1)
@
@ [p] L S1 R [q]
@..r r ..r
.. ..@
.. .. @
.. ... @r
r
(4, 0) DL ... .. DR (0, 0)
.. ( 12 ) ...
.. ..
.. ..
.. b N
.. R R ...
.. ..
.. ..
(2, 4) r UL .... ( 12 )
..
.. UR r (1, 0)
@ .. ..
@ ... ..
..r
@.r r
[1 − p] L S2 R [1 − q] @
@
(0, 1) r DL DR@r (1, 2)

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 17 / 39
Separating Equilibria (cont’d)

I Bayes rule implies that p = 0 and q = 1.

I Given these beliefs it is then a best reply for R to choose:

I UR following the observed choice of R.

I UL following the observed choice of L.

I Notice that in this case player S1 earns an equilibrium payoff


of 2 and can only earn a payoff of 1 by deviating.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 18 / 39
Separating Equilibria (cont’d)

I Similarly in this case player S2 earns an equilibrium payoff of 2


and can only earn a payoff of 1 by deviating.

I In other words it is a best reply for players S1 and S2 to


choose strategies R, respectively L.

I The Separating Perfect Bayesian Equilibrium of this game is:


 
(R, L); (UR , UL ), p = 0, q = 1

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 19 / 39
Spence Signaling Model

Consider the following educational choice model:


I There are two types of workers: high productivity workers θH
and low productivity workers θL
I A worker is of type θi wth probability πi
I Before entering the labor market workers may signal their type
by acquiring education.
I Different types of workers have different costs of acquiring
education.
I Employers can distinguish workers only by their education and
do not observe their ability.
I Employers compete in wages to hire workers given such
information.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 20 / 39
Timing

1. Nature determines the type θi of each worker with probability


πi .

2. Workers decide how much education ei to acquire.

3. Employers simultaneously and independently make wage offers


w (ei ) to each worker (they Bertrand compete for each
worker).

4. Workers decide which offer to accept.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 21 / 39
Educational Investment: Workers

I Workers acquire a level e ∈ [0, 1] of education


I The cost of acquiring education e for type θi is

c(e|θi )

I Assume the cost of education is convex:

c(0|θi ) = 0 ce (e|θi ) > 0 cee (e|θi ) > 0

I Marginal cost of education is higher for the low productivity


worker θL than for the high productivity worker θH :

ce (e|θH ) < ce (e|θL )

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 22 / 39
Workers’ Preferences

I If the worker accept the wage offer w (e) then the payoff of a
worker of type θi with education e is:

u(e|θi ) = w (e) − c(e|θi )

I Assumptions on the marginal costs of education and on


preference guarantee that the single crossing condition is
satisfied.

I The indifference curves of the two types of workers cross once:


the Spence-Mirrlees Single Crossing Condition are satisfied.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 23 / 39
Employers

I The employers’ technology is such that the productivity of a


worker of type θi is

f (θi ) where f (θH ) > f (θL )

I Initially employers know only the prior probability πi that a


worker is of type θi .
I Employers do observe the educational investment e of workers
I After workers have made their educational investments,
employers
I update their beliefs on the basis of this new observed
information e,
I offer a wage w (e) that depends on education.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 24 / 39
Types of Equilibria: Separating Equilibria

This model has two different types of equilibria:

I Separating equilibria these are characterized by the fact that


the two types of worker:

1. choose different education levels: eHs > eLs

2. are paid different wages: w (eHs ) > w (eLs )

3. prefer not to mimic the other type by choosing the educational


level selected by the other type.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 25 / 39
Types of Equilibria: Pooling Equilibria

I Pooling equilibria these are characterized by the fact that the


two types of worker:

1. choose the same education level: eHp = eLp

2. are paid the same wage: w (eHp ) = w (eLp )

3. prefer not to be separated from the other type by choosing a


different educational level than the one selected by the other
type.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 26 / 39
Separating Equilibria: Characterization

Separating Equilibria are such that:

I Workers of different type choose different education levels ei ,


i ∈ {H, L}

I Employers upon observing the level of education ei perfectly


identify each type θi .

I Employers makes an offer w (ei ) to each worker.

I The worker decides which offer to accept.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 27 / 39
Separating Equilibria: Perfect Bayesian Equilibrium

I We are constructing a Perfect Bayesian Equilibrium of this


imperfect information game.
I We solve the model backward ad start from theemployers’
Bertrand competition for each worker.
I Assume there exists two potential employers h ∈ {1, 2} for
each worker.
I Given two offers w1 (ei ) and w2 (ei ) the worker will choose the
offer (and hence the employer) such that

wh (ei ) = max {w1 (ei ), w2 (ei )}

I If two offers are identical w1 (ei ) = w2 (ei ) the worker will


randomize with equal probability the offer to accept.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 28 / 39
Bertrand Competition
I Each employer h’s payoff is then:

 f (θi ) − wh (ei )
 if wh (ei ) ≥ w−h (ei )
1
Π(wh (ei )) =
 2 [f (θi ) − wh (ei )] if wh (ei ) = w−h (ei )
0 if wh (ei ) < w−h (ei )

I Each employer h’s best reply is then:



 wh (ei ) = w−h (ei ) + ε if w−h (ei ) < f (θi )

wh (ei ) ≤ w−h (ei ) if w−h (ei ) = f (θi )

wh (ei ) < w−h (ei ) if w−h (ei ) > f (θi )

I The unique Bayesian Nash equilibrium of the Bertrand


Competition subgame is then
wh (ei ) = w−h (ei ) = f (θi ), ∀i ∈ {H, L}

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 29 / 39
Employers’ Beliefs

I We now move back to the employers believes upon observing


each worker education investment ei , i ∈ {H, L}.

I Assume that the two types of workers separate at the eduction


investment stage: θH workers choose eH and θL choose eL
where eH 6= eL .

I Bayes rule implies that the only equilibrium posterior beliefs of


employers compatible with a separating equilibrium are such
that:
Pr {θ = θi |ei } = 1

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 30 / 39
Educational Investment

I We now move back to the workers’ choice of education.


I It must be a best reply for each worker of type θi to choose
the level of educations ei :

w (eH ) − c(eH |θH ) ≥ w (eL ) − c(eL |θH )

w (eL ) − c(eL |θL ) ≥ w (eH ) − c(eH |θL )

I Given the equilibrium wage offer w (ei ) these no deviation


(incentive compatibility) conditions are:

f (θH ) − c(eH |θH ) ≥ f (θL ) − c(eL |θH )

f (θL ) − c(eL |θL ) ≥ f (θH ) − c(eH |θL )

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 31 / 39
Low Productivity and Education

I Notice first that in this model education is a pure signal, it


has no effect on productivity.

I Therefore the only Bayesian equilibrium choice of education


on the part of θL workers is

eL∗ = 0

I Assume not: eL∗ > 0.

I The incentive compatibility constraints imply eH > eL .

I Then a θL worker has a profitable deviation choosing eL < eL∗ ,


since
f (θL ) > f (θL ) − c(eL |θL )

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 32 / 39
High Productivity and Education

I The incentive compatibility constraints can then be written as:

c(eH |θH ) ≤ f (θH ) − f (θL ) ≤ c(eH |θL )

I Hence, incentive compatibility conditions imply:

eH ∈ [e, e] where c(e|θH ) = f (θH ) − f (θL ) = c(e|θL )

I All Bayesian Nash equilibria of the Spence Education model


are such that
eH ∈ [e, e] eL = 0
with beliefs:

1 if e = eH
Pr {θ = θH |e} =
0 if e = eL

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 33 / 39
Off the Equilibrium Path Beliefs

I To guarantee that no worker chooses e 6∈ {eH , eL } impose:



1 if e ≥ eH
Pr {θ = θH |e} =
0 if e < eH

I Recall that Bayes rule does not impose any constraint on the
off-the-equilibrium-path beliefs.

I The beliefs above imply that:



f (θL ) if e < eH
w (e) =
f (θH ) if e ≥ eH

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 34 / 39
Off the Equilibrium Path

I Given these beliefs and wage offers no θH worker wants to


deviate:

f (θH ) − c(eH |θH ) ≥ f (θH ) − c(e|θH ) for all e > eH


f (θH ) − c(eH |θH ) ≥ f (θL ) − c(e|θH ) for all e < eH

I Moreover no θL worker wants to deviate:

f (θL ) ≥ f (θH ) − c(e|θL ) for all e > eH


f (θL ) ≥ f (θL ) − c(e|θL ) for all e < eH

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 35 / 39
Multiplicity of Equilibria

There is a multiplicity of separating Perfect Bayesian equilibria

I They are characterized by the education levels satisfying:

eH ∈ [e, e] & eL = 0

I Workers receive the efficient wage, namely their productivity


I But no equilibrium is efficient since θH workers waist resources
to signal their θH type by investing in education
I The Pareto dominant equilibrium is the one in which eH = e
since the cost of acquiring education is the lowest
I The multiplicity is due to the off-the-equilibrium-path beliefs.

Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 27 February 2014 36 / 39