Mathematical Economics

1. Strategic games with incomplete information

Peter Wagner, Ph.D.
Department of Economics
University of York

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Signals and Information
Suppose we have a random outcome x which is relevant for a decision maker (DM)
The DM receives information x in form of a "signal" s(x)
Here s(⋅) is some function that assigns a signal s(x) to each outcome x
Applications:
firms have private information about demand (s(x) is signal about demand x)
workers have private information about their ability (s(x) is signal about ability x)
bidders have private information about their valuations (x is profile of valuations,
s(x) is a bidders own valuation)
etc.
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Example 1: signals about a coin flip
We flip a coin: possible outcomes "heads" or "tails"
There are many ways to signal information about the coin
But what information is contained in these different messages?

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Expressing information through "types"
What matters is not the actual nature of the signal, but rather whether these signals
are the same or different for different outcomes
Whenever signals are different, DM can infer the outcome of the coin flip, when the
signals are the same he cannot infer the outcome
We call the different states of knowledge "types"
if DM does learn which side comes up, he has two possible types, one type for
heads and one type for tails
if DM does not learn which side comes up, he has only one possible type
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Formal construction of "types"
Fix a finite probability space (X, p)
Signal function: s : X → T , where T is some arbitrary set, called the "type space"
The information contained in a type t ∈ T is represented by the inverse
s−1 (t) = {x ∈ X∣s(x) = t}

We call the set s (t) the "information set" of type t

−1

The information set contains all outcomes that generate type t

The information contained in the signal function s is represented by the information
partition defined as
{s−1 (t)∣t ∈ T }

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In the previous example:
Outcomes: X = {heads, tails}, probabilities: p = (0.5, 0.5)
Set type space T = {heads, tails} (arbitrary)
Signal functions:
s(heads) = heads and s(tails) = tails (="coin shown")
s(heads) = heads and s(tails) = heads (="coin hidden")
Information partitions
{{heads, tails}} (="coin hidden")
{{heads}, {tails}} (="coin shown")
Here, each type is equally likely
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Strategic games with incomplete information
We now embed this modelling of uncertainty and information into strategic games
We extend the familiar definition of a strategic game as follows:
assign to each player a type space
define a probability distribution over "type profiles"

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Example: "meeting game"
Suppose two friends fix a time and place in the week to meet and go for a run
Person 1 likes to exercise, and always wants to meet
Person 2 sometime likes to exercise and sometimes doesn't
Person 2 does not find out how she feels until just before the meeting time
Each person must decide whether to leave the house (L) or stay home (H )
Suppose Person 2 cannot communicate with Person 1 prior to their meeting
Person 1 believes there is an equal chance that Person 2 wants to meet
Payoffs...
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Payoffs
0
Person 2 wants to meet Person 2 doesn’t want to meet

L H L H
L 2, 2 0, 0 L 2, 0 0, 1
H 0, 0 1, 1 H 0, 0 1, 2
Prob.= 12 Prob.= 12
0

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What are the Nash equilibria of the meeting game?
We now want to find the Nash equilibria of this game
How do we deal with the uncertainty?
Strategies?
Beliefs?
Payoffs?
One option: treat Nature as a player and include random outcome as its action
incomplete information in static game → "imperfect" information in extensive game
We can then use the standard definition of Nash equilibrium (see autumn term)
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Equivalence: incomplete information equivalent to imperfect information

... let us find the Nash equilibria of this game!!!

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Information:
Person 1 does not know Person 2's type. Person 1 assigns probability to each.
1
2

Person 2 knows her own type, but also knows that Person 1 is uncertain
Pure strategy: Strategy specifies an action for each type
Person 1: one type, two actions → 2 strategies: L, H
Person 2: two types, two actions → 4 strategies: (L, L), (L, H), (H, L) (H, H)
Best responses: Calculate expected payoffs given own information to find best-
responses
(Bayes-) Nash Equilibrium: Combination of mutual best responses
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Best responses for Person 2
If Person 2's wants to meet and
Person 1 chooses L: best response is L
Person 1 chooses H : best response is H
If Person 2's doesn't want to meet the best response is H ,
regardless of what Person 1 does
Best responses
Best response to L is (L, H)
Best response to H is (H, H)
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Expected payoffs for Person 1
If Person 2's strategy is (L, L),
If choose L then expected payoff is 2 + 2 = 2.
1
2
1
2
If choose H then expected payoff is 0 + 0 = 0.
1
2
1
2

If Person 2's strategy is (L, H),

If choose L then expected payoff is 2 + 0 = 1.
1
2
1
2
If choose H then expected payoff is 0 + 1 = .
1
2
1
2
1
2

If Person 2's strategy is (H, L),

If choose L then expected payoff is 0 + 2 = 1.
1
2
1
2
If choose H then expected payoff is 1 + 0 = .
1
2
1
2
1
2

What are the exp. payoffs when Person 2's strategy is (H, H)?
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Best response for Person 1
(L, L) (L, H) (H, L) (H, H)
L 2 1 1 0
1 1
H 0 2 2 1

Best responses:
Best response to (L, L) is L
Best response to (L, H) is L
Best response to (H, L) is L
Best response to (H, H) is H
(Note: those are of course independent of Person 2's type!!)
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Equilibria of the meeting game
Bayes-Nash equilibrium: combination of strategies such that each player maximises
her expected payoff at each information set, given the other players' strategies
To find a pure-strategy Bayes-Nash equilibrium in the meeting game, look at best
response correspondences!

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Best responses for Person 1:
Best response to (L, L) is L
Best response to (L, H) is L
Best response to (H, L) is L
Best response to (H, H) is H
Best responses for Person 2:
Best response to L is (L, H)
Best response to H is (H, H)
Two Bayes-Nash Equilibria:
(L, (L, H))
(H, (H, H))
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General definition of a "Bayesian Game"
DEFINITION: A finite strategic game with incomplete information ("Bayesian game")
consists of a set of players N = {1, … , n} and for each player i ∈ N
a set of actions A i

a set of types T
i

a payoff function u (a, t) where a ∈ A := A ×…×A is a profile action for all players
1
and t ∈ T := T × … × T is a profile of types.
i n

1 n

and a probability distribution P (⋅) over type profiles t ∈ T

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In our previous "meeting game"...
Players: N = {1, 2}
Action sets A = A = {L, H}
1 2

Type space T = {∅} and T = {meet, avoid}

1 2

Probability distribution P (t) = 1/2 for all t ∈ T

1 × T2 .
Payoff functions: given in the tables.

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Strategies, beliefs and expected payoffs
A strategy for player i in strategic game with incomplete information is a function from
types into actions
σi : Ti → Ai

A belief for player i of type t is a probability distribution μ (t ∣t ) ∈ ΔT over the set

−i −i
of profiles of other players' types T = T × … × T × T × … × T
i i i

−i 1 i−1 i+1 n

The expected payoff for player i given her type t , a strategy profile σ = (σ , σ ) and −i
her belief μ (t ∣t ) over type profiles is
i i

i −i i

E[ui (σ(t), t)∣ti ] = ∑ μi (t−i ∣ti )ui ((σi (ti ), σ−i (t−i )), (ti , t−i )).
t−i ∈T−i

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DEFINITION: A Bayes-Nash equilibrium in a strategic game of incomplete information is a
combination of strategies (σ , … , σ ) and beliefs (μ , … , μ ) such that
1 n 1 n

I. For each player i, the strategy σ maximises her expected payoff for each type, i.e.
i

E[ui (σi (ti ), σ−i (t−i )∣ti ] ≥ E[ui (α, σ−i (t−i )∣ti ] ∀α ∈ Ai

II. For each type t of player i, the belief μ (t

i i −i ∣ti ) is consistent with Bayes' rule, that is
Pr(ti , t−i ) Pr(ti ∣t−i ) Pr(t−i )
μi (t−i ∣ti ) = = .
Pr(ti ) ∑t′ Pr(ti ∣t′−i ) Pr(t′−i )
−i

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Example: More information can be bad
In decision problems, more information is always better, because a DM can ignore info.
In a non-cooperative game, both players may be worse off with more information!!
Consider the following "degenerate" Bayesian game:
L M R L M R
U 0, 3 1, 0 1, 4 U 0, 3 1, 4 1, 0
D 7, 7 0, 0 0, 8 D 7, 7 0, 8 0, 0

Suppose each table is equally likely, and neither player knows which one they play
Since there is no private information, we can reduce this situation in one payoff matrix
with each players expected payoffs
L M R
U 0, 3 1, 2 1, 2
D 7, 7 0, 4 0, 4

Clearly, this game has a unique equilibrium (D, L) which generates payoffs (7, 7) 23
Suppose now, player 2 learns the true game, while player 1 does not

We see here, player 2 has a strictly dominating strategy which is to play R in the left
table and M in the right table
The best response for player 1 against (R, M ) of player 2 is to play U .
So there is a unique BNE (U , (R, M )) that generates exp. payoffs (1, 4).
Hence, by giving player 2 more information, everyone is worse off!!!
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Example: Cournot oligopoly with incomplete information
Players: Firm 1 and Firm 2
Actions: Output q ∈ [0, ∞)
i

Types: Firm 1 has a single type (no private info), Firm 2 has two types {l, h}
Payoffs:
u1 (q1 , q2 , t) = q1 (1 − q1 − q2 − c)
u2 (q1 , q2 , t) = q2 (1 − q1 − q2 − ct )

Probability of type l is denoted by θ

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Define
q~2 = θq2 (l) + (1 − θ)q2 (h)
c~ = θcl + (1 − θ)ch

Expected payoff for firm 1:

θq1 (1 − q1 − q2 (l) − c) + (1 − θ)q1 (1 − q1 − q2 (h) − c) = q1 (1 − q1 − q~2 − c)

Best responses for firm 1: F.o.c.

1 1~ 1
1 − 2q1 − q~2 − c = 0 ⇒ q1 = − q2 − c
2 2 2

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Best responses for firm 2: F.o.c.
1 1 1
1 − q1 − ct − 2q2 = 0 ⇒ q2 (t) = − q1 − ct
2 2 2

Take expectations:
~ 1 1 1~
q2 = − q1 − c
2 2 2

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Substitute into firm 1's best response
1 1 1 1 1~ 1
q1 = − ( − q1 − c) − c
2 2 2 2 2 2
And simplify
1 1~ 2
q1 = + c− c
3 3 3

Substitute into q (t):

2

1 1 1 1~ 2 1
q2 (t) = − ( + c − c) − ct
2 2 3 3 3 2
And simplify
1 1 1~ 1
q2 (t) = + c − c − ct
3 3 6 2
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