1. Uncertainty and Information
Games Of Strategy
Chapter 8
Dixit, Skeath, and Reiley

2. Terms to Know Adverse Selection Moral Hazard Babbling Equilibrium
Bayesian Nash Equilibrium
Cheap Talk Equilibrium
Incentive Compatibility Condition (Constraint)
Moral Hazard
Negatively Correlated
Partially Revealing Equilibrium
Participation Condition (Constraint)
Perfect Bayesian Equilibrium

3. Terms to Know Cont. Pooling Semisepaparating Equilibrium
Pooling of Types
Pooling Equilibrium
Positively Correlated
Screening
Screening Device
Self-Selection
Semisepaparating Equilibrium
Separating Equilibrium
Separation of Types
Signal
Signaling
Signal Jamming
Type

4. Introductory Game 1
Line up based on the last letter of your first name; ties are decided by a game of rock- paper-scissors where the winner is on the right of the loser
Count off from 1 to the number of individuals in the class
Odd individuals will go to one side of the room and even individuals will go to the other side

5. Introductory Game 1 Cont.
If you are an odd person, you will receive 150 if a number the professor has drawn is odd and 50 if it is even
If you are an even person, you will receive 150 if a number the professor has drawn is even and 50 if it is odd
Individuals can make any deals they want with each other based on the payoffs that will be given
These deals must be written down

6. Introductory Game 1 Cont.
A random number will be drawn by the professor
Your final score is based on the number drawn, the payoff between you, and any deal that was made

7. Introductory Game 1 Discussion
What was your risk?
Did any deals get made?
How could you have mitigated your risk to guarantee an outcome?
Did anyone pay a premium to get rid of or gain risk?

8. Introductory Game 2
Line up based on the person with the highest payoff from the previous game being on the right
Ties will be by rock-paper-scissors
Count off from 1 to N with N being the number of students in the class
Even people will be known as employers and odd people will be known as undergraduates

9. Introductory Game 2: Employer Basics
You get a value of 200 for an employee who has high skill and 50 for an employee with low skills
You get to set an educational level you would like high skill employees to demonstrate
You get to determine the wage of both your high skill and low skill employees with the knowledge that a high skill employee can come to Dr. Hurley and receive a wage of 60 and a low skill employee can get a pay of 30 without either showing their skill level
Your goal is to maximize the value you receive from hiring an employee minus the wage it costs you to hire and you are only allowed to hire one individual

10. Introductory Game 2: Undergraduate Basics
You will be allocated a skill level based on a random draw
This skill level will be told to you by Dr. Hurley and will only be known for sure by him
You have to decide the number of hard classes you are going to take which you must get from Dr. Hurley
For individuals who have high skill, your cost for these hard classes are 5 per class while the low skill individuals have a cost of 10 per class

11. Introductory Game 2: Undergraduate Basics Cont.
Your decision is how many hard classes you are going to take, what type of job you want to apply for (high or low skill), and who you want to work for, i.e., any of the employers or Dr. Hurley, based on the salary they are willing to offer and the number of hard classes they require for the particular job
It may be in your interest not to reveal your type to an employer until after you have been hired

12. Introductory Game 2: Undergraduate Basics Cont.
If you choose an educational level, you must come to Dr. Hurley to get “certified” for your education
There is nothing that requires you to tell the truth during negotiations regarding your skill level
Your payoff is based your wage that you get minus any educational expenses

13. Introductory Game 2: Play the Game
You will have the next fifteen minutes to make your decision
The employer can hirer for either a high skill or a low skill job
For a high skill job the employer can require to see certification
The undergraduate and the employee must come to an agreement on type of job, wage, and educational level
Once you have come to an agreement, you will need to come to Dr. Hurley to solidify your agreement

14. Discussion Employers, how did you make your hiring decision?
Undergraduates, how did you decide on the number of hard classes to take?
Would there have been a benefit to knowing who was high versus low skill without anyone needing to be certified?
Other thoughts?

15. Moral Hazard
This is a situation where there is imperfect asymmetric information
It occurs when actions or strategies are difficult to observe in the game
It requires incentive mechanisms to influence players to take actions that benefit the other players

16. Dealing with Risk When Imperfect Information Exists
Sharing Risk
As long as your risk and the other players risk are not perfectly positively correlated, it is possible for each of you to contract with the other to reduce risk
This can come from a mutually agreed upon contract
Individuals risk preferences can have an effect of each’s payoff based on how the risk is shared

17. Dealing with Risk When Imperfect Information Exists Cont.
Paying to reduce risk
There could be an incentive that one player could pay to another player to have the risk assumed by the player who is paid
In this situation, one player pays another so they can guarantee certain outcomes
This is the basis of insurance

18. Dealing with Risk When Imperfect Information Exists Cont.
Manipulating risks in contests
There are certain times when a player can have an effect on the risks associated with the game
This situation allows for one player to manipulate the risk of the other player to gain a strategic advantage
You can do this by manipulating the amount of risk as well as the correlation of the risk each player undergoes

19. Basic Ideas to Asymmetric Information
Better informed players in a game may have a strategic advantage by concealing the known information, provide misleading information, or give selected information truthfully
When do you think each would occur?
Less informed players may want to gather information, filter information, or remain ignorant

20. Basic Ideas to Asymmetric Information Cont.
More informed players may want to employ signaling to other players to give the other player information
If the less informed player can conclude the information is bad, the well informed player may want to employ signal jamming
The less informed player may want to use screening devices to have the other player reveal useful information

21. Basic Ideas to Asymmetric Information Cont.
It is important to know what type of player you are in a game, e.g., better informed or less informed
When the types of players can be revealed, you can have a separating equilibrium
When types cannot be revealed, you could have a pooling equilibrium

22. Cheap Talk
This is when there is very little to no cost of conveying information, either good or bad
You can use it to change other players belief to affect the outcomes and payoffs of the game
This requires players to consider the credibility of what is being said
This method of communication can lead to cheap talk equilibrium

23. Different Situations that are Encountered with Cheap Talk
Perfectly aligned interests
Totally conflicting interests
Partially aligned interests
Short-term versus long-term relationships matter
In long-term relationships, you need to consider the importance of full and partial revelation

24. Adverse Selection, Signaling, and Screening
Adverse selection is when a player’s type is known only to the player and is based on asymmetric information
Adverse selection can cause market failure where the market does not clear because of asymmetric information (“Market for Lemons”)

25. Adverse Selection, Signaling, and Screening Cont.
Signaling and screening can be accomplished through offering:
Different coverages like what happens in the insurance industry
Warranties as seen in the appliance and car industries
Price discrimination as seen in the airline and sports industries
Items with excellent product design or expensive advertising

26. Labor Market Signaling
When hiring employees, a company would like to hire the appropriate individual for the job
These individuals can be categorized based on their abilities
Companies typically want to pay higher wages for individuals with higher skills
Companies want to set-up a system that helps reveal which type each potential employee could be

27. Incentive Compatibility Conditions/Constraint (ICC)
This is a way of setting up incentives and payoffs in such a way that individuals will reveal their true abilities/type
This constraint is set-up such that the higher ability individuals are willing to indicate/demonstrate that they are the type with higher abilities, while those of the lower abilities do not have incentive to emulate individuals with higher abilities

28. Participation Condition (PC)
Typically there is an outside opportunity that exists for any type of individual; i.e., another job at a different company offering a different offer for employment
This condition requires that the incentive compatibility condition that was set-up to have each type truly reveal his/her abilities also provides incentive for each individual to participate in the given opportunity rather than an outside alternative opportunity

29. Example of ICC and PC
Suppose there are two agribusiness students looking to get the best job possible after graduation
Suppose that one of the individuals is much better at marketing and the other individual is much better at analytical analysis
Assume that there is a produce company looking for a highly analytical individual and a marketing individual
Suppose that the company is moving towards big data analysis so they currently value analytical skills higher than marketing skills

30. Example of ICC and PC Cont.
Also suppose that the company is willing to pay the analytical person $60,000 and the marketing person $40,000
Suppose that the company has hired multiple students who have taken Dr. Hurley’s class and have come to believe that individuals who take his class have the analytical skills needed to be successful for the analytical job
Since each type individual has different skills, we shall assume that it costs the analytical person $1,000 in future psychiatric treatment for every Dr. Hurley class the individual takes while the marketing person incurs a cost of $5,000 for each Dr. Hurley class

31. Example of ICC and PC Cont.
There is another opportunity for the marketing person to work for $35,000 for another company while the analytical person can work for $50,000 from another job opportunity
What are the ICC and PC for this situation?
How many Dr. Hurley classes should the company require the possible applicant to take to ensure that it hires the analytical person for the analytical job and the marketing person for the other position

32. Pooling of Types
When the employer does not or cannot use a screening device, then they have to offer the same pay and benefits to all types of players and assume that they are getting a random draw from the population of types
In a competitive market, the employer will pay the expected value of the employee hired

33. Final Discussion, Questions, and Thoughts