Problem set 7: Equilibria in extensive-form games

1. (a) By backward induction, in period 2:1

q2 arg max [q2 (1 q1 q2 )] q2 0 1q1 2

And thus in period 1:

q2 (q1 )

if q1 1 otherwise.

q1 arg max [q1 (1 q1 q2 (q1 ))] q1 0 q1 =

1 2 1 q2 = . 4
1 8 and 2 = 1 . 16

This path yields 1 =

We also need to check the other paths since

the FOC for player 2 might yield negative payo on the other paths.2 For each q1 (each player 2s history), if rm 2 chooses the quantity derived by the FOC, its payo is 1 q1 2 1 q1 1 q1 2 = (1 q1 )2 0. 4

Thus, both players have no incentive to deviate from the following strategy prole:
q1

1 = , q2 (q1 ) = 2

1q1 2

if q1 1 otherwise

which is SPE. (b) We can write rm 2s (discontinuous) prot function:3 2 (q1 , q2 ) =

1

q2 (1 q1 q2 ) f 0

if q2 > 0 if q2 = 0

We assume q1 , q2 0. If there is no restriction, the question will be easier. Of course, in this question, we do not need to worry about this by the form of the payo function, unlike part (b). 3 Here, we assume that q2 = 0 means staying out.
2

Since FOC for q2 > 0 does not change, if rm 1 chooses q1 = chooses q2 =

1 4

1 2

as before, rm 2

and thus 2 =

1 16

f . Firm 1 earns = 1 . 8

However, rm 1 may prefer to deter entry, that is, we need to check the other paths as in part (a). For each q1 (each player 2s history), if rm 2 chooses the quantity derived by the FOC, its payo is
q2 (q1 )(1 q1 q2 (q1 )) f =

(1 q1 )2 f. 4

If

(1q1 )2 4

f , that is, 1 2 f q1 1 + 2 f , rm 2 weakly prefers inaction. f , we can always nd such q1 in this case. Since < 1 2 f q1 . When q2 = 0, rm 1s payo is globally
(1q1 )2 4 (1q1 )2 4

Note that, since 0 f <

1 , 16

we have

1 2

maximized at q1 = 1 . This argument implies that if 2 action is q1 = 1 2 f 1, which yields

f , rm 1s optimal

1 = (1 2 f ) 1 (1 2 f ) = 2 f (1 2 1 2 2 2+ 2 if f . 8 8 8 If f is suciently close to SPE is as follows:

q1 1 , 16

f)

the above inequality is satised. Since 1 + 2 f 1,

12 f
1 2

q2 (q1 ) =

0
1q1 2

f (< > f, if q1 1 2 f if q1 < 1 2 f . if if

2 2 8 2 2 8

1 4

<

2+ 2 ) 8

Intuitively, if the xed cost is high, the rm 1s cost of deterring entry is low and so it is worthwhile for rm 1 to do so.4
When rm 1 chooses 1 2 f , it would hope that rm 2 chooses 0 but it is not strictly guaranteed since 1q1 is also optimal for rm 2 and this is a strictly worse choice for rm 1 if f > 0. One might think about 2 slightly larger quantity of rm 1 than 1 2 f to guarantee the better choice, that is, q2 = 0, but, in this case, we can always nd a better action, which means this cannot constitute SPE.
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2. First, it is straightforward to check that the strategy pair dened in the question is a subgame perfect equilibrium as in Proposition 122.1. Actually, we can show this game satises the one deviation property (Exercise 123.1 in MOAR). In the proof of Lemma 98.2 in MOAR, we suppose one protable deviant strategy si of player i in nite subgame (h ) but we can apply this logic to this game since any innite subgame in this game yields the worst outcome. This implies that we can ignore any innite path when you consider some protable deviation. Second, we show the uniqueness. Step 1. M1 (G1 ) = m1 (G1 ) = 1 and M2 (G2 ) = m2 (G2 ) = c1 . Let Mi (Gi ) and mi (Gi ) be as in the proof of Proposition 122.1 in MOAR for i = 1, 2. By the argument for (124.1) in MOAR with the roles of the players reversed we have M2 (G2 ) 1 m1 (G1 ) + c1 , or m1 (G1 ) 1 M2 (G2 ) + c1 . Now suppose that M2 (G2 ) c2 . Then by the argument for (123.2) in MOAR with the roles of the players reversed we have m1 (G1 ) 1 M2 (G2 ) + c2 , a contradiction (since c1 < c2 ). Thus M2 (G2 ) < c2 . But now the argument for (123.2) implies that m1 (G1 ) 1, so that m1 (G1 ) = 1 and hence M1 (G1 ) = 1. Since (124.1) implies that M2 (G2 ) 1 m1 (G1 ) + c1 we have M2 (G2 ) c1 ; by (123.2) we have m2 (G2 ) c1 , so that M2 (G2 ) = m2 (G2 ) = c1 . The remainder of the argument follows as in the proof of Proposition 122.1 in MOAR: Step 2. In every SPE of G1 player 1s initial proposal is 1, which player 2 immediately accepts. Step 3. In every SPE of G1 player 2s strategy accepts any proposal. 3. Suppose that player 2 adheres to tit-for-tat. Consider player 1s behavior in subgames following histories that end in each of the following outcomes. (C, C) If player 1 adheres to tit-for-tat the outcome is (C, C) in every period, so that 3

her discounted average payo in the subgame is x. If she chooses D in the rst period of the subgame, then adheres to tit-for-tat, the outcome alternates between (D, C) and (C, D), and her discounted average payo is y/(1 + ). Thus we need x y/(1 + ), or (y x)/x, for a one-period deviation from tit-for-tat not to be protable for player 1. (C, D) If player 1 adheres to tit-for-tat the outcome alternates between (D, C) and (C, D), so that her discounted average payo is y/(1 + ). If she deviates to C in the rst period of the subgame, then adheres to tit-for-tat, the outcome is (C, C) in every period, and her discounted average payo is x. Thus we need y/(1 + ) x, or (y x)/x, for a one-period deviation from tit-for-tat not to be protable for player 1. (D, C) If player 1 adheres to tit-for-tat the outcome alternates between (C, D) and (D, C), so that her discounted average payo is y/(1 + ). If she deviates to D in the rst period of the subgame, then adheres to tit-for-tat, the outcome is (D, D) in every period, and her discounted average payo is 1. Thus we need y/(1 + ) 1 for a one-period deviation from tit-for-tat not to be protable for player 1. (D, D) If player 1 adheres to tit-for-tat the outcome is (D, D) in every period, so that her discounted average payo is 1. If she deviates to C in the rst period of the subgame, then adheres to tit-for-tat, the outcome alternates between (C, D) and (D, C), and her discounted average payo is y/(1 + ). Thus we need 1 y/(1+) for a one-period deviation from tit-for-tat not to be protable for player 1. The same arguments apply to deviations by player 2, so we conclude that (tit-fortat, tit-for-tat) is a subgame perfect equilibrium if and only if = (y x)/x and 4

y/(1 + ) = 1, or y x = 1 and = 1/x. 4. First we will prove that there are no separating equilibria. I will call player 1 the sender and player 2 the receiver. Let the receivers beliefs be q Pr(t1 chooses m1 ) and r Pr(t1 chooses m2 ). Separating equilibria: In a separating equilibrium all types must choose to send dierent messages, so there are two cases for us to check. First, lets try this: m(t1 ) = m1 , m(t2 ) = m2 . If the sender plays this strategy, the best response for the receiver is this: a(m1 ) = a2 , a(m2 ) = a1 since q = 1 and r = 0 by Bayes rule. However, in that case the sender of type t1 prefers to send m2 rather than m1 , since then he gets a payo 0 rather than 1. This cannot be an equilibrium. Next lets try this: m(t1 ) = m2 , m(t2 ) = m1 . The best response for the receiver is then: a(m1 ) = a1 , a(m2 ) = a2 since q = 0 and r = 1. However, then sender type t1 prefers to send m1 rather than m2 , earning 5 rather than 1. This cannot be an equilibrium. There are thus no separating equilibria. Pooling equilibria: In a pooling equilibrium all types choose to send the same message. There are three pooling equilibria here. First, lets try this: m(t1 ) = m(t2 ) = m1 . 5

The receivers belief must put probability p < her best response is:

1 2

on type t1 after observing m1 . Thus

a(m1 ) = a1 . We also need to specify a(m2 ). First: a(m2 ) = a1 . Then both types of sender are happy to send m1 since this earns a payo of 5 rather than 0. If the receiver puts probability r
1 2

on t1 , a1 is also a best response to m2 ,

and so with these supporting beliefs there is a rst pooling equilibrium at: m(t1 ) = m(t2 ) = m1 a(m1 ) = a(m2 ) = a1 1 1 q =p < , r . 2 2 There is a second pooling equilibrium at: m(t1 ) = m(t2 ) = m1 a(m1 ) = a1 , a(m2 ) = a2 1 1 q =p < , r . 2 2 This is similar to the rst except that the receiver responds to the o-equilibrium message m2 with a2 ; the only change is that the senders incentive to deviate to m2 is even lower than under a(m2 ) = a1 . The third pooling equilibrium features: m(t1 ) = m(t2 ) = m2 . In that case, the receivers beliefs must again be equal to the prior p and so her best response is a(m2 ) = a1 . 6

If the receiver plays a(m1 ) = a1 this cannot be an equilibrium, since then both types of sender would deviate to m1 . However, if the receiver plays a(m1 ) = a2 , neither type of sender would like to deviate to m1 . The third pooling equilibrium is then at: m(t1 ) = m(t2 ) = m2 a(m1 ) = a2 , a(m2 ) = a1 1 1 q , r=p< . 2 2 5. Let the receivers beliefs be q Pr(t1 chooses m1 ) and r Pr(t1 chooses m2 ). First notice we get one thing for free: m2 is strictly dominated for the sender t1 , so m(t1 ) = m1 . Separating equilibria: Given this, the only possible separating equilibrium is at: m(t1 ) = m1 , m(t2 ) = m2 . The receivers best response to this is: a(m1 ) = a1 , a(m2 ) = a1 since q = 1 and r = 0. Given this, sender type t1 indeed prefers to send m1 as we saw above; send type t2 is indierent between sending m1 and sending m2 , since he earns 3 either way. He is thus willing to send m2 , and so there is indeed a separating equilibria with the preceding strategies. Pooling equilibria: Again, the only possible pooling equilibria is: m(t1 ) = m(t2 ) = m1 . The receivers belief in response to m1 must then be q = p < response is: a(m1 ) = a2 . 7
1 , 2

and so her best

Next see that a(m2 ) cannot be a1 in equilibrium, since then sender type t2 will deviate to m2 and earn 3 instead of 1. What about a(m2 ) = a2 ? For this to be part of an equilibrium, the receiver must put probability 1 on the o-equilibrium message m2 having come from player 1 - this is perfectly OK in weak perfect Bayesian equilibrium since this node is reached with probability zero, meaning that Bayes Rule is not applicable and the receiver can hold any beliefs. Given a(m2 ) = a2 , it is indeed optimal for both types of sender to choose m1 . There is indeed then a pooling equilibrium at: m(t1 ) = m(t2 ) = m1 a(m1 ) = a(m2 ) = a2 1 q =p < , r = 1. 2 This one does not survive Cho-Kreps intuitive criterion. As in the lecture note, lets consider some o-equilibrium path, that is, the receivers information set given by m2 . Since m2 is strictly dominated for type t1 , type 2 can convince the receiver to believe that m2 is sent by t2 . Hence, if the receiver observed m2 , he would have r = 0 and choose a1 . However, this means type t2 would never choose m1 since a(m1 ) = a2 . 6. Let the buyers beliefs be Pr(B chooses b) and Pr(B chooses g and the government chooses n). i. Buyer must play not purchase whenever a challenge is observed, since this reveals that the product is bad. ii. The government must thus challenge whenever they are called on to decide, since they get 1 instead of 0. iii. Then the seller must send message b when the product is bad B.

iv. Suppose the seller send message b for both states, so that he always sends b. At the information set for the buyer where b is observed, the buyer must put probability =
3 4

on the sellers type being B. The buyer will therefore choose not to

purchase, since purchasing has an expected payo of 1 . This is sequentially 2 rational for the seller when his type is B, since if he sends message g instead he would get 1 (by point ii.). It is sequentially rational for the type G seller only if the buyer would also choose not to purchase if he saw message g. This information set is never reached on the equilibrium path, so this can indeed form a weak PBE. The equilibrium is: Seller: play b when type B, play b when type G. Buyer: play not purchase when observing b, when observing g and a challenge, and when observing g and no challenge. Government: challenge when called on to act. Beliefs: buyer puts probability =
3 4

and 1 . 2

v. Now suppose the seller plays g when of type G. In this case the buyer must put probability 1 on G when observing g and probability 1 on B when observing b. From there it is simple to see that there is another weak PBE at: Seller: play b when type B, play g when type G. Buyer: play not purchase when observing b and when observing g and a challenge. Play purchase when observing g and no challenge. Government: challenge when called on to act. Beliefs: buyer puts probability = 1 and = 0. vi. The second of these weak PBE must also be a sequential equilibrium since all information sets are reached in equilibrium. vii. The rst of the weak PBE is also a sequential equilibrium. Pick the totally mixed 9

strategies as follows. Given [ 1 , 1), let the sellers probability of a mistake 2 when type B (i.e., playing g) be type G (i.e., playing g) be mistake (playing n) be
1 n 33 2n2 2n

(0, 1) and his probability of a mistake when

(0, 1). Let the governments probability of a

(0, 1). Then we have n =

3 4 3 4 2n2 +1 4

2n2

33 2n2

= ,

which converges to any [ 1 , 1) as n . 2 n =

3 (1 4 3 (1 2n ) 4 , ) + 1 (1 33 ) 2 2n 4 2n

which converges to 3/4 as n . For = 1, let those probabilities of the mistakes be

1 n

(0, 1),

1 n3

(0, 1), and n =

3 4n2 3 4n2

1 n

(0, 1), respectively. Then we have = 3n , 3n + 1

1 4n3

which converges to 1 as n and n =

1 3 (1 n ) 4 1 ) + 1 (1 n 4 1 , ) n3

3 (1 4

which converges to 3/4 as n . Thus, since the assessment is consistent, the rst of the weak PBE is a sequential equilibrium. 7. (a) Let player 2s belief be Pr(player 1 chooses a) and player 3s beliefs be Pr(player 1 chooses b and player 2 chooses d) and Pr(player 1 chooses b and player 2 chooses c). The normal form is c d a 2, 2, 2 4, 3, 1 b 3, 0, 1 3, 1, 0 e c d a 2, 2, 2 0, 0, 0 b 0, 0, 0 1, 0, 1 f

The pure strategy Nash equilibria are (a, c, f ), (a, d, e), and (b, d, f ). Since the only subgame is the game itself, all are subgame perfect equilibria. Note that 10

(a, d, e) and (b, d, f ) reach every information set, so the weak perfect Bayesian equilibria are as follows: (a, d, e, = 1, = 0, = 0) and (b, d, f, = 0, = 1, = 0). So consider the equilibrium (a, c, f ). (a, c, f, = 1,
1 ) 2

is a weak perfect

Bayesian equilibrium. To see this, note that player 2s belief must put probability 1 on the node where player 1 plays a ( = 1) and player 3s belief is not pinned down by the strategies. By the sequential rationality, you could choose make f optimal for player 3. Turning to sequential equilibrium, we know that every sequential equilibrium is a weak perfect Bayesian equilibrium. Hence we only need to check the three weak perfect Bayesian equilibria: (a, d, e, = 1, = 0, = 0), (b, d, f, = 0, = 1, =
1 0), and (a, c, f, = 1, 2 ). The rst two reach every information set, so they 1 2

to

must be sequential. To see this, simply note that any totally mixed strategies that converge to these must generate beliefs converging to the unique weakly consistent beliefs. Hence both satisfy consistency, not just weak consistency. However, (a, c, f, = 1, 1 ) is not a sequential equilibrium. Clearly, the action 2
1 f is sequentially rational if and only if 2 . Is this consistent? Suppose it is.

Let pn be player 1s probability on a and qn be player 2s probability on c in our sequence of totally mixed strategies converging to this equilibrium. We must have pn 1 and qn 1. Let n be the probability put on the node in question by Bayes Rule with these strategies. Then n = (1 pn )(1 qn ) (1 pn )(1 qn ) + qn (1 pn ) + pn (1 qn ) (1 pn )(1 qn ) < = 1 pn . (1 pn )(1 qn ) + pn (1 qn )

Since pn 1, we must have n 0. Hence we cannot converge to these beliefs, so 11

the beliefs are not consistent and the equilibrium is not a sequential equilibrium. (b) Let player 2s belief be Pr(player 1 chooses a) and player 3s beliefs be Pr(player 1 chooses a and player 2 chooses d). The normal form is c d a 1, 2, 0 1, 1, 0 b 2, 1, 3 0, 3, 2 e c d a 1, 2, 0 0, 3, 1 b 2, 1, 3 1, 1, 0 f

Note that 1 has a strictly dominant strategy of b. Hence he must play this in every Nash equilibrium. There are two Nash equilibria in pure strategies: (b, d, e) and (b, c, f ). Because there is only one subgame, all are subgame perfect equilibria. It is easy to see that (b, d, e, = 0, = 0) is a weak perfect Bayesian equilibrium. We can also show that (b, c, f, = 0, equilibrium by the sequential rationality. Are the weak PBEs sequential equilibria? Since (b, d, e, = 0, = 0) reaches
2 every information set, it must be sequential. Is (b, c, f, = 0, 3 )? No there 2 are no totally mixed strategies and beliefs converging to (b, c, f, = 0, 3 ). To 2 ) 3

is also a weak perfect Bayesian

see this, let pn be the probability player 1 makes a mistake (plays a) and let qn be the probability player 2 makes a mistake in this equilibrium (plays d). Then by Bayes rule, the probability is pn qn pn q n = = pn . pn qn + (1 pn )qn qn But this must go to zero as n . Hence player 3 must put probability zero on the left-hand node, meaning that f cannot be sequentially rational given any consistent belief. Therefore, this equilibrium is not a sequential equilibrium.

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