Perfect Bayesian

Equilibrium
Lyyla Khalid
What do you do when the game is sequential
and has incomplete information?
Timing: Simultaneous Information: Sequential

Complete Information Solved for NASH equilibria Solved for SPNE

Incomplete Information Bayesian Nash Equilibrium Perfect Bayesian Equilibrium

Perfect Bayesian Equilibrium -PBE
• A perfect Bayesian Equilibrium is a set of strategies and beliefs such
that the strategies are sequentially rational given the players beliefs
and the players update their beliefs via Bayes rule wherever possible

• PBE consists of strategies and beliefs – together form an equilibrium

• Strategies are sequentially rational – threats should be credible –
incomplete information I don’t know your type –
• You will update your information as the game proceeds – bayes rule
requires an outcome to occur for it to work
 PBE
• Credibility of threats depends on beliefs.

Types of games:
Screening games: Where the uninformed actors move first – much easier to work
with

Signaling games: Where informed actors move first (diff to update via bayes rule)
-pooling equilibrium
-separating equilibrium
-semi separating equilibrium
Screening Games – uninformed actors move first

• Remember we are looking at sequential games of incomplete

information. Players are taking turns and can see the actions taken by
the other players before them. But at least one party has asymmetric
information about the payoffs associated with various parts of the
game.
Example: Screening Game – motivating example
Solution? Start with Backward Induction
• How will we write the equilibrium?
• Strategies and beliefs
Another application – Sequential Games of Incomplete
Information
• We will look at another example of adverse selection
• Recall: Adverse selection – One player knows something important
that the other player does not
Example: Insurance Market
• Insurance Company – uninformed agent
• Customer – informed agent
An insurer can offer a plan at a high price $1000 or a low price $500
• Healthy costs $400 to cover
• Unhealthy cost $800 to cover – more expensive
Customer is healthy or unhealthy
• Healthy willing to pay $750 for insurance
• Unhealthy willing to pay up to $1250 for insurance
Strategies

• Insurance Company can offer: High Price or Low Price

• The Customer: Buy or Pass
Insurance market example
Backward Induction Allows us to reduce the
game
Next, lets look at it from player 1’s perspective

If he offers the High Price Product:

E(H) = 0.6 (0) + (0.4) 200 = 80

If he offers the Low Price Product:

E( L)= 0.6 (400) + (0.4) (-300) = -60

Insurer offers High Price , Unhealthy Buys the Insurance, Healthy does
not buy
Extension
• What would have been the First best Outcome Here?
• The one under symmetric Information?
What would the Insurance Company have offered the healthy
individual?

• Inefficiencies arise because of this information asymmetry. How do

we get around this? Provide universal health care to all.
Lets Look at Market Inefficiencies
Principal Agent Problems
• Insurance company and customer
• Employer and Employee
Adverse Selection
• Asymmetric Information – one side has information that other has not
• 2 Players – one is more informed than the other – eq quality of good
being sold/ health insurance – person’s health- private information-
hidden information
• In many strategic environments some parties have inside information
which they know, and the opponent does not
Principal Agent Problem- 2 sides – one player on either side
• Principal – Proposer – makes a take-it-or-leave-it offer
Could be many different contracts – at different prices- prices are non negotiable
• Agent- has inside information – accepts or rejects the offer- party with
private information
• That is why these are screening games
Sometimes, there can be other actions
involved
Moral Hazard : Hidden Action
Agent’s action during the term of the contract is not observable to
principal (Moral Hazard) e.g. reckless behavior – insured car – do not
lock
Agents after signing the contracts and during the term of the contract
Moral Hazard vs Adverse Selection
• Hidden Information( Type):
Agent has private information about the state that matters to both
players before signing the contract – Adverse Selection
The Principal offers the contract without the knowledge of this information. Eg insurance company
does not know how sick the individual is.
Hidden Action:
Agent’s action during the term of the contract is not observable to
principal (Moral Hazard) e.g. reckless behavior – insured car – do not
lock
Agents after signing the contracts and during the term of the contract
Some examples
Principal Agent Hidden Info Hidden Actions
Shareholders Managers Managerial skills Effort
Manager Employee Job Skill Effort
Car Owner Mechanic Severity of problem Effort/Repairs
Student Tutor Subject knowledge Preparation
Insurance Company Customer Preexisting condition Risky type

Hidden action because shareholders cannot observe effort- only consequence-

maybe principal put in effort but low profits due to recession
Hidden action – you don’t have cholesterol free food as doctor said

We design contracts to get rid of some of the negative consequences of asymmetric information- we call these
First best , second best etc
We will not focus on Moral Hazard
• Instead we will look at some take it or leave it offers , under adverse
selection – again, screening games
First Best Contracts- bench mark hypothetical
• Full information contracts
• All information is perfectly observable by all the players – not true in
reality – but those contracts where this is hypothetically the case
Second Best Contracts
• Contracts that maximize the payoffs or the interests of the Principal
subject to constraint
• The info asymmetry becomes constraint- The constraint is that the
agent is more informed than the principal
3rd Best Contracts
• Have an additional constraint compared to 2nd best contracts
• eg restricting yourself to an additional constraint- contracts are simple
like charging a fixed price per output – constant per unit price

• More constraints – 4th best , 5th best etc

Lets start with a simple principal-agent model-
screening model - First Best solution
• There is a monopolist who sells packs of bottled water (x)
• For simplicity we will assume decimal points as well
• Lets look at the cost function
• C(x)= 0.5x ( x is an element of the positive real number set)
• Profit = P – 0.5x
• Two types of customer – equally likely prob=1/2
• Type 1 customer – U1 (x,p)= 4 x1/2 – p ( high willingness to pay)
• Type 2 customer – U2 (x,p)= 3 x1/2 –p (low willingness to pay)
• What are the profit-maximizing packages?
First best solution – outcome where monopolists can
distinguish between the types
• He can observe the type of customer
• Different packages for each type
• Type 1: Max profit subject to constraint
• Recall profit = p - 0.5x (choose values of x and p) subject to
constraint- willingness to pay i.e U1 (x,p)= 4 x1/2 – p ≥ 0
• Individual Rationality constraint of type 1
• U1 (x,p)= 3 x1/2 – p ≥ 0 IR constraint for type 2 customer

• No outside option – if no trade then no utility for each- not buying is

an option
Solution?
• I do not want to leave a surplus for customer