EC319 Economic Theory and Its Applications, Part II: Lecture 2

EC319 Economic Theory and Its Applications,
Part II: Lecture 2
Leonardo Felli
NAB.2.14
23 January 2014
Static Bayesian Game
Consider the following game of incomplete information:
= {N, , Ai , Ti , i , ui }
where
I N is the set of players,

I is the set of states,
I Ai is the action space for each player i
I Ti is the set of types for every player i
I i are the beliefs of player i
I ui is player is payoff for a given state .
Leonardo Felli (LSE) EC319 Economic Theory and Its Applications 23 January 2014 2 / 32
Bayesian Strategies and Payoffs
I A strategy for player i is a mapping from Ti to Ai . Let Si be

the set of player is strategies. It is a contingent plan of
actions for each type configuration.
I Given s = (s1 , . . . , sn ) and i , player is interim (given he

knows ti but not ti ) expected payoff for type ti is:
E,Ti {ui (si (ti ), si (ti ); )|ti }
Bayesian Nash Equilibrium
A strategy profile s = (s1 , . . . , sn ) is a Bayesian Nash Equilibrium

if for every i N, given the beliefs i , si assigns an optimal action
for each ti that maximizes player is interim expected payoff.
Definition (Bayesian Nash Equilibrium)

The strategy profile s = (s1 , . . . , sn ) is a Bayesian Nash
Equilibrium if and only if
(t ); )|t
E,Ti ui (si (ti ), si

i i
(t ); )|t

E,Ti ui (ai , si i i
ai Ai , ti Ti , i N
First-Price Sealed Bid Auction
I Two bidders N = {1, 2};
I Both bidders can submit any non-negative bid:
A1 = {b1 0} A2 = {b2 0}
I The highest bidder obtains the good and pays a price equal to
his bid.
I We assume that if both players submit the same bid the

object is allocated to each bidder with probability 1/2.
I We assume that the value of the good to each bidder is

known to the bidder but it is not known to the opponent.
First-Price Sealed Bid Auction (contd)
I Let v1 and v2 be the values of the good to player 1 respectively

player 2.
I We assume that these values can be any number between 0

and 1:
0 v1 1, 0 v2 1.
I We assume that each bidder believes that the value of the

opponent is uniformly distributed in [0, 1].
I In other words from the point of view of each player:
Pr{v2 v } = v , 1 (v ) = 1, 0v 1
Pr{v1 v } = v , 2 (v ) = 1, 0v 1
I The payoffs to the players are:

v1 b1 if b1 > b2
u1 (b1 , b2 ) = (1/2) (v1 b1 ) if b1 = b2
0 if b1 < b2

v2 b2 if b2 > b1
u2 (b1 , b2 ) = (1/2) (v2 b2 ) if b2 = b1
0 if b2 b1

I Strategies for both players are the functions b(v1 )and b(v2 ).
I Assume that b() is strictly increasing and differentiable.
I The best reply of player i, that knows vi , is:
max (vi bi ) Pr{bi > b(vi )} +

bi
1
+ (vi bi ) Pr{bi = b(vi )}
2
I Recall that since i is a density then
Pr{bi = b(vi )} = 0.
I Moreover, let vi = b 1 (bi ) be the valuation that bidder i

must have to choose action bi .
I Then:
Pr{bi > b(vi )} = Pr{b 1 (bi ) > vi } =
= Pr{vi < b 1 (bi )} = b 1 (bi ).
I Hence player is best reply is:
max (vi bi ) b 1 (bi )

bi
I with first order conditions:
d b 1 (bi )
b 1 (bi ) + (vi bi ) =0
d bi
I these are a pair of differential equations defining b(vi ) and

b(vi ).
I We restrict ourselves to bi = b(vi ): symmetric Bayesian Nash

equilibria.
I Substituting bi = b(vi ) into the first order conditions of player

is best reply, we get:
d b 1 (b(vi ))
b 1 (b(vi )) + (vi b(vi )) =0
d bi
I Clearly b 1 (b(vi )) = vi and
d b 1 (b(vi )) 1 1
= 0 1 = 0 .
d bi b (b (bi )) b (vi )
I In other words:
1
vi + (vi b(vi )) =0
b 0 (vi )
or
b 0 (vi ) vi + b(vi ) = vi
I Notice that:
d b(vi ) vi
= b 0 (vi ) vi + b(vi )
d vi
I Hence
d b(vi ) vi
= vi
d vi
I Integrating both sides we get:

1 2
b(vi ) vi = v +K
2 i
I Notice that a boundary condition on individual strategies is

that no player bids more than his/her valuation:
b(vi ) vi
I which for vi = 0 implies:
b(0) = 0
I Substituting in the solution to the difference equation we get:
K =0
I Hence the unique Bayesian Nash equilibrium of this auction

game is for every i = 1, 2:
1
b(vi ) = vi .
2
Second-Price Sealed Bid Auction
As above:
I Two bidders N = {1, 2};
I Action spaces:
A1 = {b1 0} A2 = {b2 0}
I The value of the good to the bidders:

0 v1 1, 0 v2 1
or the type spaces of the bidders are:
T1 = [0, 1], T2 = [0, 1]
.
I We assume that each bidder believes that the value of the
opponent is uniformly distributed in [0, 1].
Second-Price Sealed Bid Auction (contd)
I The beliefs of each bidder are:
1 (v ) = 1, 2 (v ) = 1
I The key difference is that the bidder that submits the highest
bid gets the good but only pays the second highest bid.
I The payoffs to the players are then:

v1 b2 if b1 > b2
u1 (b1 , b2 ) = (1/2) (v1 b2 ) if b1 = b2
0 if b1 < b2

v2 b1 if b2 > b1
u2 (b1 , b2 ) = (1/2) (v2 b2 ) if b2 = b1
0 if b2 b1

I Symmetric strategies for both players are the functions b(v1 )

and b(v2 ) (strictly increasing and differentiable).
I Once again, we have that
{bi > b(vi )} = {b 1 (bi ) > vi } = {vi < b 1 (bi )}
I The expected payoff of player i, that knows vi and takes

expectations on vi , is then:
Z b 1 (bi )
Evi <b1 (bi ) {vi b(vi )} = (vi b(vi ))dvi
0
I Hence player is best reply is:
Z b1 (bi )
max (vi b(vi ))dv1
bi 0
I Using Leibnizs rule:
!
Z (y )

G (x, y )dx =
y (y )
= G ((y ), y ) 0 (y ) G ((y ), y )0 (y ) +
Z (y )
G (x, y )
+ dx
(y ) y
I the first order conditions of player is best reply problem are:
d b 1 (bi )
(vi b(b 1 (bi ))) =0
d bi
I in other words
1
(vi bi ) =0
b 0 (v i)
I these are a pair of differential equations defining b(vi ) and

b(vi ).
I We restrict ourselves to strategies such that b 0 (vi ) > 0.
I From
1
(vi bi ) =0 i {1, 2}
b 0 (vi )
I We then conclude that the unique Bayesian Nash equilibrium

of this auction game is for every i = 1, 2:
b(vi ) = vi . i {1, 2}
I In other words the unique Bayesian Nash equilibrium of this

auction is for each bidder to bid exactly his/her own valuation.
Purification of Mixed Strategies
I Consider the following battle of sexes game:
M C
M 1, 2 0, 0
C 0, 0 2, 1
I Recall that this game has three mixed strategy Nash equilibria:
I two pure strategy Nash equilibria (M, M) and (C , C );
I one non-degenerate mixed strategy Nash equilibrium

1 2
,
3 3
Purification of Mixed Strategies (contd)
I We focus on the non-degenerate mixed strategy Nash

equilibrium.
I Recall that this equilibrium is characterized by the fact:
I each player when choosing his/her strategy is completely

indifferent among all choices;
I at every stage of the game each player is uncertain about
which strategy the opponent chooses.
I The important feature of mixed strategies is the fact that

there exist uncertainty about the opponent play.
I It is less important that each player is indifferent when

choosing a strategy.
I To highlight this we are going to show that similar behaviour

is foreseen in an environment in which uncertainty arises from
a little incomplete information.
I In particular, we modify the battle of sexes game introducing

a small uncertainty that each player has on the payoff faced
by the opponent.
I In particular assume that the game played is the following:
M C
M 1, 2 + t2 0, 0
C 0, 0 2 + t1 , 1
I where t1 and t2 both take values between 0 and x > 0 where

we take x to be small.
I We assume that t1 is known to player 1 but unknown to

player 2.
I Player 2 believes that t1 is uniformly distributed in [0, x]:

y
Pr{t1 y } = , 0 y x.
x
I We assume that symmetrically t2 is known to player 2 but

unknown to player 1,
I Player 1 believes that t2 is uniformly distributed in [0, x]:

y
Pr{t2 y } = , 0 y x.
x
I In the terminology of static games of incomplete information:

1
N = {1, 2}, Ai = {M, C } Ti = [0, x] i = .
x
I Consider now the following pure strategies for this incomplete

information game:
I Player 1 plays C if t1 > c1 , where 0 < c1 < x;
I Player 1 plays M if t1 < c1 .
I Player 2 plays M if t2 > c2 , where 0 < c2 < x;
I Player 2 plays C if t2 < c2 .
I Consider now player 1s expected payoff if he decides to play

C:
c2
(2 + t1 ) Pr{t2 < c2 } + 0 Pr{t2 > c2 } = (2 + t1 ) .
x
since
c2 c2
Pr{t2 < c2 } = , Pr{t2 > c2 } = 1 .
x x
I Player 1s expected payoff if he decides to play M:

c2
0 Pr{t2 < c2 } + 1 Pr{t2 > c2 } = 1 .
x
I Hence for player 1 playing C is optimal if and only if:

x
t1 3.
c2
I Consider now player 2s expected payoff if he decides to play

M:
c1
(2 + t2 ) Pr{t1 < c1 } + 0 Pr{t1 > c1 } = (2 + t2 ) .
x
I Player 2s expected payoff if he decides to play C :

c1
0 Pr{t1 < c1 } + 1 Pr{t1 > c1 } = 1 .
x
I Hence for player 2 playing M is optimal if and only if:

x
t2 3.
c1
I Hence in equilibrium it must be the case that:

x x
c1 = 3, c2 = 3.
c2 c1
I Solving these two non linear equations we get:
c1 = c2 = c, c 2 + 3c x = 0.
or
3 + 9 + 4x
c= .
2
I Hence player 1 will choose M with probability
(c/x);
while player 2 chooses M with probability
1 (c/x).
I Consider now these probabilities as x converges to zero.
I Notice first that:

c 3 + 9 + 4 x 0
lim = lim =
x0 x x0 2x 0
I Hence using the Hospital rule we get:

4
lim
x0 2 9 + 4 x 1
=
lim 2 3
x0
I This implies that when the incomplete information converges

to zero:
1
I player 1 chooses M with probability ,
3
2
I while player 2 chooses M with probability .
3
I A pair of strategies that coincide with the mixed strategies of

the perfect information game.
I This construction is known as purification of mixed strategies.

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EC319 Economic Theory and Its Applications, Part II: Lecture 2

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EC319 Economic Theory and Its Applications,

Part II: Lecture 2

Consider the following game of incomplete information:

I N is the set of players,

I A strategy for player i is a mapping from Ti to Ai . Let Si be

I Given s = (s1 , . . . , sn ) and i , player is interim (given he

E,Ti {ui (si (ti ), si (ti ); )|ti }

A strategy profile s = (s1 , . . . , sn ) is a Bayesian Nash Equilibrium

Definition (Bayesian Nash Equilibrium)

I Two bidders N = {1, 2};

I Both bidders can submit any non-negative bid:

I We assume that if both players submit the same bid the

I We assume that the value of the good to each bidder is

I Let v1 and v2 be the values of the good to player 1 respectively

I We assume that these values can be any number between 0

I We assume that each bidder believes that the value of the

I In other words from the point of view of each player:

I The payoffs to the players are:

I Assume that b() is strictly increasing and differentiable.

I The best reply of player i, that knows vi , is:

max (vi bi ) Pr{bi > b(vi )} +

I Recall that since i is a density then

I Moreover, let vi = b 1 (bi ) be the valuation that bidder i

I Hence player is best reply is:

max (vi bi ) b 1 (bi )

I with first order conditions:

I these are a pair of differential equations defining b(vi ) and

I We restrict ourselves to bi = b(vi ): symmetric Bayesian Nash

I Substituting bi = b(vi ) into the first order conditions of player

I Clearly b 1 (b(vi )) = vi and

I Integrating both sides we get:

I Notice that a boundary condition on individual strategies is

I which for vi = 0 implies:

I Substituting in the solution to the difference equation we get:

I Hence the unique Bayesian Nash equilibrium of this auction

I The value of the good to the bidders:

I The payoffs to the players are then:

I Symmetric strategies for both players are the functions b(v1 )

I Once again, we have that

{bi > b(vi )} = {b 1 (bi ) > vi } = {vi < b 1 (bi )}

I The expected payoff of player i, that knows vi and takes

I Using Leibnizs rule:

I the first order conditions of player is best reply problem are:

I these are a pair of differential equations defining b(vi ) and

I We restrict ourselves to strategies such that b 0 (vi ) > 0.

I We then conclude that the unique Bayesian Nash equilibrium

I In other words the unique Bayesian Nash equilibrium of this

I Consider the following battle of sexes game:

I We focus on the non-degenerate mixed strategy Nash

I Recall that this equilibrium is characterized by the fact:

I each player when choosing his/her strategy is completely

I The important feature of mixed strategies is the fact that

I It is less important that each player is indifferent when

I To highlight this we are going to show that similar behaviour

I In particular, we modify the battle of sexes game introducing

I In particular assume that the game played is the following:

I where t1 and t2 both take values between 0 and x > 0 where

I We assume that t1 is known to player 1 but unknown to

I Player 2 believes that t1 is uniformly distributed in [0, x]:

I We assume that symmetrically t2 is known to player 2 but

I Player 1 believes that t2 is uniformly distributed in [0, x]:

I In the terminology of static games of incomplete information:

I Consider now the following pure strategies for this incomplete