WIRTSCHAFTSUNIVERSITÄT WIEN

DEPARTMENT OF STRATEGY AND INNOVATION

INSTITUTE FOR MARKETS AND STRATEGY

SBWL Strategy and Data

Strategic Thinking and Analysis II

Lecture II-1
 Organization
§ Name tags.

§ Aims of this course:

• Economics (game-theoretical) tools applied to
managerial decision-making

• Strategic thinking
• Analysis of strategic situations and behavior
• (Behavioral insights)

© WU IMS
 Organization
§ About your lecturer
§ About you

§ Contact
• Administrative: ims@wu.ac.at
• Content: bgreiner@wu.ac.at
• D5, 4th floor

§ Consultations after appointment by email.

§ Learn@WU: slides, assignments, instructions, data,
discussions, other materials …
§ Ask questions!
(Some answers may need a little more time.)
© WU IMS
 Organization
§ Experiments:
• Interactive decision situations
§ Homework: Analysis of
• strategic situations
• data from real decisions
• individually or in groups of up to 3
§ Presentations and discussions:
• Cold calls
• Comment, question, answer
§ Lecture:
• Game-theoretical background, research findings
• Slides after class

© WU IMS
 Organization
§ No required textbook

§ But:
• Dixit & Skeath (&Reiley): Games of Strategy
§ comes closest in terms of level and content

© WU IMS
 Organization
§ Marking:
• 30% preparation/participation
– Prepare well
– Be in time
– Participate (including experiments)
• 2 x 10% written homework, announced when given out
• 50% exam
– Exercise by participating
§ Exam
• Strategic situation: like instructions
• Data on behavior: like experimental data
• à Strategic analysis, discussion of data: like homework

© WU IMS
 Organization

§ Questions?

© WU IMS
 Organization

§ Recap

§ Incomplete and imperfect information

§ Penalty kicks without and with bribery

§ Job market signaling

© WU IMS
 Recap: Definitions
§ A Game is defined by
• the players
• their potential strategies (possible courses of action)
• utility payoffs associated with combinations of strategies
§ A Strategy is
• a complete plan of action for the game, conditional on
time, nature, information, actions of other players .
§ A Nash Equilibrium is
• a combination of strategies leads to an outcome of a
game in which – given the strategies of the other players
– no player wants to deviate by choosing a different
strategy.

© WU IMS
 Recap: Normal Form
§ Normal form representation
Players
Player 2
Strategies
left right
1 0
up 2 0
Player 1
0 2
down
0 1

Payoffs of Player 1
Payoffs of Player 2
© WU IMS
 Recap: Extensive Form
§ Extensive form representation
Decision nodes left (2,1)
Root 2
up
right (0,0)
1 Outcomes

left (0,0)
down
2
right (1,2)
Branches

© WU IMS
 Recap: Information Sets
§ Extensive form – Information sets
left (2,1)
2
up
right (0,0)
1
left (0,0)
down
2
right (1,2)
Information set
Player 2 doesn’t know at which
of the the two nodes she is
© WU IMS
 Recap: Finding Nash Equilibria
§ In normal form of game, inspect:
• For each column player 2 might choose, find best
responses (best rows) of player 1, mark payoff with *
• For each row player 1 might choose, find best
responses (best columns) of player 2, mark with *
• All cells in which all players Player B
play best responses are
– per definition – left right
Nash equilibria 2* 1
up 1* 8*
Player A
6* 5
down
0 6
© WU IMS
 Recap: Finding Nash Equilibria
Extensive ( 0, 4)
up
form 2 down
up ( 30 , 5 )
1 up
( 2 , 20 )
down 2 down ( 50 , 19 )

The same game 2

in Normal form u:up- u:up- u:down- u:down-
d:up d:down d:up d:down
up 0,4 0,4 30*, 5* 30, 5*
1
down 2*, 20* 50*, 19 2 , 20* 50*, 19
© WU IMS
 Recap: Finding subgame perfect NEs
up ( 0, 4)
2 down
up ( 30 , 5 )
1 up
( 2 , 20 )
down 2 down ( 50 , 19 )
§ Find Subgame Perfect Nash equilibria by rollback:
• For the last decision nodes, find the optimal choice.
• Then, given these choices, find the optimal choice at
the nodes before. Continue until root of the game tree.
§ In subgame 1, 2 should choose “down”.
§ In subgame 2, 2 should choose “up”.
§ In subgame 3 (=full game), given behavior in subgames 1
and 2, 1 should choose “up”.
© WU IMS
 9, 11, 12
Recap: Finding NEs and SPNEs
§ To find Nash equilibria:
• Derive all possible strategies and corresponding payoffs
• Write down payoff matrix
• Inspection of payoff matrix

§ To find subgame perfect Nash equilibria:

• Write down extensive form
• Rollback: inspection of each node (each subgame),
beginning from the end of the game tree

§ à In simultaneous move games (all players make only

one decision, all at the same time):
Nash equilibria = subgame perfect Nash equilibria
© WU IMS
 Game theory and information

© WU IMS
 Game theory and information
§ Incomplete information:
• There is information missing about some players’
strategies or utility payoffs (= players’ types)

§ Imperfect information:
• There is information missing about other players’
(prior) moves.
à Every simultaneous move game is one of imperfect
information.

© WU IMS
 Example: Incomplete information
Boeing is Boeing is
weak strong
( 30 , 30 ) ( 30 , 30 )
Boe accommodate
enter ing
Air ( -10 , 20 ) ( -10 , 35 )
bus price war

stay out ( 0 , 100 ) ( 0 , 100 )

§ Airbus doesn’t know whether Boeing is weak or strong.
§ If Boeing is weak, the threat of price war is not credible,
so Airbus should enter.
§ If Boeing is strong, the threat of price war is very credible,
so Airbus should stay out.
§ What should Airbus do?
© WU IMS
 Example: Imperfect information
left (2,1)
2
up (0,0)
right
1 left (0,0)
down 2
right
( 1 , 2 )
§ When deciding, player 2 does not know whether player 1
has chosen up or down.
§ If player 1 had chosen “up”, player 2 should choose left.
§ If player 1 had chosen “down”, player 2 should choose
right.
§ What should player 2 do? What should player 1 do?
• à Inspect Normal Form to find Nash Equilibria.
© WU IMS
 Game theory and information
§ Incomplete information:
• There is information missing about some players’
strategies or utility payoffs (= players’ types)

§ Imperfect information:
• There is information missing about other players’
(prior) moves.
à Every simultaneous move game is one of imperfect
information.

§ Every incomplete information game can be transformed

into a game of imperfect information, by introducing a
player called nature who draws the types.

© WU IMS
 Incomplete à imperfect information
( 30 , 30 )
Boe accommodate
enter ing
Boeing is Air ( -10 , 20 )
bus price war
weak
p stay out ( 0 , 100 )
Nat
ure
1-p ( 30 , 30 )
Boe accommodate
Boeing is enter ing
Air ( -10 , 35 )
strong bus price war
stay out ( 0 , 100 )
§ Player “Nature” will choose “weak” as the type of Boeing
with probability p, and “strong” with probability 1-p.
© WU IMS
 Incomplete à imperfect information
§ What does it mean to add nature as a player?
§ We just use it to model that there is some
uncertainty/randomness in the type of the other
player(s).
§ Each player with uncertainty forms subjective
probabilities about the other player’s type.
§ Two equivalent interpretations:
• We know who the other player is, but we do not know
her preferences/strategies. “I know I am playing against
Tom, but I do not know whether he is selfish or nice.”
• We know the preferences of different players, but we
but we do not know against whom we are playing: “I
know that Tom is selfish and Jerry is nice, but I do not
know whether I play with Tom or with Jerry.”
© WU IMS
 Incomplete à imperfect information
Boe accommodate ( 30 , 30 )
ing
enter price war
Boeing is Air
weak p bus ( -10 , 20 )
stay out ( 0 , 100 )
Nat
ure accommodate
1-p Boe
( 30 , 30 )
Air enter
Boeing is ing price war
bus
strong
( -10 , 35 )
stay out
( 0 , 100 )
§ Airbus needs to form a subjective probability assessment
(i.e. a p) and can play a best reply to that probability.
§ Airbus should enter if p · 30 + (1-p) · -10 > p · 0 + (1-p) · 0 .
§ Thus, if p>0.25, Airbus should enter. If p<0.25, Airbus
should stay out.
© WU IMS
 Incomplete & imperfect information
§ Every incomplete information game can be transformed
into a game of imperfect information, by introducing a
player called nature who draws the types.

© WU IMS
 Definitions
§ Under complete information:
• A Game is defined by
– the players
– their potential strategies
– utility payoffs for outcomes

§ Under incomplete information:

• A Game is defined by
– the players and their possible types
– their potential strategies
– utility payoffs for outcomes
– a (initial and common) belief about distribution of
types
© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Bayesian Equilibria
Simultaneous Sequential
(static) games (dynamic) games
NE + Refinement:
Complete Nash equilibrium subgame-perfect
information (NE) Nash equilibrium
(SPNE)
BNE + Refinement:
Incomplete/
Bayesian Nash Perfect Bayesian
imperfect
Equilibrium (BNE) Nash Equilibrium
information
(PBNE)

© WU IMS
 Bayesian Equilibria
Simultaneous Sequential
(static) games (dynamic) games
NE + Refinement:
Complete Nash equilibrium subgame-perfect
information (NE) Nash equilibrium
(SPNE)
BNE + Refinement:
Incomplete/
Bayesian Nash Perfect Bayesian
imperfect
Equilibrium (BNE) Nash Equilibrium
information
(PBNE)

© WU IMS
 Experiment 20a

a) Experiment 20a is very similar to Experiment 19 (The

Hermit and the Socializer). Review your analysis and
the lecture slides of that game (experiment 19) and
apply the analysis analogously to this game
(experiment 20a). What is the Nash equilibrium of
this game?

© WU IMS
 Experiment 20a: Penalty kick
Keeper
Left q Right 1-q
p 20 -20
§ No pure strategy NE Left
-20 20
Striker
1-p -20 20
Right
20 -20

§ But a mixed strategy Nash equilibrium:

§ Striker chooses p such that p*20+(1-p)*-20=p*-20+(1-p)*20
§ Keeper chooses q such that q*-20+(1-q)*20=q*20+(1-q)*-20

§ In the unique (mixed) Nash Equilibrium, each player

chooses Left/Right with 50%.

© WU IMS 31
 Experiment 20a: Penalty kick
Keeper
Round 1 Left 40% Right 60%
Left 33% -20, 20 20, -20
Striker
Right 66% 20, -20 -20, 20
Keeper
Round 2 Left 60% Right 40%
Left 33% -20, 20 20, -20
Striker
Right 66% 20, -20 -20, 20
Keeper
Round 3 Left 47% Right 53%
Left 53% -20, 20 20, -20
Striker
Right 47% 20, -20 -20, 20

© WU IMS
 Experiment 20b

a) Write down the possible (pure) strategies of the two

players in the game of experiment 20b. Note that the
Striker knows her type and thus can choose strategies
which condition her action on her own type, for
example: “If I am bribed, then I shoot right, but if I am
not bribed, then I shoot left.” So there should be 2
different strategies for the Keeper and 4 different
strategies for the Striker.

© WU IMS
 Experiment 20b
The Striker is assigned the type “bribed” or “not bribed”,
each with 50% probability.
§ If the Striker is bribed, then payoffs are:
• K: left, S: left K: E$ 20, S: $ 10
• K: left, S: right K: E$ 0, S: $ 0
• K: right, S: left K: E$ 0, S: $ 0
• K: right, S: right K: E$ 10, S: $ 20
§ If the Striker is not bribed, then payoffs are:
• K: left, S: left K: E$ 20, S: $ 0
• K: left, S: right K: E$ 0, S: $ 20
• K: right, S: left K: E$ 0, S: $ 10
• K: right, S: right K: E$ 10, S: $ 0

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 20b
The Striker is assigned the type “bribed” or “not bribed”,
each with 50% probability.
Nat
ure
p (=50%) 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

© WU IMS
 Experiment 20b
The Striker is assigned the type “bribed” or “not bribed”,
each with 50% probability.
Nat
ure
p (=50%) 1-p (=50%)

K K
left right left right

S S S S
left right left right right right
left left
K,S 20,10 0,0 0,0 20,10 20,0 0,20 0,10 10,0

© WU IMS
 Experiment 20b
The Striker is assigned the type “bribed” or “not bribed”,
each with 50% probability.
Nat
Or, equivalently: ure
1-p (=50%)
p (=50%)

S S
left right left right

K K K K
left right left right right right
left left
K,S 20,10 0,0 0,0 20,10 20,0 0,10 0,20 10,0

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 20b
The Striker is assigned the type “bribed” or “not bribed”,
each with 50% probability.
Nat
ure
p (=50%) 1-p (=50%)

S S
left right left right

K K K K
left right left right right right
left left
K,S 20,10 0,0 0,0 20,10 20,0 0,10 0,20 10,0
Available Available strategies for S:
strategies for K: • if bribed then left, if not bribed then left
• left • if bribed then left, if not bribed then right
• if bribed then right, if not bribed then left
• right
• if bribed then right, if not bribed then right
© WU IMS
 Experiment 20b
c) Using these strategies, write down the Normal Form
of the game. To calculate the respective (expected)
payoffs of the player for each cell, use the
information that the Striker’s likelihood to be bribed
is 50%.

© WU IMS
 Experiment 20b
Nat
p (=50%) ure 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right

left
K
right

© WU IMS
 Experiment 20b
Nat
p (=50%) ure 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0
left
K
right

© WU IMS
 Experiment 20b
Nat
p (=50%) ure 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0
left
p20+(1-p)20
K
right

© WU IMS
 Experiment 20b
Nat
p (=50%) ure 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0 p10+(1-p)20
left
p20+(1-p)20 p20+(1-p)0
K
right

© WU IMS
 Experiment 20b
Nat
p (=50%) ure 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0 p10+(1-p)20 p0+(1-p)0
left
p20+(1-p)20 p20+(1-p)0 p0+(1-p)20
K
right

© WU IMS
 Experiment 20b
Nat
p (=50%) ure 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0 p10+(1-p)20 p0+(1-p)0 p0+(1-p)20
left
p20+(1-p)20 p20+(1-p)0 p0+(1-p)20 p0+(1-p)0
K
right

© WU IMS
 Experiment 20b
Nat
p (=50%) ure 1-p (=50%)

S (bribed) S (not bribed)

left right left right
10 0 0 20
left left
20 0 20 0
K K
0 20 10 0
right right
0 10 0 10

S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0 p10+(1-p)20 p0+(1-p)0 p0+(1-p)20
left
p20+(1-p)20 p20+(1-p)0 p0+(1-p)20 p0+(1-p)0
K
p0+(1-p)10 p0+(1-p)0 p20+(1-p)10 p20+(1-p)0
right
p0+(1-p)0 p0+(1-p)10 p10+(1-p)0 p10+(1-p)10
© WU IMS
 Experiment 20b
d) Given these expected payoffs, solve for Nash
Equilibria.

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 20b
S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0 p10+(1-p)20 p0+(1-p)0 p0+(1-p)20
left
p20+(1-p)20 p20+(1-p)0 p0+(1-p)20 p0+(1-p)0
K
p0+(1-p)10 p0+(1-p)0 p20+(1-p)10 p20+(1-p)0
right
p0+(1-p)0 p0+(1-p)10 p10+(1-p)0 p10+(1-p)10

§ Our equilibrium analysis will depend on p – the prior

belief that the Striker is bribed or not …
§ Let’s look at p=0.5

© WU IMS
 Experiment 20b
S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
5 15 0 10
left
20 10 10 0
K
5 0 15 10
right
0 5 5 10

© WU IMS
 Experiment 20b
S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
5 15* 0 10
left
20* 10* 10* 0
K
5 0 15* 10
right
0 5 5 10*

§ With p=0.5, there is only one Bayesian Nash Equilibrium:

§ Keeper chooses left
§ Striker chooses “If bribed, then left; if not bribed, then right”

© WU IMS
 Experiment 20b
S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
p10+(1-p)0 p10+(1-p)20 p0+(1-p)0 p0+(1-p)20
left
p20+(1-p)20 p20+(1-p)0 p0+(1-p)20 p0+(1-p)0
K
p0+(1-p)10 p0+(1-p)0 p20+(1-p)10 p20+(1-p)0
right
p0+(1-p)0 p0+(1-p)10 p10+(1-p)0 p10+(1-p)10

§ What if p=0.8,
i.e. the prior belief that the Striker is bribed is 80% ?

© WU IMS
 Experiment 20b
S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
8 12 0 4
left
20 16 4 0
K
2 0 18 16
right
0 2 8 10

§ What if p=0.8,
i.e. the prior belief that the Striker is bribed is 80% ?

© WU IMS
 Experiment 20b
S
If Br: left, If Br: left, If Br: right, If Br: right,
If nBr: left If nBr: right If nBr: left If nBr: right
8 12* 0 4
left
20* 16* 4 0
K
2 0 18* 16
right
0 2 8* 10*

§ With p=0.8, there are two Bayesian Nash Equilibria:

§ 1)
§ Keeper chooses left
§ Striker chooses “If bribed, then left; if not bribed, then right”
§ 2)
§ Keeper chooses right
§ Striker chooses “If bribed, then right; if not bribed, then left”

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 20b
The Striker is assigned the type “bribed” or “not bribed”,
each with 50% probability.
Nat
ure
p (=50%) 1-p (=50%)

S S
left right left right

K K K K
left right left right right right
left left
K,S 20,10 0,0 0,0 20,10 20,0 0,10 0,20 10,0
§ Since the Keeper cannot observe any action of the Striker,
she cannot update her beliefs about the Strikers’s type.
Thus, we don’t need to check for Perfect Bayesian Nash
Equilibrium. All Bayesian NEs are “perfect” here.
© WU IMS
 Experiment 20b

e) How did participants decide in the experiment? Did

they play equilibrium? Did behavior change over
time?

© WU IMS
 Experiment 20b
With p=0.5, one BNE:
S
K: left
If Br: left, If Br: left, If Br: right, If Br: right,
S: left if bribed, If nBr: left If nBr: right If nBr: left If nBr: right
right if not bribed
5 15* 0 10
left
20* 10* 10* 0
K
5 0 15* 10
right
0 5 5 10*

Frequency of “left”
Keeper Striker: bribed Striker: not bribed
§ Predicted 100% 100% 0%
§ Round 1 47% 75% 29%
§ Round 2 67% 57% 25%
§ Round 3 60% 20% 0%
© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 21

a) Depending on the probability p that the employee is

randomly assigned to a high skill level rather than a
low skill level, derive the optimal wage offer of the
firm.
b) What should the firm offer with the 40% probability
used in the experiment?

© WU IMS
 Workers and firms
§ Skill: low or high
§ Wage: low 20, high 40
§ Profitability: low skill: 40, high skill: 40+2*Wage

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Workers and firms
§ Skill: low or high
§ Wage: low 20, high 40
§ Profitability: low skill: 40, high skill: 40+2*Wage
E is high skill
E High wage ( 40 , 80 )

Nat
p F Low wage (20 , 60 )
ure
1-p
E is low skill
E ( 40 , 0 )
High wage
F Low wage ( 20 , 20 )

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Workers and firms
§ Skill: low or high
§ Wage: low 20, high 40
§ Profitability: low skill: 40, high skill: 40+2*Wage
E is high skill
E High wage ( 40 , 80 )

Nat
p F Low wage (20 , 60 )
ure
1-p
E is low skill
E ( 40 , 0 )
High wage
F Low wage ( 20 , 20 )

§ In this game, the Employee (E) has no choice to make.

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Workers and firms
§ Skill: low or high
§ Wage: low 20, high 40
§ Profitability: low skill: 40, high skill: 40+2*Wage
E is high skill
E High wage ( 40 , 80 )

Nat
p F Low wage (20 , 60 )
ure
1-p
E is low skill
E ( 40 , 0 )
High wage

§ What should the firm choose?

F Low wage ( 20 , 20 )

• Indifferent if 80p + (1-p)0 = 60p + (1-p)20 à p = ½

• If p < ½ then F should choose low wage, else high wage.
§ à 40% high skill workers à firm always chooses low wage
© WU IMS
 Experiment 21
§ Data
c) How do participants decide in the experiment? Does
behavior change over time?

© WU IMS
 Experiment 21
Wage = 20 Wage = 40
§ 1. Round 47% 53%
§ 2. Round 53% 47%
§ 3. Round 60% 40%
§ Further rounds … ? ?

© WU IMS
 Experiment 22

a) Write down the extensive form of this game. Start

with a move by player “Nature” which randomly
decides whether the worker is high skill or low skill.
After that, write down the respective subgames for
the case that the worker is low skill and for the case
that the worker is high skill. Use “information sets” to
indicate the sets of decision nodes where the firm
does not know at which node within that set it is,
because it could not observe the move of nature.

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 22
§ Wage: l: 20, h: 40, Profitability: l. sk: 40, h. sk: 40+2*Wage
§ Master Costs: high skill: 10, low skill 25
High wage ( 30 , 80 )

Master
F Low wage ( 10 , 60 )
E is high skill
E High wage ( 40 , 80 )

Nat
p
No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
1-p High wage
F Low wage ( -5 , 20 )
E is low skill
E Master

( 40 , 0 )
High wage
No education F Low wage ( 20 , 20 )

© WU IMS
 Experiment 22

b) Assume, for the moment, that the firm knows for sure
that the worker has a high skill level. What would be
the subgame perfect Nash equilibrium of this game?
Then assume that the firm knows for sure that the
worker has a low skill level. What would be the SPNE
then?

© WU IMS
 Experiment 22

High wage ( 30 , 80 )

Master
F Low wage ( 10 , 60 )
E is high skill
E High wage ( 40 , 80 )

Nat
p
No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
1-p High wage
F Low wage ( -5 , 20 )
E is low skill
E Master

( 40 , 0 )
High wage
No education F Low wage ( 20 , 20 )
§ If E is high skill, it’s always better for F to offer a high wage.
So there is no need for E to invest in an Master.
§ If E is low skill, F is always better off paying a low wage, and
will do so. So E will not get an Master.
© WU IMS
 Experiment 22

c) Now, the problem is that the firm does not know the
skill level of the worker. Is it possible to solve the
game by backward induction?
d) Solve for all Nash equilibria using the Normal Form of
the game …

© WU IMS
 Information updating
§ Backward induction? Not possible, due to information sets
containing more than one node.
High wage ( 30 , 80 )

Master
F Low wage ( 10 , 60 )
E is high skill
E High wage ( 40 , 80 )

Nat
p
No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
1-p High wage
F Low wage ( -5 , 20 )
E is low skill
E Master

( 40 , 0 )
High wage
No education F Low wage ( 20 , 20 )

© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 16
High wage ( 30 , 80 )

MCom
F Low wage ( 10 , 60 )
P1 is high skill
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
High wage
F Low wage ( -5 , 20 )
P1 is low skill
E MCom

( 40 , 0 )
High wage
No education F Low wage ( 20 , 20 )

§ Expected payoff for firm/worker =

0.6*payoff if this is a low skill worker + 0.4*payoff if this is a high skill worker
F
If Master, high wage, If Master, high wage, If Master, low wage, If Master, low wage,
If no Master, high wage If no Master, low wage If no Master, high wage If no Master, low wage
If high skill, Master,
If low skill, Master 21 , 32 21 , 32 1 , 36 1 , 36
If high skill, Master,
If low skill, no Master 36 , 32 24 , 44 28 , 24 16 , 36
E If high skill, no Master,
If low skill, Master 25 , 32 17 , 24 13 , 44 5 , 36
If high skill, no Master,
If low skill, no Master 40 , 32 20 , 36 40 , 32 20 , 36
© WU IMS
 Experiment 16
High wage ( 30 , 80 ) 40% likelihood
F Low wage ( 10 , 60 )
P1 is high skill MCom
Employee:
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 ) 0.6*15+0.4*30=21
ure
( 15 , 0 ) 60% likelihood
High wage
F Low wage ( -5 , 20 ) Firm:
P1 is low skill
E MCom

( 40 , 0 ) 0.6*0 +0.4*80=32
High wage
No education F Low wage ( 20 , 20 )

§ Expected payoff for firm/worker =

0.6*payoff if this is a low skill worker + 0.4*payoff if this is a high skill worker
F
If Master, high wage, If Master, high wage, If Master, low wage, If Master, low wage,
If no Master, high wage If no Master, low wage If no Master, high wage If no Master, low wage
If high skill, Master,
If low skill, Master 21 , 32 21 , 32 1 , 36 1 , 36
If high skill, Master,
If low skill, no Master 36 , 32 24 , 44 28 , 24 16 , 36
E If high skill, no Master,
If low skill, Master 25 , 32 17 , 24 13 , 44 5 , 36
If high skill, no Master,
If low skill, no Master 40 , 32 20 , 36 40 , 32 20 , 36
© WU IMS
 Experiment 16
High wage ( 30 , 80 )
F Low wage ( 10 , 60 )
P1 is high skill MCom
Employee:
E High wage ( 40 , 80 ) 40% likelihood
Nat No education
F Low wage (20 , 60 ) 0.6*-5+0.4*40=13
ure
( 15 , 0 )
High wage
F Low wage ( -5 , 20 ) 60% likelihood Firm:
P1 is low skill
E MCom

( 40 , 0 ) 0.6*20+0.4*80=44
High wage
No education F Low wage ( 20 , 20 )

§ Expected payoff for firm/worker =

0.6*payoff if this is a low skill worker + 0.4*payoff if this is a high skill worker
F
If Master, high wage, If Master, high wage, If Master, low wage, If Master, low wage,
If no Master, high wage If no Master, low wage If no Master, high wage If no Master, low wage
If high skill, Master,
If low skill, Master 21 , 32 21 , 32 1 , 36 1 , 36
If high skill, Master,
If low skill, no Master 36 , 32 24 , 44 28 , 24 16 , 36
E If high skill, no Master,
If low skill, Master 25 , 32 17 , 24 13 , 44 5 , 36
If high skill, no Master,
If low skill, no Master 40 , 32 20 , 36 40 , 32 20 , 36
© WU IMS
 Experiment 16
High wage ( 30 , 80 )
F Low wage ( 10 , 60 )
P1 is high skill MCom
Employee:
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 ) 40% likelihood 0.6*20+0.4*20=20
ure
( 15 , 0 )
High wage
F Low wage ( -5 , 20 ) Firm:
P1 is low skill
E MCom

( 40 , 0 ) 0.6*20+0.4*60=36
High wage
No education F Low wage ( 20 , 20 ) 60% likelihood
§ Expected payoff for firm/worker =
0.6*payoff if this is a low skill worker + 0.4*payoff if this is a high skill worker
F
If Master, high wage, If Master, high wage, If Master, low wage, If Master, low wage,
If no Master, high wage If no Master, low wage If no Master, high wage If no Master, low wage
If high skill, Master,
If low skill, Master 21 , 32 21 , 32 1 , 36 1 , 36
If high skill, Master,
If low skill, no Master 36 , 32 24 , 44 28 , 24 16 , 36
E If high skill, no Master,
If low skill, Master 25 , 32 17 , 24 13 , 44 5 , 36
If high skill, no Master,
If low skill, no Master 40 , 32 20 , 36 40 , 32 20 , 36
© WU IMS
 Experiment 16
High wage ( 30 , 80 )

MCom
F Low wage ( 10 , 60 )
P1 is high skill
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
High wage
F Low wage ( -5 , 20 )
P1 is low skill
E MCom

( 40 , 0 )
High wage
No education F Low wage ( 20 , 20 )

§ Expected payoff for firm/worker =

0.6*payoff if this is a low skill worker + 0.4*payoff if this is a high skill worker
F
If Master, high wage, If Master, high wage, If Master, low wage, If Master, low wage,
If no Master, high wage If no Master, low wage If no Master, high wage If no Master, low wage
If high skill, Master,
If low skill, Master 21 , 32 21 , 32 1 , 36 1 , 36
If high skill, Master,
If low skill, no Master 36 , 32 24 , 44 28 , 24 16 , 36
E If high skill, no Master,
If low skill, Master 25 , 32 17 , 24 13 , 44 5 , 36
If high skill, no Master,
If low skill, no Master 40 , 32 20 , 36 40 , 32 20 , 36
© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Experiment 22
High wage ( 30 , 80 )

MCom
F Low wage ( 10 , 60 )
P1 is high skill
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
F
High wage
Low wage ( -5 , 20 )
§ Expected payoff for
P1 is low skill
E MCom

( 40 , 0 )
firm/worker = 0.6*payoff if this
High wage is a low skill worker + 0.4*payoff
No education F Low wage ( 20 , 20 ) if this is a high skill worker

F
If Master, high wage, If Master, high wage, If Master, low wage, If Master, low wage,
If no Master, high wage If no Master, low wage If no Master, high wage If no Master, low wage
If high skill, Master,
If low skill, Master 21 , 32 21 , 32 1 , 36* 1 , 36*
If high skill, Master,
If low skill, no Master 36 , 32 24*, 44* 28 , 24 16 , 36
E If high skill, no Master,
If low skill, Master 25 , 32 17 , 24 13 , 44* 5 , 36
If high skill, no Master,
If low skill, no Master 40*, 32 20 , 36* 40*, 32 20*, 36 *
© WU IMS
 Experiment 22
High wage ( 30 , 80 )

MCom
F Low wage ( 10 , 60 )
P1 is high skill
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
F
High wage
Low wage ( -5 , 20 )
§ Expected payoff for
P1 is low skill
E MCom

( 40 , 0 )
firm/worker = 0.6*payoff if this
High wage is a low skill worker + 0.4*payoff
No education F Low wage ( 20 , 20 ) if this is a high skill worker
Pooling Equilibrium
Separating
Equilibrium F
If Master, high wage, If Master, high wage, If Master, low wage, If Master, low wage,
If no Master, high wage If no Master, low wage If no Master, high wage If no Master, low wage
If high skill, Master,
If low skill, Master 21 , 32 21 , 32 1 , 36* 1 , 36*
If high skill, Master,
If low skill, no Master 36 , 32 24*, 44* 28 , 24 16 , 36
E If high skill, no Master,
If low skill, Master 25 , 32 17 , 24 13 , 44* 5 , 36
If high skill, no Master,
If low skill, no Master 40*, 32 20 , 36* 40*, 32 20*, 36 *
© WU IMS
 Incomplete & imperfect information

§ When we encounter a game with incomplete information:

§ We introduce a player called “Nature” who determines
the type of a player.
§ We assume that this player has to form a strategy
conditional on her type.
§ We solve for Nash Equilibria. à Bayesian Nash Eq.
§ (We test whether beliefs about player types are
correctly updated along the equilibrium path. à
Perfect Bayesian Nash Equilibrium)

© WU IMS
 Pooling equilibrium
§ Wage: l: 20, h: 40, Profitability: l. sk: 40, h. sk: 40+2*Wage
§ Master Costs: high skill: 10, low skill 25
High wage ( 30 , 80 )

Master
F Low wage ( 10 , 60 )
E is high skill
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
High wage
F Low wage ( -5 , 20 )
E is low skill
E Master

( 40 , 0 )
High wage
No education F Low wage ( 20 , 20 )

§ The following is a (Perfect) Bayesian Nash equilibrium:

• E: no Master if high skill, no Master if low skill
• F: low wage if E has Master, low wage if E has no Master
© WU IMS
 Separating equilibrium
§ Wage: l: 20, h: 40, Profitability: l. sk: 40, h. sk: 40+2*Wage
§ Master Costs: high skill: 10, low skill 25
High wage ( 30 , 80 )

Master
F Low wage ( 10 , 60 )
E is high skill
E High wage ( 40 , 80 )

Nat No education
F Low wage (20 , 60 )
ure
( 15 , 0 )
High wage
F Low wage ( -5 , 20 )
E is low skill
E Master

( 40 , 0 )
High wage
No education F Low wage ( 20 , 20 )

§ The following is a (Perfect) Bayesian Nash equilibrium:

• E: Master if high skill, no Master if low skill
• F: high wage if E has Master, low wage if E has no Master
© WU IMS
 Experiment 22
§ Data
e) Compare the equilibrium prediction with the behavior
of participants in the game. Is there a change in
behavior over time?

© WU IMS
 Experiment 22
Avg. Emp income Master % high Avg. Firm income
Skill type % Master
no M./Master observed wage low w. / high w.
Round 1 low 29% 24 / -5 no 17% 28 / 0
high 88% 20 / 19 yes 33% 47 / 80
Round 2 low 29% 20 / 5 no 25% 27 / 80
high 63% 33 / 22 yes 57% 47 / 60
Round 3 low 33% 20 / 15 no 18% 33 / 80
high 17% 28 / 30 yes 100% - / 20
Round 4 low 0% 22 / - no 9% 28 / 0
high 67% 20 / 30 yes 100% - / 80
Round 5 low 10% 24 / 15 no 20% 25 / 0
high 80% 20 / 25 yes 80% 60 / 60

© WU IMS
 Experiment 22
Avg. Emp income Master % high Avg. Firm income
Skill type % Master
no M./Master observed wage low w. / high w.
Round 1 low 29% 24 / -5 no 17% 28 / 0
high 88% 20 / 19 yes 33% 47 / 80
Round 2 low 29% 20 / 5 no 25% 27 / 80
high 63% 33 / 22 yes 57% 47 / 60
Round 3 low 33% 20 / 15 no 18% 33 / 80
high 17% 28 / 30 yes 100% - / 20
Round 4 low 0% 22 / - no 9% 28 / 0
high 67% 20 / 30 yes 100% - / 80
Round 5 low 10% 24 / 15 no 20% 25 / 0
high 80% 20 / 25 yes 80% 60 / 60

© WU IMS
 Signaling
§ Note that by just introducing an additional costly
education option we reach a “pareto-improvement”:
nobody is worse off but some are better off.
• Old situation: low wage, on average F earns
20*0.6+60*0.4=36, E low earns 20, E high earns 20
• New situation: wage depends on Master’s, on average
F earns 20*0.6+80*0.4=44, E low earns 20, E high
earns 30
§ What is driving this result is the fact that IF a degree
leads to a higher wage, then
• it pays for the high skill worker to invest in a Master,
• while it doesn’t pay for a low skill worker to do the
same.

© WU IMS
 Signaling
§ Thus, investing in a Master’s degree reliably signals a high
skill (because for low-skill employees doing a Master does
not pay even if they get a high wage).

§ This does not mean that you don’t learn anything in a

Master’s degree, or that you just need it as a certificate.

§ The game shows that, even if there would be no other

effect of a degree than just its different costs for high skill
and low skill people, it might be worthwhile to obtain a
degree for a high skill worker, to signal her ability.

§ The education you receive during your studies should

even increase this effect.
© WU IMS
 Information, Beliefs, and Surprise

§ Surprises in Game Theory

© WU IMS
 Information, Beliefs, and Surprise
Hangman’s paradox:
§ A condemned criminal is given an unusual sentence by an
eccentric judge. He is told that he will be executed
sometime next week before the weekend, but the exact
day of the execution will be a surprise.
§ The prisoner reasons that the execution cannot be on
Friday because if he was still alive on Friday the day would
be known with certainty. He reasons that it cannot be on
Thursday either since if he were alive on Thursday the
execution must be on that day (since Friday is ruled out).
Repeating this reasoning, the prisoner concludes that the
execution cannot happen at all.
§ Satisfied with his reasoning, imagine his surprise when
he’s led to the gallows at high noon on Wednesday. The
judge’s sentence was right after all.
© WU IMS
 Surprise and Beliefs
§ Another version:
§ You can never surprise your partner with flowers!
• Say your partner either expects flowers tonight, or not.
• You want to surprise him/her: you want to bring flowers when
they are unexpected.
• Thus, if they are unexpected, you should bring them.
• But if that’s your strategy, she/he reasons the same: if she/he
does not expect them, you will bring them, so she/he should
expect them when she does not expect them.
§ Surprise in game theoretical terms:
• 1) A player’s belief is that there is a 0% probability that another
player chooses a certain action.
• 2) The other player chooses the action.

§ There is no room for surprise in game theory!

© WU IMS
 Surprise and Beliefs
§ A surprise is something which is unexpected.
§ But in equilibrium, this cannot happen.
• If you are rational, then your strategy is a best reply to
your beliefs about the strategies the other players
choose.
• In equilibrium, your strategy is a best reply to the
strategies the other players choose.
• So in equilibrium, beliefs must be correct, and the
strategies chosen by other players are expected.
§ However, players might randomize over their strategy.
• E.g., you might randomise whether you bring flowers or
not. Or the judge might randomise the day of execution.
• In equilibrium, you believe that something happens
only with some (small) probability. But you are not
surprised if it happens.
© WU IMS
 Summary
§ Information plays an important role in strategic decisions.

§ In many situations, you can deduce the information of

other people from their choices.

§ Sometimes, certain costly choices are just made to convey

that information (signaling).

§ Sometimes, choice menus are designed and offered to

reveal such information (screening, sorting).

© WU IMS
 Break

§ Break for 10 minutes.

§ Then experiments …

© WU IMS