Bayes Nash Equilibrium and Auctions

Christopher Makler

Stanford University Department of Economics

Econ 51: Lecture 13

-1

Most of the really big mistakes you'll make in your life
aren't because you play the game wrong,
but because you don't know the game you're playing.

Games of
Incomplete Information

Suppose one of these
two games is being played.

Both players know there is an equal probability of each game.

Only player 1 knows which game is being played right now.

What is player 1's strategy space?
Player 2's?

pollev.com/chrismakler

Nature

Heads

(1/2)

Tails

(1/2)

Both players know there is an equal probability of each game.

Only player 1 knows which game is being played right now.

We can model this "as if" there is a nonstrategic player called Nature who moves first,

\(A^H\)

\(B^H\)

\(A^T\)

\(B^T\)

flips a coin, and picks which game is being played based on the coin flip.

Player 1 observes Nature's move, so they have to choose what to do if Nature flips Heads (\(A^H\) or \(B^H\)) and if Nature flips Tails (\(A^T\) or \(B^T\)).

Player 2 does not, so their information set spans the entire game: they are only choosing X or Y.

Nature

Heads

(1/2)

Tails

(1/2)

\(A^H\)

\(B^H\)

\(A^T\)

\(B^T\)

The Bayesian Normal Form representation of the game shows the expected payoffs for each of the strategies the players could play:

\(A^HA^T\)

\(A^HB^T\)

\(B^HA^T\)

\(B^HB^T\)

Bayes Nash Equilibrium is the NE of this game. It maps private information onto (simultaneously taken) actions.

One-Shot Bayesian Game

Nature reveals private information to one or more of the players:
e.g., a firm's cost, the state of demand, a person's valuation of a good

The players take simultaneous actions (e.g., submit bids, produce a good)

Payoffs are revealed

Critical feature: there is no opportunity for information to be revealed through play;
we get to that next time with Perfect Bayesian Equilibria!

Cournot with Unknown Costs

Market demand: \(p = 10 - Q\)

Firm 1's costs: \(c_1(q_1) = 0\)

Firm 2's costs: \(c_2(q_2) = \begin{cases}0 & \text{ w/prob }\frac{1}{2}\\4q_2 & \text{ w/prob }\frac{1}{2}\end{cases}\)

Firm 2 knows its own costs; Firm 1 knows that firm 2's costs are 0 and 4q with equal probability.

pollev.com/chrismakler

What is a strategy for firm 1?

What is a strategy for firm 2?

Market demand: \(p = 10 - Q\)

Firm 1's costs: \(c_1(q_1) = 0\)

Firm 2's costs: \(c_2(q_2) = \begin{cases}0 & \text{ w/prob }\frac{1}{2}\\4q_2 & \text{ w/prob }\frac{1}{2}\end{cases}\)

Firm 1's strategy is a single quantity (\(q_1\)), since it doesn't know firm 2's costs.
Its expected profit is based on its profit if firm 2 has low cost and produces \(q_2^L\), or high cost and produces \(q_2^H\).

\pi_1(q_1|q_2^L, q_2^H) =

\pi_2^H(q_2^H|q_1) =

\pi_2^L(q_2^L|q_1) =

Firm 2's strategy must be to choose an amount to produce if it has low costs (\(q^L\)),
and an amount to produce if it is has high costs (\(q^H\)). It will choose the amount, knowing its own cost.

(10 - q_1 - q_2^H)q_2^H - 4q_2^H

(10 - q_1 - q_2^L)q_2^L

={1 \over 2}\left[(10 - q_1 - q_2^L)q_1\right] + {1 \over 2}\left[(10 - q_1 - q_2^H)q_1\right]

(if \(MC_2 = 0\))

(if \(MC_2 = 4\))

Bayes Nash Equilibrium will specify:
\(q_1\) which is a best response to firm 2 playing \(q_2^L\) and \(q_2^H\) with equal probability;
and \(q_2^L\) and \(q_2^H\) which are each best responses to \(q_1\) in their respective states of the world.

\Pr\{q_2 = q_2^L\} \times \pi_1(q_1,q_2^L)

\Pr\{q_2 = q_2^H\} \times \pi_1(q_1,q_2^H)

\pi_1(q_1|q_2^L, q_2^H)

\pi_2^H(q_2^H|q_1) =

\pi_2^L(q_2^L|q_1) =

(10 - q_1 - q_2^H)q_2^H - 4q_2^H

(10 - q_1 - q_2^L)q_2^L

={1 \over 2}\left[(10 - q_1 - q_2^L)q_1\right] + {1 \over 2}\left[(10 - q_1 - q_2^H)q_1\right]

Calculate Best Responses

{\partial \pi_2^L(q_2^L|q_1) \over \partial q_2^L} =

10 - q_1 - 2q_2^L

q_2^L(q_1) = 5 - {1 \over 2}q_1

Firm 2's best response to \(q_1\) if MC = 0

{\partial \pi_2^H(q_2^H|q_1) \over \partial q_2^H} =

10 - q_1 - 2q_2^H - 4

q_2^H(q_1) = 3 - {1 \over 2}q_1

Firm 2's best response to \(q_1\) if MC = 4

=(10 - q_1 - ({1 \over 2}q_2^L + {1 \over 2}q_2^H))q_1

{\partial \pi_1(q_1|q_2^L, q_2^H) \over \partial q_1} =

10 - 2q_1 - ({1 \over 2}q_2^L + {1 \over 2}q_2^H)

q_1(q_2^L,q_2^H)=5 - {1 \over 2}({1 \over 2}q_2^L + {1 \over 2}q_2^H)

Firm 1's best response to firm 2 playing \(q_2^L\) and \(q_2^H\) with equal probability

Solve for Nash Equilibrium

q_2^L = 5 - {1 \over 2}q_1

q_2^H = 3 - {1 \over 2}q_1

q_1=5 - {1 \over 2}({1 \over 2}q_2^L + {1 \over 2}q_2^H)

q_1=5 - {1 \over 2}({1 \over 2}(5 - {1 \over 2}q_1) + {1 \over 2}(3 - {1 \over 2}q_1))

q_1=5 - {1 \over 2}(4 - {1 \over 2}q_1)

q_1=5- 2 + {1 \over 4}q_1

{3 \over 4}q_1=3

q_1=4

q_2^L = 5 - {1 \over 2} \times 4

q_2^L = 3

q_2^H = 3 - {1 \over 2} \times 4

q_2^H = 1

Interestingly, the firm with unknown costs produces less (and therefore makes less profits) than the firm with known costs, even when they both have no costs.

Can you figure out why?

Auctions

Private-Value Auctions

A single object is being auctioned off. Rules of the auction:

each player \(i\) submits bid \(b_i\)
a rule determines who gets the object, and how much they pay,
as a function of the vector of bids \(b = (b_1, b_2, \cdots, b_n)\)
examples of rules:
- who gets the object?
  - today: always the highest bidder
- sealed-bid vs. open bid: are bids public information?
  - today: sealed bid, so the game is a simultaneous game
- first-price vs. second-price: what does the winner pay, based on the bids?
  - first-price: the winner pays their own bid
  - second-price: the winner pays the second-highest bid

Auction Payoffs

u_i(v_i,b) = v_i - b

Each player \(i\) knows their own valuation of the object, \(v_i\).

(We can think of this as a move by nature that occurs before the game begins.)

If you win the auction and pay some amount \(b\), your payoff is

If you lose, your payoff is zero.

We assume there is no additional emotional payoff from the fact that you won or lost.

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

What is an optimal bidding strategy?

Nature reveals private valuations \(v_i\),
uniformly distributed along [0, 100].

100

v_i

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

If you bid 90 and the highest other bid is 65, you win the object and pay 65; payoff is 80 - 65 = 15

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

-5

If you bid 90 and the highest other bid is 85, you win the object and pay 85; payoff is 80 - 85 = -5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

-5

If you bid 90 and the highest other bid is 95, you don't win the object and your payoff is 0.

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_i

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

b_i=v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

b_i=v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

b_i=v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

b_i=v_i

100

Suppose your valuation is \(v_i = 80\). Let's make a payoff matrix based on your bid and the highest bid other than yours.

Your bid

Highest bid other than yours

b_{-i}

-5

Second-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of the second highest bid.

v_i

100

Your bid

Highest bid other than yours

-5

Bidding your true valuation is sometimes
better than underbidding, and never worse

Bidding your true valuation is sometimes better than overbidding, and never worse.

Bidding your true valuation is a
weakly dominant strategy!

First-Price, Sealed-Bid Auction

Bidders simultaneously submit secret bids.

The highest bidder pays the amount of their own bid.

What is an optimal bidding strategy?

Nature reveals private valuations \(v_i\), uniformly distributed along [0, 100].

100

First--Price, Sealed-Bid Auction

Nature reveals private valuations \(v_i\), uniformly distributed along [0, 100].

Suppose you believe player 2 is bidding some fraction \(a\) of their valuation.
What is the distribution of their bid? What is your probability of winning if you bid \(b_1\)?

u(b_i) = (v_i - b_i) \times \frac{b_i}{100a}

If the other bidder is bidding fraction \(a\) of their valuation, and their valuation is
uniformly distributed over [0, 100], what's your optimal bid if your valuation is \(v_i\)?

u'(b_i) = \frac{v_i - 2b_i}{100a} = 0 \Rightarrow b_i^* = \frac{1}{2}v_i

PAYOFF IF WIN

PROBABILITY OF WINNING

OPTIMAL TO BID HALF YOUR VALUE

Aside: Order Statistics

Two bidders: expected value of higher value is \(\frac{2}{3}\overline v\), lower value is \(\frac{1}{3}\overline v\)

Nature reveals private valuations \(v_i\), uniformly distributed along \([0, \overline v]\).

\overline v

\frac{2}{3}\overline v

What is the expected revenue from a second-price, sealed-bid auction? From a first-price auction?

\frac{1}{3}\overline v

Revenue equivalence theorem: for certain economic environments, the expected revenue and bidder profits for a broad class of auctions will be the same provided that bidders use equilibrium strategies.

Private value auction: everyone has their own personal valuation of an object.

Common value: the object has an intrinsic value, but that value is unknown

Common Value Auctions

Example: auctioning off land with an unknown amount of oil. Everyone can perform their own test (drill a hole somewhere on the land), and bids based on their private information from that test result.

Suppose I were to auction off this jar of coins.

Who would win the auction?

Suppose everyone gets a signal about the value of the coins in the jar, and that the signal is unbiased: its mean is the true value.

The winner's curse says that
in a common value auction,
then if you win the auction,
you've almost certainly overpaid.

(we won't do the math on this, it's just cool so we mention it)

Common Value Auctions

Dynamic Games of Incomplete Information

Christopher Makler

Stanford University Department of Economics

Econ 51: Lecture 14

Complete information: everyone knows everything about the game
- Incomplete information: players have private information
  (e.g., they know what their valuation of a good is)
Perfect information: everyone can perfectly observe everyone else's moves
- Imperfect information: players' moves are hidden from other players
  (e.g. I cannot observe how much time you spend studying)

Information

Time

Information

Static

(Simultaneous)

Dynamic

(Sequential)

Complete

Incomplete

WEEK 5

WEEK 6

LAST TIME

TODAY

Prisoners' Dilemma

Cournot

Entry Deterrence

Stackelberg

Auctions

Job Market Signaling

Collusion

Cournot with Private Information

Poker

Time

Information

Static

(Simultaneous)

Dynamic

(Sequential)

Complete

Incomplete

Strategy: an action

Equilbirium: Nash Equilibrium

Strategy: a mapping from the history of the game onto an action.

Equilibrium: Subgame Perfect NE

Strategy: a plan of action that
specifies what to do after every possible history of the game, based on one's own private information and (updating) beliefs about other players' private information.

Equilibrium: Perfect Bayesian Equilibrium

Strategy: a mapping from one's private information onto an action.

Equilibrium: Bayesian NE

WEEK 5

WEEK 6

LAST TIME

TODAY

Prisoners' Dilemma

Cournot

Entry Deterrence

Stackelberg

Auctions

Job Market Signaling

Collusion

Cournot with Private Information

Poker

Example: Gift-Giving

She chooses to give one of three gifts:
X, Y, or Z.

Player 1 makes the first move.

Example: Gift-Giving

Twist: Gift X is unwrapped,
but Gifts Y and Z are wrapped.
(Player 1 knows what they are,
but player 2 does not.)

After each of player 1's moves,
player 2 has the move: she can either accept the gift or reject it.

Accept X

Reject X

We represent this by having an information set connecting
player 2's decision nodes
after player 1 chooses Y or Z.

Accept Y

Reject Y

Accept Z

Reject Z

Also: player 2 cannot make her action contingent on Y or Z; her actions must be "accept wrapped" or "reject wrapped"

Accept Wrapped

Reject Wrapped

Accept Wrapped

Reject Wrapped

Example: Gift-Giving

After player 2 accepts or rejects the gift, the game ends (terminal nodes) and payoffs are realized.

–1

Accept X

Reject X

Accept Wrapped

Reject Wrapped

Accept Wrapped

Reject Wrapped

In this game, both players get a payoff of
0 if any gift is rejected,
1 if gift X is accepted, and
2 if gift Y is accepted.

If gift Z is accepted, player 1 gets a payoff of 3, but player 2 gets a payoff of –1.

–1

Accept X

Reject X

Accept Wrapped

Reject Wrapped

Accept Wrapped

Reject Wrapped

Intuitively, what should the equilibrium of this game be? Why?

Player 2:

Player 1:

Accept X

Reject a Wrapped Gift

Player 2:

Player 1:

Accept everything

This is a subgame. From this subgame,
we know player 2 will accept X if given X.

What about player 2's other strategy?

Why isn't this an equilibrium?

–1

Accept X

Reject X

Accept Wrapped

Reject Wrapped

Accept Wrapped

Reject Wrapped

We need some new concept to make player 2 reject a wrapped gift, if offered one.

Solution: we'll say that player 2 has to have beliefs about which gift was given, if it is wrapped.

\ p\

\ 1- p\

–1

Accept X

Reject X

Accept Wrapped

Reject Wrapped

Accept Wrapped

Reject Wrapped

Solution: we'll say that player 2 has to have beliefs about which gift was given, if it is wrapped.

\ p\

\ 1- p\

Player 2:

Player 1:

Accept X

Reject a Wrapped Gift

STRATEGIES

BELIEFS

Player 2:

\(p < {1 \over 3}\)

(Player 2 believes that if they're given a wrapped gift, it's probably Z.