Finitely Repeated Games

In the previous lecture, we showed how

dynamic incentives can sustain collusive
behaviour.
• When players are sufficiently patient,
current payoff gains obtained by de-
viating from a ‘collusive’ play can be
offset by losses in future payoffs due
to the switch to uncooperative play.
In particular, we showed that trigger strate-
gies are a subgame perfect equilibrium.
The structure of such a strategy is fairly
simple:
• It plays ‘cooperatively’ as long as the
play has been ‘cooperative’ in every
previous period.
• A defection from cooperation ‘trig-
gers’ a ‘punishment’: it switches to a
stage-game Nash equilibrium for good.
One important observation is that the pun-
ishment is ‘credible’: a permanent play of
a stage-game Nash equilibrium is a Nash
equilibrium of the (remainder of) repeated
game.

A key assumption in our analysis is that

the game is repeated an infinite number
of periods: no final time is of strategic
significance. What if there is a final time?
1
Consider again the Cournot model and
suppose that its repetition lasts only for
two periods. Take an arbitrary subgame
in period 2 following an arbitrary quantity
choice (q1, q2) in the first period.
• This subgame is a one-period game
that is identical to the stage game.
• Subgame perfection implies that the
firms play a Nash equilibrium in this
subgame.
• Hence, subgame perfection implies that
the firms play the Cournot equilibrium:
(q1∗ , q2∗ ) = (24, 24).
Recall that the first-period quantities were
arbitrary:
• Regardless of the quantities chosen in
the first period, in a subgame per-
fect equilibrium the firms will play the
Cournot equilibrium in the second (last)
period.
Since the second period play is constant
no matter what the first period choices
are, no dynamic incentives are possible:
• A quantity in the first period is a best
response if and only if it is a best re-
sponse for the stage game. 2
Hence, in a sugbame perfect equilibrium
firms play the Cournot equilibrium (q1∗ , q2∗ ) =
(24, 24) in the first period as well:
• collusion is not sustainable with two
periods.
This conclusion easily extends to any fi-
nite number of periods: subgame perfec-
tion implies that constant repetition of
the stage-game Nash equilibrium:
• In the final period, firms will play the
Cournot equilibrium regardless of the
history.
• Then, no dynamic incentives are pos-
sible in period T − 1: firms play the
Cournot equilibrium in period T − 1 as
well.
• Since the play is constant in the last
two periods for any previous history,
no dynamic incentives are possible in
period T − 2.......and so on.
This conclusion hinges on the stage-game
Nash equilibrium being unique: if there
are two or more stage-game Nash equilib-
ria, it can be shown that ‘collusive’ play
can be sustained even when a game is re-
peated for a finite number of periods.
3
 Bayesian Games

We have seen strategic settings where play-

ers have different information and, in par-
ticular, we have used information sets to
model a player’s knowledge about the actions
of the opponents.

We have so far omitted an important as-

pect of strategic interaction: factors other
than the opponents’ actions may be un-
certain and affect payoffs. For example:
• Market demand and realised prices may
depend on stochastic, unobserved vari-
ables.
• The size of the surplus over which two
parties are bargaining may be uncer-
tain.
Furthermore, players may have asymmet-
ric information about some uncertain fac-
tors:
• A firm may know its own costs but its
competitors do not.
• A negotiator may know her own val-
uation of the surplus but the other
party does not.
• A seller may know the quality of an
item but the buyer does not. 4
We call games where uncertain factors af-
fect payoffs and where players have asym-
metric information over them Bayesian
games or games with incomplete in-
formation.

In Bayesian games, we will use a special

modelling device to determine the occur-
rence of uncertain factors: they will be
chosen by a ‘fictitious’ player called ‘Na-
ture’ in a manner that we will see shortly.

Let’s consider the following story. Sup-

pose that we wish to describe a market
where an existing firm (the incumbent)
initially has no competitors but faces the
potential entry of another firm (the en-
trant). Information is asymmetric:
• Prior to entry, the incumbent’s costs
are known to the incumbent but not
to the entrant.
• The entrant’s costs are known to both
firms.
• Prior to entry, the incumbent firm sets
a price for the product that is ob-
served by the entrant.
• Having observed the price, the entrant
decided whether or not to enter the
market.
Let’s see how we can use a Bayesian game
to provide a simple model for this market.
5
1. There are two players, an incumbent
(firm 1) and an entrant (firm 2).
2. The incumbent has either high costs
(H) or low costs (L). The entrant’s
costs are known and certain.
• In Bayesian games we say that the in-
cumbent has two types, H and L.
3. Nature chooses the incumbent’s type
randomly: it selects H with probability
q and L with probability 1 − q.
• We represent uncertainty with a new
player: Nature.
4. The incumbent observes its own type
(the cost) but the entrant does not
observe the type of the incumbent.
• We say that the type of the incum-
bent is private information.
5. The incumbent chooses a price contingent
on its own type. For simplicity, there
are only two possible prices, high (p)
or low (p).
6. The entrant, having observed the price
but not the type of the incumbent,
chooses whether to enter (E) or not
to enter (N) the market.
6
The extensive form below represents this
game:

This extensive form contains the typical

elements of a Bayesian game:
• Players have ‘types’ that are private
information: they are known to the
players themselves but not to the other
players.
• Nature determines the types of the
players according to a probability dis-
tribution.
• Payoffs depend on the types and on
the actions of the players.
7
Let’s summarise and elaborate further on
the ‘story’ behind this model. We envis-
age a market interaction over two ‘stages’:
• In the first stage, the incumbent is
a monopolist and chooses between a
high price or a low price. The high
price leads to higher monopoly profits.
The incumbent knows its costs.
• In the second stage, the entrant, hav-
ing observed the price in the first stage,
chooses whether to enter the market.
The entrant does not know whether
the incumbent has high or low costs:
the entrant believes that the incum-
bent’s costs are low with probability
1 − q and high with probability q.
• If the entrant enters the market, the
firms compete. Entry is profitable for
the entrant if the incumbent’s costs
are high. If they are low, the entrant
incurs a loss because of stronger com-
petitive pressures.
• The price in the first stage has no ‘di-
rect’ effect on the price in the second
stage: the incumbent cannot commit
to a price prior to entry.
• We do not model the competition stage
explicitly. We simply include the final
continuation payoffs in the extensive
form.
8
The strategies for Bayesian games are de-
fined in the standard way: a pure strategy
for a player is a complete, contingent plan
that selects an action at each information
set of the player.
• Firm 1 (the incumbent) has two in-
formation sets: one corresponding to
Nature’s choice H and one to choice
L.
• Firm 2 (the entrant) has two informa-
tion sets: one corresponding to firm
1’s choice p and one to choice p .
Firm 1 has four pure strategies:
pp, pp, pp, pp
• The first component is the price after
H and the second the price after L.
Hence, pp is the strategy that select the
low price when costs are high and the high
price when costs are low.

Similarly, firm 2 has four pure strategies

EE, EN, NE, NN
• The first component is the entry deci-
sion after p and the second entry de-
cision after p.
Hence, EN is the strategy that select en-
try when the observed price is low and no
entry when it is high.
9
The normal form for Bayesian games is
called the Bayesian normal form. Its
construction is the same as for any ex-
tensive form game. The only subtlety
is that for any pure strategy profile we
have a probability distribution over the fi-
nal nodes (because of Nature’s moves):
• We need to calculate ‘expected’ pay-
offs.
Suppose for instance that firm 1 chooses
pp and firm 2 NE.

Firm 1’s payoff: 25(1−q)+4q = 25−21q.

Firm 2’s payoff: 0(1 − q) + 8q = 8q.

10
Proceeding in this fashion for all pure strat-
egy profiles we construct the Bayesian nor-
1
mal form. Let’s suppose that q = . The
2
Bayesian normal form is:

EE EN NE NN
pp 5.5, 3.5 5.5, 3.5 14, 0 14, 0
pp 8, 3.5 14.5, 4 10, −0.5 16.5, 0
pp 8, 3.5 10, −0.5 [14.5, 4] 16.5, 0
pp [10.5, 3.5] 19, 0 10.5, 3.5 19, 0

We call the Nash equilibria of the Bayesian

normal form Bayesian Nash equilibria. We
have two equilibria

(pp, EE) and (pp, NE)

• In the Bayesian Nash equilibrium (pp, EE)
the incumbent chooses a high price
regardless of its costs and the entrant
enters the market regardless of the
price.
• In the Bayesian Nash equilibrium (pp, NE)
the incumbent chooses a high price if
the cost is high and a low price if the
cost is low. The entrant enters if the
price is high and stays out if the price
is low.

11
Remark: In the literal interpretation of
the model Nature moves first, then the in-
cumbent learns Nature’s move and chooses
a price, and then the entrant learns the
price and chooses whether to enter.
Of course, the move of Nature is not nec-
essarily ‘real’. It is a modelling device
we use to describe a strategic situation
in which the incumbent knows its costs
but the entrant does not. In reality, the
incumbent might have been of one type
all along. In this case, in a Bayesian Nash
equilibrium we specify not only what the
‘actual’ type of the incumbent does but
also what the ‘other’ type would do, since
the latter is critical to determine the en-
trant’s best response.

12
Consider the equilibrium (pp, NE).

The high-cost type chooses the high price

p and the low-cost type the low price p.
The entrant chooses to enter the mar-
ket if it observes p and to stay out if it
observes p. We call this equilibrium a sep-
arating equilibrium: the types of the in-
cumbent choose separate actions.
• The pricing decision of the incumbent
prior to entry reveals its type.
• The entrant who observes a high price
learns that the incumbent has high
costs and responds by entering the
market.
• The entrant who observes a low price
learns that the incumbent has low costs
and responds by staying out. 13
This is an example of limit pricing: the
low-cost incumbent sets a low pre-entry
price when it is monopolist to deter entry:
• A low price functions as a credible sig-
nal to the entrant: only the low-cost
incumbent has an incentive to set a
low price. The high-cost incumbent
would be worse off by ‘imitating’ the
low-cost incumbent to deter entry.
Hence, by setting a low price the incum-
bent credibly ‘signals’ that it has low costs
and that the entrant would be better off
staying out of the market.

It is unclear whether limit pricing is ben-

eficial or detrimental to consumers.
• On the one hand, consumers could be
better off since the price is temporar-
ily set below the monopoly price.
• On the other hand, consumers could
be worse off since entry and thus com-
petition are deterred: in this exam-
ple, the price returns to the monopoly
price when the entrant stays out.
There is a trade-off between the benefits
of low pre-entry prices and the costs from
entry being limited.
14
We see here a new angle of strategic in-
teraction: actions can operate as signals
that credibly reveal information. In this
equilibrium the entrant learns the type of
the incumbent by observing the price set
in the first stage.

Bayesian games having a structure as in

the above example are called signalling
games. In a signalling game we have:
• A sender who can be of several types
(in our example, the incumbent), knows
its type and chooses actions contin-
gent on its type.
• A receiver (in our example, the en-
trant) who observes the sender’s ac-
tion but not sender’s type and chooses
actions contingent on the sender’s ac-
tions.

15
One important observation on Bayesian
Nash equilibria. The incumbent’s best re-
sponses in the Bayesian normal form are
determined by choosing actions contingent
on the type that maximise the expected
payoff
q·(payoff given H)+(1−q)·(payoff given L)
Suppose that we regard each type as a
‘separate’ player and find the best responses
of each type separately. Will it make any
difference? Take the high-cost incum-
bent. It is clear that this type has no in-
centive to deviate in the separating Bayesian
Nash equilibrium:

It is easily verified that neither does the

low-cost type.

As long as all types have positive probabil-

ity, it makes no difference whether we find
Bayesian Nash equilibria via the Bayesian
normal form or by treating types as sepa-
rate players. We will see another example
of the latter method shortly.
16
Now consider the equilibrium (pp, EE).

Both types of the incumbent choose p.

The entrant chooses to enter the market
whatever the price. We call this equilib-
rium a pooling equilibrium.
• The behaviour of the incumbent prior
to entry does not reveal any infor-
mation to the entrant about its type:
both types act identically by ‘pooling’
their choices.
• Hence, having observed p the entrant
believes that the incumbent is equally
likely to have high or low costs: the
expected payoff from entry is 3.5.
17
Let’s now consider an example of the ap-
proach to solving Bayesian games by treat-
ing types as separate players. Suppose we
take the model of Cournot duopoly with
incomplete information from the textbook.
The inverse demand is given by

P (q) = 10 − q
where q is the total quantity produced.
The quantity produced by firm 1 is de-
noted by q1. The costs of firm 1 are equal
to zero.

Firm 2 has two types:

1. With probability 1/2, the type is L.
Type L has zero costs.
2. With probability 1/2, the type is H.
Type H has constant marginal costs
equal to 4.
Firm 2 knows its type but firm 1 only
knows that each type of firm 2 is equally
likely. Thus, the type of firm 2 is pri-
vate information. We denote the quanti-
ties chosen by the two types of firm 2 by
q2L and q2H , respectively.

Let’s find the best responses of each type

of firm 2 separately.
18
When firm 2’s type is L, its profits are

(10 − q1 − q2L)q2L.
To find the best response of type L, we
set the partial derivative with respect to
q2L equal to zero

10 − q1 − 2q2L = 0.
Solving for q2L we obtain the best response
of type L of firm 2

BR2 L (q ) = 5 − q1 .
1
2
When firm 2’s type is H, its profits are

(10 − q1 − q2H )q2H − 4q2H .

Setting the partial derivative with respect

to q2H equal to zero we have

10 − q1 − 2q2H − 4 = 0
and solving forq2H we obtain the best re-
sponse of type H of firm 2
H q1
BR2 (q1) = 3 − .
2

19
Since firm 1 knows that each type has
probability equal to 1/2, its expected prof-
its are
1 1
(10 − q1 − q2 )q1 + (10 − q1 − q2H )q1.
L
2 2
Setting the partial derivative with respect
to q1 equal to zero we have
1 1
(10 − 2q1 − q2 ) + (10 − 2q1 − q2H ) = 0
L
2 2
and solving for q1 we obtain the best re-
sponse of firm 1

L H q2L q2H
BR1(q2 , q2 ) = 5 − − .
4 4
Therefore, a profile (q1, q2L, q2H ) is a Bayesian
Nash equilibrium if it satisfies
q2L q2H
q1 = 5 − −
q 4 4 q
1
q2L = 5 − q2H = 3 − 1 .
2 2
Solving the above equations we have

(q1, q2L, q2H ) = (4, 3, 1).

Hence, firm 1 produces 4 units, firm 2

produces 3 units when the cost is low and
1 unit when the cost is high.

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