BE

510 Business Economics 1 - Autumn 2021

Problem Set 9

1. Consider the three-player game shown in the figure below. Determine all (pure-strategy)
Nash Equilibria, Subgame Perfect Equilibria and Perfect Bayesian Equilibria.

Forward Exit
A B 1, 1, 1

Down Pass

C C

ft ft

Ri
Ri

Le Le

gh
gh

t
t

3, 2, 2 0, 0, 0 4, 4, 0 0, 0, 1

2. Alan and Beth want to cook together. They shop independently and simultaneously for
ingredients but either of them is only allowed to buy ONE core ingredient (it’s a weird game
they play). For Alan the options are rice or vegetables. Beth can bring home either fish or
potatoes. They agree that rice with potatoes would make a very sad dinner. Both very much
like fish with vegetables but Beth would even more like to try out a vegetable and potato
recipe she has heard about. Alan thinks that this is a terrible idea. Fish and rice would be just
ok for both. Alan’s and Beth’s payoffs are shown in the table below.
Beth
Fish Potatoes
Rice 5, 5 −2, −2
Alan
Vegetables 10, 9 0, 10

(a) Find all Nash equilibria of this game.

(b) Suppose now that Alan moves first, i.e., buys his ingredient first and tells Beth about it
before she makes her purchase. Determine the subgame-perfect Nash equilibrium and
compare this to what you found in (a).
(c) Assume the same situation as in (b) except that Alan doesn’t inform Beth directly but
informs Charlie who in turn informs Beth. The twist is that Charlie may mix up the
ingredients: If Alan buys rice there is a 1% chance that Charlie reports “vegetables” to
Beth, and if Alan buys vegetables there is a 1% chance that Charlie reports “rice” to Beth.
(Charlie is not a strategic player; he is simply distracted sometimes.) Draw the game tree
and determine the pure-strategy Perfect Bayesian Equilibrium. Why does the result differ
from that in (b)?

 BE 510 Business Economics 1 - Autumn 2021

Problem Set 9 - Solutions

No guarantees for correctness. If you find errors in the proposed solutions, please let us know.

1. Consider the three-player game shown in the figure below. Determine all (pure-strategy)
Nash Equilibria, Subgame Perfect Equilibria and Perfect Bayesian Equilibria.

Forward Exit
A B 1, 1, 1

Down Pass

C C

ft ft

Ri
Ri

Le Le

gh
gh

t
t

3, 2, 2 0, 0, 0 4, 4, 0 0, 0, 1

This game is known as “Selten’s horse”—guess why. In this game A makes the first move by
deciding whether B or C continues the game. If B gets to move, she can either end the game
herself (“exit”) or can pass on to C. If C gets to move, he knows that either A or B must have
chosen to let him play but he doesn’t know who. What makes this tricky for player C is that
the consequences of “left” and “right”—in particular which one is the better choice for C—
depend on whether it was A who chose “down” or B who chose “pass”.
Pure-strategy Nash Equilibria
What are the Nash equilibria of this game? Let’s start with the case that player A chooses
“down”. Player C’s best response to this is “left” and player B doesn’t get to move (thus,
anything is a best response for her). Conversely, given that player C chooses “left”, is “down”
a best response for A? Well, that depends on player B’s strategy. If player B’s plan is “exit”
then “down” is a best response. But if B’s plan is “pass” then “forward” is player A’s best
response (given C’s “left”). Thus, (Down, Exit, Left) is a Nash equilibrium.
Given that player A chooses “forward” and player B “pass”, player C’s best response is “right”
but given the choice of “right”, “pass” is not a best response for player B. If player B chooses
“exit”, “right” is of course still a best response (the choice of “right” or “left” is inconsequential)
and indeed A is also best responding by choosing “forward” since “down” would yield a payoff
of 0 for A (given C’s “right”). Thus, (Forward, Exit, Right) is a Nash equilibrium.
We could also write down the normal form here to find the same solutions.
Subgame-Perfect Equilibria
This game has no proper subgames. The only subgame is the game itself. Thus, both Nash
equilibria are subgame-perfect.
Problem Set 9 - Solutions BE 510 Business Economics 1 - Autumn 2021

Perfect Bayesian Equilibria

In a PBE the usual requirements of Nash equilibrium still apply: Players must best respond to
the other players’ given strategies whenever it is their turn to move. In addition, PBE requires
(a) that players’ beliefs are made explicit for any location in the game tree they might find
themselves in, (b) that players behave in a sequentially rational way given these beliefs, and
(c) that these beliefs are consistent with the assumed strategies. The only player where these
beliefs have to be inspected more closely is player C. We will refer to his beliefs as 𝛼
(probability he attaches to being at the first decision node following “down”) and 1 − 𝛼
(probability he attaches to being at the second decision node following “pass”).
Consider the (Down, Exit, Left) equilibrium from above. Is this a PBE? In this case player C’s
information set is reached with probability 1 and is reached on one specific path (namely via
player A choosing “down”) and so PBE requires that player C attaches a probability of 𝛼 = 1
to the first decision node.
PBE also requires that player B chooses optimally given her beliefs and the other players’
strategies. What about her beliefs? Since player B has only a single decision node there is no
question about her beliefs. If she were to find herself in a position where she is asked to make
a decision, she could not have any doubts about her location in the tree.
What about player B’s optimal behavior? PBE requires that she acts rationally in this off-the-
equilibrium-path scenario, and given C’s choice of “left” she ought to choose “pass” and not
“exit”. Hence, (Down, Exit, Left) is not a PBE.
Now consider the (Forward, Exit, Right) equilibrium. This is different because now player C’s
information set is reached with probability zero, i.e., C’s information set is off the equilibrium
path. The Nash equilibrium requires C to choose “right.” What are suitable beliefs that would
make this the sequentially rational choice for player C? Well, “right” is a best response if player
C’s beliefs are such that 2𝛼 ≤ 1 − 𝛼 or 𝛼 ≤ 1⁄3. Thus, for this equilibrium to survive the PBE
refinement, the following must hold: In the event that player C is (unexpectedly) asked to
make a decision he may conclude that either A or B deviated from the (Forward, Exit, Right)
equilibrium but he is not allowed to assume that these two possibilities are equally likely;
instead he must believe that the chance of him being located at the second decision node is at
least 2⁄3. Thus (Forward, Exit, Right, 𝜶 ≤ 𝟏⁄𝟑) is a PBE.

2. Alan and Beth want to cook together…

Beth
Fish Potatoes
Rice 5, 5 −2, −2
Alan
Vegetables 10, 9 0, 10

2

Problem Set 9 - Solutions BE 510 Business Economics 1 - Autumn 2021

(a) Find all Nash equilibria of this game.

There is one pure-strategy Nash equilibrium: Vegetables and potatoes (which is not a
good outcome for Alan). There are no MSEs because Alan has a strictly dominant strategy
and given that he plays it Beth prefers potatoes.
(b) Suppose now that Alan moves first, i.e., buys his ingredient first and tells Beth about his
choice before she makes her purchase. Determine the subgame-perfect Nash equilibrium
and compare this to what you found in (a).
If Alan buys rice, Beth best responds by buying fish, and so Alan would get 5. If Alan buys
vegetables, Beth best responds by buying potatoes, and so Alan would get 0. Hence, Alan
buys rice. The result is very different from that in (a): Alan does not play Veg, the strategy
that previously was dominant for him. Veg isn’t dominant anymore because Beth can now
respond differently to Alan’s two actions, and she finds it optimal to do so. As a result, Alan
can steer Beth towards buying Fish, which he prefers to the veg-potato dish, and he thus
benefits from a first-mover advantage.
To spell it out more formally, the SPE is {Rice, (Rice: Fish, Veg: Potatoes)}.
(c) Assume the same situation as in (b) except that Alan doesn’t inform Beth directly but
informs Charlie who in turn informs Beth. The twist is that Charlie may mix up the
ingredients: If Alan buys rice there is a 1% chance that Charlie reports “vegetables” to
Beth, and if Alan buys vegetables there is a 1% chance that Charlie reports “rice” to Beth.
(Charlie is not a strategic player; he is simply distracted sometimes.) Draw the game tree
and determine the pure-strategy Perfect Bayesian Equilibrium. Why does the result differ
from that in (b)?
Below you can see a game tree where Alan moves first and Nature (in the form of Charlie)
moves afterwards, which is perhaps the most natural way to think about it. Alternatively,
one could also draw a tree where Nature moves first. This is equally valid and is shown
on the next page.

5 , 5 F is 5 , 5
h
h F is
“Rice“ “Veg“
B N B
99⁄100 1⁄100 Pot
es [𝛼] [𝛽] ato
ato
−2 , −2 Pot Rice es −2 , −2

10 , 9 F is Vegetables 10 , 9
h [1 − 𝛼] [1 − 𝛽] h
F is
“Rice“ “Veg“
B N B
1⁄100 99⁄100 Pot
es
ato ato
0 , 10 Pot es 0 , 10

3

Problem Set 9 - Solutions BE 510 Business Economics 1 - Autumn 2021

First, consider the possibility that Alan chooses Rice in a PBE. Then, Beth’s beliefs would
have to be 𝛼 = 1 and 𝛽 = 1: When Charlie tells her “Rice” she believes him and when
Charlie tells her “Veg” she doesn’t believe him (given Alan’s assumed strategy of choosing
Rice). As a best response she will buy fish independently of the message she receives.
Given this strategy (fish-fish), what is Alan’s best response? Not rice, but vegetables! Thus,
this is not an equilibrium.

10 , 9 F is 5 , 5
h h
F is
Vegetables Rice
B (“Veg”)
A [9 B
9⁄ (“Rice”) Pot
at oes [1 − 𝛽] Correct
10
0] [𝛼] ato
Pot es
99
0 , 10 −2 , −2
messages 100

N
Incorrect 1
5 , 5 F is 10 , 9
h [𝛽] messages 0] [1 − 𝛼] h
F is
100
10
[1⁄
B A B
Rice Vegetables Pot
es
ato (“Veg”) ato
Pot
(“Rice”) es 0 , 10
−2 , −2

Alternatively, Alan chooses vegetables in a PBE. Then, Beth’s beliefs would have to be 𝛼 =
0 and 𝛽 = 0: When Charlie tells her “Veg” she believes him and when Charlie tells her
“Rice” she doesn’t believe him (given Alan’s strategy of choosing vegetables). As a best
response she will buy potatoes independently of the message she receives. Given this
strategy (potatoes-potatoes), what is Alan’s best response? Vegetables! Thus, the only
pure-strategy PBE is the strategy-belief combination:
{Vegetables, (“Rice”: Potatoes, “Veg”: Potatoes), 𝛼 = 0, 𝛽 = 0}.
Notice that the subgame perfect equilibrium of part (b) is not obtained, and Beth gets
what she wants! Alan has lost his first-mover advantage. A tiny bit of uncertainty in the
information transmission is enough to destroy the SPE. The reason is that with
incomplete information Beth can attribute any unexpected message that would seem to
indicate a deviation from the equilibrium path to the imperfection in the information
transmission. With complete information (part b), however, this is not possible. Thus,
while the (Veg; Potatoes/Potatoes) equilibrium of the sequential-move game is not
subgame-perfect because it is based on an empty threat (“I am going to choose potatoes
no matter what you buy, Alan”), the credibility of the threat is reestablished here (“I am
going to choose potatoes no matter what Charlie tells me because I know there is a
positive chance that Charlie’s message is wrong”).