Game Theory and Strategic Management

A. Nicolò

(University of Padova)

May 2020

(U. Padova) May 2020 1 / 20

Games with incomplete information

Up to now we assumed that players know all the relevant information

about each other.

(U. Padova) May 2020 2 / 20

Games with incomplete information

Up to now we assumed that players know all the relevant information

about each other.
In game theory a game whose structure is common knowledge is
called a game of complete information (or with a roughly equivalent
modern economic term, “symmetric information”).

(U. Padova) May 2020 2 / 20

Games with incomplete information

Up to now we assumed that players know all the relevant information

about each other.
In game theory a game whose structure is common knowledge is
called a game of complete information (or with a roughly equivalent
modern economic term, “symmetric information”).
Recall that a game of complete information need not have perfect
information: There may still be simultaneous decisions, so that a
player making a decision cannot always observe all previous decisions.

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A game of incomplete information (roughly, “asymmetric
information”) allows both simultaneous decisions and players to have
private information about the structure of the game.

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A game of incomplete information (roughly, “asymmetric
information”) allows both simultaneous decisions and players to have
private information about the structure of the game.
Example: consider two firms competing a la Cournot in a mkt. Firm
1, the incumbent firm has marginal cost equal to c1 and is common
knowledge, while the marginal cost of firm 2 is private information
and can be either c2H or c2L with equal probability.

(U. Padova) May 2020 3 / 20

Bayesian Games: private values

In a Bayesian game with private values each player has a payoff

function ui (si , s−i , θ i ) where θ i ∈ Θ is a r.v. chosen by nature and
observed by player i only. The joint distribution for all i ∈ N of θ i is
F (θ 1 , ..., θ n )

(U. Padova) May 2020 4 / 20

Bayesian Games: private values

In a Bayesian game with private values each player has a payoff

function ui (si , s−i , θ i ) where θ i ∈ Θ is a r.v. chosen by nature and
observed by player i only. The joint distribution for all i ∈ N of θ i is
F (θ 1 , ..., θ n )
A pure strategy for player i ∈ N in a Bayesian game, is a function
si (θ i ) ∈ Si which assigns a strategy choice to each realization of the
type θ i .

(U. Padova) May 2020 4 / 20

Bayesian Games: private values

In a Bayesian game with private values each player has a payoff

function ui (si , s−i , θ i ) where θ i ∈ Θ is a r.v. chosen by nature and
observed by player i only. The joint distribution for all i ∈ N of θ i is
F (θ 1 , ..., θ n )
A pure strategy for player i ∈ N in a Bayesian game, is a function
si (θ i ) ∈ Si which assigns a strategy choice to each realization of the
type θ i .
Player i 0 s expected payoff given a strategy profile s1 (·), ...sn (·) is

(U. Padova) May 2020 4 / 20

Bayesian Games: private values

In a Bayesian game with private values each player has a payoff

function ui (si , s−i , θ i ) where θ i ∈ Θ is a r.v. chosen by nature and
observed by player i only. The joint distribution for all i ∈ N of θ i is
F (θ 1 , ..., θ n )
A pure strategy for player i ∈ N in a Bayesian game, is a function
si (θ i ) ∈ Si which assigns a strategy choice to each realization of the
type θ i .
Player i 0 s expected payoff given a strategy profile s1 (·), ...sn (·) is

Eθ [ui (s1 (θ 1 ), ..., sn (θ n ), θ i )] = ũi (s1 (·) , ..., sn (·))

(U. Padova) May 2020 4 / 20

Bayesian Games: private values

In a Bayesian game with private values each player has a payoff

function ui (si , s−i , θ i ) where θ i ∈ Θ is a r.v. chosen by nature and
observed by player i only. The joint distribution for all i ∈ N of θ i is
F (θ 1 , ..., θ n )
A pure strategy for player i ∈ N in a Bayesian game, is a function
si (θ i ) ∈ Si which assigns a strategy choice to each realization of the
type θ i .
Player i 0 s expected payoff given a strategy profile s1 (·), ...sn (·) is

Eθ [ui (s1 (θ 1 ), ..., sn (θ n ), θ i )] = ũi (s1 (·) , ..., sn (·))

For each type profile θ = (θ i , θ −i ) we compute the outcome

generated by the strategy profile s (θ ) and the VNM expected utility
function of each player i is computed as the sum of the payoffs
ui (s (θ )) weighted by the probability that θ occurs.

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Definition
A (pure strategy) Bayesian Nash equilibrium (BNE) in pure strategy is a
strategy profile (s1 (·) , ..., sn (·)) such that for all i ∈ N

ũi (si (·) , s−i (·)) ≥ ũi si0 (·) , s−i (·)

for all si0 ∈ Si

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Lemma
A profile of strategies is a BNE if and only if for all i and for all θ i ∈ Θ
occurring with positive probability

Eθ −i [ui (s1 (θ 1 ), ..., sn (θ n ), θ i ) |θ i )] ≥ Eθ −i ui (si0 (θ i ), s−i (θ −i ), θ i ) |θ i )

 

Proof.
Immediate.

In essence, we can think of each type of player i as being a different

player who maximizes his payoff given his conditional probability
distribution over the strategy choices of his rivals.

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Example 1

Consider a Cournot duopoly with inverse-demand function P (Q ) = a − Q

where Q = q1 + q2 . The marginal cost of Firm 1 is c1 = 0, and is
common knowledge. Firm 2’s marginal cost c2 is its own private
information. It can take values of c2 = cH with probability µ,and cL with
probability 1 − µ. Each firm maximizes its expected profit.

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 Here, Firm 1 has just one type, and Firm 2 has two types: cH and cL .
A strategy for Firm 1 is a real number q1 ≥ 0, while a strategy of
Firm 2 is a pair of real numbers q2 (cH ) and q2 (cL ), one for each firm
2’s type.

max (a − (q1∗ + q2 )) q2 − cH q2
q2H

FOC

a − q1∗ − cH
q2H ∗ =
2
Similarly,
a − q1∗ − cL
q2L∗ =
2

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max a − (q1 + µq2H + (1 − µ)q2:L ) q1
q1

FOC
a − µq2H ∗ − (1 − µ)q2:L∗
q1∗ =
2
A Bayesian Nash equilibrium simultaneously solve the three equations:
a−q2H −cH a − q L − cL
2
a−µ( )−(1−µ)( ) a−(1−µ)cL +µcH
q1∗ = 2
2
2
⇒ q1∗ = 3
a−(1−µ)cL +µcH
a− −cH
q2H ∗ = 3
2 ⇒ q2H ∗ = 31 a − 12 cH − 61 µcH + 16 cL (1 − µ)
a−(1−µ)cL +µcH
a − − c
q2L∗ = 3
2
L
⇒ q2L∗ = 31 a − 12 cL − 16 µcH + 16 cL (1 − µ)

(U. Padova) May 2020 9 / 20

First Price Auction

There is an object to be sold. Two bidders want to buy it through an

auction. Simultaneously, each bidder i submits a bid bi ≥ 0. Then, the
highest bidder wins the object and pays her bid. If they bid the same
number, then the winner is determined by a coin toss. The value of the
object for bidder i = 1, 2 is vi , which is privately known by bidder i.
Assume that v1 and v2 are independently and identically distributed with
uniform distribution over [0, 1]. Assume that the player i 0 s bid function
(strategy) is an increasing function of his own value and find a symmetric
BNE.

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Each realization vi is a type for player i.

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Each realization vi is a type for player i.
Player i 0 s strategy is a function bi (vi ) : [0, 1] → R+

(U. Padova) May 2020 11 / 20

Each realization vi is a type for player i.
Player i 0 s strategy is a function bi (vi ) : [0, 1] → R+
The utility of each player i is

 vi − bi if bi > bj for j 6= i
vi −bi
ui (v1 , b1 , b2 ) = 2 if bi = bj
0 if bi < bj


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 Eui = (vi − bi )Prob(bi ≥ b (vj ))
= (vi − bi )Prob(vj ≤ b −1 (bi ))
= (vi − bi )b −1 (bi )

where the last inequality follows by the assumption of uniform distribution.

Example: if player i offers 13 , he wins with the probability that her bid is
higher than the player j’s bid, or, equivalently, that player j’s valuation is
lower than the value v 1 for which j offers 13 , and given the uniform
3
distribution assumption the probability that vj is lower than v 1 is exactly
3
v1 .
3

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Each bidder aims to maximize her expected utility. The first order
condition of the problem is then

db −1
−b −1 (bi∗ (vi )) + (vi − bi∗ (vi )) = 0
dbi |bi =bi∗ (vi )
1
−b −1 (bi∗ (vi )) + (vi − bi∗ (vi )) 0 = 0
b (vi )|bi =bi∗ (vi )

(U. Padova) May 2020 13 / 20

Each bidder aims to maximize her expected utility. The first order
condition of the problem is then

db −1
−b −1 (bi∗ (vi )) + (vi − bi∗ (vi )) = 0
dbi |bi =bi∗ (vi )
1
−b −1 (bi∗ (vi )) + (vi − bi∗ (vi )) 0 = 0
b (vi )|bi =bi∗ (vi )

Then
1
−vi + (vi − b ∗ (vi )) = 0,
b ∗0 (vi )
b ∗0 (vi )vi + b ∗ (vi ) = vi

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Easy computation shows

vi2
b ∗ ( vi ) vi = + const.
2
However the equality holds for all vi ≥ 0 and therefore also for vi = 0.
Therefore const = 0 and we can conclude
vi
b ∗ (vi ) = .
2

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