ROBUST PREDICTIONS IN GAMES WITH INCOMPLETE INFORMATION. September 2011

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1 Cowles Foundtion for Reserch in Economics t Yle University Cowles Foundtion Discussion Pper No Princeton University, Deprtment of Economics Economic Theory Center Working Pper No ROBUST PREDICTIONS IN GAMES WITH INCOMPLETE INFORMATION September 2011 Dirk Bergemnn Yle University - Cowles Foundtion - Deprtment of Economics Stephen Morris Princeton University - Deprtment of Economics

2 Robust Predictions in Gmes with Incomplete Informtion Dirk Bergemnn y Stephen Morris z September 26, 2011 Abstrct We nlyze gmes of incomplete informtion nd o er equilibrium predictions which re vlid for ll possible privte informtion structures tht the gents my hve. Our chrcteriztion of these robust predictions relies on n epistemic result which estblishes reltionship between the set of Byes Nsh equilibri nd the set of Byes correlted equilibri. We completely chrcterize the set of Byes correlted equilibri in clss of gmes with qudrtic pyo s nd normlly distributed uncertinty in terms of restrictions on the rst nd second moments of the equilibrium ction-stte distribution. We derive exct bounds on how prior informtion of the nlyst re nes the set of equilibrium distribution. As n ppliction, we obtin new results regrding the optiml informtion shring policy of rms under demnd uncertinty. Finlly, we reverse the perspective nd investigte the identi ction problem under concerns for robustness to privte informtion. We show how the presence of privte informtion leds to prtil rther thn complete identi ction of the structurl prmeters of the gme. As prominent exmple we nlyze the cnonicl problem of demnd nd supply identi ction. Jel Clssifiction: C72, C73, D43, D83. Keywords: Incomplete Informtion, Correlted Equilibrium, Robustness to Privte Informtion, Moments Restrictions, Identi ction, Informtion Bounds. We cknowledge nncil support through NSF Grnt SES We bene tted from comments of Steve Berry, Vincent Crwford, Phil Hile, Mrc Henry, Arthur Lewbel, Lrry Smuelson, nd Elie Tmer, nd reserch ssistnce from Brin Bis nd Aron Tobis. We would like to thnk seminr udiences t Boston College, the Collegio Crlo Alberto, Ecole Polytechnique, Europen University Institute, HEC, Microsoft Reserch, Northwestern University, the Pris School of Economics, Stnford University nd the University of Colordo for stimulting converstions; nd we thnk Dvid McAdms for his discussion of this work t the 2011 North Americn Winter Meetings of the Econometric Society in Denver. y Deprtment of Economics, Yle University, New Hven, CT 06520, U.S.A., dirk.bergemnn@yle.edu. z Deprtment of Economics, Princeton University, Princeton, NJ 08544, U.S.A. smorris@princeton.edu 1 Electronic copy vilble t:

3 1 Introduction In gmes of incomplete informtion, the privte informtion of ech gent typiclly induces posterior beliefs bout some pyo stte, nd posterior belief bout the beliefs of the other gents. In turn, the privte informtion of the gent, the type in the lnguge of Byesin gmes, in uences the optiml strtegies of the gents, nd ultimtely the equilibrium distribution over ctions nd sttes. The posterior belief bout the pyo stte represents the knowledge bout the pyo environment tht the plyer is fcing, wheres the posterior belief bout the beliefs of the other gents represents the knowledge bout the belief environment tht the plyer is fcing. The objective of this pper is to obtin equilibrium predictions for given pyo environment which re independent of - nd in tht sense robust to - the speci ction of the belief environment. We de ne the pyo environment s the complete description of the gents preferences nd the common prior over the pyo sttes. The fundmentl uncertinty bout the set of fesible pyo s is thus completely described by the common prior over the pyo sttes, which we lso refer to s fundmentl stte. We de ne the belief environment by complete description of the common prior type spce over nd bove the informtion contined in the common prior distribution of the pyo sttes. The belief environment then describes potentilly rich type spce which is only subject to the constrint tht the mrginl distribution over the fundmentl vrible coincides with the common prior over pyo sttes. A pir of pyo environment nd belief environment form stndrd Byesin gme. Yet, for given pyo environment, there re mny belief environments, nd ech distinct belief environment my led to distinct equilibrium distribution over outcomes, nmely ctions nd fundmentls. The objective of the pper is to describe the equilibrium implictions of the pyo environment for ll possible belief environments reltive to the given pyo environment. Consequently, we refer to the (prtil) chrcteriztion of the equilibrium outcomes tht re independent of the belief environment s robust predictions. We exmine these issues in trctble clss of gmes with continuum of plyers, symmetric pyo functions, nd liner best response functions. A possible route towrds comprehensive description of the equilibrium implictions stemming from the pyo environment lone, would be n exhustive nlysis of ll Byes Nsh equilibri of ll belief environments which re ssocited with given pyo environment. Here we shll not pursue this direct pproch. Insted we shll use relted equilibrium notion, nmely the notion of Byes correlted equilibrium to obtin comprehensive chrcteriztion. We begin with n epistemic result tht estblishes the equivlence between the clss of Byes Nsh equilibrium distributions for ll possible belief environments nd the clss of Byes correlted equilibrium distributions. This result is nturl extension of seminl result by Aumnn (1987). In gmes with complete informtion bout the pyo environment, he estblishes the equivlence between 2 Electronic copy vilble t:

4 the set of Byes Nsh equilibri nd the set of correlted equilibri. We present the epistemic result for the clss of gmes with continuum of gent nd symmetric pyo functions, nd show tht the insights of Aumnn (1987) generlizes nturlly to this clss of gmes with incomplete informtion. Subsequently we use the epistemic result to provide complete chrcteriztion of the Byes correlted equilibri in the clss of gmes with qudrtic pyo s. With qudrtic gmes, the best response function of ech gent is liner function nd in consequence the conditionl expecttions of the gents re linked through liner conditions which in turn permits n explicit construction of the equilibrium sets. The clss of qudrtic gmes hs fetured prominently in mny recent contributions to gmes of incomplete informtion, for exmple the nlysis of rtionl expecttions in competitive mrkets by Guesnerie (1992), the nlysis of the beuty contest by Morris nd Shin (2002) nd the equilibrium use of informtion by Angeletos nd Pvn (2007). We o er chrcteriztion of the equilibrium outcomes in terms of the moments of the equilibrium distributions. In the clss of qudrtic gmes, we show tht the expected men is constnt cross ll equilibri nd provide shrp inequlities on the vrince-covrince of the joint outcome stte distributions. If the underlying uncertinty bout the pyo stte nd the equilibrium distribution itself is normlly distributed then the chrcteriztion of the equilibrium is completely given by the rst nd second moments. If the distribution of uncertinty or the equilibrium distribution itself is not normlly distributed, then the chrcteriztion of rst nd second moments remins vlid, but of course it is not complete chrcteriztion in the sense tht the determintion of the higher moments is incomplete. In compnion pper, Bergemnn nd Morris (2011), we report the de nition of Byes correlted equilibrium nd the relevnt epistemic results in cnonicl gme theoretic frmework with nite number of gents, nite set of pure ction nd nite set of pyo relevnt sttes. We lso relte this to the prior literture on incomplete informtion correlted equilibrium, notbly Forges (1993). In the present pper, the nlysis will be con ned to n environment with qudrtic nd symmetric pyo functions, continuum of gents nd normlly distributed uncertinty bout the common pyo relevnt stte. This trctble clss of models enbles us to o er robust predictions in terms of restrictions on the rst nd second moments of the joint distribution over ctions nd stte. By contrst, in the compnion pper, we present the de nition of the Byes correlted equilibrium in cnonicl gme theoretic frmework. Still, the seprtion between pyo nd belief environment enbles us to sk how chnges in the belief environment ect the equilibrium set for given nd xed pyo environment. We introduce nturl prtil order on informtion structures tht cptures when one informtion structure contins more informtion thn nother. This prtil order is vrition on mny plyer generliztion of the ordering of Blckwell (1953) introduced by Lehrer, Rosenberg, nd Shmy (2010), (2011) nd there we estblish tht the set of 3

5 Byes correlted equilibri shrinks s the informtiveness of the informtion structure increses. The reltionship between the Byes Nsh equilibrium nd the Byes correlted equilibrium is lso useful to exmine the impct of the informtion structure on the welfre of the gents. The compct representtion of the Byes correlted equilibri llows us to ssess the privte nd/or socil welfre cross the entire set of equilibri nd we illustrte this in the context of informtion shring mong rms. The issue is to whether competing rms hve n incentive to shre informtion in n uncertin environment. A striking result by Clrke (1983) ws the nding tht rms, when fcing uncertinty bout common prmeter of demnd, will never nd it optiml to shre informtion. The present nlysis of the Byes correlted equilibrium llows us to modify this insight - implicitly by llowing for richer informtion structures thn previously considered - nd we nd tht the Byes correlted equilibrium tht mximizes the privte welfre of the rms is not necessrily obtined with zero or full informtion disclosure. The initil equivlence result between Byes correlted nd Byes Nsh equilibrium relied on very wek ssumptions bout the belief environment of the gents. In prticulr, we llowed for the possibility tht the gents my hve no dditionl informtion beyond the common prior bout the pyo stte. Yet, in some circumstnces the gents my be commonly known to hve some given prior informtion, or bckground informtion. Consequently, we then nlyze how lower bound on either the public or the privte informtion of the gents, cn be used to further re ne the robust predictions nd impose dditionl moment restrictions on the equilibrium distribution. The pyo environment is speci ed by the (ex-post) observble outcomes, the ctions nd the pyo stte. By contrst, the elements of the belief environment, the beliefs of the gents, the beliefs over the beliefs of the gents, etc. re rrely directly observed or inferred from the reveled choices of the gents. The bsence of the observbility (vi reveled preference) of the belief environment then constitutes seprte reson to be skepticl towrds n nlysis which relies on very speci c nd detiled ssumptions bout the belief environment. (In seprte work, Bergemnn, Morris, nd Tkhshi (2010) sk wht cn be lerned bout gents possibly interdependent preferences by observing how they behve in strtegic environments. As they re interested in identifying when two types re strtegiclly distinguishble in the sense tht they re gurnteed to behve di erently in some nite gme, their frmework is di erent from the current one, s here we consider given gme rther thn quntifying over ll gmes.) Finlly, we reverse the perspective of our nlysis nd consider the issue of identi ction rther thn the issue of prediction. In other words, we re sking whether the observble dt, nmely ctions nd pyo stte, cn identify the structurl prmeters of the pyo functions, nd thus of the gme, without stringent ssumptions on the belief environment. The question of identi ction is to sk whether the observble dt imposes restrictions on the unobservble structurl prmeters of the gme given the equilibrium 4

6 hypothesis. Similrly to the problem of robust equilibrium prediction, the question of robust identi ction then is which restrictions re common to ll possible belief environments given speci c pyo environment. In the context of the qudrtic pyo s tht we study, we nd tht the robust identi ction does llow us to identify the sign of some interction prmeters, but will leve other prmeters, in prticulr whether the gents re plying gme of strtegic substitutes or complements, unidenti ed, even in terms of the sign of the interction. The identi ction results here, in prticulr the contrst between Byes Nsh equilibrium nd Byes correlted equilibrium, re relted to, but distinct from the results presented in Ardills-Lopez nd Tmer (2008). In their nlysis of n entry gme with incomplete informtion, they document the loss in identi ction power tht rises with more permissive solution concept, i.e. level k-rtionlizbility. As we compre Byes Nsh nd correlted equilibrium, we show tht the lck of identi ction is not necessrily due to the lck of common prior, s ssocited with rtionlizbility, but rther the richness of the possible privte informtion structures (but ll with common prior). In recent yers, the concern for robust equilibrium nlysis in gmes of incomplete informtion hs been rticulted in mny wys. In mechnism design, where the rules of the gmes cn be chosen to hve fvorble robustness properties, number of positive results hve been obtined. Dsgupt nd Mskin (2000), Bergemnn nd Välimäki (2002) nd Bergemnn nd Morris (2005), mong others, show tht the e cient socil lloction cn be implemented in n ex-post equilibrium nd hence in Byes Nsh equilibrium for ll type spces, with or without common prior. 1 But in given rther thn designed gmes, such strong robustness results seem out of rech for most clsses of gmes. In prticulr, mny Byesin gmes simply do not hve ex post or dominnt strtegy equilibri. In the bsence of such globl robustness results, nturl rst step is then to investigte the robustness of the Byes Nsh equilibrium to smll perturbtion of the informtion structure. For exmple, Kjii nd Morris (1997) consider Nsh equilibrium of complete informtion gme nd sy tht the Nsh equilibrium is robust to incomplete informtion if every incomplete informtion gme with pyo s lmost lwys given by the complete informtion gme hs n equilibrium which genertes behvior close to the Nsh equilibrium. In this pper, we tke di erent pproch nd use the dichotomy between the pyo environment nd the belief environment to nlyze the equilibrium behvior in given pyo environment while llowing for ny rbitrry, but common prior, type spce, s long s it is consistent with the given common prior of the pyo type spce. In the current contribution, we trce out the Byes Nsh equilibri ssocited with ll possible informtion structures. A relted literture seeks to identify the best informtion structure consistent with the given common prior over pyo types. For exmple, Bergemnn nd Pesendorfer (2007) 1 Jehiel nd Moldovnu (2001) nd Jehiel, Moldovnu, Meyer-Ter-Vehn, nd Zme (2006) demonstrte the limits of these results by considering multi-dimensionl pyo types. 5

7 chrcterizes the revenue-mximizing informtion structure in n uction with mny bidders. Similrly, in clss of sender-receiver gmes, Kmenic nd Gentzkow (2010) derive the sender-optiml informtion structure. Chwe (2006) discusses the role of sttisticl informtion in single-gent nd multi-gent decision problems. In series of relted settings, he rgues tht the correltion between the reveled choice of n gent, referred to s incentive comptibility, nd rndom vrible, not controlled by the gent, llows us n nlyst to infer the nture of the pyo interction between the gent s choice nd the rndom vrible. For exmple, in 2 2 gmes, observing the signed covrince in the ctions is su cient to identify pure strtegy Nsh equilibri. In the context of two plyer gme with qudrtic pyo s nd complete informtion, he shows tht the sign of the covrince of the gents ctions cn be predicted cross ll correlted equilibri. The reminder of the pper is orgnized s follows. Section 2 de nes the relevnt solution concepts nd estblishes the epistemic result which reltes the set of Byes Nsh equilibri to the set of Byes correlted equilibri. Beginning with Section 3, we con ne our ttention to clss of qudrtic gmes with normlly distributed uncertinty bout the pyo stte. Section 4 reviews the stndrd pproch to gmes with incomplete informtion nd nlyses the Byes Nsh equilibri under bivrite belief environment in which ech gent receives privte nd public signl bout the pyo stte. Section 5 begins with the nlysis of the Byes correlted equilibrium nd we present complete description of the equilibrium set in terms of moment restrictions on the joint equilibrium distribution. We then estblish the link between the set of Byes correlted equilibri nd the set Byes Nsh equilibrium under the bivrite belief environment. In Section 6 we nlyze how prior informtion bout the belief environment cn further restrict the equilibrium predictions. In Section 7, we turn from prediction to the issue of identi ction. We sk how much we cn lern from the observble ctions nd pyo sttes bout the structurl prmeters of the gme. Here we consider both the cse of observble individul ctions s well s observble ggregte ctions. With only ggregte ctions observble, we consider the possibility of robust identi ction within the context of the clssic demnd nd supply identi ction problem. Section 8 discusses some possible extensions nd o ers concluding remrks. The Appendix collects some of the proofs from the min body of the text. 6

8 2 Set-Up We rst de ne the solution concept of Byes correlted equilibrium. We then relte the notion of Byes correlted equilibrium to robust equilibrium predictions in clss of continuum plyer gmes with symmetric pyo. In the compnion pper, Bergemnn nd Morris (2011), we develop this solution concept nd its reltionship to robust predictions in cnonicl nite plyer nd nite ction gmes. In the compnion pper, we lso show how the results there cn be dpted nd re ned rst to symmetric pyo s nd then to the continuum of gents nd continuum of ctions nlyzed here. Pyo Environment There is continuum of plyers nd n individul plyer is indexed by i 2 [0; 1]. Ech plyer chooses n ction 2 R. There will then be relized popultion ction distribution h 2 (R). There is pyo stte 2. All plyers hve the sme pyo function u : R (R)! R, where u (; h; ) is plyer s pyo if she chooses ction, the popultion ction distribution is h nd the stte is. There is prior distribution 2 (). A pyo environment is thus prmeterized by (u; ). We lso refer to (u; ) s the "bsic gme" s 2 () only speci es the common prior distribution over the pyo stte 2 wheres it does not specify the privte informtion the gents my hve ccess to. Belief Environment Ech plyer will observe signl (or relize type) t 2 T. In ech stte of the world 2, there will be relized distribution of signls g 2 (T ) drwn ccording to distribution k 2 ( (T )). Let :! ( (T )) give the distribution over signl distributions. Thus the belief environment, or lterntively n informtion structure, is prmeterized by (T; ). Byes Correlted Equilibrium We will be interested in probbility distributions 2 ( (R) ) with the interprettion tht is the joint distribution of the popultion ction distribution h nd the stte. For ny such, we write b for the induced probbility distribution on R (R) if (h; ) 2 (R) re drwn ccording to nd there is then conditionlly independent drw of 2 R ccording to h. For ech 2 R, we write b (j) for the probbility on (R) conditionl on (we will write s if it is uniquely de ned). De nition 1 (Byes Correlted Equilibrium ) A probbility distribution 2 ( (R) ) is Byes correlted equilibrium (BCE) of (u; ) if E b(j) u (; h; ) E b(j) u 0 ; h; (1) for ech nd 0 ; nd mrg = : 7

9 In our de nition of Byes correlted equilibrium, the types T i re implicit in the sense tht the probbility distribution will induce belief over ctions nd beliefs of the other plyers. Thus, our de nition extends the notion of correlted equilibrium in Aumnn (1987) to n environment with uncertin pyo s, represented by the stte of the world. We introduce the lnguge of types lter on when we consider gmes in which the plyers re known to hve privte informtion bout the stte of world, which is encoded in the types. In our compnion pper, Bergemnn nd Morris (2011), the notion of Byes correlted equilibrium is de ned somewht more generlly s joint distribution over ction, sttes nd types, i.e. s joint distribution 2 (A T ). In the lnguge of the more generl notion o ered there, the Byes correlted equilibrium de ned here is the Byes correlted informtion with the null informtion structure, i.e. the cse in which the gents re not ssumed priori to hve ccess to speci c informtion structure (T; ). Here, we choose this miniml notion of Byes correlted equilibrium to obtin robust predictions for n observer who only knows the pyo environment but hs null informtion bout the belief environment of the gme. But, just s in the compnion pper, Bergemnn nd Morris (2011), we cn nlyze the impct of privte informtion on the size of the Byes correlted equilibrium set. In fct in Section 6, we nlyze how prior knowledge of the belief environment cn re ne the set of equilibrium predictions. We mintin our restriction to normlly distributed uncertinty, now normlly distributed types, to obtin explicit descriptions of the resulting restriction on the equilibrium set. By contrst, in Bergemnn nd Morris (2011), we llow for generl informtion structures nd derive mny plyer generliztion of the ordering of Blckwell (1953) s necessry nd su cient conditions to order the set of Byes correlted equilibrium. However, within this generl environment, we do not obtin n explicit nd compct description of the equilibrium set in terms of the rst nd second moments of the equilibrium distributions, s we do in the present nlysis. The generl notion of Byes correlted informtion lso fcilittes the discussion of the reltionships between the notion of Byes correlted equilibrium, nd relted, but distinct notions of correlted equilibrium in gmes of incomplete informtion, most notbly in the work of Forges (1993), which is titled nd identi es ve legitimte de nitions of correlted equilibrium in gmes with incomplete informtion. We refer to the reder to the compnion pper, Bergemnn nd Morris (2011) for detiled discussion nd comprison. Byes Nsh Equilibrium The pyo environment (u; ) nd the belief environment (T; ) together de ne gme of incomplete informtion ((u; ) ; (T; )). A symmetric strtegy in the gme is then de ned by : T! (R). The interprettion is tht (t) is the relized distribution of ctions mong those plyers observing signl t (i.e., we re "ssuming the lw of lrge numbers" on the continuum). A 8

10 distribution of signls g 2 (T ) nd 2 induce probbility distribution g 2 (R). The prior 2 () nd signl distribution :! (T ) induce probbility distribution 2 ( (T ) ). As before, write [ for the probbility distribution on T (T ) if (g; ) 2 (T ) re drwn ccording to nd there is then conditionlly independent drw of t 2 T ccording to the relized g 2 (T ). For ech t 2 T, we write [ (jt) for the probbility on (T ) conditionl on t (we will write s if it is uniquely de ned). De nition 2 (Byes Nsh Equilibrium) A strtegy 2 is Byes Nsh equilibrium (BNE) of ((u; ) ; (T; )) if E [ (jt) u (; g ; ) E [(jt) u 0 ; g ; ; for ll t 2 T, in the support of ( jt) nd 0 2 R. Let be the probbility distribution on ( (R) ) induced if (g; ) 2 (T ) re drwn ccording to nd h 2 (R) is set equl to g. De nition 3 (Byes Nsh Equilibrium Distribution) A probbility distribution 2 ( (R) ) is BNE ction stte distribution of ((u; ) ; (T; )) if there exists BNE of ((u; ) ; (T; )) such tht =. Epistemic Result Nsh equilibri. We re now in position to relte the Byes correlted equilibri with the Byes Proposition 1 A probbility distribution 2 ( (R) ) is Byes correlted equilibrium of (u; ) if nd only if it is BNE ction stte distribution ((u; ) ; (T; )) for some informtion structure (T; ). Proof. Suppose tht is BCE of (u; ). Let T = R, let :! (T ) be set equl to the conditionl probbility :! (R) nd let be the "truth-telling" strtegy with type choosing ction with probbility 1. Now E [ (j) u 0 ; g ; = E b(j) u 0 ; h; by construction nd the BCE equilibrium conditions imply the BNE equilibrium conditions. Suppose tht is BNE of ((u; ) ; (T; )) nd so E [ (jt) u (; g ; ) E [(jt) u 0 ; g ; (2) 9

11 for ll t 2 T, in the support of ( jt) nd 0 2 R. Now E [ (jt) u (0 ; g ; ) is function of t. The expecttion of this expecttion conditionl on being drwn under strtegy is E \ (j) u 0 ; g ; nd thus tking the expecttion of both sides of (2) estblishes tht is BCE. Aumnn (1987) estblishes the reltion between Nsh equilibri nd correlted equilibri in gmes with complete informtion. In the compnion pper, Bergemnn nd Morris (2011), we estblish the relevnt epistemic results for cnonicl gme theoretic environments in more detil. 3 Environment with Qudrtic Pyo s nd Norml Uncertinty For the reminder of this pper, we consider qudrtic nd symmetric model of interction. There is continuum of gents, i 2 [0; 1]. The individul ction is denoted by i 2 R nd the verge ction is denoted by A 2 R: Z A, i di. The pyo of gent i is denoted by u i ( i ; A; ) nd depends on the individul ction i, the verge ction A nd the pyo stte 2 R. The pyo s re qudrtic nd symmetric cross gents nd given by: u i ( i ; A; ), 0 A 1 C A 0 0 i 1 0 i i A C A + A 1 C A A i A A C B A A A C A : (3) The vector = ( ; A ; ) represents the liner returns nd the mtrix = ij represents the interction structure of the gme, together nd in the interction mtrix completely describe the pyo s of the gents. The entries re uniformly denoted by. The prmeters with single subscript, nmely ; A ;, refer the digonl entries in the interction mtrix in the own ction: < 0;. We ssume tht the pyo s re concve nd tht the interction of the individul ction nd the verge ction (the indirect e ect ) is bounded by the own ction (the direct e ect ): A = < 1, + A < 0. (4) The concvity nd the moderte interction jointly imply tht the complete informtion gme hs unique nd bounded Nsh equilibrium. The gme displys strtegic complementrity if A > 0 nd 10

12 strtegic substitutes if A < 0. We ssume tht the informtionl externlity is nonzero to hve the fundmentl, i.e. the pyo stte, mtter. The entries in the interction mtrix the individul ction i, i.e. the entries in the lower submtrix of A A A, nmely which do not refer to 5 (5) re not relevnt for the determintion of either the Byes Nsh or the Byes correlted equilibrium. These entries my gin relevnce if we were to pursue welfre nlysis, where the ggregte behvior per se would in uence the evlution of n equilibrium or policy intervention (see for exmple Angeletos nd Pvn (2009)). As this is not the subject of the pper, the entries in the lower submtrix (5) do not mtter for us, nd cn be uniformly set to zero. The pyo stte, or the stte of the world, is distributed normlly with N ; 2. The qudrtic environment encompsses wide clss of interesting economic environment. The following two pplictions re prominent exmples nd we shll return to them throughout the pper to illustrte some of the results. Exmple 1 (Beuty Contest) In Morris nd Shin (2002), continuum of gents, i 2 [0; 1], hve to choose n ction under incomplete informtion bout the stte of the world. Ech gent i hs pyo function given by: u i ( i ; A; ) = (1 r) ( i ) 2 r ( i A) 2. The weight r re ects concern for the verge ction A tken in the popultion. Morris nd Shin (2002) nlyze the Byes Nsh equilibrium in which ech gent i hs ccess to privte (idiosyncrtic) signl nd public (common) signl of the world. In terms of our nottion, the beuty contest model set = 1, A = r 2 (0; 1) nd = (1 r). Angeletos nd Pvn (2007) generlize the nlysis of Byes Nsh equilibrium under this bivrite informtion structure for the generl clss of qudrtic environments de ned bove by (3). Exmple 2 (Competitive Mrket) Guesnerie (1992) o er n nlysis of the stbility of the competitive equilibrium by considering continuum of producers with qudrtic cost of production nd liner inverse demnd function with either cost or demnd uncertinty. In terms of our nottion, the cost of production of the individul rm is described by c ( i ) = i i 2 i if there is common cost uncertinty, nd by c ( i ) = i 2 i if there is demnd uncertinty. In turn, the inverse demnd function is given by p (A) = A A if there is cost uncertinty, nd p (A) = + A A if there is demnd uncertinty, where the stte now determines the intercept of the inverse demnd. 11

13 4 Byes Nsh Equilibrium We initilly report the stndrd pproch to nlyze gmes of incomplete informtion. Nmely, we strt with the gme of incomplete informtion, which includes the bsic gme nd speci c type spce. Here, the type spce consists of two-dimensionl signl tht ech gent receives. In the rst dimension, the signl is privtely observed nd idiosyncrtic to the gent, wheres in the second dimension, the signl is publicly observed nd common to ll the gents. In either dimension, the signl is normlly distributed nd centered round the true stte of the world. In this clss of normlly distributed signls, speci c type spce is determined by the vrince of the noise long ech dimension of the signl. For given vrincecovrince mtrix, nd hence for given type spce, we then nlyze the Byes Nsh equilibrium/ of the bsic gme. Now, the type spce, s prmetrized by the vrince of the noise, nturlly belongs to clss of possible privte informtion environments nd hence type spces, nmely the clss of normlly distributed bivrite signl structures. In the process of the nlysis, we shll observe tht the equilibrium behvior cross this clss of normlly distributed informtion environments displys common fetures. We shll then proceed to nlyze the bsic gme with the notion of Byes Correlted equilibrium nd estblish which predictions re robust cross ll of the privte informtion environments, independent of the speci c bivrite nd norml type spce to be considered now. Accordingly, we consider the following bivrite norml informtion structure. Ech gent i is observing privte nd public noisy signl of the true stte of the world. The privte signl x i, observed only by gent i, is de ned by: x i = + " i ; (6) nd the public signl, common nd commonly observed by ll the gents is de ned by: y = + ". (7) The rndom vribles " i nd " re normlly distributed with zero men nd vrince given by 2 x nd 2 y, respectively; moreover " i nd " re independently distributed, with respect to ech other nd the stte. This model of bivrite normlly distributed signls ppers frequently in gmes of incomplete informtion, see Morris nd Shin (2002) nd Angeletos nd Pvn (2007) mong mny others. It is t times convenient to express the vrince of the rndom vribles in terms of the precision: x, 2 x ; y, 2 y ; nd 2, 2 y + 2 x + 2 ; we refer to the vector with, ( x ; y ), s the informtion structure of the gme. 12

14 A specil cse of the noisy environment is the environment with zero noise. In this environment, the complete informtion environment, ech gent observes the stte of the world without noise. We begin the equilibrium nlysis with the complete informtion environment. Given the pyo environment, the best response of gent i is given by i = + + A A. The best response re ects the, possibly con icting, objectives tht gent i fces. The qudrtic pyo function induces ech gent to solve prediction-like problem in which he wishes to mtch with his ction, with the stte nd the verge ction A. The interction prmeters, the indirect e ects nd A, determine the weight tht ech component receives in the delibertion of the gent, nd the direct e ect ; determines the overll responsiveness to stte nd verge ction A. If there is zero strtegic interction, or A = 0, then ech gent fces pure prediction problem. Now, it follows tht the resulting Nsh equilibrium strtegy is given by: (),. (8) + A + A Given the erlier ssumptions on individul nd ggregte concvity of the pyo function, nmely < 0 nd A + < 0, it follows tht the symmetric strtegy () ; given ny reliztion, is the unique Nsh equilibrium of the gme with complete informtion. In fct, () is lso the unique correlted equilibrium of the gme; Neymn (1997) gives n elegnt rgument. Next, we nlyze the gme with incomplete informtion, where ech gent receives bivrite noisy signl (x i ; y). In prticulr, we shll compre how responsive the strtegy of ech gent is to the underlying stte of the world reltive to the responsiveness in the gme with complete informtion. To this end, we shll refer to the terms in equilibrium strtegy (8), = ( + A ) nd = ( + A ), s the equilibrium intercept nd the equilibrium slope, respectively. In the gme with incomplete informtion, gent i receives pir of signls, x i nd y, generted by the informtion structure (6) nd (7). The prediction problem now becomes more di cult for the gent. First, he does not observe the stte, but rther he receives some noisy signls, x i nd y, of. Second, since he does not observe the other gents signls either, he cn only form n expecttion bout their ctions, but gin hs to rely on the signls x i nd y to form the conditionl expecttion. The best response function of gent i then requires tht ction is justi ed by the conditionl expecttion, given x i nd y: i = + E [ jx i ; y ] + A E [A jx i ; y ]. In this liner qudrtic environment with norml distributions, we conjecture tht the equilibrium strtegy is given by function liner in the signls x i nd y: (x i ; y) = 0 + x x i + y y. (9) 13

15 The equilibrium is then identi ed by the liner coe cients 0 ; x ; y ; which we expect to depend on the interction mtrix nd the informtion structure. Proposition 2 (Liner Byes Nsh Equilibrium) The unique Byes Nsh equilibrium is liner equilibrium: (x; y) = 0 + xx + yy with the coe cients given by: 0 = + A 2 + A A x 2 + ; (10) 2 y = x = 2 x A 2 x + 2 ; (11) y 2 + A A x 2 + : (12) 2 The derivtion of the liner equilibrium strtegy lredy ppered in mny contexts, e.g., in Morris nd Shin (2002) for the beuty contest model, nd for the present generl environment, in Angeletos nd Pvn (2007). The Byes Nsh equilibrium shres the uniqueness property with the Nsh equilibrium, its complete informtion counterprt. We observe tht the liner coe cient x nd y disply the following reltionship: y x = 2 x 2. (13) y + A Thus, if there is zero strtegic interction, or A = 0, then the signls x i nd y receive weights proportionl to the precision of the signls. The fct tht x i is privte signl nd y is public signl does not mtter in the bsence of strtegic interction, ll tht mtters is the bility of the signl to predict the stte of the world. By contrst, if there is strtegic interction, A 6= 0, then the reltive weights lso re ect the informtiveness of the signl with respect to the verge ction. Thus if the gme displys strtegic complements, A > 0, then the public signl y receives lrger weight. The commonlity of the public signl cross gents mens tht their decision is responding to the public signl t the sme rte, nd hence in equilibrium the public signl is more informtive bout the verge ction thn the privte signl. By contrst, if the gme displys strtegic substitutbility, A < 0, then ech gent would like to move wy from the verge, nd hence plces smller weight on the public signl y, even though it still contins informtion bout the underlying stte of the world. Now, if we compre the equilibrium strtegies under complete nd incomplete informtion, (8) nd (9), we nd tht in the incomplete informtion environment, ech gent still responds to the stte of the 14

16 world, but his response to is noisy s both x i nd y re noisy reliztions of, but centered round : x i = + " i nd y = + ". Now, given tht the best response, nd hence the equilibrium strtegy, of ech gent is liner in the expecttion of, the vrition in the ction is explined by the vrition in the true stte, or more generlly in the expecttion of the true stte. Thus the ows of the ction hve to be blnced by the ows of the underlying stte. But cross ll of the informtion structures, the distribution of the stte remins the sme, which suggests tht the expected ows hve to sty constnt cross the informtion structures. Proposition 3 (Attenution) The men ction in equilibrium is: E [] = 0 + x + y = + + A ; nd the sum of the weights, x + y, is: x + y = + 1 A! A x 2 +. A Thus, the verge ction in equilibrium, E [], is in fct independent of the informtion structure. In ddition, we nd tht the liner coe cients of the equilibrium strtegy under incomplete informtion re (wekly) less responsive to the true stte thn under complete informtion. In prticulr, the sum of the weights is strictly incresing in the precision of the noisy signls x i nd y. The equilibrium response to the stte of the world is diluted by the noisy signls, tht is the response is ttenuted. But s the expected ows hve to be blnced, the residul is lwys picked up by the intercept of the equilibrium response. Now, if we sk how the joint distribution of the Byes Nsh equilibrium vry with the informtion structure, then Proposition 3 estblished tht it is su cient to consider the higher moments of the equilibrium distribution. But given the normlity of the equilibrium distribution, it follows tht it is su cient to consider the second moments, tht is the vrince-covrince mtrix. The vrince-covrince mtrix of the equilibrium joint distribution over individul ctions i ; j, nd stte is given by: i ; j ; = : (14) We denote the correltion coe cient between ction i nd j shorthnd by rther thn. Above, we describe the equilibrium joint distribution in terms of ( i ; j ; ), but lterntively we cn describe it, fter replcing the individul ction j by the verge ction A, through the triple ( i ; A; ). After ll, the covrince between the individul, but symmetriclly distributed, ctions i nd j, given by 2 15

17 hs to be equl to the vrince of the verge ction, or 2 A = 2. Similrly, the covrince between the individul ction nd the verge ction hs to be equl to the covrince of ny two, symmetric, individul ction pro les, or A A = 2. Likewise, the covrince between the individul (but symmetric) ction i nd the stte hs to equl to the covrince between the verge ction nd the stte, or or = A A. The vrince-covrince mtrix of the equilibrium joint distribution over individul ctions i ; A nd stte is given by: i ;A; = Now, given the chrcteriztion of the unique Byes Nsh equilibrium in Proposition 2 bove, we cn express either of the vrince-covrince mtrices in terms of the equilibrium coe cients ( x ; y ) nd the vrinces of the underlying rndom vribles (; " i ; "), or i ;A; = : 2 x 2 x + 2 y 2 y + 2 ( x + y ) 2 2 y 2 y + 2 ( x + y ) 2 2 ( x + y ) 2 y 2 y + 2 ( x + y ) 2 2 y 2 y + 2 ( x + y ) 2 2 ( x + y ) 2 ( x + y ) 2 ( x + y ) 2 Given the structure of the vrince-covrince mtrix, we cn express the equilibrium coe cients x nd y directly in terms of the vrince nd covrince terms tht they generte: x = y; y = y q 2. (15) In other words, we ttribute to the privte signl x, through the weight x, the residul correltion between nd, where the residul is obtined by removing the correltion between nd which is due to the public signl. In turn, the weight ttributed to the public signl is proportionl to the di erence between the correltion cross ctions nd cross ction nd signl. We recll tht the ctions of ny two gents re correlted s they respond to the sme underlying fundmentl stte. Thus, even if their privte signls re independent conditionl on the true stte of the world, their ctions re correlted due to the correltion with the hidden rndom vrible. Now, if these conditionlly independent signls were the only sources of informtion, nd the correltion between ction nd the hidden stte where, then ll the correltion of the gents ction would hve to come through the correltion with the hidden stte, nd in consequence the correltion cross ctions rises indirectly, in two wy pssge through the hidden stte, or =. In consequence, ny correltion beyond this indirect pth, or generted by mens of common signl, the public signl y is 16

18 Since the correltion coe cient of the ctions hs to be nonnegtive, the bove representtion suggest tht s long s the correltion coe cient ( ; ) stisfy: 0 1, nd 2 0; (16) we cn nd informtion structures such the coe cients resulting from (15) indeed re equilibrium coef- cients of the ssocited Byes Nsh equilibrium strtegy. Proposition 4 (Correltion nd Informtion) For every ( ; ) such tht 0 1, nd 2 0; there exists unique informtion structure such tht the ssocited Byes Nsh equilibrium displys the correltion coe cients ( ; ). In the two-dimensionl spce of the correltion coe cients ; 2, the set of possible Byes Nsh equilibri is described by the re below the 45 degree line. We illustrte how prticulr Byes Nsh equilibrium with its correltion structure ( ; ) is generted by prticulr informtion structure. In Figure 1, ech level curve describes the correltion structure of the Byes Nsh equilibrium for prticulr precision x of the privte signl. A higher precision x genertes higher level curve. The upwrd sloping movement represents n increse in informtiveness of the public signl, i.e. n increse in the precision y. An increse in the precision of the public signl therefore leds to n increse in the correltion of ction cross gents s well s in the correltion between individul ction nd stte of the world. For low levels of precision in the privte nd the public signl, n increse in the precision of the public signl rst leds to n increse in the correltion of ctions, nd then only lter into n incresed correltion with the stte of the world.in Figure 2, we remin in the unit squre of the correltion coe cients ; 2. But this time, ech level curve is identi ed by the precision y of the public signl. As the precision of the privte signl increses, the level curve bends upwrd nd rst bckwrd, nd eventully forwrd. At low levels of the precision of the privte signl, n increse in the precision of the privte signl increses the dispersion cross gents nd hence decreses the correltion cross gents. But s it gives ech individul more informtion bout the true stte of the world, n increse in precision lwys leds to n increse in the correltion with the true stte of the world, this is the upwrd movement. As the precision improves, eventully the noise becomes su ciently smll so tht the underlying common vlue generted by domintes the noise, nd then serves to both increse the correltion with the stte nd cross ctions. But in contrst to the privte informtion, where the equilibrium sets moves mostly northwrds, i.e. where the improvement occurs mostly in the direction of n increse in the correltion between the stte nd the individul gent, the public informtion leds the equilibrium sets to move mostly estwrds, i.e. most of the chnge leds to n increse in the correltion cross ctions. In fct for given correltion between the individul ctions, 17

19 o x Figure 1: Byes Nsh equilibrium of beuty contest, r = 1=4, with vrying degree of precision x of privte signl. represented by, n increse in the precision of the public signl leds to the elimintion of Byes Nsh equilibri with very low nd with very high correltion between the stte of the world nd the individul ction. 5 Byes Correlted Equilibrium We now chrcterize the set of Byes correlted equilibri. We will ttention to symmetric nd normlly distributed correlted equilibri, but will lter discuss to wht extent this restriction is without loss of generlity. 5.1 Equilibrium Moment Restrictions We consider the clss of symmetric nd normlly distributed Byes correlted equilibri. The best response of gent i given ny recommendtion i hs to stisfy: i = 1 ( + E [ j i ] + A E [A j i ]). (17) With the hypothesis of normlly distributed Byes correlted equilibrium, the ggregte distribution of the stte of the world nd the verge ction A is described by: A A 2 A A AA : A A A A 2 A 18

20 y Figure 2: Byes Nsh equilibrium of beuty contest, r = 1=4, with vrying degree of precision x of public signl. In the continuum economy, we cn describe the individul ction s centered round the verge ction A with some dispersion 2, so tht = A +, for some N 0; 2. In consequence, the joint equilibrium distribution of (; A; ) is given by: 0 A 1 C A N 00 A A A A A A C A ; A A 2 A 2 A A A 2 A 2 A CC AA : (18) As the best response condition (17) uses the expecttion of the individul gent, it is convenient to introduce the following chnge of vrible for the equilibrium rndom vrible. By hypothesis of the symmetric equilibrium, we hve: = A nd 2 = 2 A + 2. The covrince between the individul ction nd the verge ction is given by: A A = 2 A; nd is identicl, by construction, to the covrince between the individul ctions: 2 = 2 A. (19) 19

21 We cn therefore express the correltion coe cient between individul ctions,, s: nd the correltion coe cient between individul ction nd the stte s: 2 A = 2 A +, (20) 2 = A A. (21) In consequence, we cn rewrite the joint equilibrium distribution of (; A; ) in terms of the moments of the stte of the world nd the individul ction s: A C A N C A ; 2 2 CC AA : (22) 2 2 With the joint equilibrium distribution described by (22), we now use the best response property (17), to completely chrcterize the moments of the equilibrium distribution. imposing the obedience condition (1) in the generl setting of Section 2. Note tht this corresponds to As the best response property (17) hs to hold for ll i in the support of the correlted equilibrium, it follows tht the bove condition hs to hold in expecttion over ll i, or by the lw of totl expecttion: E [ i ] = 1 ( + E [E [ j i ]] + A E [E [A j i ]]). (23) But by symmetry, it follows tht the expected ction of ech gent is equl to expected verge ction A, nd hence we cn use (23) to solve for the men of the individul ction nd the verge ction: E [ i ] = E [A] = + E [] + A = + + A. (24) It thus follows tht the men of the individul ction nd the men of the verge ction is uniquely determined by the men vlue of the stte of the world nd the interction mtrix equilibri. cross ll correlted The complete description of the set of correlted equilibri then rests on the description of the second moments of the multivrite distribution. The chrcteriztion of the second moments of the equilibrium distribution gin uses the best response property of the individul ction, see (17). But, now we use the property of the conditionl expecttion, rther thn the iterted expecttion to derive restriction on the covrites. The recommended ction i hs to constitute best response in the entire support of the equilibrium distribution. Hence the best response hs to hold for ll i 2 R, nd thus the conditionl expecttion of the stte E [ j i ] nd of the verge ction, E [A j i ], hve to chnge with i t exctly the rte required to mintin the best response property: 1 = 1 de [ j i ] d i + A de [A j i ] d i 20 ; for ll i 2 R.

22 Given the multivrite norml distribution (22), the conditionl expecttions E [ j i ] nd E [A j i ] re liner in i nd given by nd E [j i ] = 1 + E [Aj i ] = + A + i + + A ; (25) + + A (1 ) + i : (26) The optimlity of the best response property cn then be expressed, using (25) nd (26) s 1 = 1 + A. It follows tht we cn express either one of the three elements in the description of the second moments, ( ; ; ) in terms of the other two nd the primitives of the gme s described by the interction mtrix. In fct, it is convenient to solve for the stndrd devition of the individul ctions, or = A +. (27) The remining restrictions on the correltion coe cients nd re coming in the form of inequlities from the chnge of vribles in (19)-(21), where 2 = 2 A 2 A 2 = 2 A. (28) Finlly, the stndrd devition hs to be positive, or 0. Now, it follows from the ssumption of moderte interction, A + < 0, nd the nonnegtivity restriction of implied by (28) tht nd thus to gurntee tht 0, it hs to be tht A + < 0, 0. Thus the sign of the correltion coe cient hs to equl the sign of the interction term.nd we summrize these chrcteriztion results s follows. Proposition 5 (First nd Second Moments of BCE) A multivrite norml distribution of ( i ; j ; ) is symmetric Byes correlted equilibrium if nd only if 1. the men of the individul ction is: E [ i ] = + + A ; (29) 21

23 Figure 3: Set of Byes correlted equilibrium in terms of correltion coe cients nd 2. the stndrd devition of the individul ction is: = A + ; nd (30) 3. the correltion coe cients nd stisfy the inequlities: 2 nd 0. (31) The chrcteriztion of the rst nd second moments suggests tht the men nd the vrince 2 of the fundmentl vrible re the driving force of the moments of the equilibrium ctions. The liner form of the best response function trnsltes into liner reltionship in the rst nd second moment of the stte of the world nd the equilibrium ction. In cse of the stndrd devition the liner reltionship is ected by the correltion coe cients nd which ssign weights to the interction prmeter A nd, respectively. The set of ll correlted equilibri is grphiclly represented in Figure 3. The restriction on the correltion coe cients, nmely 2, emerged directly from the bove chnge of vrible, see (19)-(21). However, lterntively, but equivlently, we could hve disregrded the restrictions implied by the chnge of vribles, nd simply insisted tht the mtrix of second moments of (22) is indeed legitimte vrince-covrince mtrix, nd more explicitly is nonnegtive de nite mtrix. A necessry nd su cient condition for the nonnegtivity of the mtrix is tht the determinnt of the vrince-covrince mtrix is nonnegtive, or, ( 1) ( + A ) 4 0 ) 2. Lter, we extend the nlysis from the pure common vlue environment nlyzed here, to n interdependent vlue environment (in Section 5.6) nd to prior privte informtion (in Section 6). In these extensions, it 22

24 will be convenient to extrct the equilibrium restrictions in form of the correltion inequlities, directly from the restriction of the nonnegtive de nite mtrix, rther thn trce them through the relevnt chnge of vrible. In ny cse, these two procedures estblish the sme equilibrium restrictions. We observe tht t = 0, the only correlted equilibrium is given by = 1, in other words, there is discontinuity in the equilibrium set t = 0. In the symmetric equilibrium, if = 0, then this mens tht the ction of ech gent is completely insensitive to the reliztion of the true stte. But this mens, tht the gents do not respond to ny informtion bout the stte of the world beyond the expected vlue of the stte, E []. Thus, ech gent cts s if he were in complete informtion world where the true stte of the world is the expected vlue of the stte. But, we know from the erlier discussion, tht in this environment, there is unique correlted equilibrium where the gents ll choose the sme ction nd hence = 1. The condition on the vrince of the individul ction, given by (27), ctully follows the sme logic s the condition on the men of the individul ction, given by (24). To wit, for the men, we used the lw of totl expecttion to rrive t the equlity restriction. Similrly, we could obtin the bove restriction (27) by using the lw of totl vrince nd covrince. More precisely, we could require, using the equlity (17), tht the vrince of the individul ction mtches the sum of the vrinces of the conditionl expecttions. Then, by using the lw of totl vrince nd covrince, we could represent the vrince of the conditionl expecttion in terms of the vrince of the originl rndom vribles, nd obtin the exct sme condition (27). Here we chose to directly use the liner form of the conditionl expecttion given by the multivrite norml distribution. We explin towrds the end of the section tht the lter method, which restricts the moments vi conditioning, remins vlid beyond the multivrite norml distributions. 5.2 Vrince, Voltility nd Dispersion Proposition 5 documents tht the reltionship between the correltion coe cients nd depends only on the sign of the informtion externlity, but not on the strength of the prmeters ; A nd. We cn therefore focus our ttention on the vrince of the individul ction nd how it vries with the strength of the interction s mesured by the correltion coe cients ( ; ). Proposition 6 (Vrince of Individul Action) 1. If the gme displys strtegic complements, A > 0; then: () is incresing in nd j j; (b) the mximl vrince is obtined t = j j = 1: 23