Signaling games

Osborne 331-357, Gibbons 183-210

Maria Saez Marti

 Signalling games: An example

Two players, 1 and 2. Player 2 is a bully and likes to pick fights, but
only with cowards. He dislikes to pick fights with someone with courage
(brave). He likes to pick a fight with a coward but not with a brave.
Suppose the prior probability that player 1 is brave is p. Before deciding
whether to pick a fight or not, player 2 observes 1 having breakfast.
There are two types of breakfast: gipfeli or beer. If 1 is brave he prefers
beer and if he is coward gipfeli. Whatever type he is, he prefers not to
fight. What should he have for breakfast? What should the other player
do after observing the breakfast?
Payoffs for 1:

Preferred breakfast: 2

Less preferred breakfast: 1

Fight: -2

No Fight: 1

Payoff for 2:

Fight a coward: 1

Fight a brave: -1
 Extensive form

(3,0)
„D
on
1 is brave
ight“
‘t F ‘t F (2,0)
igh Don
t“ 1 „
„Beer“ „gipfeli“

p „Fig
ht“ ht“
(0,-1)
(1,-1) „ Fig

2 2

(2,0) „D ight“
‘t F (3,0)
o n‘t t
Fig on
ht“ 1 „D
„Beer“ „gipfeli“

1-p Q
„Fig
ight“ ht“
(1,1)
(0,1) „F 1 is coward
 Example

Two firms (i=1,2). Two periods.

Period 1:

both firms are in the market but only firm 1, the incumbent, takes an
action a1, which can be accommodate or pray.

The profits to firm 2, the entrant, are D2 > 0 > P2.

Firm 1 can be crazy or sane. If sane its profits are D1 > P1.

If firm 1 were a monopoly would make M1 > D1.

A crazy firm enjoys preying and always preys.

Let p1 be the prior probability that firm 1 is sane.

Period 2:

In period 2 only firm 2 takes an action a2. It can be either stay or exit.

If he stays it will receive D2 if firm 1 is sane and P2 if i is crazy.(No

reputation to be gained.)

Firm 1 gets M1 if 2 exits and D1 if 2 stays.

Firms discount profits, δ < 1 is the discount factor.

Can a sane firm convince the other that it is crazy and hence induce
exit?

1. Separating equilibria:

Crazy preys, sane accommodates.

2 learns perfectly the type, i.e has perfect information in the second
period:

μ(sane/accommodate) = 1; μ(crazy/preys) = 1

2. Pooling equilibria: The two types do the same, namely prey.

μ(sane/prey) = p1
Separating PBeq?

It is necessary that

D1 + δD1 ≥ P1 + δM1

Pooling?

The sane type must induce exit, then it must be the case that for firm
2
P2 + δ(p1D2 + (1 − p1)P2) ≤ P2 → p1D2 + (1 − p1)P2 ≤ 0
Does a sane firm want to prey? Yes, if
P1 + δM1 ≥ D1 + δD1

This ”solves” the chain store paradox.

 Signalling games: The theory

2 players: N={1,2}

Player 1 is the sender, player 2 is the receiver.

Player 1 has private information about his type. ( He knows the type
ti ∈ Ti he is).

Player 2’s type is common knowledge.

It is common knowledge that player 2 has prior beliefs p(t1) about player
1’s type.
 Timing

1 chooses an action a1 ∈ A1,which is observed by 2. This action is

typically called message.

2, after observing 1, updates his beliefs p(t1/a1) chooses an action

a2 ∈ A2,and,

the game ends.

 Strategies:

For the sender:

A probability distribution over actions. It ought to depend on the type:

γ 1(.|t1).

For the receiver:

He figures γ 1(.|t1) out and observing a1 updates (using Bayes rule, when
possible) p(t1) into p(t1/a1) and chooses a probability distribution over
actions γ 2(.|a1).
 Payoffs.

Type t1’s payoff to strategy γ 1(.|t1) when player 2 plays γ 2(.|a1) is

XX
u1(γ 1, γ 2, t1) = γ 1(a1|t1)γ 2(a2|a1)u1(a1, a2, t1)
a1 a2
player 2’s ex-ante payoff to γ 2(.|a1) when 1 plays γ 1(.|t1) is
X XX
p(t1)( γ 1(a1|t1)γ 2(a2|a1)u2(a1, a2, t1))
t1 a1 a2

Player 2 maximizes his payoff conditional on the signal a1, where the
conditional payoff to γ 2(.|a1) is
X XX
p(t1/a1)u2(a1, γ 2(.|a1), t1) = p(t1/a1)γ 2(a2|a1)u2(a1, a2, t1))
t1 t1 a2
A perfect Bayesian equilibrium of the signaling game is a set of strategies
γ ∗1(.|t1) and γ ∗2(.|a1) and a posterior belief p∗(t1/a1) such that:

1. For all a1, γ ∗2(|a1) maximizes

X
p∗(t1/a1)u2(a1,γ 2(.|a1), t1)
t1

2. For all t1, γ ∗1(.|t1) maximizes u1(γ 1, γ ∗2, t1) and

3.
p(t1)γ ∗1(a1|t1) X
∗(a |t) > 0
p(t1/a1) = P ∗(a |t) if p(t)γ 1 1
t∈T1 p(t)γ 1 1 t∈T1
p(t1/a1) can be any probability distribution over T1
P
if t∈T1 p(t)γ ∗1(a1|t) = 0.
Taxonomy of equilibria:

Pooling equilibria:

in equilibrium all types choose the same action (signal). Player 2 does
not learn anything: p(t1/a1) = p(t1)

Separating equilibria:

Different types take different actions and the receiver learns the type.
 Spence model.

A worker knows his ability θ.

The firm does not know θ.

The employer offer wages.

The worker sends a signal: the education level e.

θ ∈ {θL, θH } with probabilities pL and pH

The firm observes the education and offers wages w(e). (Assume com-
petition so that the worker is paid his expected productivity).
The firm profits are
θ−w

The worker’s payoffs:

w(e) − e/θi i = L, H
 Pooling equilibria

Workers choose the same education e∗. Firm learns nothing,

μ(θL|e∗) = pL and μ(θH |e∗) = pH

Expected productivity
pLθL + pH θH
Is w(e∗) = pLθL + pH θH an equilibrium?

It has to be the case that for all e

w(e) − e/θH ≤ w(e∗) − e∗/θH

w(e) − e/θL ≤ w(e∗) − e∗/θL

What to believe in a deviation, i.e e 6= e∗?

Assume the firm believes that the deviation comes from the low ability
type

μ(θL|e) = 1
and then offers
w(e) = θL.
If a worker deviates he will do to e = 0. (w(0) = θL)

Then
w(0) ≤ w(e∗) − e∗/θH
and
w(0) ≤ w(e∗) − e∗/θL.

The binding one is the last one

θL ≤ pLθL + pH θH − e∗/θL,
hence
e∗ ≤ θLpH (θH − θL)
 Separating equilibrium

Different types choose different educations.

eL = 0 and eH = e∗ .

Beliefs:if someone deviates, it is the low type.

We need that no type wants to deviate

θL ≤ θH − e∗/θH
and
θL ≥ θH − e∗/θL
or
θL(θH − θL) ≤ e∗ ≤ θH (θH − θH )