Note on Signalling Games1

Structure of the game:

Period 1.a: Nature decides the type of person i.
Period 1.b: Individual observes his/her type, and responds with a message m

Period 2.a: After observing m, individual j decides on an action a

Period 2.b: Payoffs of individual players are realized based on message of player i, and action
of player j.

Example discussed in the class:

Airbus has a patent for a particular design of an aircraft, and therefore, is a monopolist in the
market in the first period. In the second period, Boeing observes the price set by Airbus and
decides on whether or not to enter the market. Needless to say, Airbus would love it if
Boeing does not enter the market.2

Separating Equilibrium

Source of uncertainty: Airbuss cost function is known to Airbus alone. However, Boeing
knows that the marginal cost of Airbus is 15 with probability of 0.6 and 5 with a probability
of 0.5.

Structure of game: Airbus sets its price in the first period. Therefore, the price set by Airbus
would serve as a signal for Boeing. After observing the signal Boeing decides whether or not
to enter. If Boeing were to enter, it incurs a setup cost of 40. Moreover, there is going to be a
price war. If Airbus is a low cost firm, then Boeing cannot sustain the price war; i.e., Boeing
cannot make enough money to offset its setup costs. However, if Airbus is a high cost firm,
then Boeing can make money by entering.

1
Source: Games of Strategy, by Dixit, Skeat and Riley, Viva-Norton, 2010, pg 334
2
While Airbus and Boeing are substitutes, they are not perfect substitutes. So, even if the prices are different
(up to a certain degree), both of them would end up getting positive demand.

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First period payoffs (only Airbus):
If marginal cost of Airbus is 5 it essentially has only one choice. (You can easily reason this
out. Airbus knows that Boeing cannot compete with it in second period if it is a low cost
firm. And, moreover, Airbus surely has an advantage in deterring Boeing from entering.
Therefore, it will never charge a high price We can even prove it rigorously, but it is not that
important.)
Price charged by Airbus is 15 and profit for Airbus is 100.3

If marginal cost of Airbus is 15 it has two choices in the first period:

It is just honest about its cost structure and charges 20. This ensures a profit of 25.
It can bluff by charging 15 instead, and try to confuse Boeing of its true nature. If it
charges 15, it makes no profit in the first period.

Second period payoffs (both Airbus and Boeing):4

If marginal cost of Airbus is 5 then:
If Boeing enters, it gets a profit of 11, and if it does not enter, it gets a payoff of 0.
Therefore, total payoff for Boeing upon entering is 11 40 = 29
If Boeing enters, then Airbus gets a payoff of only 69 due to resultant price war.
Therefore, total payoff for Airbus is 100 in the first period plus 69 in the second
period: aggregate of 169.5
If Boeing does not enter, Airbus retains its monopoly position both periods and makes
a profit of 100 in the second period. Therefore, the aggregate profit is 200.

If marginal cost of Airbus is 15 then:

If Boeing enters, it gets a profit of 45, and if it does not enter, it gets a payoff of 0.
Therefore, total payoff for Boeing upon entering is 45 40 = 5.
If Boeing enters, Airbus gets a profit of 3 due to resultant price war.6
o Therefore, if Airbus charged a price of 15 in the first period, it obtains an
aggregate profit of 0 + 3 = 3 both periods put together.

3
If the demand function in the monopoly market is P = 25-Q, this payoff makes sense.
4
Realize that I do not make any reference to prices in the second period.
5
Just to keep things simple, lets assume that there is no time value of money. Interpretations we draw based
on the results do not change even if we bring in discounting.
6
It is implicitly understood that the firm with lower marginal cost will be able to withstand price war better
than the firm with cost disadvantage.

2
 o Similarly, if Airbus charged a price of 20 in the first period, it obtains an
aggregate profit of 25 + 3 = 28 both periods put together.
If Boeing does not enter, it retains its monopoly position in the second period and
makes another 25. Therefore, both periods put together it gets a profit of 50.

I can summarize the entire thing in the game three below:

Nature

Low MC
High MC
Prob = 0.4
Prob = 0.6

Airbus

Airbus
P = 15
P = 15
25
P = 20
Boeing

Boeing
Out
In Out In

Out In

169 200
28 3 25
50
-29 0
5 5 0
0

Note: Dashed line indicates the uncertainty part for Boeing.

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 It is very clear that if Airbus charges P = 20 in the first period, then Boeing would surely
guess that the MC of Airbus is 15, and hence enter. This is because Boeing would get a
payoff of 5 from entering as against 0 from not entering. Given this, it is interesting only if
Airbus sets the price at P = 15 in the first period.

Airbus has two strategies:

Bluff: Set the price P = 15 if MC is 10, and P = 15 if MC is 15
Honest: Set the price P = 15 if MC is 10 and P = 20 if MC is 15
Similarly, Boeing has two strategies:
Unconditional entry: Enter no matter what the price in the first period is.
Conditional entry: Enter if the first period price is high (P = 20), else do not enter.

We will solve the game from ex-ante perspective; that is, even before nature determined the
type of Airbus.7 Therefore, the normal form of the game matrix looks as follows:

Boeing
Always Enter Conditional Entry
0.4 x 169 + 0.6 x 3 = 69.4 0.4 x 200 + 0.6 x 25 = 95
Bluff
0.4 x -29 + 0.6 x 5 = -8.6 0
Airbus 0.4 x 169 + 0.6 x 28 = 84.4 0.4 x 200 + 0.6 x 28 = 96.8
Honest
0.4 x -29 + 0.6 x 5 = -8.6 0.6 x 5 = 30

Here is an explanation for the Table. Consider the upper left quadrant. This implies Boeing
has entered the second period. And no matter what its costs are, Airbus will always charge a
low price of P = 15 in the first period. In such case, if Airbus is low cost, it makes a payoff
of 169 (100 in the first period and 69 in the second period), which happens with probability
of 0.4. On the other hand, if Airbus is high cost, it makes a payoff of 3 (zero in the first
period and 3 in the second period), which happens with a probability of 0.6

Consider the upper right quadrant. Since P = 15 in the first period, Boeing will not enter, and
hence makes 0. If Airbus is high cost, it makes a payoff of 25 (zero in the first period and 25

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Even if I were to solve the game from the point after Airbus realizes its cost, it really does not make a
difference.

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in the second period), which happens with a probability of 0.6. If Airbus is low cost, it makes
a payoff of 200 (100 + 100), which happens with a probability of 0.4.

Similarly, the bottom two quadrants can be filled up. DO RAISE THE ISSUE IN THE
CLASS IN CASE YOU DO NOT FOLLOW.

Now, it is easy to see that the dominant strategy for Airbus is to be honest. Therefore, Airbus
charges P = 15 in the first period if the marginal cost is 5, and P = 20 if the marginal cost is
15. Suffice it to say that the signal given by Airbus is sufficient to break the problem of
asymmetric information in the market.

Pooling Equilibrium

Consider the same problem as above with a very small change. Suppose the marginal cost of
Airbus is 10 with a probability of 0.4 and 15 with a probability of 0.6. The only difference in
that case would be, the optimal monopoly price for Airbus is 17.5 and profit is 56 (rounded
off to nearest decimal).

Therefore, the signal that Airbus can give is P = 17.5 or P = 20 in the first period. Rest of the
game remains identical. The payoffs change when compared to the previous scenario in two
different ways.
If Airbus is low cost, it charges 17.5 and makes a profit of 56. Moreover, it has
reduced ability to sustain a price war in the second stage. Therefore, it makes a payoff
of only 25 in the second period if Boeing decides to enter. Therefore, the combined
payoff for Airbus is 56+25 = 81 if it is a low cost firm, and Boeing has decided to
enter.
If the marginal cost of Airbus is 20, and it charges a low price of 17.5 in the first
period, it ends up making a profit of 2.5 per unit sold in the first period. It adds up to
a total profit of 19 (rounded off to nearest decimal) even if it charges a low price. In
the earlier scenario, Airbus would have made zero profit in the first period had it
charged low price in spite of being a high cost firm.

For this new situation, the game tree would look as follows:

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 Nature

Low MC
High MC
Prob = 0.4
Prob = 0.6

Airbus

Airbus
P = 17.5
P = 17.5

P = 20
Boeing

Boeing
Out
In Out In

Out In

56+25 =81 56+56 = 112

50 = 25 +25 28 = 25 + 3 22=19+3 44 =19+25
-15 0
0 5 5 0

The normal form representation of the game will look like:

Boeing
Always Enter Conditional Entry
0.4 x __ + 0.6 x __ =__ 0.4 x __ + 0.6 x __ = __
Bluff
Airbus 0.4 x __ + 0.6 x __ = __ 0
0.4 x __ + 0.6 x __ = __ 0.4 x __ + 0.6 x __ = __
Honest
0.4 x __ + 0.6 x __ = __ 0.6 x __ = __

Once again, I will leave it to you to determine how I filled up the four boxes. The logic is
similar to the one I had used for filling up the previous normal form game. But, what you
should be noticing is that Conditional Entry becomes strictly dominant strategy for Boeing.
Given this, you must observe that Bluff becomes dominant strategy for Airbus. Therefore,

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the final outcome of the game is, Airbus always reports low price of P = 15 regardless of
marginal cost and Boeing never enters.

As an aside, in the strategy literature, P = 17.5 by Airbus in spite of having a higher marginal
cost of 15, has a definite term. It is called as limit price. That is, Airbus charges lower than
optimal price in a period so that it deters entry or limits the entry of its competitors in the
subsequent periods. Limit pricing is certainly a very common phenomenon in the market
characterized by high entry costs. If the entry costs are high, a threat of price-war or
significant competition post entry can act as a significant deterrent for the entrant. Moreover,
if the incumbent is charging low price, there is an added confusion that the incumbent is
perhaps working with superior technology. In electricity generation sector, it is common that
most generators routinely undercharge when compared to what they potentially can, so that
new generators have no incentive to enter the market. Threat of entry by low cost carriers has
kept the prices in airline sector low in India. However, as the time passes by, the strength of
bluff weakens, and at some point, you have to observe that the prices reach to the levels
predicted by the models of competition. Also, limit pricing is common, especially in
industries protected by patents. While the prices would be high in the market, prices
plummet significantly just before the patent expiry.

Nevertheless, it is easy to note that the signal given out by Airbus is completely useless. It
gives out a signal of low price, and it does not help Boeing in anyway in order to unravel the
information about Airbus, unlike in the previous case. This is referred to as pooling
equilibrium.

Semi-separating equilibrium

While this issue has limited application, it helps a great deal in understanding the idea of
asymmetric information, and implications thereof very clearly. Everything remains exactly
as in the previous case, except that Airbus realizes lower marginal cost of 10 with a
probability of 0.1 and higher marginal cost of 15 with a probability of 0.9. I am only going to
reproduce the normal form of the game here, and will leave it to you to work out the details
of how to fill out the table.

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 Boeing
Always Enter Conditional Entry
27.9 50.8
Bluff
Airbus 3 0
33.3 36.4
Honest
3 4.5

It is easy to check that the above game does not have any equilibrium in pure strategies. It,
however, has equilibrium (unique) in mixed strategies. Suppose p is the probability with
which Airbus plays bluff, and q is the probability with which Boeing plays strategy Always
Enter. This necessarily means

3p + 3(1-p) = 0.p + 4.5 (1-p)

This implies p = 1/3. Similarly, for calculating the value of q, we need the following equality
to hold:
27.9q + 50.8 (1-q) = 33.3q + 36.4(1-q)

This implies q = 0.727.

Therefore, Airbus bluffs with a probability of 1/3. Given this, let us interpret the signal sent
by Airbus. If Airbus signals P = 20 in the first period, it necessarily means that its marginal
cost is 15. However, if Airbus signals P = 17.5 in the first period, it is either bluffing or is
genuinely low cost. Therefore, while one signal breaks information asymmetry, the other
signal maintains information asymmetry further. Therefore, this is referred to as semi-
separating equilibrium.

It is also informative to calculate various probabilities to understand belief revision:

Probability that marginal cost of Airbus is low and its price is low is 0.1

Probability that marginal cost of Airbus is low and its price is high is 0

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 Probability that marginal cost of Airbus is high and its price is low =
Probability that marginal cost of Airbus is high x Probability that Airbus bluffs
0.9 x 1/3 = 0.3

Probability that marginal cost of Airbus is high and its price is high =
Probability that marginal cost of Airbus is high x Probability that Airbus is truthful
0.9 x 2/3 = 0.6

The table below summarizes this situation:

Airbus's price
Low High
P(Airbus cost is low) =
Low 0.1 0
0.1
Airbus's cost
P(Airbus cost is high) =
High 0.3 0.6
0.9
P(Airbus price is low) = P(Airbus price is high) =
0.4 0.6

Can we now calculate the probability that Airbuss cost is low given that the price is low?