BE

510 Business Economics 1 - Autumn 2021

Problem Set 10

Little Suzy is feeling miserable because she has lost her favorite teddy bear. To take the edge off
she is considering buying some crystal meth from drug dealer Jesse. However, she thinks that
there is a 95% chance that Jesse is not trustworthy (and this is common knowledge). So, she
decides that if she goes ahead at all, she will buy a small quantity first. If Jesse then delivers bad
quality her utility will be −15 and Jesse’s will be 50, and Suzy won’t buy from him again. If Jesse
delivers good quality Suzy may decide to buy another, larger batch. If she doesn’t go ahead with
this second transaction both Suzy’s and Jesse’s utility will be 25. But if she does and Jesse delivers
good quality again both Suzy’s and Jesse’s utility will increase to 120 (Suzy is oblivious to the
terrible consequences of a possible drug addiction). If Jesse delivers cheap low quality this time
his utility will increase further, to 150, and hers will drop to 15. In case that Jesse is trustworthy
after all (which is assumed to occur with a 5% chance), his payoffs are as described above but
he will not behave like a rational utility maximizing player—instead he will simply deliver good
quality on both occasions without thinking any further about it. If Suzy decides not to buy any
crystal meth at all both she and Jesse end up with a utility of 0.
Find all perfect Bayesian equilibria.

 BE 510 Business Economics 1 - Autumn 2021

Problem Set 10 - Solution

No guarantees for correctness. If you find errors in the proposed solutions, please let us know.

The extensive form of the game is shown below. First, Nature determines Jesse’s type: He is
trustworthy (“good”) with probability 0.05 and not trustworthy (“bad”) with probability 0.95.
Second, Suzy decides whether or not to buy any crystal meth at all. If she doesn’t (“Exit1”) both
players get a payoff of 0. Suzy makes this decision not knowing Jesse’s type, so we have to link
her two decision nodes here. We refer to her belief of being in the upper decision node (bad
Jesse) as 𝛼 here. Since the only thing that has happened before is Nature’s move, the only
possible belief for Suzy at this point is 𝛼 = 0.95.

Bad Jesse buy hq BUY HQ

Nature Suzy Jesse Suzy Jesse 120, 120
0.95 [𝛼] [𝛽]
Exit2
Exit1
Good Jesse

LQ
lq

0.05
0, 0 −15, 50 25, 25 15, 150
Exit1
Suzy 0, 0
buy

[1 − 𝛼]
Jesse
hq

Exit2
Suzy 25, 25
BUY

[1 − 𝛽]
Jesse
HQ

120, 120

Third, if Suzy chooses to buy a small amount of the drug (“buy”) it will be Jesse’s turn next and
he will either deliver high quality (“hq”) or low quality (“lq”). If he is trustworthy the quality is
definitely high. If he isn’t then he might choose lq in which case Suzy gets −15 and he gets 50.
Jesse obviously knows his own type, so his decision nodes aren’t connected.
Fourth, should the game continue at this stage (the quality is high) Suzy decides whether to buy
a large amount of crystal meth from Jesse (“BUY”) or to consume the small batch that she’s got
from him before (“Exit2”). In the latter case her payoff is 25 (and so is Jesse’s). She still can’t
know for sure that Jesse is trustworthy, so we link her decision nodes again. Her belief of being
in the upper decision node (bad Jesse) is now labelled 𝛽. Note that 𝛽 is not necessarily 0.95
because bad Jesse’s strategic behavior in the stage before could differ from good Jesse’s behavior
in that stage.
Problem Set 10 - Solution BE 510 Business Economics 1 - Autumn 2021

Fifth, and finally, if Suzy BUYs now Jesse will either give her a large quantity of low quality (“LQ”)
or a large quantity of high quality (“HQ”). In the former case, which only bad Jesse can opt for,
Suzy goes home with a utility level of 15 and bad Jesse enjoys a utility level of 150. If the quality
is high both get 120.
Simple backward induction is insufficient to find PBEs. Nevertheless, approaching the problem
backwards is certainly sensible due to the requirement of sequential rationality. We just have to
keep an eye on the beliefs and be aware that, in the end, they will have to be compatible with the
strategies chosen in earlier parts of the game.
The last choice here is made by bad Jesse (if it comes to that) and he will choose LQ since 150 is
greater than 120. This is a singleton, so we don’t have to worry about his beliefs.
If we go one step back we see Suzy deciding between Exit2 and BUY. Exit2 gives her 25 for sure
whereas BUY yields either 15 or 120. Her expected payoff from BUY depends on her belief 𝛽 and
depending on the value of 𝛽 this might be greater than, less than, or equal to 25.
Suppose that she is optimistic about Jesse being trustworthy (𝛽 is sufficiently small) and she
BUYs. Could that be part of a PBE? Well, given that she buys the large batch, bad Jesse will rub
his hands with glee and definitely choose “hq” in the decision node earlier in order to screw her
over later. But given that he chooses “hq”, we know her belief 𝛽 (at least if this information set
will turn out to be on the equilibrium path). This is because bad Jesse, in his first decision node
in the game, now behaves exactly like good Jesse. Consequently, 𝛽 = 0.95 (no updating). This
implies that
95 5 81
𝑢S (BUY) = × 15 + × 120 = = 20.25
100 100 4
which is less than 𝑢S (Exit2) = 25. Hence, contrary to our starting point Suzy would not BUY! This
doesn’t lead us to an equilibrium.
Suppose now instead that Suzy is pessimistic about Jesse being trustworthy (𝛽 is sufficiently
large) and she exits after Jesse has delivered high quality the first time. Could that be part of a
PBE? Well, given that she doesn’t buy the large batch, bad Jesse has no reason to deliver high
quality the first time. Hence, if Suzy ever observes “hq” it must have come from good Jesse!
Hence, this time Suzy would have to update her belief radically: 𝛽 = 0, and hence
𝑢S (BUY) = 0 × 15 + 1 × 120 = 120
which is of course greater than 𝑢S (Exit2) = 25. Thus, she should BUY and this again contradicts
our starting point. This doesn’t lead us to an equilibrium either!
The only remaining possibility is that Suzy randomizes in this information set and chooses BUY
with some probability 𝑝 and Exit2 with probability 1 − 𝑝. Now, this can only work if Suzy is
precisely indifferent between BUY and Exit2, and that in turn can only be the case if she has a
specific belief 𝛽 such that
𝑢S (BUY) = 15𝛽 + 120(1 − 𝛽) = 25 = 𝑢S (Exit2)

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Problem Set 10 - Solution BE 510 Business Economics 1 - Autumn 2021

which means 𝛽 = 19⁄21 ≈ 0.905.

How can such a belief come about? Above we have seen that if bad Jesse chooses “hq” in
equilibrium Suzy’s belief must be 𝛽 = 0.95 and if bad Jesse chooses “lq” in equilibrium Suzy’s
belief must be 𝛽 = 0. Thus, 𝛽 = 19⁄21 is only possible if Jesse randomizes in a particular way
between “hq” and “lq”. Suppose that he chooses “hq” with probability 𝑞 . How would this
determine Suzy’s belief? Bayes’ rule says that
0.95𝑞
𝛽=
0.95𝑞 + 0.05 × 1
The intuition for the formula is as follows: With probability 0.95 Jesse is not trustworthy.
Assuming that Suzy buys at all, untrustworthy Jesse’s first decision node is reached and then he
chooses “hq” with probability 𝑞. This is one possibility why she might observe “hq”. The other
possibility is that Jesse is trustworthy in which case he chooses “hq” with probability 1.
Consequently, her belief 𝛽 of being in the upper decision node is calculated as shown.
Note again that this assumes that there is at least a tiny probability that Suzy buys the small
batch. If she didn’t buy at all in equilibrium, we would get a problem here. To see this, let’s say
that Suzy buys the small amount with some probability 𝑟. This illustrates that the Bayes’ formula
above should actually have been formulated more precisely as
0.95𝑟𝑞
𝛽=
0.95𝑟𝑞 + 0.05𝑟 × 1 .
The 𝑟 cancels out and so we end up with the simpler formula above. However, if 𝑟 = 0 the 𝑟
cannot be cancelled out and we would get 𝛽 = 0⁄0 which is not defined. This is the problem with
beliefs off the equilibrium path. We’ll return to this below but for the moment we’ll continue with
the assumption that 𝑟 > 0.
We already know the required value of 𝛽. What value of 𝑞 generates 𝛽 = 19⁄21? The answer is
0.05(19⁄21) 1
𝑞= =
0.95(1 − 19⁄21) 2 .
However, is it really possible that bad Jesse is willing to randomize between “hq” and “lq”? Yes,
it is: If Jesse chooses “lq” he gets 50 for sure. If he chooses “hq” instead he will either get 25 or
150, and this depends on Suzy’s probability of BUYing, 𝑝. Hence, if
𝑢J (hq) = 150𝑝 + 25(1 − 𝑝) = 50 = 𝑢J (lq),

which implies 𝑝 = 1⁄5, he really is indifferent between “hq” and “lq” and might randomize.
Now, given all this, should Suzy buy in the first place? If she chooses Exit1 she’ll get 0. If she
chooses “buy” her expected payoff will be

𝑢S (buy) = 0.95 :𝑞;15𝑝 + 25(1 − 𝑝)< + (1 − 𝑞)(−15)= + 0.05;120𝑝 + 25(1 − 𝑝)< = 6.

Thus, Suzy best responds by buying.

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Problem Set 10 - Solution BE 510 Business Economics 1 - Autumn 2021

In summary, there is a perfect Bayesian equilibrium in which Suzy buys a small amount from
Jesse with probability 1; bad Jesse delivers high quality with probability 0.5; if he does deliver
high quality, Suzy updates her belief of dealing with bad Jesse from 0.95 to 0.905; she buys a
large amount with probability 0.2; and if she does this, bad Jesse delivers low quality with
probability 1.
Finally, consider the possibility that Suzy chooses “Exit1” which implies that everything that
follows “buy” is off the equilibrium path. Could there be PBE like this? This hinges on Suzy’s belief
𝛽. It seems as if 𝛽 could take any value now because the relevant information set is off the
equilibrium path. As a result 𝛽 could be sufficiently large such that Suzy would choose “Exit2”
for sure (e.g. 𝛽 = 0.95). Sequential rationality would then require Jesse to choose “lq”. Suzy best
responds by going for “Exit1” since 0.95 × (−15) + 0.05 × 25 < 0.
The mainstream view, however, is that this outcome would be strange and fragile: If Suzy doesn’t
buy literally with probability 0 but instead with some very small probability 𝜀, everything falls
into place and 𝛽 is no longer arbitrary. Moreover, in this example it is Suzy herself who chooses
between “Exit1” and “buy” and whose beliefs we are considering. When present Suzy
contemplates her choice between “Exit1” and “buy”, why would she expect that future Suzy will
end up with a belief that is incompatible with Jesse’s given strategy? Thus, under this view Suzy
would effectively have to form her belief according to the simpler variant of Bayes’ rule
discussed above (the one without the 𝑟).