# 10 Dynamic Games of Incomple Information

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1 10 Dynamic Games of Incomple Information DRAW SELTEN S HORSE In game above there are no subgames. Hence, the set of subgame perfect equilibria and the set of Nash equilibria coincide. However, the sort of logic that led us to consider subgame perfection also suggests that player 2 should play down if he/she gets the chance to play (2>1). That would break the Nash equilibrium indicated above Beliefs and Sequential Rationality De nition 1 Given an extensive form game K; a system of beliefs is a map : T nz! [0; 1] such that P x2h (x) = 1 for every information set h 2 H: De nition 2 (; ) is sequentially rational if for every i and every information et h that belongs to i; the continuation strategy is a best reply to the continuation startegies of the other players given beliefs : That is Eu i (s i jh; jh; ) Eu i (s i jh; b i jh; i jh; ) holds for every i; h and every alternative continuation strategy b i jh: De nition 3 A strategy pro le is said to be sequentially rational if there exists such that the pair (; ) is sequentially rational. 68

2 Remark 1 In games with perfect information is sequentially rational if and only if is a backwards induction equilibrium. This can be seen by noting that all information sets are singletons, so Eu i (s i jh; jh; ) Eu i (s i jh; b i jh; i jh; ) simply asks the player to optimize given the history in nodes preceeding the endnodes...and so on, meaning that will be a backwards induction equilirbium by construction. De nition 4 (; ) is said to be a (quali er missing) perfect Bayesian equilibrium if it is sequentially rational and if is obtained from by Bayes rule whenever Bayes rule is applicable. [In MWG the quali er in weak and whenever Bayes rule is applicable is taken to mean on the equilibrium path Example (0,0) (1,2) (-2,-2) (2,3) (1,2), (-2,-2) t e e e e e,, p L1 [1/2] [1/2] jn R1 t,,, Q q QQQ (-1,0) t t, 1-p L2 R2 1-q, (2,3) (0,0) (-1,2) Figure 1: A Simple Signaling Game (R 1 L 2 ; at ) ; (p; q) = (0; 1) is Perfect Bayesian 69

3 Bayes rule p = Pr [t 1 jl] = = = 0 q = Pr [t 1 jr] = Pr [Ljt 1 ] Pr [t 1 ] Pr [Ljt 1 ] Pr [t 1 ] + Pr [Ljt 2 ] Pr [t 2 ] Pr [Rjt 1 ] Pr [t 1 ] Pr [Rjt 1 ] Pr [t 1 ] + Pr [Rjt 2 ] Pr [t 2 ] = = 1 CHECK! (L 1 L 2 ; bb) ; (p; q) = ( 1 2 ; q) is a PBE if q 2 5 (free to specify beliefs at unreached information sets, but must be done so that they support equilibrium strategies). CHECK! (R 1 R 2 ; ct ) is a Nash equilibrium, but not a PBE Example: How to Play Poker Consider the following simpli cation of poker. There are two players, a professor and a student. First, each player rst puts a dollar down (the ante). As we wont consider this to be a choice we will not make this part of the extensive form of the game (the reason for describing the setup this way is that it is a natural way of generating the payo s). Then the professor draws a single card from a deck consisting of an equal number of queens and kings. Only the professor draws a card. After observing the card, the professor may either bet or fold. If the professor folds, the student wins the pot containing the ante (implying that the student wins 1 and the professor loses 1). If the professor bets, he places another dollar in the pot. The student then has the option between fold and call. If the student folds, then the professor takes the pot (implying a net transfer of 1 from the student to the professor). If the student calls he adds another dollar to the pot. In this case the 70

4 professor wins if he has a king (in which case there is a net transfer of 2 from student to professor) and the student wins if the professor has a queen (in which case there is a net transfer of 2 from professor to student. The extensive form is depicted in Figure??. (2,-2) r (1,-1) (-2,2) r (1,-1) in (-1,1) (-1,1) Figure 2: Simple Form of Poker This game has a unique equilibrium, which is in mixed strategies. Let q = Pr [betjqueen] be the randomization probability for the professor. The student also needs to randomize and let p be the probability that the student calls. The probability that the professor has a king when betting is Pr [kingjbet] = = Pr [betjking] Pr [king] Pr [betjking] Pr [king] + Pr [betjqueen] Pr [queen] q 1 2 = q The student is indi erent if q ( 2) = 1 + q = q ( 1) ( 1) 1 + q Solving this we get q = 1 : To make the professor with a Queen indi erent between folding 3 and calling it must be that 1 = (1 p) 1 2p; 71

5 which can be solved for p = 2 : I will not show it, but by succesive elimination of all remaining 3 possibilities you ll nd that this is the unique Nash equilibrium (as well as the unique perfect Bayesian equilibrium). Notice that the game puts the player who can observe the card at an advantage: If the professor gets a king, the expected payo s are p2 + (1 p) = = 5 for the professor 3 5 for the the student 3 If the professor gets a queen, the expected payo s are q ( 1) + (1 q) (p ( 2) + (1 p) 1) = ( 2) + 1 = 1 3 for professor and 1 for student. Hence the expected payo for the professor is 10.4 De ning Signaling ( 1) = 1 3 : The concept of signaling refers to strategic models where one or more informed agents take some observable actions before one or more uninformed agents make their strategic decisions. This leads to situations where the uninformed agent care about the actions taken by the informed agent not only because the actions a ect payo s directly, but also because the action taken say something about the type of the player. This in turn creates incentives to select actions to send the right signal about type. Formally, There are two players. We refer to player 1 as the sender and to player 2 as the receiver. Player 1 has private information about his type. We denote the type space by and write for a generic element. The set of available actions for the sender is M; so a (pure) strategy is function s 1 with s 1 () 2 M for every type : We let p denote the (prior) probability distribution over the senders type space. 72

6 Player 2, the receiver, observes the action chosen by the sender and then take some action in A: A pure strategy for player is a function s 2, where s 2 (m) 2 A for every m 2 M Utility functions, u 1 (a; m; ) for the sender u 2 (a; m; ) for the receiver, 10.5 Forward Induction in Signalling Games Example We note that (ub; b) is subgame perfect (and perfect Bayesian). However, many game theorists would argue that the outcome is implausible. The argument is that if player 2 would see that her information set is reached, then she couldn t possibly believe that player 1 is aiming at the (1; 5) outcome. Then, it would be better for player 1 to play up. The reduced normal form is t b u 2; 0 2; 0 AB 0; 0 1; 5 AT 5; 1 0; 0 and here we see that, indeed, AB is strictly dominated by up. Many forward induction ideas are based on the normal form. Re nements by forward induction-like criteria have been used extensively in signalling and many concepts are developed speci cally for signalling games. One of the simplest is: 73

7 De nition 5 Consider a signalling game for which there exists a perfect Bayesian equilibrium with equilibrium payo u 1 () for a sender of type : Then, we say that message m is equilibrium dominated for type 2 if u 1 () > max a2a u 2 (a; m; ) De nition 6 A Perfect Bayesian equilibrium passes the test of equilibrium domination if for all out of equilibrium messages m 2 M; the reciever assigns probability 0 to m being sent by if m is equilibrium dominated for and if there exists some other type 0 such that m is not equilibrium dominated for 0 : EXAMPLE-TRUTH GAME 10.6 Sequental Equilibrium Example-Weak Perfect Bayesian not structurally consistent 9.C.4 in MGW Example Weak Perfect Bayesian not subgame perfect 9.C.5 in MGW 74

8 Sequental Equilibrium There are several attempts to x the notion of Perfect Bayesian equilibrium. However, it turns out that a relatively satisfactory solution solves some of the issues by taking a quite di erent approach. De nition 7 (; ) is said to be a sequential equilibrium if: 1. (; ) is sequentially rational 2. There exists a sequence of mixed strategies with full support k 1 with k=1 k! such that = lim k!1 k ; where k are the beliefs derived from k using Bayes rule. 9:C:4 9:C: A Simple Version of the Spence Model Suppose: 75

9 Types are given by 2 f1; 2g 0 is the probability that = 2 A Worker may choose (i.e. commit to) any education of length t 0 The utility is given by u (w; t; ) = w t Game: 1) Worker choose education. 2) Firms compete Bertrand for workers and get a pro t = w if it manages to attract the worker. Let (t) denote the probability that rms asses that = 2. In a sequential equilibrium beliefs must be consistent (and the same for both rms) and rms must both optimize given beliefs, implying that w (t) = 2 (t) + (1 (t)) = 1 + (t) Separating Equilibria Note that: t(1) = 0 in any separating sequential equilibrium (since (t(1)) = 0 ) w(t(1)) = 1 and w (0) 1) Neither type can have an incentive to mimic the other w (t (1)) t (1) w(t(2)) t(2) 1 2 t(2), t (2) 1 and w (t (2)) 2 t (2) w(t(1)) t(1) 2 t (2) 1, t (2)

10 By setting beliefs 8 < 1 if t = t(2) (t) = : 0 if t 6= t (2) 8 < 1 if t t(2) or (t) = : 0 if t < t (2) any t (2) 2 [1; 2] can be supported as a sequential equilibrium Pooling Equilibria To support as large a set of education levels as pooling equilibria, suppose that t(1) = t (2) = t is a pooling equilibrium and let beliefs be 8 < 0 if t = t (t) = ; : 0 if t 6= t which obviously is consistent with Bayes rule where relevant. The best deviation for both types is then to t = 0 and this is not pro table for the low productivity/high cost of education type if 0 t 1: Clearly, the high productivity type has no incentive to deviate if the low [productivity type has no incentive to deviate, so any t 2 [0; 1 0 ] can be supported as a pooling equilibrium. 77

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