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Ko C University: Levent Ko Ckesen (Ko C University) Levent Ko Ckesen (Ko C University)
Ko C University: Levent Ko Ckesen (Ko C University) Levent Ko Ckesen (Ko C University)
Game Theory and Strategy Game theory studies strategic interactions within a group of
Introduction individuals
◮ Actions of each individual have an effect on the outcome
◮ Individuals are aware of that fact
Levent Koçkesen Individuals are rational
◮ have well-defined objectives over the set of possible outcomes
Koç University ◮ implement the best available strategy to pursue them
Rules of the game and rationality are common knowledge
Levent Koçkesen (Koç University) Introduction 1 / 10 Levent Koçkesen (Koç University) Introduction 2 / 10
Beril B V B V
Bonds Venture
Bonds 110, 110 110, 100 110, 110 110, 100 100, 110 120, 120
Ali
Venture 100, 110 120, 120
Levent Koçkesen (Koç University) Introduction 5 / 10 Levent Koçkesen (Koç University) Introduction 6 / 10
quite A funny
Beril Beril
Bonds Venture Bonds Venture
dump dump
Bonds 110, 110 110, 100 Bonds 110, 110 110, 120 0, 0 (1/3) smart −1, 0
Ali
Venture 100, 110 120, 120 Venture 100, 110 120, 120
B Nature B
Normal (p) Crazy (1 − p)
2, 0 (2/3) dumb −1, 0
marry marry
quite A funny
dump dump
0, 1 −3, 1
Levent Koçkesen (Koç University) Introduction 7 / 10 Levent Koçkesen (Koç University) Introduction 8 / 10
Game Forms Outline of the Course
1. Strategic Form Games
2. Dominant Strategy Equilibrium and Iterated Elimination of
Dominated Actions
Information
3. Nash Equilibrium: Theory
4. Nash Equilibrium: Applications
4.1 Auctions
Complete Incomplete 4.2 Buyer-Seller Games
4.3 Market Competition
Strategic Form Strategic Form 4.4 Electoral Competition
Simultaneous
Games with Games with 5. Mixed Strategy Equilibrium
Complete Incomplete
6. Games with Incomplete Information and Bayesian Equilibrium
Information Information
7. Auctions
8. Extensive Form Games: Theory
Moves
8.1 Perfect Information Games and Backward Induction Equilibrium
8.2 Imperfect Information Games and Subgame Perfect Equilibrium
Extensive Form Extensive Form 9. Extensive Form Games: Applications
Games with Games with
Sequential 9.1 Stackelberg Duopoly
Complete Incomplete
Information Information 9.2 Bargaining
9.3 Repeated Games
10. Extensive Form Games with Incomplete Information
10.1 Perfect Bayesian Equilibrium
10.2 Signaling Games
Levent Koçkesen (Koç University) Introduction 9 / 10 Levent Koçkesen (Koç University) Introduction 10 / 10
Split or Steal
Game Theory
Strategic Form Games
Episode 1
Levent Koçkesen
Koç University
Levent Koçkesen (Koç University) Strategic Form Games 1 / 44 Levent Koçkesen (Koç University) Strategic Form Games 2 / 44
Levent Koçkesen (Koç University) Strategic Form Games 3 / 44 Levent Koçkesen (Koç University) Strategic Form Games 4 / 44
Prisoners’ Dilemma Contribution Game
Name:
N = {1, 2}
A1 = A2 = {c, n} Your Contribution:
A = {(c, c), (c, n), (n, c), (n, n)}
Write your name and an integer between 0 and 10
u1 (c, c) = −5, u1 (c, n) = 0, etc.
We will collect them and enter into Excel
We will choose one player randomly and pay her
Click here for the EXCEL file
Levent Koçkesen (Koç University) Strategic Form Games 5 / 44 Levent Koçkesen (Koç University) Strategic Form Games 6 / 44
N = {T, W }
Toys“R”Us and Wal-Mart have to decide whether to sell a particular W AT = AW = {H, L}
toy at a high or low price H L
uT (H, H) = 10
They act independently and without knowing the choice of the other H 10, 10 2, 15
T uW (H, L) = 15
store L 15, 2 5, 5
etc.
We can write this game in a bimatrix format What should Toys“R”Us play?
Does that depend on what it thinks Wal-Mart will do?
Wal-Mart
Low is an example of a dominant strategy
High Low
High 10, 10 2, 15 it is optimal independent of what other players do
Toys“R”Us
Low 15, 2 5, 5 How about Wal-Mart?
(L, L) is a dominant strategy equilibrium
Levent Koçkesen (Koç University) Strategic Form Games 7 / 44 Levent Koçkesen (Koç University) Strategic Form Games 8 / 44
Dominant Strategies Dominant Strategy Equilibrium
a−i = profile of actions taken by all players other than i
A−i = the set of all such profiles If every player has a (strictly or weakly) dominant strategy, then the
corresponding outcome is a (strictly or weakly) dominant strategy
An action ai strictly dominates bi if equilibrium.
Levent Koçkesen (Koç University) Strategic Form Games 9 / 44 Levent Koçkesen (Koç University) Strategic Form Games 10 / 44
Round 1
A reasonable solution concept
It only demands the players to be rational Name:
It does not require them to know that the others are rational too Your guess:
But it does not exist in many interesting games
Write your name and a number between 0 and 100
We will collect them and enter into Excel
The number that is closest to half the average wins
Winner gets 6TL (in case of a tie we choose randomly)
Click here for the EXCEL file
Levent Koçkesen (Koç University) Strategic Form Games 11 / 44 Levent Koçkesen (Koç University) Strategic Form Games 12 / 44
Beauty Contest Beauty Contest
The Beauty Contest Thats Shaking Wall St., ROBERT J. SHILLER, NYT
3/9/2011
John Maynard Keynes supplied the answer in 1936, in “The
General Theory of Employment Interest and Money,” by
comparing the stock market to a beauty contest. He described a
newspaper contest in which 100 photographs of faces were
displayed. Readers were asked to choose the six prettiest. The New York Times online version
winner would be the reader whose list of six came closest to the
most popular of the combined lists of all readers.
The best strategy, Keynes noted, isn’t to pick the faces that are
your personal favorites. It is to select those that you think others
will think prettiest. Better yet, he said, move to the “third
degree” and pick the faces you think that others think that still
others think are prettiest. Similarly in speculative markets, he
said, you win not by picking the soundest investment, but by
picking the investment that others, who are playing the same
game, will soon bid up higher.
Levent Koçkesen (Koç University) Strategic Form Games 13 / 44 Levent Koçkesen (Koç University) Strategic Form Games 14 / 44
Wal-Mart
High Low M atch
High 10, 10 2, 15 10, 10
Toys“R”us Low 15, 2 5, 5 5, 5
M atch 10, 10 5, 5 10, 10
Levent Koçkesen (Koç University) Strategic Form Games 15 / 44 Levent Koçkesen (Koç University) Strategic Form Games 16 / 44
Price Matching Price Matching
Therefore we have the following “effective” game
Wal-Mart
High Low M atch
High 10, 10 2, 15 10, 10 Wal-Mart
Toys“R”us Low 15, 2 5, 5 5, 5 Low M atch
M atch 10, 10 5, 5 10, 10 Low 5, 5 5, 5
Toys“R”us
M atch 5, 5 10, 10
High is weakly dominated and Toys“R”us is rational
◮ Toys“R”us should not use High Low becomes a weakly dominated strategy for both
High is weakly dominated and Wal-Mart is rational Both companies will play Match and the prices will be high
◮ Wal-Mart should not use High The above procedure is known as Iterated Elimination of Dominated
Each knows the other is rational Strategies (IEDS)
◮ Toys“R”us knows that Wal-Mart will not use High
◮ Wal-Mart knows that Toys“R”us will not use High To be a good strategist try to see the world from the perspective of your
◮ This is where we use common knowledge of rationality rivals and understand that they will most likely do the same
Levent Koçkesen (Koç University) Strategic Form Games 17 / 44 Levent Koçkesen (Koç University) Strategic Form Games 18 / 44
while
ui (ai , a−i ) < ui (bi , a−i ) for some a−i ∈ A−i .
Levent Koçkesen (Koç University) Strategic Form Games 19 / 44 Levent Koçkesen (Koç University) Strategic Form Games 20 / 44
IESDS vs. IEWDS Effort Game
Start with U We will randomly choose one round and one student and pay her
Start with M Enter your name and effort choice for Round 1
Click here for the EXCEL file
Levent Koçkesen (Koç University) Strategic Form Games 21 / 44 Levent Koçkesen (Koç University) Strategic Form Games 22 / 44
Is there a dominant strategy? An outcome a∗ = (a∗1 , ..., a∗n ) is a Nash equilibrium if for each player i
What are the likely outcomes? ui (a∗i , a∗−i ) ≥ ui (ai , a∗−i ) for all ai ∈ Ai
If you expect the other to choose L, what is your best strategy (best
response)? Nash equilibrium is self-enforcing: no player has an incentive to
If you expect the other to choose H, what is your best strategy (best deviate unilaterally
response)? One way to find Nash equilibrium is to first find the best response
correspondence for each player
(L, L) is an outcome such that
◮ Best response correspondence gives the set of payoff maximizing
◮ Each player best responds, given what she believes the other will do
◮
strategies for each strategy profile of the other players
Their beliefs are correct
... and then find where they “intersect”
It is a Nash equilibrium
Levent Koçkesen (Koç University) Strategic Form Games 23 / 44 Levent Koçkesen (Koç University) Strategic Form Games 24 / 44
Nash Equilibrium Best Response Correspondence
Levent Koçkesen (Koç University) Strategic Form Games 25 / 44 Levent Koçkesen (Koç University) Strategic Form Games 26 / 44
Levent Koçkesen (Koç University) Strategic Form Games 27 / 44 Levent Koçkesen (Koç University) Strategic Form Games 28 / 44
Nash Demand Game Optimization
Let f : Rn → R and D ⊂ Rn . A constrained optimization problem is
argmax{f (x)|x ∈ D}
A Graphical Example
Example
f (x)
max x3 − 3x2 + 2x + 1 subject to 0.1 ≤ x ≤ 2.5
f (x)
D
x ∗ x
0.1 2.5 x
Levent Koçkesen (Koç University) Strategic Form Games 31 / 44 Levent Koçkesen (Koç University) Strategic Form Games 32 / 44
A Simple Case
Example
Let f : R → R and consider the problem maxx∈[a,b] f (x).
max −(x − 1)2 + 2 s.t. x ∈ [0, 2].
f (x)
f (x)
f ′ (x∗ ) = 0
f ′ (x∗∗ ) = 0
x
a x∗ x∗∗ b x
We call a point x∗ such that f ′ (x∗ ) = 0 a critical point.
Levent Koçkesen (Koç University) Strategic Form Games 33 / 44 Levent Koçkesen (Koç University) Strategic Form Games 34 / 44
Theorem
Let f : R → R and suppose a < x∗ < b is a local maximum (minimum) of Let f : R → R be a differentiable function and consider the problem
f on [a, b]. Then, f ′ (x∗ ) = 0. maxx∈[a,b] f (x). If the problem has a solution, then it can be found by the
following method:
Known as first order conditions 1. Find all critical points: i.e., x∗ ∈ [a, b] s.t. f ′ (x∗ ) = 0
Only necessary for interior local optima 2. Evaluate f at all critical points and at boundaries a and b
◮ Not necessary for global optima
◮ Not sufficient for local optima.
3. The one that gives the highest f is the solution
To distinguish between interior local maximum and minimum you can We can use Weierstrass theorem to determine if there is a solution
use second order conditions Note that if f ′ (a) > 0 (or f ′ (b) < 0), then the solution cannot be at
Theorem a (or b)
Let f : R → R and suppose a < x∗ < b is a local maximum (minimum) of
f on [a, b]. Then, f ′′ (x∗ ) ≤ 0 (f ′′ (x∗ ) ≥ 0).
Levent Koçkesen (Koç University) Strategic Form Games 35 / 44 Levent Koçkesen (Koç University) Strategic Form Games 36 / 44
Example Example
max x2 s.t. x ∈ [−1, 2]. max −(x − 1)2 + 2 s.t. x ∈ [0, 2].
Solution Solution
f is continuous and [0, 2] is compact. Therefore, the problem has a
x2 is continuous and [−1, 2] is closed and bounded, and hence compact.
solution. f ′ (x) = −2(x − 1) = 0 is solved at x = 1, which is the only
Therefore, by Weierstrass theorem the problem has a solution.
critical point. We have f (1) = 2, f (0) = 1, f (2) = 1. Therefore, 1 is the
f ′ (x) = 2x = 0 is solved at x = 0, which is the only critical point. We
global maximum. Note that f ′ (0) > 0 and f ′ (2) < 0 and hence we could
have f (0) = 0, f (−1) = 1, f (2) = 4. Therefore, 2 is the global maximum.
have eliminated 0 and 2 as candidates.
f (x) f (x)
x
x
Levent Koçkesen (Koç University) Strategic Form Games 39 / 44 Levent Koçkesen (Koç University) Strategic Form Games 40 / 44
Claim
Best response correspondence of firm i 6= j is given by
( a−c−bq
j
, qj < a−c Claim
Bi (qj ) = 2b b
0, qj ≥ a−c The set of Nash equilibria of the Cournot duopoly game is given by
b
a−c a−c
Proof. N(G) = ,
3b 3b
If q2 ≥ a−c
b , then u1 (q1 , q2 ) < 0 for any q1 > 0. Therefore, q1 = 0 is
the unique payoff maximizer. Proof.
If q2 < a−c
b , then the best response cannot be q1 = 0 (why?). Suppose (q1∗ , q2∗ ) is a Nash equilibrium and qi∗ = 0. Then,
Furthermore, it must be the case that q1 + q2 ≤ a−c a
b ≤ b , for qj∗ = (a − c)/2b < (a − c)/b. But, then qi∗ ∈ / Bi (qj∗ ), a contradiction.
otherwise u1 (q1 , q2 ) < 0. So, the following first order condition must Therefore, we must have 0 < qi∗ < (a − c)/b, for i = 1, 2. The rest follows
hold from the best response correspondences.
∂u1 (q1 , q2 )
= a − c − 2bq1 − bq2 = 0
∂q1
(a − c)2
a−c
9b
b
B1 (q2 ) Is there a way for these two firms to increase profits?
What if they form a cartel?
They will maximize
U (q1 + q2 ) = (a − c − b(q1 + q2 ))(q1 + q2 )
a−c
2b Optimal level of total production is
Nash Equilibrium a−c
a−c
3b q1 + q2 =
2b
Half of the maximum total profit is
B2 (q1 )
(a − c)2
q1
a−c
3b
a−c
2b
a−c
b
8b
Game Theory
1 Auctions
Strategic Form Games: Applications
Koç University
3 Elections
Levent Koçkesen (Koç University) Strategic Form Games 1 / 21 Levent Koçkesen (Koç University) Strategic Form Games 2 / 21
page.3 page.4
Auctions Auction Formats
Many economic transactions are conducted through auctions 1. Open bid auctions
treasury bills art work 1.1 ascending-bid auction
⋆ aka English auction
foreign exchange antiques ⋆ price is raised until only one bidder remains, who wins and pays the
publicly owned companies cars final price
1.2 descending-bid auction
mineral rights houses ⋆ aka Dutch auction
airwave spectrum rights government contracts ⋆ price is lowered until someone accepts, who wins the object at the
current price
Also can be thought of as auctions 2. Sealed bid auctions
takeover battles 2.1 first price auction
⋆ highest bidder wins; pays her bid
queues
2.2 second price auction
wars of attrition ⋆ aka Vickrey auction
lobbying contests ⋆ highest bidder wins; pays the second highest bid
Levent Koçkesen (Koç University) Strategic Form Games 3 / 21 Levent Koçkesen (Koç University) Strategic Form Games 4 / 21
page.5 page.6
Auction Formats Strategically Equivalent Formats
Auctions also differ with respect to the valuation of the bidders English Auction ! Second Price
1. Private value auctions
◮ each bidder knows only her own value
◮ artwork, antiques, memorabilia
Dutch Auction ! First Price
2. Common value auctions
◮ actual value of the object is the same for everyone
◮ bidders have different private information about that value
◮ oil field auctions, company takeovers We will study sealed bid auctions
For now we will assume that values are common knowledge
◮ value of the object to player i is vi dollars
For simplicity we analyze the case with only two bidders
Assume v1 > v2 > 0
Levent Koçkesen (Koç University) Strategic Form Games 5 / 21 Levent Koçkesen (Koç University) Strategic Form Games 6 / 21
page.7 page.8
Second Price Auctions Second Price Auctions
I. Bidding your value weakly dominates bidding higher
Highest bidder wins and pays the second highest bid
In case of a tie, the object is awarded to player 1
Strategic form: 20
Suppose your value is $10 but you bid $15. Three cases:
1. N = {1, 2}
1. The other bid is higher than $15 (e.g. $20)
2. A1 = A2 = R+ ◮ You loose either way: no difference
3. Payoff functions: For any (b1 , b2 ) ∈ R2+ 2. The other bid is lower than $10 (e.g. $5)
15 bid
( ◮ You win either way and pay $5: no difference
v1 − b2 , if b1 ≥ b2 , 12
u1 (b1 , b2 ) = 3. The other bid is between $10 and $15 (e.g. $12)
0, otherwise. 10 value
◮ You loose with $10: zero payoff
◮ You win with $15: loose $2
(
v2 − b1 , if b2 > b1 ,
u2 (b1 , b2 ) = 5
0, otherwise.
Levent Koçkesen (Koç University) Strategic Form Games 7 / 21 Levent Koçkesen (Koç University) Strategic Form Games 8 / 21
page.9 page.10
Second Price Auctions First Price Auctions
II. Bidding your value weakly dominates bidding lower
Highest bidder wins and pays her own bid
In case of a tie, the object is awarded to player 1
Suppose your value is $10 but you bid $5. Three cases:
1. The other bid is higher than $10 (e.g. $12) Strategic form:
◮ You loose either way: no difference 12 1. N = {1, 2}
2. The other bid is lower than $5 (e.g. $2) 2. A1 = A2 = R+
◮ You win either way and pay $2: no difference 10 value 3. Payoff functions: For any (b1 , b2 ) ∈ R2+
3. The other bid is between $5 and $10 (e.g. $8) (
◮ You loose with $5: zero payoff v1 − b1 , if b1 ≥ b2 ,
◮ You win with $10: earn $2 8 u1 (b1 , b2 ) =
0, otherwise.
Levent Koçkesen (Koç University) Strategic Form Games 9 / 21 Levent Koçkesen (Koç University) Strategic Form Games 10 / 21
page.11 page.12
Nash Equilibria of First Price Auctions Necessary Conditions
Let (b∗1 , b∗2 ) be a Nash equilibrium. Then,
1. Player 1 wins: b∗1 ≥ b∗2
3. v2 ≤ b∗1 ≤ v1
Proof
Exercise
Levent Koçkesen (Koç University) Strategic Form Games 11 / 21 Levent Koçkesen (Koç University) Strategic Form Games 12 / 21
page.13 page.14
Sufficient Conditions Price Competition Models
So, any Nash equilibrium (b∗1 , b∗2 ) must satisfy Quantity (or capacity) competition: Cournot Model
◮ Augustine Cournot (1838)
v2 ≤ b∗1 = b∗2 ≤ v1 .
Price Competition: Bertrand Model
◮ Joseph Bertrand (1883)
Is any pair (b∗1 , b∗2 ) that satisfies these inequalities an equilibrium?
Two main models:
Set of Nash equilibria is given by 1. Bertrand Oligopoly with Homogeneous Products
2. Bertrand Oligopoly with Differentiated Products
{(b1 , b2 ) : v2 ≤ b1 = b2 ≤ v1 }
Levent Koçkesen (Koç University) Strategic Form Games 13 / 21 Levent Koçkesen (Koç University) Strategic Form Games 14 / 21
page.15 page.16
Bertrand Duopoly with Homogeneous Products Nash Equilibrium
Two firms, each with unit cost c ≥ 0 Suppose P1∗ , P2∗ is a Nash equilibrium. Then
They choose prices
◮ The one with the lower price captures the entire market 1. P1∗ , P2∗ ≥ c. Why?
◮ In case of a tie they share the market equally 2. At least one charges c
Total market demand is equal to one (not price sensitive) ◮ P1∗ > P2∗ > c?
◮ P2∗ > P1∗ > c?
Strategic form of the game:
◮ P1∗ = P2∗ > c?
1. N = {1, 2}
3. P2∗ > P1∗ = c?
2. A1 = A2 = R+
3. Payoff functions: For any (P1 , P2 ) ∈ R2+ 4. P1∗ > P2∗ = c?
The only candidate for equilibrium is P1∗ = P2∗ = c, and it is indeed an
P1 − c, if P1 < P2 ,
equilibrium.
u1 (P1 , P2 ) = P12−c , if P1 = P2 ,
0, if P1 > P2 . The unique Nash equilibrium of the Bertrand game is (P1∗ , P2∗ ) = (c, c)
P2 − c, if P2 < P1 , What if unit cost of firm 1 exceeds that of firm 2?
u2 (P1 , P2 ) = P22−c , if P2 = P1 ,
What if prices are discrete?
0, if P2 > P1 .
Levent Koçkesen (Koç University) Strategic Form Games 15 / 21 Levent Koçkesen (Koç University) Strategic Form Games 16 / 21
page.17 page.18
Bertrand Duopoly with Differentiated Products A Model of Election
Spatial Voting Models
Two firms with products that are imperfect substitutes Candidates choose a policy
◮ 10% tax rate vs. 25% tax rate
The demand functions are ◮ pro-EU vs anti-EU
Levent Koçkesen (Koç University) Strategic Form Games 17 / 21 Levent Koçkesen (Koç University) Strategic Form Games 18 / 21
page.19 page.20
Strategic Form of the Game
Nash Equilibrium
1. N = {1, 2} Suppose p∗1 , p∗2 is a Nash equilibrium. Then
The unique Nash equilibrium of the election game is (p∗1 , p∗2 ) = (1/2, 1/2)
Levent Koçkesen (Koç University) Strategic Form Games 19 / 21 Levent Koçkesen (Koç University) Strategic Form Games 20 / 21
page.21
Other Election Models
Levent Koçkesen
Goalie
Koç University Lef t Right
Lef t −1, 1 1, −1
Kicker
Right 1, −1 −1, 1
No solution?
You should try to be unpredictable
Choose randomly
Levent Koçkesen (Koç University) Mixed Strategies 1 / 18 Levent Koçkesen (Koç University) Mixed Strategies 2 / 18
page.3 page.4
Drunk Driving Drunk Driving
Chief of police in Istanbul concerned about drunk driving.
He can set up an alcohol checkpoint or not
◮
Let’s work with numbers:
a checkpoint always catches drunk drivers
◮ but costs c
f = 2, c = 1, d = 4, r = 2, a = 1
You decide whether to drink wine or cola before driving.
◮ Value of wine over cola is r So, the game becomes:
◮ Cost of drunk driving is a to you and f to the city
⋆ incurred only if not caught Police
◮ if you get caught you pay d Check No
Wine −2, −1 1, −2
You
Police Cola 0, −1 0, 0
Check No
Wine r − d, −c r − a, −f What is the set of Nash equilibria?
You
Cola 0, −c 0, 0
Levent Koçkesen (Koç University) Mixed Strategies 5 / 18 Levent Koçkesen (Koç University) Mixed Strategies 6 / 18
page.7 page.8
Mixed Strategy Equilibrium Mixed Strategy Equilibrium
Levent Koçkesen (Koç University) Mixed Strategies 7 / 18 Levent Koçkesen (Koç University) Mixed Strategies 8 / 18
page.9 page.10
Hawk-Dove Mixed and Pure Strategy Equilibria
Player 2
H D How do you find the set of all (pure and mixed) Nash equilibria?
H 0, 0 6, 1 In 2 × 2 games we can use the best response correspondences in
Player 1
D 1, 6 3, 3 terms of the mixed strategies and plot them
Consider the Battle of the Sexes game
How would you play?
What could be the stable population composition? Player 2
Nash equilibria? m o
◮ (H, D) m 2, 1 0, 0
◮ (D, H) Player 1
o 0, 0 1, 2
How about 3/4 hawkish and 1/4 dovish?
◮ On average a dovish player gets (3/4) × 1 + (1/4) × 3 = 3/2 Denote Player 1’s strategy as p and that of Player 2 as q (probability
◮ A hawkish player gets (3/4) × 0 + (1/4) × 6 = 3/2
◮
of choosing m)
No type has an evolutionary advantage
This is a mixed strategy equilibrium
Levent Koçkesen (Koç University) Mixed Strategies 9 / 18 Levent Koçkesen (Koç University) Mixed Strategies 10 / 18
page.11 page.12
m o What is Player 1’s best response? m o What is Player 2’s best response?
m 2, 1 0, 0 Expected payoff to m 2, 1 0, 0 Expected payoff to
o 0, 0 1, 2 ◮ m is 2q o 0, 0 1, 2 ◮ m is p
◮ o is 1 − q ◮ o is 2(1 − p)
If 2q > 1 − q or q > 1/3 If p > 2(1 − p) or p > 2/3
◮ best response is m (or equivalently p = 1) ◮ best response is m (or equivalently q = 1)
If 2q < 1 − q or q < 1/3 If p < 2(1 − p) or p < 2/3
◮ best response is o (or equivalently p = 0) ◮ best response is o (or equivalently q = 0)
If 2q = 1 − q or q = 1/3 If p = 2(1 − p) or p = 2/3
◮ he is indifferent ◮ she is indifferent
◮ best response is any p ∈ [0, 1] ◮ best response is any q ∈ [0, 1]
Player 1’s best response correspondence: Player 2’s best response correspondence:
{1} , if q > 1/3
{1} , if p > 2/3
B1 (q) = [0, 1], if q = 1/3 B2 (p) = [0, 1], if p = 2/3
{0} , if q < 1/3 {0} , if p < 2/3
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page.13 page.14
Dominated Actions and Mixed Strategies
Up to now we tested actions only against other actions
An action may be undominated by any other action, yet be
{1} , if q > 1/3
dominated by a mixed strategy
B1 (q) = [0, 1], if q = 1/3 q
B2 (p)
Consider the following game
{0} , if q < 1/3
1 b
B1 (q)
L R
T 1, 1 1, 0
{1} , if p > 2/3
M 3, 0 0, 3
B2 (p) = [0, 1], if p = 2/3
B 0, 1 4, 0
{0} , if p < 2/3 1/3 b
No action dominates T
b
Set of Nash equilibria 0 2/3 1 p But mixed strategy (α1 (M ) = 1/2, α1 (B) = 1/2) strictly dominates
T
{(0, 0), (1, 1), (2/3, 1/3)}
A strictly dominated action is never used with positive probability in a
mixed strategy equilibrium
Levent Koçkesen (Koç University) Mixed Strategies 13 / 18 Levent Koçkesen (Koç University) Mixed Strategies 14 / 18
page.15 page.16
Dominated Actions and Mixed Strategies What if there are no strictly dominated actions?
An easy way to figure out dominated actions is to compare expected L R
payoffs T 2, 0 2, 1
Let player 2’s mixed strategy given by q = prob(L) M 3, 3 0, 0
B 0, 1 3, 0
Denote player 2’s mixed strategy by q = prob(L)
L R
u1 (T, q) = 1 u1 (T, q) = 2, u1 (M, q) = 3q, u1 (B, q) = 3(1 − q)
T 1, 1 1, 0
M 3, 0 0, 3 u1 (M, q) = 3q
B 0, 1 4, 0 u1 (B, q) = 4(1 − q) u1 (., q) Pure strategy Nash eq. (M, L)
u1 (., q) Mixed strategy equilibria?
4 u1 (B, q)
An action is a never best 3
u1 (B, q)
u1 (M, q)
◮ Only one player mixes? Not possible
response if there is no belief (on ◮ Player 1 mixes over {T, M, B}? Not possible
2 u1 (T, q)
3 u1 (M, q) A−i ) that makes that action a 3/2
◮ Player 1 mixes over {M, B}? Not possible
best response ◮ Player 1 mixes over {T, B}? Let p = prob(T )
2
12/7
T is a never best response q = 1/3, 1 − p = p → p = 1/2
◮ Player 1 mixes over {T, M }? Let p = prob(T )
1 u1 (T, q)
An action is a NBR iff it is 0 1 q
1/3 1/2 2/3
q = 2/3, 3(1 − p) = p → p = 3/4
0 q strictly dominated
4/7
0 1
Levent Koçkesen (Koç University) Mixed Strategies 15 / 18 Levent Koçkesen (Koç University) Mixed Strategies 16 / 18
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Real Life Examples? Penalty Kick
L R
L 58, 42 95, 5
R 93, 7 70, 30
Ignacio Palacios-Huerta (2003): 5 years’ worth of penalty kicks
Kicker must be indifferent
Empirical scoring probabilities
58p + 95(1 − p) = 93p + 70(1 − p) ⇒ p = 0.42
L R
L 58, 42 95, 5 Goal keeper must be indifferent
R 93, 7 70, 30
42q + 7(1 − q) = 5q + 30(1 − q) ⇒ q = 0.39
R is the natural side of the kicker
What are the equilibrium strategies?
Theory Data
Kicker 39% 40%
Goallie 42% 42%
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Bayesian Games Bayesian Games
We will first look at incomplete information games where players
move simultaneously
◮ Bayesian games
Later on we will study dynamic games of incomplete information
What is new in a Bayesian game?
Each player has a type: summarizes a player’s private information Incomplete information can be anything about the game
◮ Type set for player i: Θi ◮ Payoff functions
⋆ A generic type: θi ◮ Actions available to others
◮ Set of type profiles: Θ = ×i∈N Θi ◮ Beliefs of others; beliefs of others’ beliefs of others’...
⋆ A generic type profile: θ = {θ1 , θ2 , . . . , θn }
Each player has beliefs about others’ types Harsanyi showed that introducing types in payoffs is adequate
◮ pi : Θi → △ (Θ−i )
◮ pi (θ−i |θi )
Players’ payoffs depend on types
◮ ui : A × Θ → R
◮ ui (a|θ)
Different types of same player may play different strategies
◮ ai : Θi → Ai
◮ αi : Θi → △ (Ai )
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Bayesian Equilibrium Bank Runs
Levent Koçkesen (Koç University) Bayesian Games 5 / 15 Levent Koçkesen (Koç University) Bayesian Games 6 / 15
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Bank Runs Separating Equilibria
W N W N
The payoffs can be summarized as follows W 50, 50 100, 0 W 50, 50 100, 0
N 0, 100 150, 150 N 0, 100 0, 0
W N W N Good q Bad (1 − q)
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Pooling Equilibria Cournot Duopoly with Incomplete Information about Costs
W N W N
W 50, 50 100, 0 W 50, 50 100, 0
N 0, 100 150, 150 N 0, 100 0, 0
Two firms. They choose how much to produce qi ∈ R+
Good q Bad (1 − q)
Firm 1 has high cost: cH
1. (Good: N, Bad: N) Firm 2 has either low or high cost: cL or cH
◮ Not possible since W is a dominant strategy for Bad Firm 1 believes that Firm 2 has low cost with probability µ ∈ [0, 1]
2. (Good: W, Bad: W) payoff function of player i with cost cj
Player 1’s expected payoffs
W: q × 50 + (1 − q) × 50 ui (q1 , q2 , cj ) = (a − (q1 + q2 )) qi − cj qi
N: q × 0 + (1 − q) × 0
Player 1 chooses W. Player 2 of Good type’s best response is W. Strategies:
Therefore, for any value of q the following is the unique q1 ∈ R+ q2 : {cL , cH } → R+
Pooling Equilibrium
Player 1: W, Player 2: (Good: W, Bad: W)
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Complete Information Complete Information
Firm 1
max (a − (q1 + q2 )) q1 − cH q1
q1 Nash Equilibrium
Best response correspondence
If Firm 2’s cost is cH
a − cH
a − q2 − cH q1 = q2 =
BR1 (q2 ) = 3
2
If Firm 2’s cost is cL
Firm 2
max (a − (q1 + q2 )) q2 − cj q2 a − cH − (cH − cL )
q2 q1 =
3
Best response correspondences a − cH + (cH − cL )
q2 =
a − q1 − cL 3
BR2 (q1 , cL ) =
2
a − q1 − cH
BR2 (q1 , cH ) =
2
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Incomplete Information Bayesian Equilibrium
Firm 2
max (a − (q1 + q2 )) q2 − cj q2
q2
page.15
Complete vs. Incomplete Information
a − cH a − cH
BR1 (q2 )
a−cL
2
BR2 (q1 , cL )
q2 (cL )
a−cH E[q2 ]
2
q2 (cH )
BR2 (q1 , cH )
q1 q1
a−cH a − cH a − cL q1 a−cH a − cH a − cL
2 2
1 Auctions: Examples
7 Auction Design
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Auctions Auction Formats
Many economic transactions are conducted through auctions 1. Open bid auctions
treasury bills art work 1.1 ascending-bid auction
⋆ aka English auction
foreign exchange antiques ⋆ price is raised until only one bidder remains, who wins and pays the
publicly owned companies cars final price
1.2 descending-bid auction
mineral rights houses ⋆ aka Dutch auction
airwave spectrum rights government contracts ⋆ price is lowered until someone accepts, who wins the object at the
current price
Also can be thought of as auctions 2. Sealed bid auctions
takeover battles 2.1 first price auction
⋆ highest bidder wins; pays her bid
queues
2.2 second price auction
wars of attrition ⋆ aka Vickrey auction
lobbying contests ⋆ highest bidder wins; pays the second highest bid
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Auction Formats Strategically Equivalent Formats
Auctions also differ with respect to the valuation of the bidders English Auction ! Second Price
1. Private value auctions
◮ each bidder knows only her own value
◮ artwork, antiques, memorabilia Dutch Auction ! First Price
2. Common value auctions
◮ actual value of the object is the same for everyone
◮ bidders have different private information about that value
◮ oil field auctions, company takeovers We will study sealed bid auctions
1. Private values
◮ Second price
◮ First price
2. Common values
◮ Winner’s curse
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Independent Private Values Auctions as a Bayesian Game
Levent Koçkesen (Koç University) Auctions 7 / 21 Levent Koçkesen (Koç University) Auctions 8 / 21
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Second Price Auctions Second Price Auctions
I. Bidding your value weakly dominates bidding higher II. Bidding your value weakly dominates bidding lower
Suppose your value is $10 but you bid $5. Three cases:
Suppose your value is $10 but you bid $15. Three cases: 20 1. There is a bid higher than $10 (e.g. $12)
◮ You loose either way: no difference 12
1. There is a bid higher than $15 (e.g. $20)
◮
2. 2nd highest bid is lower than $5 (e.g. $2)
You loose either way: no difference
15 bid ◮ You win either way and pay $2: no difference 10 value
2. 2nd highest bid is lower than $10 (e.g. $5)
◮
3. 2nd highest bid is between $5 and $10 (e.g. $8)
You win either way and pay $5: no difference 12 ◮ You loose with $5: zero payoff
3. 2nd highest bid is between $10 and $15 (e.g. $12) ◮ You win with $10: earn $2
10 value 8
◮ You loose with $10: zero payoff
◮ You win with $15: loose $2
5 bid
5
2
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First Price Auctions Bayesian Equilibrium of First Price Auctions
Only 2 bidders
You are player 1 and your value is v > 0
You believe the other bidder’s value is uniformly distributed over [0, 1]
You believe the other bidder uses strategy β(v2 ) = av2
Highest bidder wins and pays her bid
Your expected payoff if you bid b
Would you bid your value?
(v − b)prob(you win) = (v − b)prob(b > av2 )
What happens if you bid less than your value?
◮ You get a positive payoff if you win = (v − b)prob(v2 < b/a)
◮ But your chances of winning are smaller b
◮
= (v − b)
Optimal bid reflects this tradeoff a
Bidding less than your value is known as bid shading Maximizing implies first derivative equal to zero
b v−b
− + =0
a a
Solving for b
v
b=
2
Bidding half the value is a Bayesian equilibrium
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Bayesian Equilibrium of First Price Auctions Which One Brings More Revenue?
n bidders Second Price
You are player 1 and your value is v > 0 ◮ Bidders bid their value
You believe the other bidders’ values are independently and uniformly
◮ Revenue = second highest bid
distributed over [0, 1]
You believe the other bidders uses strategy β(vi ) = avi First Price
Your expected payoff if you bid b ◮ Bidders bid less than their value
◮ Revenue = highest bid
(v − b)prob(you win)
Which one is better?
(v − b)prob(b > av2 and b > av3 . . . and b > avn ) Turns out it doesn’t matter
This is equal to
Revenue Equivalence Theorem
(v−b)prob(b > av2 )prob(b > av3 ) . . . prob(b > avn ) = (v−b)(b/a)n−1
Any auction with independent private values with a common distribution
in which
Maximizing implies first derivative equal to zero 1. the number of the bidders are the same and the bidders are
−(b/a)n−1 + (n − 1)
v−b
(b/a)n−2 = 0
risk-neutral,
a
2. the object always goes to the buyer with the highest value,
Solving for b
n−1 3. the bidder with the lowest value expects zero surplus,
b= v
n
yields the same expected revenue.
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Common Value Auctions and Winner’s Curse Common Value Auctions and Winner’s Curse
Suppose you are going to bid for an offshore oil lease
If everybody bids her estimate winning is “bad news”
Value of the oil tract is the same for everybody
This is known as Winner’s Curse
But nobody knows the true value
Optimal strategies are complicated
Each bidder obtains an independent and unbiased estimate of the
Bidders bid much less than their value to prevent winner’s curse
value
Your estimate is $100 million To prevent winner’s curse
How much do you bid? Base your bid on expected value conditional on winning
Suppose everybody, including you, bids their estimate and you are the
winner Auction formats are not equivalent in common value auctions
What did you just learn? Open bid auctions provide information and ameliorates winner’s curse
Your estimate must have been larger than the others’ ◮ Bids are more aggressive
The true value must be smaller than $100 million Sealed bid auctions do not provide information
◮ Bids are more conservative
You overpaid
Levent Koçkesen (Koç University) Auctions 15 / 21 Levent Koçkesen (Koç University) Auctions 16 / 21
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Auction Design: Failures Auction Design: Failures
New Zeland Spectrum Auction (1990) Australian TV Licence Auction (1993)
◮ Two satellite-TV licences
◮ Used second price auction with no reserve price
◮ Used first price auction
◮ Estimated revenue NZ$ 240 million
◮ Huge embarrasment
◮ Actual revenue NZ$36 million
High bidders had no intention of paying
Some extreme cases They bid high just to guarantee winning
Winning Bid Second Highest Bid They also bid lower amounts at A$5 million intervals
They defaulted
NZ$100,000 NZ$6,000 ◮ licences had to be re-awarded at the next highest bid
NZ$7,000,000 NZ$5,000 ◮ those bids were also theirs
NZ$1 None
Outcome after a series of defaults
Source: John McMillan, “Selling Spectrum Rights,” Journal of Economic Perspectives, Summer 1994
Initial Bid Final Price
A$212 mil. A$117 mil.
Problems
◮ Second price format politically problematic
A$177 mil. A$77 mil.
Source: John McMillan, “Selling Spectrum Rights,” Journal of Economic Perspectives, Summer 1994
⋆ Public sees outcome as selling for less than its worth
◮ No reserve price Problem: No penalty for default
Levent Koçkesen (Koç University) Auctions 17 / 21 Levent Koçkesen (Koç University) Auctions 18 / 21
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Auction Design: Failures Auction Design
Turkish GSM licence auction
Good design depends on objective
April 2000: Two GSM 1800 licences to be auctioned
◮ Revenue
Auction method: ◮ Efficiency
1. Round 1: First price sealed bid auction ◮ Other
2. Round 2: First price sealed bid auction with reserve price
⋆ Reserve price is the winning bid of Round 1 One common objective is to maximize expected revenue
Bids in the first round In the case of private independent values with the same number of
Bidder Bid Amount risk neutral bidders format does not matter
Is-Tim $2.525 bil. Auction design is a challenge when
Dogan+ $1.350 bil. ◮ values are correlated
Genpa+ $1.224 bil. ◮ bidders are risk averse
Koc+ $1.207 bil. Other design problems
Fiba+ $1.017 bil. ◮ collusion
Bids in the second round: NONE! ◮ entry deterrence
◮ reserve price
Problem: Facilitates entry deterrence
Levent Koçkesen (Koç University) Auctions 19 / 21 Levent Koçkesen (Koç University) Auctions 20 / 21
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Auction Design
Levent Koçkesen (Koç University) Extensive Form Games 1 / 20 Levent Koçkesen (Koç University) Extensive Form Games 2 / 20
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Entry Game Extensive Form Games
Levent Koçkesen (Koç University) Extensive Form Games 3 / 20 Levent Koçkesen (Koç University) Extensive Form Games 4 / 20
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Game Trees Extensive Form Game Strategies
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Extensive Form Game Strategies Backward Induction Equilibrium
K
What should Polaroid do if
1 C 2 C 1 C Kodak enters?
2, 4 Out In
Given what it knows about
P
Polaroid’s response to entry,
0, 20
S S S what should Kodak do?
F A
This is an example of a
backward induction equilibrium
1, 0 0, 2 3, 1 −5, 0 10, 10
At a backward induction equilibrium each player plays optimally at
every decision node in the game tree (i.e., plays a sequentially rational
S1 = {SS, SC, CS, CC} strategy)
S2 = {S, C} (In, A) is the unique backward induction equilibrium of the entry
game
Levent Koçkesen (Koç University) Extensive Form Games 7 / 20 Levent Koçkesen (Koç University) Extensive Form Games 8 / 20
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Backward Induction Equilibrium Power of Commitment
1 C 2 C 1 C
2, 4
K
Remember that (In, A) is the
S S S unique backward induction
Out In
equilibrium of the entry game.
P
Polaroid’d payoff is 10.
1, 0 0, 2 3, 1 0, 20
Suppose Polaroid commits to
F A
fight (F ) if entry occurs.
What would Kodak do? −5, 0 10, 10
What should Player 1 do if the game reaches the last decision node?
Given that, what should Player 2 do if the game reaches his decision Outcome would be Out and Polaroid would be better off
node? Is this commitment credible?
Given all that what should Player 1 do at the beginning?
Unique backward induction equilibrium (BIE) is (SS, S)
Unique backward induction outcome (BIO) is (S)
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Dr. Strangelove
Thomas Schelling
The power to constrain an adversary depends upon the power to bind
oneself.
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Credible Commitments: Burning Bridges Strategic Form of an Extensive Form Game
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Strategic Form of an Extensive Form Game Extensive Form Games with Imperfect Information
1. N = {K, P } K We have seen extensive form games with perfect information
◮ Every player observes the previous moves made by all the players
2. SK = {Out, In}, SP = {F, A}
Out In What happens if some of the previous moves are not observed?
3. Payoffs in the bimatrix P We cannot apply backward induction algorithm anymore
P 0, 20 Consider the following game between Kodak and Polaroid
F A F A
Out 0, 20 0, 20 Kodak doesn’t know whether K
K Polaroid will fight or
In −5, 0 10, 10 −5, 0 10, 10
accommodate Out In
Set of Nash equilibria = {(In, A), (Out, F )} The dotted line is an P
(Out, F ) is sustained by an incredible threat by Polaroid information set: 0, 20
◮ a collection of decision nodes F A
Backward induction equilibrium eliminates equilibria based upon
that cannot be distinguished
incredible threats K K
by the player
Nash equilibrium requires rationality F A F A
We cannot determine the
Backward induction requires sequential rationality optimal action for Kodak at
◮ Players must play optimally at every point in the game that information set −5, −5 5, 15 15, 5 10, 10
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Subgame Perfect Equilibrium Subgame Perfect Equilibrium
We will introduce another solution concept: Subgame Perfect Equilibrium
Definition Extensive form game strategies
A subgame is a part of the game tree such that A pure strategy of a player specifies an action choice at each information
1. it starts at a single decision node, set of that player
2. it contains every successor to this node,
3. if it contains a node in an information set, then it contains all the Definition
nodes in that information set. A strategy profile in an extensive form game is a subgame perfect
equilibrium (SPE) if it induces a Nash equilibrium in every subgame of the
This is a subgame This is not a subgame game.
P P
To find SPE
F A A 1. Find the Nash equilibria of the “smallest” subgame(s)
K K K 2. Fix one for each subgame and attach payoffs to its initial node
F A F A F A 3. Repeat with the reduced game
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Subgame Perfect Equilibrium Subgame Perfect Equilibrium
Consider the following game The “smallest” subgame Its strategic form
K P
P
F A
Out In F A
K K
F −5, −5 8, 5
K
P F A F A A 5, 8 10, 10
0, 20
−5, −5 5, 8 8, 5 10, 10
F A
Out In
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Ultimatum Bargaining Subgame Perfect Equilibrium of Ultimatum Bargaining
We can use backward induction
B’s optimal action
◮ x < 1 → accept
A
◮ x = 1 → accept or reject
Two players, A and B, bargain
over a cake of size 1 1. Suppose in equilibrium B accepts any offer x ∈ [0, 1]
x ◮ What is the optimal offer by A? x = 1
Player A makes an offer ◮ The following is a SPE
x ∈ [0, 1] to player B B
x∗ = 1
If player B accepts the offer
(Y ), agreement is reached s∗B (x) = Y for all x ∈ [0, 1]
Y N
◮ A receives x
◮ B receives 1 − x 2. Now suppose that B accepts if and only if x < 1
◮ What is A’s optimal offer?
If player B rejects the offer (N ) x, 1 − x 0, 0
⋆ x = 1?
both receive zero ⋆ x < 1?
Unique SPE
x∗ = 1, s∗B (x) = Y for all x ∈ [0, 1]
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Bargaining Bargaining
Two individuals, A and B, are trying to share a cake of size 1
If A gets x and B gets y,utilities are uA (x) and uB (y)
Bargaining outcomes depend on many factors If they do not agree, A gets utility dA and B gets dB
◮ Social, historical, political, psychological, etc.
What is the most likely outcome?
Early economists thought the outcome to be indeterminate uB
John Nash introduced a brilliant alternative approach
1
◮ Axiomatic approach: A solution to a bargaining problem must satisfy
certain “reasonable” conditions
⋆ These are the axioms
◮ How would such a solution look like?
◮ This approach is also known as cooperative game theory
dB
Later non-cooperative game theory helped us identify critical strategic
considerations
dA 1 uA
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Bargaining Bargaining
Let’s simplify the problem How about now? dA = 0.3, dB = 0.4
uA (x) = x, and uB (x) = x
uB
dA = dB = 0
1 45◦
A and B are the same in every other respect
What is the most likely outcome?
uB
0.55
0.4
1 ◦
45
0.3 0.45 1 uA
In general A gets
John Nash (1950): The Bargaining Problem, Econometrica
1
dA + (1 − dA − dB ) 1. Efficiency
2 ⋆ No waste
B gets 2. Symmetry
⋆ If bargaining problem is symmetric, shares must be equal
1 3. Scale Invariance
dB + (1 − dA − dB )
2 ⋆ Outcome is invariant to linear changes in the payoff scale
4. Independence of Irrelevant Alternatives
But why is this reasonable? ⋆ If you remove alternatives that would not have been chosen, the
Two answers: solution does not change
1. Axiomatic: Nash Bargaining Solution
2. Non-cooperative: Alternating offers bargaining game
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Nash Bargaining Solution Alternating Offers Bargaining
What if parties have different bargaining powers?
Two players, A and B, bargain over a cake of size 1
Remove symmetry axiom
At time 0, A makes an offer xA ∈ [0, 1] to B
Then A gets ◮ If B accepts, A receives xA and B receives 1 − xA
◮ If B rejects, then
xA = dA + α(1 − dA − dB )
at time 1, B makes a counteroffer xB ∈ [0, 1]
◮ If A accepts, B receives xB and A receives 1 − xB
B gets
◮ If A rejects, he makes another offer at time 2
xB = dB + β(1 − dA − dB ) This process continues indefinitely until a player accepts an offer
If agreement is reached at time t on a partition that gives player i a
α, β > 0 and α + β = 1 represent bargaining powers share xi
If dA = dB = 0 ◮ player i’s payoff is δit xi
◮ δi ∈ (0, 1) is player i’s discount factor
xA = α and xB = β
If players never reach an agreement, then each player’s payoff is zero
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Alternating Offers Bargaining
xA
B
Stationary No-delay Equilibrium A
Y N
1. No Delay: All equilibrium offers are accepted xA
B
B
xA , 1 − xA
2. Stationarity: Equilibrium offers do not depend on time
Y N
A xB
◮ δB x∗B A
Y N
Therefore, we must have Y N
A A
δA (1 − xB ), δB xB
1 − x∗A = δB x∗B δA (1 − xB ), δB xB
xA
xA
B
B Similarly
1 − x∗B = δA x∗A Y N
A
Y N
2 x , δ 2 (1 − x )
δA A B A
A
2 x , δ 2 (1 − x )
δA A B A
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Alternating Offers Bargaining Properties of the Equilibrium
Bargaining Power
There is a unique solution
Player A’s share
1 − δB 1 − δB
x∗A = πA = x∗A =
1 − δA δB 1 − δA δB
1 − δA Player B’s share
x∗B = δB (1 − δA )
1 − δA δB πB = 1 − x∗A =
1 − δA δB
There is at most one stationary no-delay SPE
Still have to verify there exists such an equilibrium Share of player i is increasing in δi and decreasing in δj
The following strategy profile is a SPE Bargaining power comes from patience
Example
Player A: Always offer x∗A , accept any xB with 1 − xB ≥ δA x∗A
Player B: Always offer x∗B , accept any xA with 1 − xA ≥ δB x∗B δA = 0.9, δB = 0.95 ⇒ πA = 0.35, πB = 0.65
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Properties of the Equilibrium Capacity Commitment: Stackelberg Duopoly
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Nash Equilibrium of Cournot Duopoly Cournot Best Response Functions
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Stackelberg Model Backward Induction Equilibrium of Stackelberg Game
The game has two stages:
Sequential rationality of Firm 2 implies that for any Q1 it must play a
1. Firm 1 chooses a capacity level Q1 ≥ 0 best response:
2. Firm 2 observes Firm 1’s choice and chooses a capacity Q2 ≥ 0 a − c − bQ1
Q2 (Q1 ) =
1 2b
Firms 1’s problem is to choose Q1 to maximize:
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Backward Induction Equilibrium of Stackelberg Game
Backward Induction Equilibrium
a−c
Qs1 =
2b
a − c − bQ1
Qs2 (Q1 ) =
2b
(a − c)2 (a − c)2
π1s = > = π1c There is first mover advantage
8b 9b
(a − c)2 (a − c)2
π2s = < = π2c
16b 9b
Levent Koçkesen (Koç University) Extensive Form Games: Applications 23 / 23
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Repeated Games
Levent Koçkesen (Koç University) Repeated Games 1 / 32 Levent Koçkesen (Koç University) Repeated Games 2 / 32
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Dynamic Rivalry Implicit Collusion
Levent Koçkesen (Koç University) Repeated Games 3 / 32 Levent Koçkesen (Koç University) Repeated Games 4 / 32
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Repeated Games Payoffs
Players play a stage game repeatedly over time
If there is a final period: finitely repeated game If starting today a player receives an infinite sequence of payoffs
If there is no definite end period: infinitely repeated game
◮ We could think of firms having infinite lives u1 , u2 , u3 , . . .
◮ Or players do not know when the game will end but assign some
probability to the event that this period could be the last one The payoff consequence is
Today’s payoff of $1 is more valuable than tomorrow’s $1
◮ This is known as discounting (1 − δ)(u1 + δu2 + δ2 u3 + δ3 u4 · · · )
◮ Think of it as probability with which the game will be played next
period Example: Period payoffs are all equal to 2
◮ ... or as the factor to calculate the present value of next period’s payoff
(1 − δ)(2 + δ2 + δ2 2 + δ3 2 + · · · ) = 2(1 − δ)(1 + δ + δ2 + δ3 + · · · )
Denote the discount factor by δ ∈ (0, 1)
1
In PV interpretation: if interest rate is r = 2(1 − δ)
1−δ
1 = 2
δ=
1+r
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Repeated Game Strategies Equilibria of Repeated Games
Strategies may depend on history There is no end period of the game
Cannot apply backward induction type algorithm
Samsung We use One-Shot Deviation Property to check whether a strategy
High Low profile is a subgame perfect equilibrium
High 2, 2 0, 3
Micron
Low 3, 0 1, 1 One-Shot Deviation Property
A strategy profile is an SPE of a repeated game if and only if no player can
Tit-For-Tat gain by changing her action after any history, keeping both the strategies
◮ Start with High of the other players and the remainder of her own strategy constant
◮ Play what your opponent played last period
Grim-Trigger (called Grim-Trigger II in my lecture notes) Take an history
◮ Start with High
◮
For each player check if she has a profitable one-shot deviation (OSD)
Continue with High as long as everybody always played High
◮ If anybody ever played Low in the past, play Low forever Do that for each possible history
What happens if both players play Tit-For-Tat? If no player has a profitable OSD after any history you have an SPE
If there is at least one history after which at least one player has a
How about Grim-Trigger?
profitable OSD, the strategy profile is NOT an SPE
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Grim-Trigger Strategy Profile
There are two types of histories Histories in which somebody played Low in some period
1. Histories in which everybody always played High Payoff to G-T
2. Histories in which somebody played Low in some period
(1 − δ)(1 + δ + δ2 + δ3 + · · · ) = 1
Histories in which everybody always played High
Payoff to G-T Payoff to OSD (play High today and go back to G-T tomorrow)
(1 − δ)(2 + δ2 + δ2 2 + δ3 2 + · · · ) = 2(1 − δ)(1 + δ + δ2 + δ3 + · · · ) (1 − δ)(0 + δ + δ2 + δ3 + · · · ) = (1 − δ)δ(1 + δ + δ2 + δ3 + · · · )
= 2 = δ
Payoff to OSD (play Low today and go back to G-T tomorrow)
We need
2 ≥ 3(1 − δ) + δ or δ ≥ 1/2
Levent Koçkesen (Koç University) Repeated Games 9 / 32 Levent Koçkesen (Koç University) Repeated Games 10 / 32
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Forgiving Trigger Forgiving Trigger Strategy
Cooperative Phase
Grim-trigger strategies are very fierce: they never forgive Payoff to F-T = 2
Can we sustain cooperation with limited punishment Payoff to OSD Outcome after a OSD
◮ For example: punish for only 3 periods
(L, H), (L, L), (L, L), . . . , (L, L), (H, H), (H, H), . . .
| {z }
Forgiving Trigger Strategy k times
δk+1 − 2δ + 1 ≤ 0
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Imperfect Detection Imperfect Detection
For simplicity let’s make payoff to (Low,Low) zero for both firms
If your competitor cuts prices it is more likely that your sales will be
lower Samsung
Adopt a threshold trigger strategy: Determine a threshold level of High Low
sales s and punishment length T Micron High 2,2 -1,3
◮ Start by playing High Low 3,-1 0,0
◮ Keep playing High as long as sales of both firms are above s
◮ The first time sales of either firm drops below s play Low for T Denote the discounted sum of expected payoff (NPV) to threshold
periods; and then restart the strategy trigger strategy by v
pH : probability that at least one firm’s sales is lower than s even v = 2 + δ (1 − pH )v + pH δT v
when both firms choose high prices
We can solve for v
pL : probability that the other firm’s sales are lower than s when one 2
firm chooses low prices v=
1 − δ [(1 − pH ) + pH δT ]
pL > pH
Value decreases as
pH and pL depend on threshold level of sales s ◮ Threshold increases (pH increases)
◮ Higher the threshold more likely the sales will fall below the threshold ◮ Punishment length increases
◮ Therefore, higher the threshold higher are pH and pL You don’t want to trigger punishment too easily or punish too harshly
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Imperfect Detection How to Sustain Cooperation?
Main conditions
What is the payoff to cheating? Future is important
It is easy to detect cheaters
3 + δ (1 − pL )v + pL δT v
Firms are able to punish cheaters
Threshold grim trigger is a SPE if
What do you do?
2 + δ (1 − pH )v + pH δT v ≥ 3 + δ (1 − pL )v + pL δT v 1. Identify the basis for cooperation
◮ Price
that is ◮ Market share
δv(1 − δT )(pL − pH ) > 1 ◮ Product design
It is easier to sustain collusion with harsher punishment (higher T ) 2. Share profits so as to guarantee participation
although it reduces v 3. Identify punishments
◮ Strong enough to deter defection
The effect of the threshold s is ambiguous: an increase in s
◮ But weak enough to be credible
◮ decreases v
◮ may increase pL − pH 4. Determine a trigger to start punishment
5. Find a method to go back to cooperation
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Lysine Cartel: 1992-1995 Cartel Behavior
John M. Connor (2002): Global Cartels Redux: The Amino Acid
Lysine Antitrust Litigation (1996)
This is a case of an explicit collusion - a cartel
Archer Daniels Midland (ADM) and four other companies charged
April 1990: A, KH and S started meetings
with fixing worldwide lysine (an animal feed additive) price
June 1992: five firm oligopoly formed a trade association
Before 1980s: the Japanese duopoly, Ajinomoto and Kyowa Hakko
Multiparty price fixing meetings amongst the 5 corporations
Expansion mid 1970s to early 1980s to America and Europe
Early 1993: a brief price war broke out
In early 1980s, South Korean firm, Sewon, enters the market and
expands to Asia and Europe 1993: establishment of monthly reporting of each company’s sales
1986 - 1990: US market divided 55/45% btw. Ajinomoto and Kyowa Prices rose in this period from 0.68 to 0.98, fell to 0.65 and rose
Hakko again to above 1$
Prices rose to $3 per pound ($1-$2 btw 1960 and 1980)
In early 1991 ADM and Cheil Sugar Co turned the lysine industry into
a five firm oligopoly
Prices dropped rapidly due to ADMs aggressive entry as a result of its
excess capacity
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Cartel Meetings Caught on Tape Cartel Meetings Caught on Tape
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Cartel Meetings Caught on Tape Stickleback Fish
Levent Koçkesen (Koç University) Repeated Games 23 / 32 Levent Koçkesen (Koç University) Repeated Games 24 / 32
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Stickleback Fish Vampire Bats
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Vampire Bats Medieval Trade Fairs
If a bat has more than 24 hours to starvation it is usually not fed In 12th and 13th century Europe long distance trade took place in
◮ Benefit of cooperation is high fairs
Primary social unit is the female group Transactions took place through transfer of goods in exchange of
◮ They have opportunities for reciprocity promissory note to be paid at the next fair
Adult females feed their young, other young, and each other Room for cheating
◮ Does not seem to be only kin selection
No established commercial law or state enforcement of contracts
Unrelated bats often formed a buddy system, with two individuals
feeding mostly each other Fairs were largely self-regulated through Lex mercatoria, the
”merchant law”
◮ Reciprocity
◮ Functioned as the international law of commerce
Also those who received blood more likely to donate later on ◮ Disputes adjudicated by a local official or a private merchant
If not in the same group, a bat is not fed ◮ But they had very limited power to enforce judgments
◮ If not associated, reciprocation is not very likely Has been very successful and under lex mercatoria, trade flourished
It is not only kin selection How did it work?
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Medieval Trade Fairs Medieval Trade Fairs
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Medieval Trade Fairs Medieval Trade Fairs
If the cost of querying and appeal are not too high and players are
Milgrom, North, and Weingast (1990) construct a model to show how sufficiently patient the following strategy is a subgame perfect
this can work equilibrium:
The stage game: 1. A trader querries if he has no unpaid judgments
2. If either fails to query or if query establishes at least one has unpaid
1. Traders may, at a cost, query the judge, who publicly reports whether
judgement play Cheat, otherwise play Honest
any trader has any unpaid judgments
3. If both queried and exactly one cheated, victim appeals
2. Two traders play the prisoners’ dilemma game
4. If a valid appeal is filed, judge awards damages to victim
3. If queried before, either may appeal at a cost
5. Defendant pays judgement iff he has no other unpaid judgements
4. If appealed, judge awards damages to the plaintiff if he has been
honest and his partner cheated This supports honest trade
5. Defendant chooses to pay or not An excellent illustration the role of institutions
6. Unpaid judgments are recorded by the judge ◮ An institution does not need to punish bad behavior, it just needs to
help people do so
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Extensive Form Games with Incomplete Information
Koç University
Signaling Games: Informed player moves first
◮ Warranties
◮ Education
Screening Games: Uninformed player moves first
◮ Insurance company offers contracts
◮ Price discrimination
Levent Koçkesen (Koç University) Signaling Games 1 / 27 Levent Koçkesen (Koç University) Signaling Games 2 / 27
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Signaling Examples Signaling Games: Used-Car Market
Used-car dealer You want to buy a used-car which may be either good or bad (a
◮
lemon)
How do you signal quality of your car?
◮ Issue a warranty A good car is worth H and a bad one L dollars
An MBA degree You cannot tell a good car from a bad one but believe a proportion q
◮ How do you signal your ability to prospective employers? of cars are good
◮ Get an MBA The car you are interested in has a sticker price p
Entrepreneur seeking finance
The dealer knows quality but you don’t
◮ You have a high return project. How do you get financed?
◮ Retain some equity The bad car needs additional work that costs c to make it look like
Stock repurchases good
◮ Often result in an increase in the price of the stock The dealer decides whether to put a given car on sale or not
◮ Manager knows the financial health of the company You decide whether to buy or not
◮ A repurchase announcement signals that the current price is low
Assume
Limit pricing to deter entry
H>p>L
◮ Low price signals low cost
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Signaling Games: Used-Car Market Signaling Games: Used-Car Market
p, H − p p, H − p
Yes
Yes
Hold D Offer
Hold D Offer 0, 0
0, 0
No
good (q) 0, 0
No
good (q) 0, 0
Nature Y
bad (1 − q) p − c, L − p
Nature Y Yes
0, 0
(1 − q) p − c, L − p Hold D Offer
bad
Yes No
−c, 0
0, 0
Hold D Offer
Dealer will offer the bad car if you will buy
No
−c, 0
You will buy if the car is good
We have to introduce beliefs at your information set
We cannot apply backward induction
◮
Given beliefs we want players to play optimally at every information
No final decision node to start with
set
We cannot apply SPE ◮ sequential rationality
◮ There is only one subgame - the game itself We want beliefs to be consistent with chance moves and strategies
We need to develop a new solution concept ◮ Bayes Law gives consistency
Levent Koçkesen (Koç University) Signaling Games 5 / 27 Levent Koçkesen (Koç University) Signaling Games 6 / 27
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Bayes Law Bayes Law
Suppose a fair die is tossed once and consider the following events: Given two events A and B such that P (B) 6= 0 we have
A: The number 4 turns up.
B: The number observed is an even number. P (A and B)
P (A | B) =
The sample space and the events are P (B)
Note that since
S = {1, 2, 3, 4, 5, 6} P (A and B) = P (B | A) P (A)
A = {4} We have
P (B | A) P (A)
B = {2, 4, 6} P (A | B) =
P (B)
Ac : complement of A
P (A) = 1/6, P (B) = 1/2 P (B) = P (B | A) P (A) + P (B | Ac ) P (Ac )
Suppose we know that the outcome is an even number. What is the Therefore,
probability that the outcome is 4? We call this a conditional probability
P (B | A) P (A)
P (A | B) =
1 P (B | A) P (A) + P (B | Ac ) P (Ac )
P (A | B) =
3 The probability P (A) is called the prior probability and P (A | B) is called
the posterior probability.
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Bayes Law: Example Bayes Law
p, H − p
A machine can be in two possible states: good (G) or bad (B) Hold D Offer
Yes
0, 0
It is good 90% of the time
The item produced by the machine is defective (D) good (q)
No
0, 0
defective? 0, 0
Hold D Offer
No
−c, 0
P (G) = 0.9, P (B) = 1 − 0.9 = 0.1, P (D | G) = 0.01, P (D | B) = 0.1 Dealer’s strategy: Offer if good; Hold if bad
Therefore, by Bayes’ Law What is your consistent belief if you observe the dealer offer a car?
P (offer and good)
P (D | G) P (G)
P (good|offer) =
P (G | D) = P (offer)
P (D | G) P (G) + P (D | B) P (B)
0.01 × 0.9
P (offer|good)P (good)
= =
0.01 × 0.9 + 0.10 × 0.1 P (offer|good)P (good) + P (offer|bad)P (bad)
.00 9 ∼ 1×q
= = . 47
.0 19 =
1 × q + 0 × (1 − q)
In this example the prior probability that the machine is in a good
= 1
condition is 0.90, whereas the posterior probability is 0.47.
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Strategies and Beliefs Perfect Bayesian Equilibrium
Sequential Rationality
At each information set, strategies must be optimal, given the beliefs and
A solution in an extensive form game of incomplete information is a
subsequent strategies
collection of
1. A behavioral strategy profile Weak Consistency
2. A belief system Beliefs are determined by Bayes Law and strategies whenever possible
We call such a collection an assessment
The qualification “whenever possible” is there because if an information
A behavioral strategy specifies the play at each information set of the
set is reached with zero probability we cannot use Bayes Law to determine
player
◮
beliefs at that information set.
This could be a pure strategy or a mixed strategy
A belief system is a probability distribution over the nodes in each Perfect Bayesian Equilibrium
information set An assessment is a PBE if it satisfies
1. Sequentially rationality
2. Weak Consistency
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Back to Used-Car Example Pooling Equilibria
p, H − p
Yes
Hold D Offer
0, 0
p, H − p No
good (q) 0, 0
Yes
Hold D Offer
0, 0 Nature Y
No bad (1 − q) p − c, L − p
good (q) 0, 0 Yes
0, 0
Hold D Offer
Nature Y
No
−c, 0
bad (1 − q) p − c, L − p
Yes
Both types Offer
0, 0
Hold D Offer
What does Bayes Law imply about your beliefs?
No
−c, 0
P (offer and good)
P (good|offer) =
As in Bayesian equilibria we may look for two types of equilibria: P (offer)
P (offer|good)P (good)
1. Pooling Equilibria: Good and Bad car dealers play the same strategy =
P (offer|good)P (good) + P (offer|bad)P (bad)
2. Separating Equilibrium: Good and Bad car dealers play differently 1×q
= =q
1 × q + 1 × (1 − q)
Makes sense?
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Pooling Equilibria: Both Types Offer Pooling Equilibria: Both Types Hold
If you buy a car with your prior beliefs your expected payoff is You must be saying No
◮ Otherwise Good car dealer would offer
V = q × (H − p) + (1 − q) × (L − p) ≥ 0
Under what conditions would you say No?
What does sequential rationality of seller imply? P (good|of f er) × (H − p) + (1 − P (good|of f er)) × (L − p) ≤ 0
You must be buying and it must be the case that What does Bayes Law say about P (good|of f er)?
p≥c Your information set is reached with zero probability
◮ You cannot apply Bayes Law in this case
So we can set P (good|of f er) = 0
Under what conditions buying would be sequentially rational?
V ≥0 Pooling Equilibrium II
The following is a PBE
Pooling Equilibrium I
Behavioral Strategy Profile: (Good: Hold, Bad: Hold),(You: No)
If p ≥ c and V ≥ 0 the following is a PBE
Belief System: P (good|of f er) = 0
Behavioral Strategy Profile: (Good: Offer, Bad: Offer),(You: Yes)
Belief System: P (good|of f er) = q This is complete market failure: a few bad apples (well lemons) can ruin a
market
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Separating Equilibria Separating Equilibria
Good:Offer and Bad:Hold Good:Hold and Bad:Offer
What does Bayes Law imply about your beliefs? What does Bayes Law imply about your beliefs?
P (good|of f er) = 1 P (good|of f er) = 0
What does you sequential rationality imply? What does you sequential rationality imply?
◮ You say Yes ◮ You say No
Is Good car dealer’s sequential rationality satisfied?
Is Good car dealer’s sequential rationality satisfied?
◮ Yes ◮ Yes
Is Bad car dealer’s sequential rationality satisfied?
Is Bad car dealer’s sequential rationality satisfied?
◮ Yes if p ≤ c
◮ No
Separating Equilibrium I
There is no PBE in which Good dealer Holds and Bad dealer Offers
If p ≤ c the following is a PBE
Behavioral Strategy Profile: (Good: Offer, Bad: Hold),(You: Yes) If p > c and V < 0 only equilibrium is complete market failure: even the
Belief System: P (good|of f er) = 1 good cars go unsold.
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Mixed Strategy Equlilibrium Mixed Strategy Equilibrium
The following is a little involved so let’s work with numbers What does Bayes Law imply?
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Separating Equilibria Separating Equilibria
Only High ability gets an MBA Only Low ability gets an MBA
What does Bayes Law imply? What does Bayes Law imply?
pM = 1, pC = 0 pM = 0, pC = 1
What does High ability worker’s sequential rationality imply? What does High ability worker’s sequential rationality imply?
H − cH ≥ L H≥L
which is satisfied
What does Low ability worker’s sequential rationality imply? High ability worker is quite happy: she gets high wages and doesn’t
have to waste money on MBA
L ≥ H − cL
What does Low ability worker’s sequential rationality imply?
L − cL ≥ H
Combining
cH ≤ H − L ≤ cL which is impossible
which is satisfied by assumption Too bad for High ability workers: Low ability workers want to mimic
MBA is a waste of money but High ability does it just to signal her them
ability No such equilibrium: A credible signal of high ability must be costly
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Pooling Equilibria Pooling Equilibria
Both get an MBA Neither gets an MBA
What does Bayes Law imply? What does Bayes Law imply?
pM = q, pC = indeterminate pC = q, pM = indeterminate
wM = qH + (1 − q)L, wC = pC H + (1 − pC )L wC = qH + (1 − q)L, wM = pM H + (1 − pM )L
High ability worker’s sequential rationality imply High ability worker’s sequential rationality imply
qH + (1 − q)L − cH ≥ pC H + (1 − pC )L qH + (1 − q)L ≥ pM H + (1 − pM )L − cH
Low ability worker’s sequential rationality imply Low ability worker’s sequential rationality imply
qH + (1 − q)L − cL ≥ pC H + (1 − pC )L qH + (1 − q)L ≥ pM H + (1 − pM )L − cL
Since we assumed cL > H − L the last inequality is not satisfied These are satisfied if cH ≥ (pM − q)(H − L). If, for example, pM = q
No such equilibrium: It is not worth getting an MBA for low ability High ability workers cannot signal their ability by getting an MBA
workers if they cannot fool the employers. because employers do not think highly of MBAs
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Signaling Recap
Signaling works only if
◮ it is costly
◮ it is costlier for the bad type