Lecture 23: Sequential Games of Incomplete

Information: Screening Games

Vera Sharunova

In the last two weeks, we will focus on sequential, or dynamic, games of incomplete
information that can generally be divided into two types: (i) screening games, where
the uninformed player moves first, and (ii) signaling games, where the informed player
moves first. In screening games, the uninformed player may sometimes choose to elicit
the informed player’s true type by using screening devices. In signaling games, the
informed player may sometimes choose to reveal their type to the uninformed player by
using signals. In order to solve screening and signaling games, we will introduce a new
equilibrium concept, called perfect Bayesian Nash equilibrium. This equilibrium concept
is a combination of subgame-perfect and Bayesian Nash equilibria since it requires both
sequential rationality and formation of beliefs about the opponent’s type according to
Bayes’ rule.

1 Screening Games
Screening games are sequential Bayesian games in which the uninformed player moves
first. In certain games, the uniformed player may choose to reduce their informational
disadvantage by using screening devices – strategies that elicit the informed player’s
true type. For example, insurance companies want to know an enrollee’s medical history
and lifestyle choices in order to assess their risk class and potential medical costs.1 In
other cases, ignorance may benefit the uninformed player, so they would choose not to
elicit the informed player’s type.

A Simple Screening Game

Consider a very simple screening game below. Let us start by solving this game without
defining the perfect Bayesian Nash equilibrium formally. After we have done this, it will
be easier to digest the definition of PBNE.

1
Explicit price discrimination based on pre-existing conditions is illegal, but insurance companies
may offer a menu of plans with different premia and coverage such that high-risk customers willingly
choose a more expensive plan. In this case, the menu of plans is a screening device.

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The 1990s Russia was known for wide-spread racketeering – businesses could not operate
without “protection” from organized crime, and numerous rival gangs engaged in this
activity. Imagine a gang that is roaming the streets of Moscow and looking for a firm to
attack. A firm can be either protected by a rival gang with probability p or unprotected
with probability 1 − p. It could either concede or fight back, on their own or by calling
its designated gang. The payoffs in this game are as follows:

Nature
Un
d pro
te cte tec
Pro ted

Gang p 1−p Gang

Attack Not Not Attack

Firm 0, 0 0, 0 Firm

Concede Fight Fight Concede

3, -3 -2, 1 2, -2 3, -1

Of course, it is best for the gang to attack if the firm is unprotected and to pass oth-
erwise. However, the gang is the uninformed player in this game, therefore it cannot
choose distinct actions depending on the type of the firm. Therefore, which strategy will
be chosen depends on the gang’s prior belief p about the firm’s type.

We can start solving this game by using backward induction. If attacked, a protected
firm would choose to fight, so the payoff to the gang is -2. An unprotected firm would
choose to concede, so the gang’s payoff is 3. Therefore, the optimal strategy of the gang
must have a threshold p̂ such that:

1. If the prior belief p < p̂, the gang chooses to attack.

2. If the prior belief p = p̂, the gang is indifferent between attacking or not.

3. If the prior belief p > p̂, the gang chooses not to attack.

The threshold p̂ makes the gang indifferent between attacking or not. The payoff from
not attacking is zero for both types of firms.

EUG (Attack) = pUG (Attack, Fight) + (1 − p)UG (Attack, Concede)

−2p + 3(1 − p) = 3 − 5p = 0 ⇒ p̂ = 0.6

As we can see, the equilibrium of this game will depend on the gang’s belief about the
firm’s type. The perfect Bayesian Nash equilibrium of this game is:

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• If p < 0.6,
– The gang believes that the firm is protected with probability p.
– The gang attacks.
– The firm fights if protected and concedes if unprotected.
• If p > 0.6,
– The gang believes that the firm is protected with probability p.
– The gang does not attack.
– The firm fights if protected and concedes if unprotected.

Or PBNE = {(Attack, Fight Concede; p ≤ 0.6), (Don’t Attack, Fight Concede; p ≥ 0.6)}
for short. Now let us formally define what a perfect Bayesian Nash equilibrium is.
Definition 1. A perfect Bayesian Nash equilibrium is a set of strategies and beliefs such
that the strategies are sequentially rational given the players’ beliefs and players derive
their beliefs via Bayes’ rule at each possible information set.
A few notes are in order:
• Strategies chosen by the firm are sequentially rational since, even though the Attack
node is never reached if p > 0.6, the firm still chooses to fight (and not concede) in
the Attack node.
• Beliefs must be specified for each non-singleton information set. There is only one
non-singleton information set in this game, so we only specify a single belief p.
• The application of Bayes’ rule is trivial in this case since no information is revealed
to the uninformed player before the move. This implies that the posterior belief is
equal to the prior belief. This is the reason that screening games are often easier
than signaling games.

Screening in the Labor Market

Consider now a slightly more complicated screening game as applied to a hiring pro-
cess. Suppose that college graduates can be of two types when it comes to employment:
quantitatively-oriented (Q) or not (Q). A potential tech employer is willing to pay
$160,000 a year to a Q-student and $60,000 a year to a Q-student. Assume also that a
Q-student will generate $200,000 a year for the employer and a Q-student will generate
$80,000. Alternative employment opportunities yield $125,000 to type Q and $30,000 to
type Q. Because the tech employer cannot directly observe any particular job applicant’s
type, it has to look for other credible means of distinguishing among them.2

2
Assume that alternative offers could be easily forged, so they cannot credibly reveal the applicant’s
type.

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Suppose that types differ in their tolerance for taking quantitatively-intense courses.
Each type must sacrifice some free time or other activities to take a quantitative course,
but this sacrifice is easier to bear for a quantitatively-oriented student. Assume that
the cost of each course is equivalent to $3,000 a year for Q types and $15,000 for Q
types. The tech employer could use this difference in costs to screen the applicants and
potentially tell them apart. All information regarding the two types is summarized in
the table below and is common knowledge.

Type Salary Revenue Effort cost Alternative

Q 160,000 200,000 3,000 125,000
Q 60,000 80,000 15,000 30,000

The employer cannot distinguish between Q and Q types, but can design a hiring policy
such that the Q types accept the high-salary offer wH and reject the low-salary offer wL
and Q types accept the low-salary offer and reject the high-salary offer. Consider the
following hiring policy: anyone who has taken at least n̂ quantitative courses will be
regarded as a Q type and offered a high salary wH = 160, 000, and anyone who has taken
less than n̂ quantitative courses will be regarded as a Q type and offered a low salary of
wL = 60, 000. We will assume that the employer cannot adjust the salaries and can only
choose n̂. We summarize this hiring policy as (n̂, wH , wL ). Notice that both applicants
can receive their alternative offers without having to complete n̂ quantitative offers; this
policy is only relevant in the tech firm. The extensive form of this game is illustrated in
Figure 1 below.

−80, 160 − 15n

Employer Applicant AR
RA 20, 60
(n̂, wH , wL ) n
p
1−
1 − pn

e Q,
RR

Typ 0, 30

Nature
Typ 40, 160 − 3n
e
pn

Q, p Applicant AR
RA 140, 60
(n̂, wH , wL ) n
RR
Employer 0, 125

Figure 1: Extensive form of the hiring game.

The employer’s strategies are all possible integer choices of the threshold n̂ ∈ [0, 32].
This game illustrates a situation when the employer faces a candidate who completed n
courses. The employer still does not know with certainty if a candidate in front of her is
a Q type or not. Therefore, there is an information set that envelopes the two possible
decision nodes – a Q type with n courses and a Q type with n courses. The posterior

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belief is that the applicant is a Q type with probability pn and a Q type with probability
1 − pn . Each value of n would span its own information set.

The applicant’s strategies are AR (accept if wH , reject if wL ), RA (reject if wH , accept

if wL ), and RR (reject if wH , reject if wL ). Notice that it is possible to accept the low
salary and the reject the high salary, since the high salary only comes with completing n
costly courses. It is impossible to accept both offers.

Note also that the employer wants to hire both types of applicants, irrespective of their
types, since both types generate a positive profit for the employer when paid according
to their type. Of course, the employer would prefer to hire a Q type at the low salary,
but this would never be possible because the alternative offer for a Q type is higher than
wL . Therefore, the objective of the employer is to separate applicants of different types
by choosing a threshold n̂ such that:

1. Q types take n̂ or more courses, reveal themselves as Q, and choose AR. This hap-
pens if the payoff of a Q-type applicant from choosing AR is greater than those from
choosing RA or RR.
In mechanism design, the AR ≥ RA inequality is called the incentive-compatibi-
lity constraint since it constraints the values of n̂ to those that create incentives
for Q types to complete n̂ courses and accept the high wage as opposed to not
completing enough courses and settling for the low wage.

UQ (AR) ≥ UQ (RA) = 160 − 3n̂ ≥ 60 ⇒ n̂ ≤ 33.33

The AR ≥ RR inequality is called the participation constraint because it re-

stricts the values of n̂ to those that would not make the candidate choose the
alternative offer.

UQ (AR) ≥ UQ (RR) = 160 − 3n̂ ≥ 125 ⇒ n̂ ≤ 11.67

As you can see, the incentive-compatibility constraint is automatically satisfied

whenever the participation constraint holds.

2. Q types take n̂ or less courses, reveal themselves as Q, and choose RA. This hap-
pens if the payoff of a Q-type applicant from choosing RA is greater than those from
choosing AR or RR.
The RA ≥ AR is Q’s incentive-compatibility constraint that ensures that they
would choose not to take n̂ courses in order to mimic Q types.

UQ (RA) ≥ UQ (AR) = 60 ≥ 160 − 15n̂ ⇒ n̂ ≥ 6.67

The AR ≥ RR is Q’s participation constraint that is trivially satisfied, 60 ≥ 30.

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The full set of conditions that achieves separation of types is then 7 ≤ n̂ ≤ 11. The
perfect Bayesian Nash equilibrium in this game is called a separating equilibrium
because it reveals the candidate’s true type:

PBNE = {(n̂, wH , wL ), AR if Q & RA if Q; pn = 1 if n ≥ n̂, pn = 0 if n < n̂, 7 ≤ n̂ ≤ 11}.