Uncertainty and Contracts Chapter 1.

Bayesian Games in Normal Form

Notes on

Chapter 1. Bayesian Games in Normal Form

UNCERTAINTY AND CONTRACTS

3rd Year

Degree in Economics
Double Bachelor’s Degree in Business and Economics
2022/2023

Iñaki Aguirre

Department of Economic Analysis

University of the Basque Country UPV/EHU

-1-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Chapter 1. Bayesian Games in Normal Form

Chapter 9, Bayesian Games (9.1, 9.2, 9.3 and 9.4) M. Osborne, An Introduction to Game Theory

Introduction.

1.1. Motivational examples.

1.2. General definitions.

1.2.1. Bayesian games.

1.2.2. Nash equilibrium.

1.3. Two examples concerning information.

1.3.1. More information may hurt.

1.3.2. Infection.

1.4. Illustration: Cournot’s duopoly game with imperfect information.

1.4.1. Imperfect information about cost.

1.4.2. Imperfect information on cost and information.

Introduction

In the subject Market Power and Strategy, we assume complete information. That is, each player

has to play in a game with perfect knowledge about her rival’s preferences and strategy spaces. In

this chapter, we relax this assumption.

Underlying the notion of Nash equilibrium is that each player holds the correct belief about the

other players’ actions. To do so, a player must know the game she is playing; in particular, she

must know the other players’ preferences. In many contexts, the agents are not perfectly informed

about their rivals’ characteristics: bargainers may not know each others’ valuations of the object of

-2-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

negotiation, firms may not know each others’ cost functions, a monopolistic firm may not know

consumers preferences, etcetera. In some situations, a participant may be well informed about her

opponents’ characteristics, but may not know how well these opponents are informed about her

own characteristics. In this chapter, we describe the model of a “Bayesian game”, which

generalizes the notion of a strategic game to allow us to analyze any situation in which each player

is imperfectly informed about an aspect of her environment that is relevant to her choice of an

action.

1.1. Motivational examples

We start with a couple of examples that serve to illustrate the main ideas in a Bayesian game. We

will define the notion of Nash equilibrium separately for each game. In the next section, we will

define the general model of a Bayesian game and the notion of Nash equilibrium for such a game.

Example 1: (Battle of the Sexes) Bach or Stravinsky?

Two people wish to go out together. Two concerts are available: one of music by Bach, and one of

music by Stravinsky. One person prefers Bach and the other prefers Stravinsky. If they go to

different concerts, each of them is equally unhappy listening to the music of either composer.

Player 1 (the one that prefers Bach) is the row player and player 2 (who prefers Stravinsky) is the

column player. The game in normal form is:

𝐵𝑎𝑐ℎ 𝑆𝑡𝑟𝑎𝑣𝑖𝑛𝑠𝑘𝑦

𝐵𝑎𝑐ℎ (2, 1) (0, 0)

𝑆𝑡𝑟𝑎𝑣𝑖𝑛𝑠𝑘𝑦 (0, 0) (1, 2)

-3-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

In this game, there are two Nash equilibria in pure strategies: (Bach, Bach) and (Stravinsky,

Stravinsky).

Example 2 (273.1): Bach or Stravinsky? Variant of BoS with imperfect information 1

Consider a variant of BoS in which player 1 is unsure whether player 2 prefers to go out with her or

prefers to avoid her, whereas player 2, as before, knows player 1’s preferences. Assume that player

1 thinks that with probability ½ player 2 wants to go out with her and with probability ½ player 2

wants to avoid her. That is, player 1 thinks that with probability ½ she is playing the game on the

left in the next figure and with probability ½ she is playing the game on the right.

1 1
2 2
1
2 2
𝐵 𝑆 𝐵 𝑆

𝐵 (2, 1) (0, 0) 𝐵 (2, 0) (0, 2)

𝑆 (0, 0) (1, 2) 𝑆 (0, 1) (1, 0)

𝑃. 2 𝑤𝑖𝑠ℎ𝑒𝑠 𝑡𝑜 𝑚𝑒𝑒𝑡 𝑃. 1 𝑃. 2 𝑤𝑖𝑠ℎ𝑒𝑠 𝑡𝑜 𝑎𝑣𝑜𝑖𝑑 𝑃. 1

We can think of there being two states (of Nature), one in which payoffs are given in the left

table and one in which payoffs are given in the right table. Player 2 knows the state (she

knows whether she wishes to meet or to avoid player 1) whereas player 1 does not know;

player 1 assigns probability ½ to each state.

-4-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

The notion of Nash equilibrium for a strategic game models a steady state in which each

player’s beliefs about the other players’ actions are correct, and each player acts optimally,

given her beliefs. We want to generalize this notion to the current situation.

From player 1’s point of view, player 2 has two possible types, one whose preferences are

given in the left table and one whose preferences are given in the right table. Player 1 does not

know player 2’s type, so to choose an action rationally she needs to form a belief about the

action of each type. Given these beliefs and her belief about the likelihood of each type, she

can calculate her expected payoff of each of her actions. We next calculate the expected

payoff of each one of player 1’s actions corresponding to each combination of actions of the

two types of player 2.

(B, B) (B, S) (S, B) (S, S)

B 2 1 1 0

S 0 1 1 1
2 2

For this situation, we define a pure strategy Nash equilibrium to be a triple of actions, one for

player 1 and one for each type of player 2, with the property that

- the action of player 1 is optimal, given the actions of the two types of player 2 (and player

1’s belief about the state).

- the action of each type of player 2 is optimal, given the action of player 1.

-5-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Now we obtain best responses of player 1 (against the possible actions of the two types of

player 2) and best responses of each type of player 2 (against the actions of player 1).

(B, B) (B, S) (S, B) (S, S)

B 2 1 1 0

S 0 1 1 1
2 2

𝐵 𝑆

𝐵 ( , 1) ( , 0)

𝑆 ( , 0) ( , 2)

𝑃. 2 𝑤𝑖𝑠ℎ𝑒𝑠 𝑡𝑜 𝑚𝑒𝑒𝑡 𝑃. 1

𝐵 𝑆

𝐵 ( , 0) ( , 2)

𝑆 ( , 1) ( , 0)

𝑃. 2 𝑤𝑖𝑠ℎ𝑒𝑠 𝑡𝑜 𝑎𝑣𝑜𝑖𝑑 𝑃. 1

It is easy to show that (B, (B, S)), where the first component is the action of player 1 and the

other component is the pair of actions of the two types of player 2, is a Nash equilibrium.

-6-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Given that the actions of the two types of player 2 are (B, S), player 1’s action B is optimal

(that is, it maximizes her expected payoff); given that player 1 chooses B, B is optimal for the

type who wishes to meet player 1 and S is optimal for the type who wishes to avoid player 1.

s1 BR2 s2 BR1

B (B, S) (B, B) B

S (S, B) (B, S) B

(S, B) B

(S, S) S

We can interpret the actions of the two types of player 2 to reflect player2’s intentions in the

hypothetical situation before she knows the state. We can tell the following story. Initially

player 2 does not know the state: she is informed of the state by a signal that depends on the

state. Before receiving this signal, she plans an action for each possible signal. After receiving

the signal, she carries out her planned action for hat signal. We can tell a similar story for

player 1. To be consistent with her not knowing the state when she takes an action, her signal

must be uninformative; it must be the same in each state. Given her signal, she is unsure of

the state; when choosing an action she takes into account her belief about the likelihood of

each state given her signal.

-7-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Example 2 (273.1): Bach or Stravinsky? Variant of BoS with imperfect information 2

Consider a variant of BoS in which neither player knows whether the other wants to go out with

her. Specifically, suppose that player 1 thinks that with probability ½ player 2 wants to go out with

her, and with probability ½ player 2 wants to avoid her, and player 2 thinks that with probability

2/3 player 1 wants to go out with her and with probability 1/3 player 1 wants to avoid her. As

before, assume that each player knows her own preferences.

We can model this situation by introducing 4 states, one for each possible configuration of

preferences. We refer to these states as:

- yy: each player wants to go out with the other.

- yn: player 1 wants to go out with player 2 but player 2 wants to avoid player 1.

- ny: player 1 wants to avoid player 2 and player 2 wants to go out with player 1.

- nn: both players want to avoid the other.

The fact that player 1 does not know player 2’s preferences means that she cannot distinguish

between states yy and yn, or between states ny and nn. Similarly, player 2 cannot distinguish

between states yy and ny, or between states yn and nn. We can model the players’ information by

assuming that each player receives a signal before choosing an action. Player 1 receives the same

signal, say 𝑦1 , in states yy and yn, and a different signal, say 𝑛1 , in states ny and nn; player 2

receives the same signal, say 𝑦2 , in states yy and ny, and a different signal, say 𝑛2 , in states yn and

nn. After player 1 receives the signal 𝑦1 , she is referred to as type 𝑦1 of player 1 (who wishes to go

out with player 2); after she receives the signal 𝑛1 , she is referred to as type 𝑛1 of player 1 (who

wishes to avoid player 2). In a similar way, player 2 has two types: 𝑦2 and 𝑛2 .

-8-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Type 𝑦1 of player 1 believes that the probability of each of the states yy and yn is ½; type 𝑛1 of

player 1 believes that the probability of each of the states ny and nn is ½. Type 𝑦2 of player 2

believes that the probability of state yy is 2/3 and that of state ny is 1/3; type 𝑛2 of player 2 believes

that the probability of state yn is 2/3 and that of state nn is 1/3. We can represent the game as:

1 1
2 2
1: 𝑦1

𝐵 𝑆 𝐵 𝑆

𝐵 (2, 1) (0, 0) 𝐵 (2, 0) (0, 2)

2
3 𝑆 (0, 0) (1, 2) 2 𝑆 (0, 1) (1, 0)
3

𝑆𝑡𝑎𝑡𝑒 𝑦𝑦 𝑆𝑡𝑎𝑡𝑒 𝑦𝑛

2: 𝑦2 2: 𝑛2
1 1
2 2

1: 𝑛1
𝐵 𝑆 𝐵 𝑆

1
𝐵 (0, 1) (2, 0) 𝐵 (0, 0) (2, 2)
1
3
3

𝑆 (1, 0) (0, 2) 𝑆 (1, 1) (0, 0)

𝑆𝑡𝑎𝑡𝑒 𝑛𝑦 𝑆𝑡𝑎𝑡𝑒 𝑛𝑛

-9-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝑦1 :
(B, B) (B, S) (S, B) (S, S)

B 2 1 1 0

S 0 1 1 1
2 2

𝑛1 :

(B, B) (B, S) (S, B) (S, S)

B 0 1 1 2

S 1 1 1 0
2 2

𝑦2 : 𝑛2 :

B S
B S
(B, B) 1 0
(B, B) 0 2

(B, S) 2 2 1 4
3 3 (B, S)
3 3

1 4
(S, B) 2 2
3 3 (S, B) 3 3

(S, S) 0 2 (S, S) 1 0

-10-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

s1 BR2 s2 BR1

(B, B) (B, S) (B, B) (B, S)

(B, S) (B, S) (B, S) (B, B)

(S, S)
(S, B) (B, B)
(S, B) (S, B)

(S, S) (S, S) (S, B)

(S, S) (S, B)

Nash equilibria: ((B, B), (B, S)) and ((S, B), (S, S)).

In each of these examples, a Nash equilibrium is a list of actions, one for each type of each

player, such that the action of each type of each player is a best response to the actions of all

the types of the other player, given the player’s beliefs about the state after she observes her

signal. We may define a Nash equilibrium in each example to be a Nash equilibrium of the

strategic game in which the set of players is the set of all types of all players in the original

situation.

In the next section, we define the general notion of a Bayesian game and the notion of Nash

equilibrium in such game.

-11-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

1.2. General definitions

1.2.1. Bayesian games

A strategic game with imperfect information is called a “Bayesian game”. As in a strategic

game, the decision-makers are called players, and each player is endowed with a set of

actions.

A key element in the specification of the imperfect information is the set of states. Each state

is a complete description of one collection of the players’ relevant characteristics, including

both their preferences and their information. For every collection of characteristics that some

player believes to be possible, there must be a state. For instance, consider the first example

of BoS and assume that player 2 wishes to meet player 1. In this case, the reason for including

in the model the state in which player 2 wishes to avoid player 1, is that player 1 believes such

a preference to be possible.

At the start of the game, a state is realized. The players do not observe this state. Rather, each

player receives a signal that may give her some information about the state. Denote the signal

player i receives in state w by 𝜏𝑖 (𝑤). The function 𝜏𝑖 is called player i’s signal function. If, for

example, 𝜏𝑖 (𝑤) is different for each value of w, then player i knows, given her signal, the

state that has occurred; after receiving her signal, she is perfectly informed about all the

players’ relevant characteristics. At the other extreme, if 𝜏𝑖 (𝑤) is the same for all states, then

player i’s signal conveys no information about the state. If 𝜏𝑖 (𝑤) is constant over some

subsets of the set of states, but is not the same for all states, then player i’s signal conveys

partial information. For example, if there are three states, 𝑤1 , 𝑤2 and 𝑤3 , and 𝜏𝑖 (𝑤1 ) ≠

-12-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝜏𝑖 (𝑤2 ) = 𝜏𝑖 (𝑤3 ), then when the state is 𝑤1 player i knows that it is 𝑤1, whereas when it is

either 𝑤2 or 𝑤3 she knows only that it is one of these two states.

We refer to player i in the event that she receives the signal 𝑡𝑖 as type 𝒕𝒊 of player i. Each type

of each player holds a belief about the likelihood of the states consistent with her signal. If,

for example, 𝑡𝑖 = 𝜏𝑖 (𝑤1 ) = 𝜏𝑖 (𝑤2 ), then type 𝑡𝑖 of player i assigns probabilities to 𝑤1 and 𝑤2 .

Each player may care about the actions chosen by the other players, as in a strategic game

with perfect information, and also about the state. The players may be uncertain about the

state, so we need to specify their preferences regarding probability distributions over pairs (a,

w) consisting of an action profile a and a state w. We assume that each player’s preferences

over such probability distributions are represented by the expected value of a Bernoulli payoff

function. We specify each player i’s preferences by giving a Bernoulli payoff function 𝑢𝑖 over

pairs (a, w).

In summary, a Bayesian game is defined as follows.

Definition 1. Bayesian game

A Bayesian game consists of

- a set of players,

- a set of states

and for each player

- a set of actions

-13-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

- a set of signals that she may receive and a signal function that associates a signal with each

state

- for each signal she may receive, a belief about the states consistent with the signal (a

probability distribution over the set of states with which the signal is associated)

- a Bernoulli payoff function over pairs (a, w), where a is an action profile and w is a state,

the expected value of which represents the player’s preferences among lotteries over the set of

such pairs.

Example 2 (273.1): Bach or Stravinsky? Variant of BoS with imperfect information 1

1 1
2 2
1
2 2
𝐵 𝑆 𝐵 𝑆

𝐵 (2, 1) (0, 0) 𝐵 (2, 0) (0, 2)

𝑆 (0, 0) (1, 2) 𝑆 (0, 1) (1, 0)

𝑃. 2 𝑤𝑖𝑠ℎ𝑒𝑠 𝑡𝑜 𝑚𝑒𝑒𝑡 𝑃. 1 𝑃. 2 𝑤𝑖𝑠ℎ𝑒𝑠 𝑡𝑜 𝑎𝑣𝑜𝑖𝑑 𝑃. 1

Players: 1 and 2

States: The set of states is {meet, avoid}

Actions: The set of actions of each player is {B, S}

Signals: Player 1 may receive a single signal, say z; her signal function 𝜏1 satisfies

𝜏1 (𝑚𝑒𝑒𝑡) = 𝜏1 (𝑎𝑣𝑜𝑖𝑑) = 𝑧 (one type of player 1). Player 2 receives one of two signals, say

-14-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

m and v; her signal function 𝜏2 satisfies 𝜏2 (𝑚𝑒𝑒𝑡) = 𝑚 and 𝜏2 (𝑎𝑣𝑜𝑖𝑑) = 𝑣. (two types of

player 2)

Beliefs: Player 1 assigns probability ½ to each state after receiving the signal z. Player 2

assigns probability 1 to the state meet after receiving the signal m, and probability 1 to the

state avoid after receiving the signal v.

Payoffs: The payoffs 𝑢𝑖 (𝑎, 𝑚𝑒𝑒𝑡) of each player i for all possible action pairs are given in the

left table and the payoffs 𝑢𝑖 (𝑎, 𝑎𝑣𝑜𝑖𝑑) are given in the right table.

Example 2 (273.1): Bach or Stravinsky? Variant of BoS with imperfect information 2

1 1
2 2
1: 𝑦1

𝐵 𝑆 𝐵 𝑆

𝐵 (2, 1) (0, 0) 𝐵 (2, 0) (0, 2)

2
3 𝑆 (0, 0) (1, 2) 2 𝑆 (0, 1) (1, 0)
3

𝑆𝑡𝑎𝑡𝑒 𝑦𝑦 𝑆𝑡𝑎𝑡𝑒 𝑦𝑛

2: 𝑦2 2: 𝑛2
1 1
2 2

1: 𝑛1
𝐵 𝑆 𝐵 𝑆

1
𝐵 (0, 1) (2, 0) 𝐵 (0, 0) (2, 2)
1
3
3

𝑆 (1, 0) (0, 2) 𝑆 (1, 1) (0, 0)

-15-
𝑆𝑡𝑎𝑡𝑒 𝑛𝑦 𝑆𝑡𝑎𝑡𝑒 𝑛𝑛
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Players: 1 and 2

States: The set of states is {yy, yn, ny, nn}

Actions: The set of actions of each player is {B, S}

Signals: Player 1 receives one of two signals, 𝑦1 and 𝑛1 ; her signal function 𝜏1 satisfies

𝜏1 (𝑦𝑦) = 𝜏1 (𝑦𝑛) = 𝑦1 and 𝜏1 (𝑛𝑦) = 𝜏1 (𝑛𝑛) = 𝑛1 (two types of player 1). Player 2 receives

one of two signals, say 𝑦2 and 𝑛2 ; her signal function 𝜏2 satisfies 𝜏2 (𝑦𝑦) = 𝜏2 (𝑛𝑦) = 𝑦2 and

𝜏2 (𝑦𝑛) = 𝜏2 (𝑛𝑛) = 𝑛2 (two types of player 2).

Beliefs: Player 1 assigns probability ½ to each of the states yy and yn after receiving the signal

𝑦1 and probability ½ to each of the states ny and nn after receiving the signal 𝑛1 . Player 2

assigns probability 2/3 to the state yy and probability 1/3 to the state ny after receiving the

signal 𝑦2 , and probability 2/3 to the state yn and probability 1/3 to the state nn after receiving

the signal 𝑛2 .

Payoffs: The payoffs 𝑢𝑖 (𝑎, 𝑤) of each player i for all possible action pairs and states are

given in previous figure.

1.2.2. Nash equilibrium

In a Bayesian game each type of each player chooses an action. In a Nash equilibrium of such

a game, the action chosen by each type of each player is optimal (that is, maximizes her

expected payoff), given the actions chosen by every type of every other player.

-16-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Example 3: Fighting an opponent of unknown strength

Two people are involved in a dispute. Person 1 does not know whether person 2 is strong or

weak; she assigns probability 𝛼 to person 2’s being strong. Person 2 is fully informed. Each

person can either fight or yield. Each person’s preferences are represented by the expected

value of a Bernoulli payoff function that assigns the payoff of 0 if she yields (regardless of the

other person’s action) and a payoff of 1 if she fights and her opponent yields; if both people

fight, then their payoff are (-1, 1) if person 2 is strong and (1, -1) if person 2 is weak.

Formulate this situation as a Bayesian game and find its Nash equilibria if 𝛼 < 12 and if 𝛼 > 12.
𝛼 1−𝛼
1
2 2
𝐹 𝑌 𝐹 𝑌

𝐹 (-1, 1) (1, 0) 𝐹 (1, -1) (1, 0)

𝑌 (0, 1) (0, 0) 𝑌 (0, 1) (0, 0)

𝑃. 2 𝑖𝑠 𝑠𝑡𝑟𝑜𝑛𝑔 𝑃. 2 𝑖𝑠 𝑤𝑒𝑎𝑘

Players: Person 1 and person 2

States: The set of states is { 𝑠𝑡𝑟𝑜𝑛𝑔, }

Actions: The set of actions of each player is {F, Y}

Signals: Person 1 receives one signal 𝑚 that is not informative; her signal function 𝜏1 satisfies

𝜏1 (𝑠𝑡𝑟𝑜𝑛𝑔) = 𝜏1 (𝑤𝑒𝑎𝑘) = 𝑚 (one type of player 1). Person 2 receives one of two signals,

-17-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

say 𝑠 and 𝑤; her signal function 𝜏2 satisfies 𝜏2 (𝑠𝑡𝑟𝑜𝑛𝑔) = 𝑠 and 𝜏2 (𝑤𝑒𝑎𝑘) = 𝑤 (two types

of player 2)

Beliefs: Player 1 assigns probability 𝛼 to state 𝑠𝑡𝑟𝑜𝑛𝑔 and 1 − 𝛼 to state 𝑤𝑒𝑎𝑘 after

receiving the signal 𝑚. Player 2 assigns probability 1 to state 𝑠𝑡𝑟𝑜𝑛𝑔 after receiving the

signal 𝑠. After receiving the signal 𝑤, she assigns probability 1 to state 𝑤𝑒𝑎𝑘.

Payoffs: The profits of each firm for all possible action pairs and any possible state are as

appear in payoffs matrices.

Strategies: 𝑆1 = {𝐹, 𝑌} and 𝑆2 = {(𝐹, 𝐹), (𝐹, 𝑌), (𝑌, 𝐹), (𝑌, 𝑌)}.

(F, F) (F, Y) (Y, F) (Y, Y)

F 1 − 2𝛼 1 − 2𝛼 1 1

Y 0 0 0 0

𝛼 < 12

s1 BR2 s2 BR1

F (F, Y) (F, F) F

Y (F, F) (F, Y) F

(Y, F) F

(Y, Y) F
NE: (F, (F, Y))

-18-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝛼 > 12

s1 BR2 s2 BR1

F (F, Y) (F, F) Y

Y (F, F) (F, Y) Y

(Y, F) F

(Y, Y) F

NE: (Y, (F, F)).

𝛼 = 12

s1 BR2 s2 BR1

F (F, Y) (F, F) F, Y

Y (F, F) (F, Y) F, Y

(Y, F) F

(Y, Y) F

NE: (F, (F, Y)) and (Y, (F, F)).

-19-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Example 3: Fighting an opponent of unknown strength 2

Assume now that person 2 does not either know whether person 1 is medium strength or super

strong; she assigns probability 𝛽 to person 1’s being medium strength. Each person can either

fight or yield. If player 1 is medium strength payoffs are (-1, 1) when both fight and person 2

is strong and (1, -1) when both fight and person 2 is weak. If player 1 is super strong, payoff

are (1, -1) when both fight independently whether person 2 is strong or weak. In the rest of

cases payoffs are as those in the previous game. That is, if one person fights, and other does

not, then she obtains a payoff 1. If one person does not fight, independently of the rival’s

behavior, then she obtains 0.

𝛼 1−𝛼

1: 𝑚1

𝐹 𝑌 𝐹 𝑌

𝐹 (-1, 1) (1, 0) 𝐹 (1, -1) (1, 0)

𝛽 𝛽
𝑌 (0, 1) (0, 0) 𝑌 (0, 1) (0, 0)

𝑆𝑡𝑎𝑡𝑒 𝑚𝑠 𝑆𝑡𝑎𝑡𝑒 𝑚𝑤

2: 𝑠2 2: 𝑤2
𝛼 1−𝛼

1: 𝑆1
𝐹 𝑌 𝐹 𝑌

𝐹 (1, -1) (1, 0) 𝐹 (1, -1) (1, 0)

1−𝛽 1−𝛽
𝑚1 :
𝑌 (0, 1) (0, 0) 𝑌 (0, 1) (0, 0)
-20-
𝑆𝑡𝑎𝑡𝑒 𝑆𝑠 𝑆𝑡𝑎𝑡𝑒 𝑆𝑤
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Represent the Bayesian game and identify the main elements of the Bayesian game. Obtain

the Nash equilibria to any 𝛼, 𝛽 ∈ [0,1]. (Problem 5).

1.3. Two examples concerning information

The notion of a Bayesian game may be used to study how information patterns affect the outcome

of strategic interaction. Here we consider two examples.

1.3.1. More information may hurt

A decision-maker in a single-person decision-problem cannot be worse off if she has more

information: if she wishes, she can ignore the information. In a game the same is not true: if a

player has more information and the other players know that she has more information, then she

may be worse off.

1
Consider, for example, the following two-player Bayesian game where 0 < 𝜖 < 2.

1 1
2 2
1 1 1
2 2
𝐿 𝑀 𝑅 2 𝐿 𝑀 𝑅

𝑇 (1, 2𝜖) (1, 0) (1, 3𝜖) 𝑇 (1, 2𝜖) (1, 3𝜖) (1, 0)

𝐵 (2, 2) (0, 0) (0, 3) 𝐵 (2, 2) (0, 3) (0, 0)

𝑆𝑡𝑎𝑡𝑒 𝑤1 𝑆𝑡𝑎𝑡𝑒 𝑤2

-21-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

In this game, there are two states, and neither player knows the state. Each player
1
assigns probability of 2
to each state. The expected payoffs are:
𝐿 𝑀 𝑅

𝑇 (1, 2𝜖) (1, 3/2𝜖) (1, 3/2𝜖)

𝐵 (2, 2) (0, 3/2) (0, 3/2)

(B, L) is the only Nash equilibrium.

Consider now the game in which player 2 knows what the state is. So the new game is:

1 1
2 2
1
2
𝐿 𝑀 𝑅 2 𝐿 𝑀 𝑅

𝑇 (1, 2𝜖) (1, 0) (1, 3𝜖) 𝑇 (1, 2𝜖) (1, 3𝜖) (1, 0)

𝐵 (2, 2) (0, 0) (0, 3) 𝐵 (2, 2) (0, 3) (0, 0)

𝑆𝑡𝑎𝑡𝑒 𝑤1 𝑆𝑡𝑎𝑡𝑒 𝑤2

-22-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝐿𝐿 𝐿𝑀 𝐿𝑅 𝑀𝐿 𝑀𝑀 𝑀𝑅 𝑅𝐿 𝑅𝑀 𝑅𝑅

𝑇 1 1 1 1 1 1 1 1 1

𝐵 2 1 1 1 0 0 1 0 0

𝐿 𝑀 𝑅 𝐿 𝑀 𝑅

𝑇 (1, 2𝜖) (1, 0) (1, 3𝜖) 𝑇 (1, 2𝜖) (1, 3𝜖) (1, 0)

𝐵 (2, 2) (0, 0) (0, 3) 𝐵 (2, 2) (0, 3) (0, 0)

NE: (T, (R, M))

Therefore, player 2 is worse off when she knows the state than when she does not know

the state.

-23-
 Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

1.3.2. Infection

The notion of a Bayesian game may be used to model not only situations in which players are

uncertain about the others’ preferences, but also situations in which they are uncertain about

each others’ knowledge. Consider the next game.

Example 4: Infection

3 1
1 3 4 1 1 4
4 4
𝐿 𝑅 2 𝐿 𝑅 2 𝐿 𝑅

𝐿 (2, 2) (0, 0) 𝐿 (2, 2) (0, 0) 𝐿 (2, 2) (0, 0)

𝑅 (3, 0) (1, 1) 𝑅 (0, 0) (1, 1) 𝑅 (0, 0) (1, 1)

𝑆𝑡𝑎𝑡𝑒 𝛼 𝑆𝑡𝑎𝑡𝑒 𝛽 𝑆𝑡𝑎𝑡𝑒 𝛾

Note that player 2’s preferences are the same in all three states, and player 1’s preferences are

the same in states 𝛽 and 𝛾. In particular, in state 𝛾, each player knows the other player’s

preferences, and player 2 knows that player 1 knows her preferences. The defect in the

players’ information in state 𝛾 is that player 1 does not know whether player 2 knows her

preferences: player 1 knows only that the state is either 𝛽 or 𝛾, and in state 𝛽 player 2 does

not know whether the state is 𝛼 or 𝛽, and hence does not know player 1’s preferences

(because player 1’s preferences in these two states differ).

There are two types of player 1 (the type who knows that the state is 𝛼 and the type who

knows that the state is 𝛽 or 𝛾) and two types of player 2 (the type who knows that the state is

-24-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝛼 or 𝛽 and the type who knows that the state is 𝛾). We next obtain the best response of each

type of each player.

𝑡1𝛼 :

(L, L) (L, R) (R, L) (R, R)

L 2 2 0 0

R 3 3 1 1

𝑡1𝛽𝑜𝑟𝛾 :

(L, L) (L, R) (R, L) (R, R)

3 1
L 2 0
2 2

R 1 3 1
0
4 4

𝑡2𝛼𝑜𝑟𝛽 : 𝑡2𝛾 :
L R

L R
(L, L) 2 0
(L, L) 2 0

(L, R) 3 1
2 4 (L, R) 0 1

1 3
(R, L)
2 4 (R, L) 2 0

(R, R) 0 1 (R, R) 0 1

-25-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

s1 BR2 s2 BR1

(L, L) (L, L) (L, L) (R, L)

(L, R) (L, R) (L, R) (R, L)

(R, L)
(R, L) (R, L) (R, R)
(R, R) (R, R) (R, R) (R, R)
NE: ((R, R) (R, R))

-26-
 Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Example 5: Infection 2

3 1
1 3 4 4 1 1
1 1 3
2 4 4 4 4
𝐿 𝑅 𝐿 𝑅 2 𝐿 𝑅 𝐿 𝑅

𝐿 (2, 2) (0, 0) 𝐿 (2, 2) (0, 0) 𝐿 (2, 2) (0, 0) 𝐿 (2, 2) (0, 0)

𝑅 (3, 0) (1, 1) 𝑅 (0, 0) (1, 1) 𝑅 (0, 0) (1, 1) 𝑅 (0, 0) (1, 1)

𝑆𝑡𝑎𝑡𝑒 𝛼 𝑆𝑡𝑎𝑡𝑒 𝛽 𝑆𝑡𝑎𝑡𝑒 𝛾 𝑆𝑡𝑎𝑡𝑒 𝛿

Consider state 𝛿. In this state, player 2 knows player 1’s preferences (because she knows that

the state is either 𝛾 or 𝛿, and in both states player 1’s preferences are the same). What player 2

does not know is whether player 1 knows whether player 2 knows player 1’s preferences. In

this game, we have 3 types of player 1 (the type who knows that the state is 𝛼, the type who

knows that the state is 𝛽 or 𝛾, and the type who knows that the state is 𝛿) and two types of

player 2 (the type who knows that the state is 𝛼 or 𝛽, and the type who knows that the state is

𝛾 or 𝛿).

𝑡1𝛼 :
(L, L) (L, R) (R, L) (R, R)

L 2 2 0 0

R 3 3 1 1

-27-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝑡1𝛽𝑜𝑟𝛾 :
(L, L) (L, R) (R, L) (R, R)

3 1
L 2 0
2 2

R 1 3 1
0
4 4
𝑡1𝛿 :
(L, L) (L, R) (R, L) (R, R)

L 2 0 2 0

R 0 1 0 1

𝑡2𝛼𝑜𝑟𝛽 : 𝑡2𝛾𝑜𝑟𝛿 :
L R

L R
(L, L, L) 2 0
(L, L, L) 2 0

(L, L, R) 2 0 3 1
(L, L, R) 2 4

3 1
(L, R, L) 1 3
2 4 (L, R, L) 2 4
3 1
(L, R, R) 2 4 0 1
(L, R, R)
1 3
(R, L, L)
2 4 (R, L, L) 2 0

(R, L, R) 1 3
3 1
2 4 (R, L, R)
2 4

(R, R, L) 0 1 1 3
(R, R, L)
2 4

(R, R, R) 0 1
(R, R, R) 0 1

-28-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

s1 BR2 s2 BR1

(L, L, L) (L, L) (L, L) (R, L, L)

(L, L, R) (L, L) (L, R) (R, L, R)

(R, L) (R, R, L)
(L, R, L) (L, R)
(R, R) (R, R, R)
(L, R, R) (L, R)

(R, L, L) (R, L)

(R, L, R) (R, L)

(R, R, L) (R, R)

(R, R, R) (R, R)

NE: ((R, R, R) (R, R))

-29-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

1.4. Illustration: Cournot’s duopoly game with imperfect information

1.4.1. Imperfect information about cost

Two firms compete in selling a homogeneous product; one firm does not know the other firm’s

cost function. We next study how this lack of information will affect the firms’ behavior.

Assume that both firms can produce the good at constant unit cost (that is, marginal cost is

constant and there are no fixed costs). Assume also that they both know that firm 1’s unit cost is 𝑐,

but only firm 2 knows its own unit cost; firm 1 believes that firm 2’s cost is 𝑐𝐿 with probability 𝜃

and 𝑐𝐻 with probability 1 − 𝜃, with 0 < 𝜃 < 1 and 𝑐𝐿 < 𝑐𝐻 . We can model this problem as a

Bayesian game.

The information structure in this game is similar to that in Example 2.1 (BoS with imperfect

information 1)

𝜃 1−𝜃
1
2: 𝑡𝐿 2: 𝑡𝐻

𝑆𝑡𝑎𝑡𝑒 𝐿 𝑆𝑡𝑎𝑡𝑒 𝐻

We next describe the Bayesian game.

Players: Firm 1 and firm 2.

States: {L, H}.

Actions: Each firm’s set of actions is the set of nonnegative outputs.

-30-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Signals: Firm 1’s signal function 𝜏1 satisfies 𝜏1 (𝐿) = 𝜏1 (𝐻) = 𝑡1 (its signal is the same in both

states; one type of firm 1); firm 2’s signal function 𝜏1 satisfies 𝜏2 (𝐿) ≠ 𝜏2 (𝐻), with 𝜏2 (𝐿) = 𝑡𝐿

and 𝜏2 (𝐻) = 𝑡𝐻 (its signal is perfectly informative of the state; two types of firm 2).

Beliefs: After receiving the (non informative) signal 𝑡1 , the single type of firm 1 assigns

probability 𝜃 to state 𝐿 and probability 1 − 𝜃 to state 𝐻. Each type of firm 2 assigns probability 1

to the single state consistent with its signal. That is, after receiving the signal 𝑡𝐿 , firm 2 assigns

probability 1 to the state 𝐿, and after receiving the signal 𝑡𝐻 , firm 2 assigns probability 1 to the

state 𝐻.

Payoffs: The firms’ Bernoulli payoffs are their profits; if the actions chosen are (𝑞1 , 𝑞2 ) and the

state is 𝐼 (either 𝐿 or 𝐻), then firm 1’s profit is [𝑝(𝑞1 + 𝑞2 ) − 𝑐]𝑞1 and firm 2’s profit is [𝑝(𝑞1 +

𝑞2 ) − 𝑐𝐼 ]𝑞2, where 𝑝(𝑞1 + 𝑞2 ) is the market price.

A Nash equilibrium of this game is a triple (𝑞1∗ , (𝑞𝐿∗ , 𝑞𝐻∗ )), where 𝑞1∗ is the output of firm 1, 𝑞𝐿∗

is the output of type 𝑡𝐿 of firm 2 (that is, firm 2 when it receives the signal 𝜏2 (𝐿)), and 𝑞𝐻∗ is

the output of type 𝑡𝐻 of firm 2 (that is, firm 2 when it receives the signal 𝜏2 (𝐻)), such that:

- 𝑞1∗ maximizes firm 1’s (expected) profit given the output 𝑞𝐿∗ of 𝑡𝐿 of firm 2 and the output 𝑞𝐻∗

of type 𝑡𝐻 of firm 2,

- 𝑞𝐿∗ maximizes the profit of type 𝑡𝐿 of firm 2 given the output 𝑞1∗ of firm 1 and

- 𝑞𝐻∗ maximizes the profit of type 𝑡𝐻 of firm 2 given the output 𝑞1∗ of firm 1.

To find a Cournot-Nash equilibrium, we first obtain the firms’ best response functions. Given

firm 1’s beliefs, its best response 𝑏1 (𝑞𝐿 , 𝑞𝐻 ) to (𝑞𝐿 , 𝑞𝐻 ) solves:

-31-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

max 𝜃[𝑝(𝑞1 + 𝑞𝐿 ) − 𝑐]𝑞1 + (1 − 𝜃)[𝑝(𝑞1 + 𝑞𝐻 ) − 𝑐]𝑞1 .

𝑞1 ≥0

Firm 2’s best response 𝑏𝐿 (𝑞1 ) to 𝑞1 when its cost is 𝑐𝐿 solves:

max[𝑝(𝑞1 + 𝑞𝐿 ) − 𝑐𝐿 ]𝑞𝐿
𝑞𝐿 ≥0

and firm 2’s best response 𝑏𝐻 (𝑞1 ) to 𝑞1 when its cost is 𝑐𝐻 solves:

max[𝑝(𝑞1 + 𝑞𝐻 ) − 𝑐𝐻 ]𝑞𝐻 .
𝑞𝐻 ≥0

A Nash equilibrium is a combination of strategies (𝑞1∗ , (𝑞𝐿∗ , 𝑞𝐻∗ )) such that:

𝑞1∗ = 𝑏1 (𝑞𝐿∗ , 𝑞𝐻∗ ), 𝑞𝐿∗ = 𝑏𝐿 (𝑞1∗ ) and 𝑞𝐻∗ = 𝑏𝐻 (𝑞1∗ ).

Example 6. Cournot imperfect information and linear demand

Consider a Cournot duopoly game where the inverse demand function is 𝑝(𝑄) = 𝛼 − 𝑄 for

𝑄 ≤ 𝛼 and 𝑝(𝑄) = 0 for 𝑄 > 𝛼. Assuming that 𝑐𝐿 and 𝑐𝐻 are such that there is a Nash

equilibrium in which all outputs are positive, obtain such equilibrium. Compare this

equilibrium with the Nash equilibrium of the (perfect information) game in which firm 1

knows that firm 2’s unit cost is 𝑐𝐿 and with the Nash equilibrium of the game in which firm 1

knows that firm 2’s unit cost is 𝑐𝐻 .

To find a Cournot-Nash equilibrium, we first obtain the firms’ best response functions. Given

firm 1’s beliefs, its best response 𝑏1 (𝑞𝐿 , 𝑞𝐻 ) to (𝑞𝐿 , 𝑞𝐻 ) solves:

max 𝜃[𝑝(𝑞1 + 𝑞𝐿 ) − 𝑐]𝑞1 + (1 − 𝜃)[𝑝(𝑞1 + 𝑞𝐻 ) − 𝑐]𝑞1 .

𝑞1 ≥0

𝜕𝜋1
=0
𝜕𝑞1

→ 𝜃[𝑝(𝑞1 + 𝑞𝐿 ) + 𝑞1 𝑝′(𝑞1 + 𝑞𝐿 ) − 𝑐] + (1 − 𝜃)[𝑝(𝑞1 + 𝑞𝐻 ) + 𝑞1 𝑝′(𝑞1 + 𝑞𝐻 ) − 𝑐] = 0

-32-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

→ 𝜃[𝛼 − 𝑞1 − 𝑞𝐿 − 𝑞1 − 𝑐] + (1 − 𝜃)[𝛼 − 𝑞1 − 𝑞𝐻 − 𝑞1 − 𝑐] = 0

→ 𝛼 − 2𝑞1 − 𝑐 − [𝜃𝑞𝐿 + (1 − 𝜃)𝑞𝐻 ] = 0

𝛼 − 𝑐 − [𝜃𝑞𝐿 + (1 − 𝜃)𝑞𝐻 ]
(𝑏1 (𝑞𝐿 , 𝑞𝐻 ) = max { , 0})
2

𝛼 − 𝑐 − [𝜃𝑞𝐿 + (1 − 𝜃)𝑞𝐻 ]
𝑏1 (𝑞𝐿 , 𝑞𝐻 ) =
2

Firm 2’s best response 𝑏𝐿 (𝑞1 ) to 𝑞1 when its cost is 𝑐𝐿 solves:

max[𝑝(𝑞1 + 𝑞𝐿 ) − 𝑐𝐿 ]𝑞𝐿
𝑞𝐿 ≥0

𝜕𝜋𝐿
= 0 → [𝑝(𝑞1 + 𝑞𝐿 ) + 𝑞𝐿 𝑝′(𝑞1 + 𝑞𝐿 ) − 𝑐𝐿 = 0 → 𝛼 − 𝑞1 − 𝑞𝐿 − 𝑞𝐿 − 𝑐𝐿 = 0
𝜕𝑞𝐿

𝛼 − 𝑐𝐿 − 𝑞1
(→ 𝑏𝐿 (𝑞1 ) = max { , 0})
2
𝛼 − 𝑐𝐿 − 𝑞1
→ 𝑏𝐿 (𝑞1 ) =
2

Firm 2’s best response 𝑏𝐻 (𝑞1 ) to 𝑞1 when its cost is 𝑐𝐻 solves:

max[𝑝(𝑞1 + 𝑞𝐻 ) − 𝑐𝐻 ]𝑞𝐻
𝑞𝐻 ≥0

𝜕𝜋𝐻
= 0 → [𝑝(𝑞1 + 𝑞𝐻 ) + 𝑞𝐻 𝑝′(𝑞1 + 𝑞𝐻 ) − 𝑐𝐻 = 0 → 𝛼 − 𝑞1 − 𝑞𝐻 − 𝑞𝐻 − 𝑐𝐻 = 0
𝜕𝑞𝐻

𝛼 − 𝑐𝐻 − 𝑞1
(→ 𝑏𝐻 (𝑞1 ) = max { , 0})
2
𝛼 − 𝑐𝐻 − 𝑞1
→ 𝑏𝐻 (𝑞1 ) =
2

A Nash equilibrium is a combination of strategies (𝑞1∗ , (𝑞𝐿∗ , 𝑞𝐻∗ )) such that:

𝛼 − 𝑐 − [𝜃𝑞𝐿∗ + (1 − 𝜃)𝑞𝐻∗ ]
𝑞1∗ = 𝑏1 (𝑞𝐿∗ , 𝑞𝐻∗ ) =
2

-33-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝛼 − 𝑐𝐿 − 𝑞1∗
𝑞𝐿∗ = 𝑏𝐿 (𝑞1∗ ) =
2

𝛼 − 𝑐𝐻 − 𝑞1∗
𝑞𝐻∗ = 𝑏𝐻 (𝑞1∗ ) =
2

𝛼 − 𝑐𝐿 − 𝑞1∗ 𝛼 − 𝑐𝐻 − 𝑞1∗
𝛼 − 𝑐 − [𝜃 + (1 − 𝜃) ]
𝑞1∗ = 𝑏1 (𝑞𝐿∗ , 𝑞𝐻∗ ) = 2 2
2

𝛼 − 2𝑐 + 𝜃𝑐𝐿 + (1 − 𝜃)𝑐𝐻 + 𝑞1∗

→ 𝑞1∗ =
4

𝛼 − 2𝑐 + 𝜃𝑐𝐿 + (1 − 𝜃)𝑐𝐻
→ 𝑞1∗ =
3

𝛼 − 2𝑐 + 𝜃𝑐𝐿 + (1 − 𝜃)𝑐𝐻
𝛼 − 𝑐𝐿 −
𝑞𝐿∗ = 𝑏𝐿 (𝑞1∗ ) = 3
2

2𝛼 − 3𝑐𝐿 + 2𝑐 − 𝜃𝑐𝐿 − (1 − 𝜃)𝑐𝐻

→ 𝑞𝐿∗ =
6

𝛼 − 2𝑐𝐿 + 𝑐 (1 − 𝜃)(𝑐𝐻 − 𝑐𝐿 )
→ 𝑞𝐿∗ = −
3 6

𝛼 − 2𝑐 + 𝜃𝑐𝐿 + (1 − 𝜃)𝑐𝐻
𝛼 − 𝑐𝐻 −
𝑞𝐻∗ = 𝑏𝐻 (𝑞1∗ ) = 3
2

2𝛼 − 3𝑐𝐻 + 2𝑐 − 𝜃𝑐𝐿 − (1 − 𝜃)𝑐𝐻

→ 𝑞𝐻∗ =
6

𝛼 − 2𝑐𝐻 + 𝑐 𝜃(𝑐𝐻 − 𝑐𝐿 )
→ 𝑞𝐻∗ = +
3 6

Perfect Information

If firm 1 knows that firm 2’s unit cost is 𝑐𝐿 , equilibrium outputs are:

𝛼 − 2𝑐 + 𝑐𝐿 𝛼 − 2𝑐𝐿 + 𝑐
𝑞1∗ = 𝑞2∗ =
3 3

-34-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

If firm 1 knows that firm 2’s unit cost is 𝑐𝐻 , equilibrium outputs are:

𝛼 − 2𝑐 + 𝑐𝐻 𝛼 − 2𝑐𝐻 + 𝑐
𝑞1∗ = 𝑞2∗ =
3 3

Therefore, in comparison with the perfect information case, under imperfect information the

low-cost firm 2 would produce a lower quantity and the high-cost firm 2 would produce a

greater quantity.

1.4.2. Imperfect information about both cost and information

Now assume that firm 2 does not know whether firm 1 knows firm 2’s cost. That is, suppose that

one circumstance that firm 2 believes to be possible is that firm 1 knows its cost (although in fact it

does not). Because firm 2 thinks this circumstance to be possible, we need four states to model this

situation which we call 𝐿0, 𝐻0, 𝐿1, and 𝐻1, with the following interpretation.

𝐿0: firm 2’s cost is low and firm 1 does not know whether it is low or high.

𝐻0: firm 2’s cost is high and firm 1 does not know whether it is low or high.

𝐿1: firm 2’s cost is low and firm 1 knows it is low.

𝐻1: firm 2’s cost is high and firm 1 knows it is high.

Firm 1 receives one of three possible signals, 0, 𝑙, and ℎ. The states 𝐿0 and 𝐻0 generate the signal

0 (firm 1 does not know firm 2’s cost), the state 𝐿1 generates the signal 𝑙 (firm 1 knows firm 2’s

cost is low), and the state 𝐻1 generates the signal ℎ (firm 1 knows firm 2’s cost is high). Firm 2

receives one of two possible signals, 𝐿, in states 𝐿0 and 𝐿1, and 𝐻, in states 𝐻0 and 𝐻1. Denote by

𝜃 (as before) the probability assigned by type 0 of firm 1 to firm 2’s cost being 𝑐𝐿 , and by 𝜇 the

-35-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

probability assigned by each type of firm 2 to firm 1’s knowing firm 2’s cost (the case 𝜇 = 0 is

equivalent to the one considered in subsection 1.4.1).

The information structure in this game is as follows

𝜃 1−𝜃
1: 0

1−𝜇 1−𝜇 𝐻0
𝐿0

2: L 2: H

1: l 1: h
𝜇 𝜇
𝐿1 𝐻1

A Bayesian game that models the situation is defined as follows.

Players: Firm 1 and Firm 2.

States: {𝐿0, 𝐿1, 𝐻0, 𝐻1}, where the first letter in the name of the state indicates firm 2’s cost and

the second letter indicates whether firm 1 knows (1) or does not know (0) firm 2’s cost.

Actions: Each firm’s set of actions is the set of its possible (nonnegative) outputs.

Signals: Firm 1 gets one of the signals 0, 𝑙, and ℎ, and its signal function 𝜏1 satisfies 𝜏1 (𝐿0) =

𝜏1 (𝐻0) = 0, 𝜏1 (𝐿1) = 𝑙, and 𝜏1 (𝐻1) = ℎ. Firm 2 gets the signal 𝐿 or 𝐻 and its signal function 𝜏2

satisfies 𝜏2 (𝐿0) = 𝜏2 (𝐿1) = 𝐿 and 𝜏2 (𝐻0) = 𝜏2 (𝐻1) = 𝐻.

-36-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

Beliefs: After receiving the (non informative) signal 0 firm 1 assigns probability 𝜃 to state 𝐿0 and

probability 1 − 𝜃 to state 𝐻0; after receiving the signal 𝑙 firm 1 assigns probability 1 to state 𝐿1;

after receiving the signal ℎ firm 1 assigns probability 1 to state 𝐻. After receiving the signal 𝐿 firm

2 assigns probability 𝜇 to state 𝐿1 and probability 1 − 𝜇 to state 𝐿0; after receiving the signal 𝐻

firm 2 assigns probability 𝜇 to state 𝐻1 and probability 1 − 𝜇 to state 𝐻0.

Payoff functions: The firms’ Bernoulli payoffs are their profits; if the actions chosen are (𝑞1 , 𝑞2 ),

then firm 1’s profit is [𝑝(𝑞1 + 𝑞2 ) − 𝑐]𝑞1 and firm 2’s profit is [𝑝(𝑞1 + 𝑞2 ) − 𝑐𝐿 ]𝑞2 in states 𝐿0

and 𝐿1, and [𝑝(𝑞1 + 𝑞2 ) − 𝑐𝐻 ]𝑞2 in states 𝐻0 and 𝐻1.

Example 7. Cournot, imperfect information about cost and information and linear demand

Write down the maximization problems that determine the best response function of each type

of each player. Denote by 𝑞0 , 𝑞𝑙 , and 𝑞ℎ the outputs of types 0, 𝑙, and h of firm 1, and by 𝑞𝐿

and 𝑞𝐻 the outputs of types 𝐿 and 𝐻 of firm 2. Suppose that the inverse demand function is

𝑝(𝑄) = 𝛼 − 𝑄 for 𝑄 ≤ 𝛼 and 𝑝(𝑄) = 0 for 𝑄 > 𝛼. Assuming that 𝑐𝐿 and 𝑐𝐻 are such that

there is a Nash equilibrium in which all outputs are positive, obtain such equilibrium. Check

that when 𝜇 = 0 the equilibrium output of type 0 of firm 1 is equal to the equilibrium output

of firm 1 corresponding to exercise 6, and that the equilibrium outputs of the two types of

firm 2 are the same as the ones corresponding to that exercise. Check also that when 𝜇 = 1

the equilibrium outputs of type l of firm 1 and type L of firm 2 are the same as the equilibrium

outputs when there is perfect information and the costs are c and 𝑐𝐿 , and that the equilibrium

outputs of type h of firm 1 and type H of firm 2 are the same as the equilibrium outputs when

there is perfect information and the costs are c and 𝑐𝐻 . Show that for 0 < 𝜇 < 1, the

-37-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

equilibrium outputs of type L and H of firm 2 lie between their values when 𝜇 = 0 and when

𝜇 = 1.

The best response 𝑏0 (𝑞𝐿 , 𝑞𝐻 ) of type 0 of firm 1 is the solution of:

max 𝜃[𝑝(𝑞0 + 𝑞𝐿 ) − 𝑐]𝑞0 + (1 − 𝜃)[𝑝(𝑞0 + 𝑞𝐻 ) − 𝑐]𝑞0 .

𝑞0 ≥0

𝜕𝜋0
=0
𝜕𝑞0

→ 𝜃[𝑝(𝑞0 + 𝑞𝐿 ) + 𝑞0 𝑝′(𝑞0 + 𝑞𝐿 ) − 𝑐] + (1 − 𝜃)[𝑝(𝑞0 + 𝑞𝐻 ) + 𝑞0 𝑝′(𝑞1 + 𝑞𝐻 ) − 𝑐] = 0

→ 𝜃[𝛼 − 𝑞0 − 𝑞𝐿 − 𝑞0 − 𝑐] + (1 − 𝜃)[𝛼 − 𝑞0 − 𝑞𝐻 − 𝑞0 − 𝑐] = 0

→ 𝛼 − 2𝑞0 − 𝑐 − [𝜃𝑞𝐿 + (1 − 𝜃)𝑞𝐻 ] = 0

𝛼 − 𝑐 − [𝜃𝑞𝐿 + (1 − 𝜃)𝑞𝐻 ]
(𝑏0 (𝑞𝐿 , 𝑞𝐻 ) = max { , 0})
2

𝛼 − 𝑐 − [𝜃𝑞𝐿 + (1 − 𝜃)𝑞𝐻 ]
𝑏0 (𝑞𝐿 , 𝑞𝐻 ) =
2

The best response 𝑏𝑙 (𝑞𝐿 , 𝑞𝐻 ) of type l of firm 1 is the solution of:

max[𝑝(𝑞𝑙 + 𝑞𝐿 ) − 𝑐]𝑞𝑙
𝑞𝑙 ≥0

𝜕𝜋𝑙
=0
𝜕𝑞𝑙

→ 𝑝(𝑞𝑙 + 𝑞𝐿 ) + 𝑞𝑙 𝑝′(𝑞𝑙 + 𝑞𝐿 ) − 𝑐 = 0

→ 𝛼 − 𝑞𝑙 − 𝑞𝐿 − 𝑞𝑙 − 𝑐 = 0

𝛼 − 𝑐 − 𝑞𝐿
(𝑏𝑙 (𝑞𝐿 , 𝑞𝐻 ) = max { , 0})
2

𝛼 − 𝑐 − 𝑞𝐿
𝑏𝑙 (𝑞𝐿 , 𝑞𝐻 ) =
2

-38-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

The best response 𝑏ℎ (𝑞𝐿 , 𝑞𝐻 ) of type h of firm 1 is the solution of:

max[𝑝(𝑞ℎ + 𝑞𝐻 ) − 𝑐]𝑞ℎ
𝑞ℎ ≥0

𝜕𝜋ℎ
=0
𝜕𝑞ℎ

→ 𝑝(𝑞ℎ + 𝑞𝐿 ) + 𝑞ℎ 𝑝′(𝑞ℎ + 𝑞𝐻 ) − 𝑐 = 0

→ 𝛼 − 𝑞ℎ − 𝑞𝐻 − 𝑞ℎ − 𝑐 = 0
𝛼 − 𝑐 − 𝑞𝐻
(𝑏ℎ (𝑞𝐿 , 𝑞𝐻 ) = max { , 0})
2

𝛼 − 𝑐 − 𝑞𝐻
𝑏ℎ (𝑞𝐿 , 𝑞𝐻 ) =
2

The best response 𝑏𝐿 (𝑞0 , 𝑞𝑙 , 𝑞ℎ ) of type L of firm 2 is the solution of:

max(1 − 𝜇)[𝑝(𝑞0 + 𝑞𝐿 ) − 𝑐𝐿 ]𝑞𝐿 + 𝜇[𝑝(𝑞𝑙 + 𝑞𝐿 ) − 𝑐𝐿 ]𝑞𝐿 .

𝑞𝐿 ≥0

𝜕𝜋𝐿
=0
𝜕𝑞𝐿

→ (1 − 𝜇)[𝑝(𝑞0 + 𝑞𝐿 ) + 𝑞𝐿 𝑝′(𝑞0 + 𝑞𝐿 ) − 𝑐𝐿 ] + 𝜇[𝑝(𝑞𝑙 + 𝑞𝐿 ) + 𝑞𝐿 𝑝′(𝑞𝑙 + 𝑞𝐿 ) − 𝑐𝐿 ] = 0

→ (1 − 𝜇)[𝛼 − 𝑞0 − 𝑞𝐿 − 𝑞𝐿 − 𝑐𝐿 ] + 𝜇[𝛼 − 𝑞𝑙 − 𝑞𝐿 − 𝑞𝐿 − 𝑐𝐿 ] = 0

→ 𝛼 − 2𝑞𝐿 − 𝑐𝐿 − [(1 − 𝜇)𝑞0 + 𝜇𝑞𝑙 ] = 0

𝛼 − 𝑐𝐿 − [(1 − 𝜇)𝑞0 + 𝜇𝑞𝑙 ]

𝑏𝐿 (𝑞0 , 𝑞𝑙 , 𝑞ℎ ) = max { , 0})
2

𝛼 − 𝑐𝐿 − [(1 − 𝜇)𝑞0 + 𝜇𝑞𝑙 ]

𝑏𝐿 (𝑞0 , 𝑞𝑙 , 𝑞ℎ ) =
2

The best response 𝑏𝐻 (𝑞0 , 𝑞𝑙 , 𝑞ℎ ) of type H of firm 2 is the solution of:

max(1 − 𝜇)[𝑝(𝑞0 + 𝑞𝐻 ) − 𝑐𝐻 ]𝑞𝐻 + 𝜇[𝑝(𝑞ℎ + 𝑞𝐻 ) − 𝑐𝐻 ]𝑞𝐻 .

𝑞𝐻 ≥0

-39-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

𝜕𝜋𝐻
=0
𝜕𝑞𝐻

→ (1 − 𝜇)[𝑝(𝑞0 + 𝑞𝐻 ) + 𝑞𝐻 𝑝′(𝑞0 + 𝑞𝐻 ) − 𝑐𝐻 ] + 𝜇[𝑝(𝑞ℎ + 𝑞𝐻 ) + 𝑞𝐻 𝑝′(𝑞ℎ + 𝑞𝐻 ) − 𝑐𝐻 ]

=0

→ (1 − 𝜇)[𝛼 − 𝑞0 − 𝑞𝐻 − 𝑞𝐻 − 𝑐𝐻 ] + 𝜇[𝛼 − 𝑞ℎ − 𝑞𝐻 − 𝑞𝐻 − 𝑐𝐻 ] = 0

→ 𝛼 − 2𝑞𝐻 − 𝑐𝐻 − [(1 − 𝜇)𝑞0 + 𝜇𝑞ℎ ] = 0

𝛼 − 𝑐𝐻 − [(1 − 𝜇)𝑞0 + 𝜇𝑞ℎ ]

𝑏𝐻 (𝑞0 , 𝑞𝑙 , 𝑞ℎ ) = max { , 0})
2

𝛼 − 𝑐𝐻 − [(1 − 𝜇)𝑞0 + 𝜇𝑞ℎ ]

𝑏𝐻 (𝑞0 , 𝑞𝑙 , 𝑞ℎ ) =
2

A Nash equilibrium is a strategy profile ((𝑞0∗ , 𝑞𝑙∗ , 𝑞ℎ∗ ), (𝑞𝐿∗ , 𝑞𝐻∗ )) such that:

𝛼 − 𝑐 − [𝜃𝑞𝐿∗ + (1 − 𝜃)𝑞𝐻∗ ]
𝑞0∗ = 𝑏0 (𝑞𝐿∗ , 𝑞𝐻∗ ) =
2

𝛼 − 𝑐 − 𝑞𝐿∗
𝑞𝑙∗ = 𝑏𝑙 (𝑞𝐿∗ , 𝑞𝐻∗ ) =
2

𝛼 − 𝑐 − 𝑞𝐻∗
𝑞ℎ∗ = 𝑏ℎ (𝑞𝐿∗ , 𝑞𝐻∗ ) =
2

𝛼 − 𝑐𝐿 − [(1 − 𝜇)𝑞0∗ + 𝜇𝑞𝑙∗ ]

𝑞𝐿∗ = 𝑏𝐿 (𝑞0∗ , 𝑞𝑙∗ , 𝑞ℎ∗ ) =
2

𝛼 − 𝑐𝐻 − [(1 − 𝜇)𝑞0∗ + 𝜇𝑞ℎ∗ ]

𝑞𝐻∗ = 𝑏𝐻 (𝑞0∗ , 𝑞𝑙∗ , 𝑞ℎ∗ ) =
2

𝛼 − 𝑐 − 𝑞𝐿∗
𝛼 − 𝑐𝐿 − [(1 − 𝜇)𝑞0∗ + 𝜇 ] 2𝛼 − 2𝑐𝐿 − [2(1 − 𝜇)𝑞0∗ + 𝜇(𝛼 − 𝑐 − 𝑞𝐿∗ )]
𝑞𝐿∗ = 2 =
2 4

2𝛼 − 2𝑐𝐿 − [2(1 − 𝜇)𝑞0∗ + 𝜇(𝛼 − 𝑐)]

𝑞𝐿∗ =
4−𝜇

𝛼 − 𝑐 − 𝑞𝐻∗
𝛼 − 𝑐𝐻 − [(1 − 𝜇)𝑞0∗ + 𝜇 ] 2𝛼 − 2𝑐𝐻 − [2(1 − 𝜇)𝑞0∗ + 𝜇(𝛼 − 𝑐 − 𝑞𝐻∗ )]
𝑞𝐻∗ = 2 =
2 4

-40-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

2𝛼 − 2𝑐𝐻 − [2(1 − 𝜇)𝑞0∗ + 𝜇(𝛼 − 𝑐)]

𝑞𝐻∗ =
4−𝜇

𝛼 − 𝑐 1 2𝛼 − 2𝑐𝐿 − [2(1 − 𝜇)𝑞0∗ + 𝜇(𝛼 − 𝑐)]

𝑞0∗ = − �𝜃
2 2 4−𝜇

2𝛼 − 2𝑐𝐻 − [2(1 − 𝜇)𝑞0∗ + 𝜇(𝛼 − 𝑐)]

+ (1 − 𝜃) �
4−𝜇

2(4 − 𝜇)𝑞0∗ = (𝛼 − 𝑐)(4 − 𝜇) − 2𝛼𝜃 + 2𝜃𝑐𝐿 + 2𝜃(1 − 𝜇)𝑞0∗ + 𝜃𝜇(𝛼 − 𝑐) − 2(1 − 𝜃)𝛼

+ 2(1 − 𝜃)𝑐𝐻 + 2(1 − 𝜃)(1 − 𝜇)𝑞0∗ + (1 − 𝜃)𝜇(𝛼 − 𝑐)

2(4 − 𝜇)𝑞0∗ − 2(1 − 𝜇)𝑞0∗

= (𝛼 − 𝑐)(4 − 𝜇) − 2𝛼𝜃 + 2𝜃𝑐𝐿 + 𝜇(𝛼 − 𝑐) − 2(1 − 𝜃)𝛼 + 2(1 − 𝜃)𝑐𝐻

6𝑞0∗ = 4(𝛼 − 𝑐) − 2𝛼 + 2𝜃𝑐𝐿 + 2(1 − 𝜃)𝑐𝐻

6𝑞0∗ = 2𝛼 − 4𝑐 + 2𝜃𝑐𝐿 + 2(1 − 𝜃)𝑐𝐻

𝛼 − 2𝑐 + 𝜃𝑐𝐿 + (1 − 𝜃)𝑐𝐻
𝑞0∗ =
3

1 2(1 − 𝜃)(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 )

→ 𝑞𝐿∗ = [𝛼 − 2𝑐𝐿 + 𝑐 − ]
3 4−𝜇

1 2𝜃(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 )
→ 𝑞𝐻∗ = [𝛼 − 2𝑐𝐻 + 𝑐 + ]
3 4−𝜇

1 (1 − 𝜃)(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 )
→ 𝑞𝑙∗ = [𝛼 − 2𝑐 + 𝑐𝐿 + ]
3 4−𝜇

1 𝜃(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 )
→ 𝑞ℎ∗ = [𝛼 − 2𝑐 + 𝑐𝐻 − ]
3 4−𝜇

When 𝜇 = 0

𝛼 − 2𝑐 + 𝜃𝑐𝐿 + (1 − 𝜃)𝑐𝐻
𝑞0∗ =
3

-41-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

1 (1 − 𝜃)(𝑐𝐻 − 𝑐𝐿 )
𝑞𝐿∗ = [𝛼 − 2𝑐𝐿 + 𝑐 − ]
3 2

1 𝜃(𝑐𝐻 − 𝑐𝐿 )
𝑞𝐻∗ = [𝛼 − 2𝑐𝐻 + 𝑐 + ]
3 2

1 (1 − 𝜃)(𝑐𝐻 − 𝑐𝐿 )
𝑞𝑙∗ = [𝛼 − 2𝑐 + 𝑐𝐿 + ]
3 4−𝜇

1 𝜃(𝑐𝐻 − 𝑐𝐿 )
𝑞ℎ∗ = [𝛼 − 2𝑐 + 𝑐𝐻 − ]
3 4

So that 𝑞0∗ is equal to the equilibrium output of firm 1 in exercise 6, and 𝑞𝐿∗ and 𝑞𝐻∗ are the

same as the equilibrium outputs of the two types of firm 2 in that exercise.

When 𝜇 = 1, then

𝛼 − 2𝑐 + 𝜃𝑐𝐿 + (1 − 𝜃)𝑐𝐻
𝑞0∗ =
3
1
𝑞𝐿∗ = [𝛼 − 2𝑐𝐿 + 𝑐]
3
1
𝑞𝐻∗ = [𝛼 − 2𝑐𝐻 + 𝑐]
3

1
𝑞𝑙∗ = [𝛼 − 2𝑐 + 𝑐𝐿 ]
3
1
𝑞ℎ∗ = [𝛼 − 2𝑐 + 𝑐𝐻 ]
3

So that 𝑞𝑙∗ and 𝑞𝐿∗ are the same as the equilibrium outputs when there is perfect information

and the costs are c and 𝑐𝐿 , and 𝑞ℎ∗ and 𝑞𝐻∗ are the same as the equilibrium outputs when there

is perfect information and the costs are c and 𝑐𝐻 .

For an arbitrary value of 𝜇, we have:

1 2(1 − 𝜃)(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 )

𝑞𝐿∗ = [𝛼 − 2𝑐𝐿 + 𝑐 − ]
3 4−𝜇

-42-
Uncertainty and Contracts Chapter 1. Bayesian Games in Normal Form

1 2𝜃(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 )
𝑞𝐻∗ = [𝛼 − 2𝑐𝐻 + 𝑐 + ]
3 4−𝜇

To show that for 0 < 𝜇 < 1 the values of these variables are between their values when 𝜇 = 0

and when 𝜇 = 1, we need to show that

2(1 − 𝜃)(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 ) (1 − 𝜃)(𝑐𝐻 − 𝑐𝐿 )

0≤ ≤ ]
4−𝜇 2

2𝜃(1 − 𝜇)(𝑐𝐻 − 𝑐𝐿 ) 𝜃(𝑐𝐻 − 𝑐𝐿 )

0≤ ≤
4−𝜇 2

Which holds since 𝑐𝐻 ≥ 𝑐𝐿 , 𝜃 ≥ 0 and 0 ≤ 𝜇 ≤ 1.

-43-