Discussion Paper No. 965

GRADUAL ADJUSTMENTAND EQUILIBRIUM UNIQUENESSUNDERNOISY MONITORING

Ryota Iijima
Akitada Kasahara

The 18th ISER-Moriguchi Prize (2015)
Awarded Paper

March 2016

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan

Gradual Adjustment and Equilibrium Uniqueness under
Noisy Monitoring∗
Ryota Iijima and Akitada Kasahara†
April 4, 2016

Abstract
We study the implications of flexible adjustment in strategic interactions using a classof finite-horizon models in continuous time. Players take costly actions to affect the evolution of state variables that are commonly observable and perturbed by Brownian noise.
The values of these state variables influence players’ terminal payoffs at the deadline, as
well as their flow payoffs. In contrast to the static case, the equilibrium is unique under a general class of terminal payoff functions. Our characterization of the equilibriumbuilds on recent developments in the theory of backward stochastic differential equations(BSDEs). We use this tool to analyze applications, including team production, hold-up
problems, and dynamic contests. In a team production model, the unique equilibrium
selects an efficient outcome when frictions vanish.

[Keywords: continuous-time game, gradual adjustment, equilibrium uniqueness, coordination problem, team production, hold-up problem, contest]∗

A previous version of this paper was circulated under the title “Gradualism and Equilibrium Uniqueness in
Stochastic Differential Games.” We are deeply grateful to Drew Fudenberg, Ben Golub, and Tomasz Strzalecki
as well as Akihiko Takahashi for continuous encouragement and invaluable advice. We thank a co-editor
and four referees for insightful and detailed comments that have substantially improved the paper. We also
acknowledge helpful comments from Nageeb Ali, Darrell Duffie, Mira Frick, George Georgiadis, Johannes Hörner,
Yuhta Ishii, Yuichiro Kamada, Kazuya Kamiya, Michihiro Kandori, David Laibson, Nicolas Lambert, Rida
Laraki, Jonathan Libgober, Bart Lipman, Chiara Margaria, Eric Maskin, Akihiko Matsui, Stephen Morris,
Nozomu Muto, Wojciech Olszewski, Daisuke Oyama, Larry Samuelson, Yuliy Sannikov, Andy Skrzypacz, Bruno
Strulovici, Takuo Sugaya, Akihiko Takahashi, Masashi Toda, Zhe Wang, Daichi Yanagisawa, Jeff Zwiebel, andseminar/conference participants at various places. This paper was awarded the 18th Moriguchi Prize by theInstitute of Social and Economic Research of Osaka University. All remaining errors are ours.
†
Iijima: Department of Economics, Harvard University, Email:riijima@fas.harvard.edu, and Kasahara: Graduate School of Business, Stanford University, Email:akitadak@stanford.edu.

11Introduction

In a variety of economic settings, strategic interactions are often modeled as one-shotgames. According to this approach, time is not explicitly modeled and the outcome ofa game is instantaneously determined as a consequence of players’ static and simultaneous decisions. However, this approach abstracts away from the fact that players often
take a certain amount of time to finalize their actions in real-world settings, such as investment or production. In these situations, players may want to gradually adjust theirpositions while additional noisy information arises. To examine the implications of such“gradual adjustment,” we propose and analyze a broad class of finite-horizon games withstochastically evolving states.
As a motivating example, consider several firms engaged in a joint project with a fixedend date, such as the development of a new product with a pre-determined release date.
Each firm continuously makes investments to improve the quality of the product, all theway up until the deadline. On the release date, demand for the new product is affected bymarket conditions and the overall quality of the product. If firms simultaneously choose
their total investment levels at the start, then they face a coordination problem in the formof equilibrium multiplicity, especially when their decisions are strategic complements.
Our key insight in this study is that gradual adjustment eliminates this coordination
problem: We show that a unique equilibrium can be obtained when firms can adjust theirinvestment levels gradually. To formalize this insight, Section 2 builds a general class ofcontinuous-time stochastic games which fit a variety of applied settings studied in theliterature, including capital investment, sticky price competition, and R&D races. We
consider a model with a fixed deadline and a commonly observed state variable whose
evolution depends on players’ actions and Brownian noise. Up until the deadline, players
make flexible and frequent adjustments to the state by influencing the drift of the statevariable process subject to convex adjustment costs. The costs can depend on the statevariables (and can thus also be interpreted as a net flow payoff), and there is a lumpsum return that depends on the final values of the state variables at the deadline. Thismodel can be interpreted as a dynamic elaboration of a one-shot game, in which players
simultaneously and directly choose the values of the state variables. We solve for the Nashequilibrium of this class of games, allowing for history-dependent strategies.
In Section 3, we show that, under a general class of terminal payoff functions, themodel has a unique equilibrium. Notably, this is true even if the adjustment costs and2noise are arbitrarily small—and, perhaps more interestingly, if the corresponding oneshot model generates multiple equilibria. In addition, the unique equilibrium has theMarkovian property, that is, each player’s adjustment at each moment in time depends
only on the current time and state and is independent of past histories.
We identify the following key assumptions needed for the uniqueness result: (i) gradualadjustment; (ii) bounded time horizon; (iii) no instantaneous strategic interdependence;and (iv) noisy state evolution. In the absence of any of these key assumptions, we canconstruct counterexamples where equilibrium multiplicity arises. For the basic intuition
behind this, consider a discrete-period environment in which players commit to fixedactions during each period. In this environment, one’s optimal choice of current action
depends on the opponents’ actions in the same period, which creates the potential for
equilibrium multiplicity. However, this coordination incentive vanishes when the period
length is very small. This follows from the fact that the opponents’ current actions
influence the state by only a small amount during any given period, and the continuation
values are continuous in the state, because discontinuities are smoothed out by Brownian
noise. Moreover, in any equilibrium the continuation values at the deadline are uniquelydetermined by the state variables, by definition. Given that payers’ flow payoffs are
independent of the opponents’ current actions, these observations enable us to solve thegame by “backward induction” and to uniquely compute the continuation values andoptimal actions for earlier periods from those for the deadline in the limit.
Section 4 illustrates the scope of our general model by analyzing three specific applications. As a prime application, we consider a team production game in Section 4.1.
Each player exerts costly effort to increase the value of a one-dimensional state variable,
representing the team’s total output, which generates a common-value benefit to the players at the deadline. There might exist multiple equilibria in the static benchmark case,even when the cost function is arbitrarily small. In our model, such a coordination failure
disappears and there is a unique equilibrium. Moreover, provided the costs and noise
are sufficiently small, this equilibrium is approximately efficient. Intuitively, this is because some noise realizations can substitute for current efforts on the part of the players
and promote subsequent efforts on their part. When the state is sufficiently close to thesocially efficient outcome near the deadline, the players can strongly coordinate on theefficient outcome with small costs and noise, which will unravel any inefficient equilibrium
because the players will anticipate that even small noise fluctuations will trigger repeated3

coordination toward the efficient outcome.
In Section 4.2, we study a hold-up problem, in which a seller can improve the quality ofa good but the price of the good is fixed ex-ante, independently of the quality. While thestatic benchmark case predicts no investment in quality, we show that in our setting with
gradual adjustment the seller chooses positive investment levels. This illustrates a formof commitment power embedded in the gradually evolving state. We provide a closedform solution of the equilibrium strategies in this game. Finally, Section 4.3 studies amodel of a dynamic contest, in which players exert costly effort to improve the qualityof their own project, and a winner is chosen by comparing all players’ quality levels at
the deadline. In contrast to the static benchmark case, players have dynamic strategic
incentives to discourage their opponents from making efforts in the future. This effect is
non-stationary because of the deadline, and we quantify the size by numerically computing
the equilibrium payoffs and strategies through partial differential equations (PDEs).
From a technical point of view, we employ techniques recently developed in the theory of backward stochastic differential equations (BSDEs). BSDEs are a form of (possibly
non-Markovian) stochastic differential equation defined backwards in time from stochastic
terminal conditions. The theory of BSDEs has been developed as a powerful approach tostochastic control problems in cases where the Hamilton-Jacobi-Bellman (HJB) equations
are not applicable. To the best of our knowledge, this study is the first to use BSDEs
to obtain equilibrium uniqueness in continuous-time games.1 In contrast to the standard
approach in continuous-time games, which is based on recursive dynamic programming,
we relate the optimality condition and equilibrium directly to BSDEs. As an importantconsequence, we do not need to require smoothness of the value functions, which is necessary the HJB equation approach but is often difficult to ensure, in particular in thecase of multi-dimensional state variables. In addition, we apply the BSDE comparison
theorem (Kobylanski, 2000) to obtain our efficiency result and other comparative statics
in Section 4.1.
The Supplementary Appendix contains results for variations of the main model, as
well as omitted proofs. In particular, we show, using a discrete-time model, that theuniqueness result holds under a Poisson noise environment as well if the period length is1

The theory of BSDEs was first introduced by Bismut (1973) for the linear case, and later by Pardoux andPeng (1990) for the uniform Lipschitz case. Duffie and Epstein (1992) used BSDE in constructing recursive
utility in continuous time, and Chen and Epstein (2002) incorporate ambiguity aversion. Recently, Williams(2011) and Cvitanic, Wan, and Zhang (2009) used BSDEs in the context of dynamic contracts, while our focus
is on strategic interactions among multiple long-run players.

4small enough.

1.1

Related Literature

We formulate a continuous-time model in which the players’ actions are imperfectly monitored with Brownian signals as in Sannikov (2007). Our paper identifies situations inwhich the strategic interdependence during a short time interval is small, which implies
the equilibrium uniqueness via the backward induction argument. This logic is different
from several studies in the repeated-game literature that examine the role of Brownian
signals in sustaining intertemporal incentives when actions are flexible.2 Sannikov andSkrzypacz (2010) show that Brownian signals are not effective for this purpose unless they
are used for linear value transfers between agents. When such a transfer is not feasible because of structural restrictions, several studies have shown that equilibria are either static
or Markovian when players’ actions are flexible enough. For example, this is the casewhen there is only one long-run agent (Fudenberg and Levine, 2007, 2009; Faingold andSannikov, 2011; Bohren, 2014) or a signal is one-dimensional (Sannikov and Skrzypacz,2007). Those structural restrictions play no role in the uniqueness result in our paper.3
The model in our paper can be seen as a differential game in which flow payoffs are
independent of the opponents’ current actions. As we will see, the model is applicableto many economic examples in the literature (see Dockner, Jorgensen, Long, and Sorger(2001) for a survey). In important economic settings such as capital accumulation or
duopoly with a sticky price, there typically exist many equilibria (Fudenberg and Tirole,
1983; Tsutsui and Mino, 1990). This paper contributes to the literature by providing auniqueness result. Lepeltier, Wu, and Yu (2009) and Hamadene and Mu (2015) consider
imperfect monitoring models similar to ours, and use BSDEs to show equilibrium existence. In these models, flow payoffs do depend on the opponents’ actions, which precludes
equilibrium uniqueness in general. We also note that their proof method does not imply uniqueness, even under the setting in our paper. Papavassilopoulos and Cruz (1979)
show that, in a certain class of deterministic models, an equilibrium is unique within the2

We choose an imperfect monitoring set-up in order to avoid technical issues that can arise in formalizing
perfect monitoring in continuous time (e.g., Simon and Stinchcombe (1989) and Bergin and MacLeod (1993)).
In Supplementary Appendix C.2.1, we show a sense in which the monitoring imperfectness itself is not importantfor our uniqueness result, by using a discrete-time model with noisy state evolution.
3
We also note that the uniqueness result continues to hold in our model, even under Poisson noise (seeSupplementary Appendix C.2.2), which is in sharp contrast to the findings of Fudenberg and Levine (2007) andFaingold and Sannikov (2011).

5

class of Markov strategies that are analytic functions of the state, provided that such anequilibrium exists.4 We note that equilibrium strategies are often not differentiable even
if there is noise. Also, discontinuity is an important source of equilibrium multiplicity, as
we show in Example 3.
There are some studies on finite-horizon models with frequent actions that examine
the effects of commitment power caused by switching or adjustment costs (most of these
papers do not allow players to receive flow payoffs in addition to the costs). We note thata similar effect is at work in our model, because players cannot make appreciable changes
in their state during a short time horizon, on account of the adjustment costs and theboundedness of the players’ controls. Caruana and Einav (2008a) study Cournot competition using a deterministic differential game model with quadratic payoffs in which firms
change the target production level before the market opens. In this study, we consider amuch wider class of payoffs and costs under history-dependent strategies with imperfectpublic monitoring, focusing on equilibrium uniqueness. Lipman and Wang (2000) study
finitely repeated games with finite actions and switching costs. They consider the effectof increasing the frequency of repetitions, which makes the switching cost disproportionally larger than a stage game payoff for each period.5 While they obtain an equilibrium
selection result in binary-coordination games, the equilibrium is not unique in general.
In Kamada and Kandori (2014), players have opportunities to revise their positions simultaneously, at the times of arrival of synchronous Poisson shocks during the preparation
phase. In contrast to our uniqueness result, they show that a broad range of outcomes canemerge as equilibria even if the static benchmark game has a unique equilibrium. In theirmodel, adjustment is not gradual and can take any size, which makes it possible to implement effective punishments against deviations even when the remaining time is short.
In contrast, our uniqueness result suggests that gradualness in adjustments can eliminate
such punishment incentives during the preparation phase. Calcagno, Kamada, Lovo, andSugaya (2014) consider a model of sequential moves that occur with asynchronous Poisson arrivals, and show that a unique equilibrium selects Pareto efficient outcome under acertain class of two-player coordination games.6
4

Wernerfelt (1987) extends this result to a certain stochastic setting. That is, an equilibrium is unique within
the class of Markov strategies that are C 2 in the state variables if such an equilibrium exists.
5
To this effect, Caruana and Einav (2008b) analyze a model in which players announce their intended actions
to be taken at the deadline and the switching cost of changing an action plan is increasing with time. Their
model is a finite-period sequential-move game, and thus generically has a unique equilibrium.
6
They provide an example of multiple equilibria when there are more than two players. Lovo and Tomala(2015) prove the existence of Makov perfect equilibria in a more general framework.

6Our focus is different from that of many papers that study gradual contributions topublic goods.7 While the details of the models vary, the existing research typically questions whether and how gradual contributions can help to mitigate free-rider problems andfocuses on the most efficient equilibrium among possible multiple equilibria. In contrast,
we show how gradual adjustments and noise help achieve equilibrium uniqueness.

2

Model

2.1

Setup

We consider a continuous-time game over a finite horizon [0, T ] played by a finite set ofplayers N = {1, 2, ..., n}. Let Xt ∈ Rd denote the value of the d-dimensional state variable
at time t. As we discuss in Section 2.2 below, the interpretation of this variable can varywith the application, representing for instance accumulated capital, project quality, or
sticky price levels. The players gradually adjust the state variable subject to random
shocks. Specifically, we assume Xt follows a process of the form
dXt = µ(At , Xt )dt + ΣdZt ,(1)where At = (Ait )i∈N is the profile of control actions chosen by the players at time t, andAit ∈ Ai is the control chosen by player i at time t.8 The control range Ai is assumed
to be a compact interval in R. Moreover, Zt = (Ztk )k=1,..,d is a d-dimensional Brownian
motion, and Σ is a d × d matrix that describes the correlation of the shocks to the statevariable. The game starts with an exogenously given initial state X0 ∈ Rd .
We impose the following restrictions on the state process in (1).
Assumption 1.
1. There exist µi ∈ Rd for each i ∈ N and a bounded, Lipschitz continuous functionPµ0 : Rd → Rd such that µ(A, X) = i∈N µi Ai + µ0 (X).
2. The correlation matrix Σ is invertible.
7
For example, see Admati and Perry (1991), Fershtman and Nitzan (1991), Marx and Matthews (2000),
Lockwood and Thomas (2002), Compte and Jehiel (2004), Pitchford and Snyder (2004), Matthews (2013), andBattaglini, Nunnari, and Palfrey (2014). Guéron (2015) considers a discrete-time infinite horizon model andobtains an equilibrium uniqueness result under an imperfect monitoring set-up.
8
We use the so-called weak formulation, which is the standard way that a continuous-time game withimperfect monitoring is formulated in the literature (see Appendix B.2 for more formal description).

7

The first condition requires that the drift term be additively separable across players
and linear in their actions. As we will see, the separability ensures that each player’s
instantaneous control choice at any given moment is independent of the control choicesof the other players at that moment, which is important for equilibrium uniqueness. The
second condition rules out perfect correlation among the components of the state variables.
At each time t, player i incurs an instantaneous adjustment cost ci (Ait , Xt )dt, where
ci : Ai × Rd → R. At the end of the game, that is, at time T , each player receives aterminal payoff U i : Rd → R as a function of the terminal state XT . To summarize,
player i’s total payoff is
U i (XT ) −Z T

ci (Ait , Xt )dt.

0

We impose the following conditions on ci and U i .
Assumption 2.
2 iic (A ,X)
1. ci is C 2 and has bounded derivatives such that inf Ai ,X ∂ (∂A
> 0.
i )2

2. U i is bounded and Lipschitz continuous.
The first condition ensures that the adjustment cost is strictly convex in the control
size. The second condition is a technical requirement.
At time t, player i observes the state Xt but does not directly observe the control
actions Ajt of the other players. Formally, player i’s (public) strategy is an Ai -valued
stochastic process Ai = (Ait )t∈[0,T ] that is progressively measurable with respect to F X ,the filtration generated by the public history of Xt . Note that this setup allows the players’
actions to depend on past histories of the Xt process.
Under any profile of feasible strategies A = (Ai )i∈N , we can define player i’s continuation value at time t as
Wti (A) = E



Z T
i
i
i
X
U (XT ) −c (As , Xs )ds Ft .

(2)t

A profile of feasible strategies A = (Ai )i∈N is a Nash equilibrium if each player maximizes
her expected payoff (2) at t = 0 given the other players’ strategies. Since the distributionof the publicly observable Xt process has full support in our setup, the Nash equilibrium concept is identical to its refinement known as public perfect equilibrium, which isfrequently used in the literature on dynamic games.

8

2.2

Discussion of the ModelIn this subsection, we discuss two interpretations of the model. Our main motivation is to
study the effects of introducing a flexible adjustment phase into a static game framework.
To see this, consider the special case in which ci does not depend on Xt and µ0 is identically
0. Such a game can be viewed as a “dynamic elaboration” of the following static game:9
Player i chooses Ai0 ∈ Ai at time 0 and receives a payoff of U i (XT ) − T ci (Ai0 )Pat time T , where XT = X0 + T i µi Ai0 .10
In this game, player i can be seen as committing to the particular control level Ai0 during
the entire interval [0, T ]. Without substantial restrictions on the functional forms of theU i , this static game can have multiple Nash equilibria. Our model elaborates on this staticgame by introducing a noise term Zt and allowing players to change their action Ait during
the preparation phase [0, T ]. As shown in the next section, this natural modification leads
to equilibrium uniqueness under a broad class of terminal payoff functions. Moreover,because the state is observable during the preparation phase [0, T ], players are facedwith dynamic strategic interactions that are absent in the static benchmark. We analyze
this dynamic aspect in Section 4, within the context of three applications, namely teamproduction, hold-up problems, and dynamic contests.
Alternatively, we can interpret −ci as player i’s net flow payoff. Under this interpretation, our model accommodates many games studied in the literature on differential
games, including the two examples given below. (See Dockner, Jorgensen, Long, andSorger (2001) for other examples.) We note that the papers mentioned below consider astationary environment without noise, and thus do not obtain equilibrium uniqueness.
Example 1 (Capital accumulation). Consider firms competing to expand their capitallevels. Let d = n, so that the number of players coincides with the dimension of the statevariable. Xti is the capital level of firm i, which follows dXti = Ai dt + dZti , and Ait is
the net investment made by i at time t. Each firm receives flow revenue as a functionof the profile of the current capital levels Xt , and incurs a flow investment cost that isconvex in Ait . Thus ci (Ait , Xt ) represents the flow revenue minus the investment cost attime t. Spence (1979) proposes this class of games, and Fudenberg and Tirole (1983) show
9

Similarly, Caruana and Einav (2008a,b), Kamada and Kandori (2014) and Calcagno, Kamada, Lovo, andSugaya (2014) analyze games in which players adjust their plans for future actions. The relationship between
these studies and ours is more extensively discussed in the Related Literature section.
10
An alternative
P but similar formulation of a corresponding static game includes a noise term by setting
XT = X0 + T i µi Ai0 + ΣZT . Similarly, multiple equilibria are possible with this formulation.

9

that there exists a continuum of multiple (Markov perfect) equilibria, in contrast to ouruniqueness result with a fixed horizon and noise.

Example 2 (Duopoly with a sticky price). Fershtman and Kamien (1987) propose amodel of duopolistic competition in a homogeneous good whose price adjusts gradually.11 Our framework extends their model by introducing noise (due to noise traders,for example) and using a one-dimensional state Xt as the price of the good at time t.
Ait represents firm i’s supply at time t. The price adjustment takes the form dXt =PPX̄ − i Ait − Xt dt + dZt , where X̄ is a fixed parameter. Here X̄ − i Ait denotes thePprice level induced by a linear demand curve based on the current output i Ait . The
flow payoff for firm i at time t, which consists of the revenue minus the production cost,is independent of (Ajt )j6=i since the current price Xt is unaffected by the firms’ current
output choices.

3

Equilibrium UniquenessIn this section, we establish equilibrium uniqueness. Section 3.1 states the formal result,while Section 3.2 provides intuition for the result, and Section 3.3 discusses the role ofour key assumptions.

3.1

Uniqueness Result

We follow DeMarzo and Sannikov (2006) in characterizing the optimality of each player’s
strategy by using the martingale representation theorem (e.g., Karatzas and Shreve (1991)).
For any profile of feasible policies A = (Ai )i∈N , the evolution of player i’s continuation
value satisfies
dWti (A) = ci (Ait , Xt )dt + βti (A) · dZt(3)along with the terminal condition
WTi (A) = U i (XT ).
11

Tsutsui and Mino (1990) construct multiple equilibria of this game.

10

(4)

Here β i (A), whose existence and uniqueness are ensured by the martingale representation,
RTis an F X -progressively measurable d-dimensional process such that E[ 0 |βti |2 dt] < ∞.12
Intuitively, βti,k (A) measures the sensitivity of player i’s continuation payoff to fluctuations
in Ztk at time t.
Rewriting dXt = µ(At , Xt )dt+ΣdZt as dZt = Σ−1 (dXt −µ(At , Xt )dt) and substituting
the latter into equation (3), we obtain




X
dWti (A) = ci (Ait , Xt ) − βti (A) · Σ−1 µj Ajt + µ0 (Xt ) dt + βti (A) · Σ−1 dXt ,jwhere we used Assumption 1. To characterize the players’ incentive compatibility constraint, we define player i’s response function f i : Rn×d × Rd → Ai as
f i (b, x) = arg max


bi · Σ−1 µi αi − ci (αi , x)αi ∈Aifor each b = (bi )i∈N ∈ Rn×d and x ∈ Rd . The maximand is taken from (the negativeof) the drift term in the expression for the continuation value above. The function f i is
well-defined because we assume strict convexity of ci in Ai (Assumption 2). Using these
response functions, the optimality of the strategies can be characterized in terms of thefollowing “local incentive compatibility condition” (Lemma 7 in Appendix): i’s strategy
Ai is optimal against A−i if and only if
Ait = f i (βt (A), Xt ) almost surely for almost all t.

(5)Lemma 1. A strategy profile (Ai )i∈N is a Nash equilibrium if and only if (3), (4), and(5) hold for some F X -progressively measurable processes W, β such thatZ T
E[ sup |Wt | ], E[|βt |2 dt] < ∞.
2

0≤t≤T

0

Combining equations (1), (3), (4), and (5) leads to a multi-dimensional backward
stochastic differential equation (BSDE)




X
dWti = ci (f i (βt , Xt )) − βti · Σ−1 µj (Xt )f j (βt , Xt ) + µ0 (Xt ) dt + βti · Σ−1 dXt
j

WTi = U i (XT )12(6)

In this paper we use | · | to denote both the Euclidean norm for vectors and the Frobenius norm for matrices.

11

under a probability measure for which the Xt process is a Brownian motion.13 A solution (W, β) to this BSDE describes the stochastic evolution of the continuation payoffs.
Moreover, the control Ait given by f i (βt , Xt ) is incentive compatible for player i and isconsistent with the evolution of the continuation payoffs.
We build on the results of Delarue (2002) and Cheridito and Nam (Forthcoming) toshow that this BSDE has a unique solution (W, β), which establishes our main claim ofequilibrium uniqueness.
Theorem 1. Under Assumptions 1 and 2, there exists a unique Nash equilibrium. Moreover, this equilibrium has the Markovian property, that is, the continuation values andthe strategies take the form Wti (A) = wi (t, Xt ) and Ait = ai (t, Xt ) for some function
wi : [0, T ] × Rd → R that is Lipschitz continuous in x ∈ Rd uniformly in t ∈ [0, T ] andsome function ai : [0, T ] × Rd → Ai .
The intuition underlying the uniqueness result and the key assumptions on which it
relies are discussed in detail in Sections 3.2 and 3.3. Recall that we allow players’ actions
to depend on past histories of Xt in a non-trivial manner. However, by Theorem 1 theunique equilibrium turns out to be Markovian.

3.2

Heuristic Explanation of UniquenessTo glean some intuition for the uniqueness result (Theorem 1), consider a discrete-timeversion of the model with a short period length ∆. This departs from the original model
only in that each player’s action remains constant within each discrete period. To simplify
the notation, we assume that d = 1 and Σ = 1. At the start of the final period, t = T − ∆,player i chooses Ait to maximize the value ofWti,∆ = −ci (Ait , Xt )∆ + E U i (XT ) |Xt = −ci (Ait , Xt )∆ + E U i Xt + 


X





µj Ajt + µ0 (Xt ) ∆ + t  Xt j∈Ngiven the opponents’ actions (Ajt )j6=i , where t is distributed N (0, ∆). Note that thesecond term depends on the actions of all the players, (Ait )i∈N . It is precisely becauseof this strategic interdependence that the subgame at the last period can have multiple
13

See Appendix B.1.1 for a formal description.

12

equilibria when ∆ is not small.
We claim that if ∆ is sufficiently small, then the strategic interdependence is “small”
and the equilibrium action profile at t = T − ∆ is unique. To see this, for now assume
that U i is twice differentiable. Then we can directly compute∂2∂Ait , ∂Ajt
E U i (XT ) |Xt = E (U i )00 (XT ) |Xt µi µj ∆2 = O(∆2 ).

Intuitively speaking, this is because each player’s action influences the state to first orderin ∆, and the interactions among their influences is of order less than ∆, since the drift inthe value of the state variable is separable across players. On the other hand, the second2

i,∆∂
is of the order of ∆ because of the strict convexity oforder partial derivative ∂(Ai )2 Wttthe adjustment cost. The first-order condition implicitly defines i’s best response against
the opponents’ actions at time t. By the implicit function theorem, its slope is bounded
by
∂2
Wti,∆
∂Ait ∂Ajt∂2
Wti,∆∂(Ait )2,

which is close to 0 when ∆ is small. This means that each player’s incentive is nearly
insensitive to her opponents’ actions, and thus the equilibrium actions at time t are
uniquely determined by the contraction mapping theorem.
In the above argument, the presence of noise becomes important when U i is not suffi
ciently smooth, because it is this noise that ensures the differentiability of E U i (XT ) |Xt
in (Aj )j∈N by convolution.14 The convexity of ci ensures that each player’s incentive problem is a well-behaved concave problem for small ∆, which implies that the best-response
function is continuous. Moreover, the continuation value at t depends on only the current
state Xt , and is Lipschitz continuous by the implicit function theorem. We can then repeat
this argument backward from the final period to recursively pin down the continuation
values.15

3.3

Key Assumptions Underlying the UniquenessIn this subsection, we identity four key assumptions underlying the result:
14

In general, this term is smooth even when U i is discontinuous. When U i is only Lipschitz continuous, we2
can show that ∂Ai∂,∂Aj E U i (XT ) |Xt = O(∆3/2 ). See Appendix B.4 for the details.
15

t

t

Strictly speaking, the Lipschitz coefficient should not grow too fast as we repeat the backward induction
steps to continue this argument. See Supplementary Appendix C.2.1 for the details.

13(i) Gradual adjustment(ii) Bounded time horizon(iii) No instantaneous strategic dependence(iv) Noisy state evolution
By the term “gradual adjustment” in (i), we mean that a player’s decision at each time
has only a small influence on the value of the state variable. In the discrete-time model
discussed in Section 3.2, this influence is of order ∆. In the case of the Poisson noisemodel (see Supplementary Appendix C.2.2), it is also of order ∆ in expectation, and we
prove that there exists a unique equilibrium if ∆ is small enough. If ∆ is large, we cannot
ensure uniqueness in general, for the same reason that a one-shot game can have multiple
equilibria. To understand why (ii) is necessary, consider the case in which the terminal
deadline T is randomly distributed and has unbounded support. Then it is not possible toapply the “backward induction” argument, which requires a definite terminal date. (SeeSupplementary Appendix C.1 for an explicit construction of multiple equilibria in the caseof a random time horizon with an unbounded distribution.) By (iii), we mean the additive
separability of the drift term of the Xt -process and the fact that ci does not depend on
the current actions of the other players, (Ajt )j6=i . When (iii) is violated, each player’s local
incentive constraint arg maxαi ∈Ai (β i · Σ−1 µ(αi , A−i , Xt ) − ci (αi , A−i , Xt )} defines an“augmented game” that, given (β, X), does not in general uniquely pin down the optimal
action profile.16 For (iv), recall that as established by Theorem 1, the continuation valuefunctions become continuous in the state variable in the presence of Brownian noise.
Without noise, it is possible that continuation value functions are discontinuous in states.
This can lead to a continuum of multiple equilibria, as in Example 3 (Section 4.1). We
also note that there is a technical issue in formulating non-Markovian strategies without
noise in continuous time (e.g., Simon and Stinchcombe (1989)).
16

Even when flow payoffs directly depend on the actions of others, we can generalize the equilibrium uniquenessresult if every pair (β, X) induces a unique enforceable action profile in the sense of Sannikov (2007), and thisunique profile is Lipschitz continuous in β and X. For example, this is the case when the payoff is an additively
separable function of opponents’ actions and own action. The same argument applies to the case in which thedrift of the Xt process is not separable across players. Analogous conditions appear as Condition 2 in Faingold
and Sannikov (2011) and Assumption 4 in Bohren (2014), and these are used to rule out multiple Markov
equilibria in games between a long-run agent and a sequence of short-run agents.

14

4

Applications

In this section we study three applications of the model. Unless stated explicitly, we
suppose Assumptions 1 and 2.

4.1

Team Production

We consider a team production model in which the state variable Xt is one-dimensional
as follows:
dXt =

X

Ait dt + σdZt ,

(7)

i∈N

where σ > 0 and Zt is a one-dimensional Brownian motion. The state variable can beinterpreted as, for example, the total production level by a team of workers, the amountof a public good, or the quality level of a joint research project. Players receive a common
terminal payoff, denoted by U : R → R. They also have the same cost function κc(·) ≥ 0,with c : A → R and a scaling parameter κ > 0, where A = [A, Ā] is the control range thatis common across the players.17
Before analyzing this model, we will demonstrate the issue of multiple equilibria andinefficiency under benchmark cases. The following simple example shows equilibrium
multiplicity under both the static benchmark and the deterministic case σ = 0 even if κ
is arbitrarily small.
Example 3. Consider a form of “debt contract” U (X) = max{0, X}. That is, players
receive a positive benefit if their total output is positive and zero payoff otherwise. Assume
that A = [0, 1] and c is strictly increasing. Also, suppose that T < −X0 < N T .
1. Consider the static benchmark model, in which player i chooses effort level Ai0 onlyP
once and the final output is determined by XT = X0 + T i Ai0 (Section 2.2). Ifκc0 (1) < 1, then there exists a Nash equilibrium Ai0 = 1 for every i. The symmetricequilibrium payoff is X0 + T N − T κc(1). On the other hand, there is always a Nashequilibrium in which Ai0 = 0 for every i. In this case, the symmetric equilibrium
payoff is X0 − T κc(0). Note that the equilibrium outcome in the latter case is Pareto
dominated by that in the former case.18
17

See Radner (1992) and Zandt (1999) for surveys of models of team production. Georgiadis (2015) andCvitanic and Georgiadis (2015) study Markov equilibria in a continuous-time model similar to ours in which
the game terminates if and only if the state variable reaches some pre-established threshold.
18
Even
Pif we consider the alternative formulation of the static benchmark model with noise, that is, XT =X0 + T i Ai0 + σZT , these two strategy profiles remain Nash equilibria when σ is small.

15

2. The equilibrium multiplicity in the static benchmark model carries over to the casewhere time is continuous but there is no noise. Consider a variation of the mainmodel in which the noise level σ is 0, and focus on Markov strategies in which thecontrol at time t depends on only t and Xt . If N ≥ 3, then for any θ ∈ (−N + 1, −1),
the symmetric strategy profile in which player i chooses control

Ait =



1

if Xt ≥ (T − t)θ


0

if Xt < (T − t)θ

is a Markov perfect equilibrium (for the details, see Appendix B.5). Thus, for a fixed
initial state, there is a continuum of equilibria parameterized by θ. If X0 ≥ T θ, theplayers always choose the maximal effort Ait = 1 on the equilibrium path, and they
achieve the symmetric equilibrium payoff X0 + T N − T κc(1). If X0 < T θ, there is noeffort at all, that is, Ait = 0, and the symmetric equilibrium payoff is X0 − T κc(0),which is lower than the former case. Note that, in this class of equilibria, thecontinuation value of each player is discontinuous at this state.19

The main model predicts a unique Nash equilibrium under arbitrary values of κ > 0and σ > 0. Below we provide some results that partially characterize the unique equilibrium payoff that is common across players. Our approach to the proofs of these results,
which is based on the BSDE comparison theorem (Kobylanski, 2000) that compares thesolutions of two different BSDEs, is of independent interest.
First, we provide (rough) bounds of the unique equilibrium payoff, and use these tocharacterize the limit equilibrium when noise and costs are small. The idea is to constructa hypothetical single-agent problem in which the agent chooses all the players’ strategies.
Formally, consider the problem of choosing a strategy profile Â = (Âi )i∈N to maximize
RT P
E[U (XT ) − 0 κ i ĉ(Âit )dt]. Let Ŵ0 denote the optimal value. Let W0 denote theequilibrium payoff under the unique equilibrium, which is symmetric across players. The
following result provides two-sided bounds on the equilibrium payoff:
Lemma 2. Consider the team production game. Then Ŵ0 + κT (N − 1)c̄ ≥ W0 ≥ Ŵ0 .
19

The nature of multiplicity is similar to that of Fudenberg and Tirole (1983) under an infinite-horizon
capacity expansion game (Example 1), in that discontinuities in the continuation value functions play a key
role.

16

We compare the BSDEs under the equilibrium and the representative agent problem.
The bounds become tight when κ is small. We can show that, under small frictions, therepresentative agent approximately achieves the efficient payoff supx∈[X0 +N T A,X0 +N T Ā] U (x),which provides an accurate lower bound on the equilibrium payoff. As a consequence, theequilibrium is shown to achieve approximate efficiency under small frictions.
Proposition 1. Consider the team production game. Then, for any  > 0, there exists
δ > 0 such that
E[U (XT )] ≥max

U (x) − x∈[X0 +N T A,X0 +N T Ā]holds under the unique equilibrium if σ, κ ≤ δ.
Recall that there can be an inefficient equilibrium even when κ is small if there is nonoise (Example 3). Proposition 1 ensures that such a coordination failure cannot occur
in our dynamic setting when frictions are sufficiently small. To informally explain why
inefficient equilibria (as in the above example) do not exist, consider the case in which
the state is sufficiently close to the socially efficient outcome near the deadline. Thenthe players can coordinate on the efficient outcome and they attain high continuation
payoffs at this state. This triggers players to coordinate to target toward the efficientstate from nearby states in earlier times. The value of the state can eventually end up
near an inefficient local maximum by an “unlucky” noise realization. In such a case,players might want to coordinate on the inefficient local maximum instead if the time left
until the deadline is insufficient to push the state toward the most efficient one. However,the probability that such an event will occur shrinks to 0 if the noise level goes to 0.
To examine the dependence of the equilibrium outcome distribution on the initialpoint X0 when frictions are not necessarily small, we conducted numerical simulations.
We specified U (x) = sin(ax)+bx−cx2 with a = 0.5, and b = c = 0.01 (Figure 1), and used
the quadratic cost function c(a) = κ2 a2 . There are two local maxima, and we cannot ruleout multiple equilibria in the static benchmark case, because the players can coordinate
on “targeting” either of the locally maximum points. In particular, the players might
coordinate on playing a Pareto-inefficient equilibrium by targeting the local maximum atx ≈ −8.30 rather than the global maximum at x ≈ 3.28.
Figure 2 shows a set of simulation results for the stated utility function with different
initial points X0 and cost levels κ. In each panel, we fix X0 ∈ {−6, 0, −5.2} and compare
the simulated distribution of XT with κ = 0.5 (grey) and that with 0.2 (black). For eachparameter specification, we compute the equilibrium strategy profile and then randomly

17generated XT 1000 times and plotted the resulting values as a histogram. We found thatwhen X0 is very close to one of the local maxima of U (XT ), as in Panels A and B, theplayers tend to coordinate on the closer of the two local maxima, regardless of cost level.
However, when the initial point is not very close to one of the local maxima, the cost levelcan significantly affect the distribution of XT . In Panel C, although X0 = −5.2 is closer
to the inefficient local maximum, players try to push the state variable toward the global
maximum in more than half of the simulations when the cost level is sufficiently small.20
Finally, we consider comparative statics of the equilibrium payoff assuming that U ismonotone. We let A(κ, N ) denote the unique equilibrium under the cost parameter κ andteam size N .
Proposition 2. Consider the team production game in which U is increasing. Then
W0 (A(κ, N )) is decreasing in κ and increasing in N .
While this result may not be surprising in and of itself, it ensures that our “equilibrium
selection” has natural properties. In general, an arbitrary selection of an equilibrium canlead to strange comparative statics results when we vary parameters locally. The proof
is based on the comparison theorem applied to the equilibrium BSDEs across different
parameters. In order to conduct the appropriate comparison, we need to ensure that βt
is always positive in the equilibrium. This is guaranteed by the co-monotonicity theorem(Chen, Kulperger, and Wei, 2005; dos Reis and dos Reis, 2013), which is useful in checking
the signs of sensitivity processes βt of BSDEs in general.
Remark 1. By the uniqueness result for a one-dimensional BSDE (Lemma 5 in the
Appendix B.1.1), the unique equilibrium result holds in the team production model evenwhen U is discontinuous in XT or depends on the entire path (Xt )0≤t≤T .

4.2

Hold-Up Problem

In this subsection we study a class of hold-up problems that highlight a form of commitment power embedded in the gradually evolving state. In particular, we obtain aclosed-form solution for the equilibrium strategy and show that a certain level of “cooperation” can be achieved, which is not possible under the static benchmark. This also
illustrates the point that Nash equilibrium outcomes in the game with gradual adjustments can be very different from those under the static benchmark model even if the20

We thank an anonymous referee for suggesting this simulation experiment.

18

U(X)
1.5
1
0.5
0
−0.5
−1
−1.5
−2
−10

−8

−6

−4

−2
X

0

2

4

6

Figure 1: Terminal payoff function with multiple local maxima

Panel A: X0 = −6250
κ = 0.5
κ = 0.2

200
150
100
50
0
−10

−8

−6

−4

−2

0

2

4

6

0

2

4

6

0

2

4

6

Panel B: X0 = 0
250
200
150
100
50
0
−10

−8

−6

−4

−2

Panel C: X = −5.2
0

250
200
150
100
50
0
−10

−8

−6

−4

−2

Figure 2: Simulated distributions of XT with different initial points X0 and cost levels κ. In eachpanel, we fix X0 ∈ {−6, 0, −5.2} and compare the simulated distributions of XT with κ = 0.5 (grey)
19 XT 1000 times and plotted them as a histogram.
and 0.2 (black). For each parameter set, we simulated
The other parameters are σ = 1, N = 2, and T = 1.

noise level is arbitrarily small.
Suppose that d = n = 2, and there are a seller (player 1) and a buyer (player 2).
Player i controls his/her own one-dimensional state dXti = Ait dt + dZti given X0i = 0.
The seller chooses investment A1t to improve the quality of a good Xt1 by incurring a flow
cost c1 (A1t ). The buyer decides the amount of the purchase, Xt2 . His adjustment costc2 (A2t ) captures the transaction costs of—or the frictions involved in loading—new goods,
such as preparing the necessary facilities. The price per unit is exogenously fixed. The
seller’s terminal payoff U 1 is her revenue, and the buyer’s terminal payoff U 2 is his utility
1∂Uof consumption. We make the following assumptions: (i) ∂X
2 > 0, that is, the seller’s
1∂U
benefit is increasing in the amount of the buyer’s purchase; (ii) ∂X
1 = 0, that is, the22seller’s revenue does not depend on the quality per se; (iii) ∂X∂ 1U∂X 2 > 0; and (iv) c1 isminimized at 0.
When the quality of a good is not contractible, incentivizing the seller to make acostly investment is a difficult problem in general. The seller and buyer could negotiate
the price of the good after observing the final quality, but this approach may not be
helpful when the buyer gains bargaining power ex post. In this subsection, we examine
an alternative scheme in which the seller and buyer agree on a fixed price ex ante andthe buyer gradually adjusts the scheduled amount of the purchase while observing theseller’s quality investment thus far. In this setting, the seller has an incentive to choose apositive level of investment under the dynamic model, because it will encourage the buyer
to purchase the good at a later time.21 This is in contrast to the static benchmark case(Section 2.2), where the seller chooses the dominant strategy, A10 = 0.
To quantify the welfare gain, we focus on the following quadratic payoffs to obtain aclosed-form solution:
U 1 (X) = X 2 , U 2 (X) = X 1 X 2 , ci (Ai ) =c̄i i 2(A )2for some c̄1 , c̄2 > 0 with Ai = R. In Supplementary Appendix D, we show that a linear equilibrium in a general quadratic game is obtained by using a system of ordinary
differential equations, which is independent of σ. Accordingly, we obtain the following
21

The logic is similar to that of Bohren (2014), who studies an infinite-horizon model in which a long-lived
seller is faced with a continuum of short-lived buyers at each moment in time. The seller has an incentive to
make an investment, since the effect is persistent over time, which will convince prospective future buyers tomake purchases. In our model, the buyer is not myopic, and his forward-looking incentive is captured by thecooperation term.

20result.
Proposition 3. Consider the hold-up problem with quadratic payoffs. Then there is aNash equilibrium A = (Ai )i=1,2 given by
A1t =

T −t
c̄1 c̄2
| {z
}

,

A2t =

cooperation term(T − t)22c̄ (c̄ )2| 1{z2 }

+

Xt1
.
c̄2

cooperation term

Moreover, the corresponding equilibrium payoffs are as follows:

W01 (A) =

T3
T 2σ2
3T 5
2
,
W
(A)
=
+
0
3c̄1 (c̄2 )24c̄220(c̄1 )2 (c̄2 )3The basic reason for the welfare improvement is that the seller can acquire commitment
power from the gradually evolving state, which encourages the seller’s investment. Also,
anticipating the positive investment incentive by the seller, the buyer has an additional
incentive to increase the purchase amount. These effects are captured by the “cooperation
terms” in the above formula, and disappear as time t approaches the deadline T .22
As an extreme form of a seller’s commitment power, we can compute the Stackelberg
equilibrium in the static benchmark game, where the seller chooses A10 = c̄1Tc̄2 , and the3buyer chooses A20 = c̄1Tc̄2 . The seller’s payoff is 2c̄1T(c̄2 )2 , which is always higher than the
5

dynamic equilibrium payoff in Proposition 3. The buyer’s payoff is 2(c̄1 )T2 (c̄2 )3 , which canbe lower than the dynamic equilibrium payoff if σ is high. This captures the value ofaction flexibility in a dynamic setting that is missing in the static case. The payoffs in thestatic benchmark case are not affected even if a noise term ZT affects the state variables.

4.3

Dynamic Contest

Next, we apply our framework to a contest model.23 In this class of games, players
compete for a fixed prize, and the value of the prize does not depend on their effort. As
an example, consider an internal labor market where colleagues compete for a promotion.
The boss gives a promotion to the employee whose project receives the highest evaluation.
In our model, each player chooses her effort level at each time to improve the quality ofher project, and the boss evaluates performance based on the final quality of each player’s
project at deadline T .
22

We note that the unbounded control ranges deviate from the original model formulation, and thus theequilibrium uniqueness is an open question.
23
See Konrad (2009) for an extensive survey of this field.

21

Consider the case of two players (d = 2). Player i exerts costly effort Ait at each time
t to improve the quality Xti of her project, which follows dXti = Ait dt + dZti given theinitial value X0i . We normalize the payoff for the winner of the prize to 1. We suppose
the winner is stochastically determined with the following additive noise:
U i (X) = Pr[X i + θi > X j + θj ],where θi is a random element that affects the contest designer’s judgment. Hence theterminal payoff for player i is increasing in the state difference XTi − XTj . By assumingthat the distribution of θ := θ1 −θ2 admits a bounded density, the terminal payoff function
U i becomes Lipschitz continuous.
In the dynamic model, the players’ equilibrium controls depend on their relative positions, which reflect their dynamic strategic incentives. To examine this point, we numerically simulated the equilibrium PDE using the symmetric quadratic cost funcitonsiexp[γX ]ci (a) = 2c̄ a2 with Ai = R and terminal payoffs with logit noise U i (X) = exp[γX
1 ]+exp[γX 2 ] ,where γ > 024 . The numerical simulation results indicate that the leader (i.e., the player
with the higher value of the state variable) generally exerts greater effort than the follower. The leader has an incentive to “discourage” the follower and get her to exert lesseffort.
Relative to the static benchmark case, we observe that the expected total payoff foreach player is higher than in the dynamic setting (Figure 3). That is, the total cost ofeffort is lower in expectation. This is because the players tend to exert less effort under
the dynamic model when the state difference becomes large (Figure 4).
Another observation from the simulations is that the equilibrium effort level ai (t, X)
is monotone in t (Figure 4). In particular, it is increasing in t when competition is fierce,that is, when X 1 ≈ X 2 . To understand this, note that the benefit of exerting effort insuch a situation is greater when t is closer to the deadline, because the magnitude of
the remaining Brownian noise is smaller. On the other hand, consider the case where|Xt1 − Xt2 | is large. Then the winner of the contest is essentially already determined if t isclose to the deadline, hence the players tend to stop choosing high effort levels, and thiscauses ai to be decreasing in t.25
24

See Appendix A. We used the unbounded control range in the simulation for simplicity.
The simulations suggest that ai tends to be increasing in t, especially when γ is small. To interpret this,note that in more random contests (smaller γ), raising the level of effort has a greater marginal effect on thewinning probability. Therefore, the players become competitive even when the difference |X 1 − X 2 | is large.
25

22

Harris and Vickers (1987) study a related model of continuous-time contest games,
called the tug-of-war model.26 In this model, the players exert effort to influence thedrift of their state variables, as in the current paper. As in our model, in each state theleader always exerts more effort than the follower. In contrast to our model, there is no
fixed deadline; one of the players wins, and the game ends if the difference between thevalues of the state variables reaches some pre-established value. Harris and Vickers focus
on time-stationary strategies, while our model allows us to investigate the effects of thelength of time remaining (before the deadline) on equilibrium behavior.
w1(0,X1,X2)+w2(0,X1,X2)
1
0.99
0.98
0.97
0.96
0.95
0.94
0.93
−2

Dynamic
Static

−1

0

1

2

X1−X2

Figure 3: Expected total payoff of the players under different initial state differences X01 − X02 . The
total payoff under the dynamic model (solid line) exceeds that under the static model (dashed line)
for each initial state. The other parameters are σ = 1 and γ = 1.

5

Conclusion

This study examines a class of games that embeds one-shot strategic interactions intoa richer continuous-time setting. The equilibrium uniqueness result holds even if theadjustment costs and noise are arbitrarily small—and, more interestingly, even if thecorresponding one-shot model generates multiple equilibria. The result suggests that, aslong as our model seems to be a more realistic description than the one-shot modeling, themultiple equilibrium problem in static games could be attributed to over-simplificationthat abstracts away certain dynamic aspects. We also identify certain situations in which
the model with gradual adjustment predicts higher efficiency than the one-shot setting.
26

Budd, Harris, and Vickers (1993) analyze a more general model. Cao (2014) also studies a model withasymmetric players and the effect of a handicapping policy. Yildirim (2005) examines a discrete-time contest
model with multiple periods. Notable differences from our result are as follows: (i) There are multiple equilibria
when the players are asymmetric, and (ii) the total effort is typically at least as great as that in the one-shotmodel. Seel and Strack (Forthcoming) consider a continuous-time model in which players solve the optimal
stopping problem with a private observation of the own state variables.

23

1

a1(t,1,−1)a (t,0.5,−0.5)
0.2

0.13
Dynamic
Static

0.195

0.125

0.19
0.12
0.185
0.115
0.18
0.11
0.175
0.105

0.17
0.165

0

0.25

0.5
t

0.75

0.1

1

0

0.25

0.5
t

0.75

1

Figure 4: Time dynamics of player 1’s optimal control policy in the dynamic contest game whenplayer 1 is the leader. The solid lines are equilibrium strategies under the dynamic model: The effort
level a1 (t, X) is increasing in t when Xt1 and Xt2 are close (left panel, with Xt1 −Xt2 = 1) but decreasing
in t otherwise (right panel, with Xt1 − Xt2 = 2). The dashed lines are the equilibrium effort levels
under the static benchmark for different initial states. The other parameters are σ = 1 and γ = 1.
These results might be useful for understanding how timing of agents’ decisions affects
welfare, which is relevant in designing policies and institutions.
In general, we believe that the BSDE-based approach provides powerful tools that are
applicable to broad classes of continuous-time games in which the standard HJB equations
cannot be used. For example, the theory of BSDEs in settings with an infinite horizon
and/or general Levy processes could be useful in other classes of economic models beyond
the finite-horizon model with Brownian noise in this paper.
In Iijima and Kasahara (2015), we show the uniqueness of an open-loop equilibrium, inwhich players observe only the Zt process. Moreover, if there exists a potential function,
the unique equilibrium maximizes the potential in the small friction limit, which serves
as an equilibrium selection result.27

27

The theory of global games (Carlsson and van Damme, 1993) is another equilibrium selection approach thatenriches a complete information game by introducing uncertainty about economic fundamentals, which leads
to equilibrium uniqueness. In contrast to our approach, the presence of private information is essential for theequilibrium uniqueness result in global games. Note that, while global games with strategic substitutes canhave multiple equilibria, even such a class of games have a unique equilibrium in our framework.

24AppendixA

PDE Characterization

In this section, we derive a PDE characterization of the unique equilibrium, where thecontinuation value solves a system of PDEs. Our intention is to facilitate numericalcalculation of the unique equilibrium, as it is often useful to be able to compute anequilibrium numerically in applications.28 In order to derive a PDE characterization, we
impose the following conditions.
Assumption 3.
ii(A ,X)
1. ci is C 2 and bounded. In addition, ci is strictly convex in Ai , and ∂c ∂A→ ∞ asi

Ai → bd(Ai ).
2. U i is C 3 and has bounded derivatives.
Assumption 3.1 ensures that player i’s optimal action is in the interior of Ai and f i
is continuously differentiable. Note that Assumption 3 is not consistent with Assumption
2. We now introduce a restriction on the class of equilibria.
Definition 1. A bounded sensitivity equilibrium is a Nash equilibrium A = (Ai )i∈N suchthat |βt (A)| is bounded, that is, there exists M > 0 such that |βti (A)| < M for any i andfor almost all t almost surely.
Proposition 4. Under Assumptions 1 and 3, if µ0 and µi for each i ∈ N are bounded andcontinuously differentiable, then there exists a unique bounded sensitivity equilibrium A.
Its continuation value take the form Wti (A) = wi (t, Xt ), where w = (wi )i∈N is a uniquesolution to the following system of PDEs:0=∂wi (t, x)
∂t

+

d
d
1 X X

2

l,m=1 k=1σlk σmk∂ 2 wi (t, x)∂xl ∂xm+Xµj aj + µ0 (x) · ∇x wi (t, x) − ci (ai , x),

j∈N

(8)
where ai (t, x) = f i (∇x wi (t, x), x) for all t, x with a terminal condition wi (T, x) = U i (x).
The equilibrium strategy takes the form Ait = f i (µi (Xt ) · ∇x wi (t, Xt ), Xt ).
28

Numerical calculation of Markovian BSDEs is an active research area, and we note that many papers thatuse Monte Carlo simulations as well (Gobet, Lemor, and Warin, 2005).

25

Here we give only a sketch of the proof; the details are provided in Supplementary
Appendix E.2. First, we construct a particular bounded sensitivity equilibrium by solving the HJB equations that lead to the PDEs (8). We rely on the theory of uniformly
parabolic PDEs (Ladyzenskaja, Solonnikov, and Ural’ceva, 1995) to prove the existenceof a unique solution to the system of PDEs. Assumption 3 is used in this step to ensure
the continuous differentiability of f i . Then we show that the constructed strategy profile
is a unique bounded sensitivity equilibrium, by truncating the original BSDEs and applying the uniqueness result for uniform Lipschitz BSDEs (Pardoux and Peng, 1990). The
bounded sensitivity assumption is used in justifying the truncation step. It is an open
question whether Nash equilibria with unbounded sensitivity exist.

B

Proofs of Main Results

B.1

Preliminaries

This section introduces results from the BSDE literature that we rely on for the proofs.

B.1.1

BSDEs

In this subsection, we define BSDEs and introduce relevant results.29
Fix any invertible d × d matrix Σ̃ throughout this subsection. Let X = {Xt }0≤t≤T
be a standard d-dimensional Brownian motion on a filtered probability space (Ω, F, P),
where F = {Ft }0≤t≤T is the augmented filtration generated by X, and T is a fixed finite
horizon. We denote by S2 the set of Rn -valued progressively measurable processes W over
[0, T ] such that"E#
sup |Wt |2 < ∞,0≤t≤T

and by H2 the set of Rn×d -valued progressively measurable processes β over [0, T ] such
that
Z T
E


|βt | dt < ∞.
20

We call g : Ω × [0, T ] × Rn × Rn×d → Rn a driver if the following conditions hold:- g(ω, t, w, b), written g(t, w, b) for simplicity, is progressively measurable for all w ∈29See, for example, Pham (2010). Note that the notation (W, β) used here corresponds to (Y, Z) in thestandard notation.

26

Rn and b ∈ Rn×d
- g(t, 0, 0) ∈ S2 (0, T )n
We call ξ a terminal condition if it is an Rn -valued random variable such that E[|ξ|2 ] < ∞.
Definition 2. Let ξ be a terminal condition, and let g be a driver. A BSDE is a stochastic
system of equations defined by30
Z T

Z T

βs · Σ̃dXs , 0 ≤ t ≤ T.

g(s, Ws , βs )ds −Wt = ξ +tt

A solution to a BSDE is a pair (W, β) ∈ S2 × H2 that satisfies the above system of
equations. A BSDE is said to be one-dimensional if n = 1.
We often write the above BSDEs in differential form as
dWt = −g(t, Wt , βt )dt + βt · Σ̃dXt ,WT = ξ.

The following result is due to Pardoux and Peng (1990).
Lemma 3 (Lipschitz BSDE). Let ξ be a terminal condition, and let g be a driver thatsatisfies the uniform Lipschitz condition. That is, there exists a constant Cg such that|g(t, w, b) − g(t, w̃, b̃)| ≤ Cg (|w − w̃| + |b − b̃|),for all w, w̃, b, b̃, dt ⊗ dP a.e.

Then there exists a unique solution (W, β) of the BSDE.
A driver g satisfies the quadratic growth condition if there is a constant C > 0 suchthat|g(t, w, b)| ≤ C(1 + |w| + |b|2 ),|g(t, w, b) − g(t, w̃, b̃)| ≤ C |w − w̃| + (|w| + |b| + |w̃| + |b̃|)|b − b̃|for all ω ∈ Ω, t ∈ [0, T ], w, w̃ ∈ Rn , and b, b̃ ∈ Rn×d .
The following results for one-dimensional BSDEs are due to Kobylanski (2000).
Lemma 4 (Comparison Theorem). Consider a pair of one-dimensional BSDEs that are˜ g̃) that satisfy the quadratic
associated with drivers and terminal conditions (ξ, g) and (ξ,30

In the standard notation, Σ̃ is usually an identity matrix. We chose to include this additional term, which
does not change any of the results in this section, in order to make it easier to see their applicability to ourmodel.

27

growth condition. Let (W, β) and (W̃ , β̃) be the corresponding solutions. If ξ ≥ ξ˜ almost
surely and g(t, Wt , βt ) ≥ g̃(t, Wt , βt ) for almost all t almost surely, then Wt ≥ W̃t for
all t almost surely. If, in addition, g(t, Wt , βt ) > g̃(t, Wt , βt ) holds for a strictly positive
measure under dt ⊗ dP, then W0 > W̃0 .
Lemma 5 (One-dimensional Quadratic BSDE). Consider a one-dimensional BSDE inwhich ξ is a terminal condition and g is a driver that satisfies the quadratic growth condition. Then there exists a unique solution (W, β) of the BSDE.

B.1.2

FBSDE

Fix a probability space (Ω, G, Q) in which {Gt }0≤t≤T satisfies the usual conditions and(Zt )0≤t≤T is a standard d-dimensional Gt -Brownian motion. Note that Gt can be larger
than the filtration generated by the Brownian motion Zt . A (Markovian) forward backward stochastic differential equation (FBSDE) is a stochastic system of equations thattakes the form
dXt = F (t, Xt , Wt , βt )dt + Σ̃dZt , X0 = x0
dWt = G(t, Xt , Wt , βt )dt + βt · dZt , WT = U (XT )(9)for some F : [0, T ]×Rd ×Rn ×Rn×d → Rn , G : [0, T ]×Rd ×Rn ×Rn×d → Rd , U : Rd → Rn ,x0 ∈ Rd , and invertible Σ̃ ∈ Rd×d .
A solution (X, W, β) to an FBSDE is an Rd × Rn × Rn×d -valued {Gt }-progressively
measurable process that satisfies (9) and
Z T

2

2

2

|Xt | + |Wt | + |βt |Edt < ∞.

0

The following result is due to Delarue (2002).31
Lemma 6 (Non-degenerate FBSDE). Consider the FBSDE (9). Assume that there exists
a constant K > 0 such that the following conditions are satisfied (for all t, x, x0 , w, w0 , b, b0 ):31

Delarue (2002) uses a more general formulation that, in particular, allows the matrix Σ̃ to depend on t
and X. He requires the condition called uniform parabolicity: There exist ν, ν 0 > 0 such that ∀ξ ∈ Rd , ν ≤1 000|ξ|2 ξ (Σ̃(t, X)Σ̃ (t, X))ξ ≤ ν for all t, X. To see that this condition is satisfied in the current framework, firstnote that Σ̃Σ̃0 has d real positive eigenvalues (λ1 , · · · , λd ), because Σ̃ is invertible, which guarantees that Σ̃Σ̃0is positive definite. By the standard results in linear algebra, 0 < (mink λk )|ξ|2 ≤ ξ 0 (Σ̃Σ̃0 )ξ ≤ (maxk λk )|ξ|2 forany non-zero ξ ∈ Rd .

28

1. F is continuous in x and satisfies|F (t, x, w, b) − F (t, x, w0 , b0 )| ≤ K(|w − w0 | + |b − b0 |)(x − x0 ) · (F (t, x, w, b) − F (t, x0 , w, b)) ≤ K|x − x0 |2|F (t, x, w, b)| ≤ K(1 + |x| + |w| + |b|)2. G is continuous in w and satisfies|G(t, x, w, b) − G(t, x0 , w, b0 )| ≤ K(|x − x0 | + |b − b0 |)(w − w0 ) · (G(t, x, w, b) − G(t, x, w0 , b)) ≤ K|w − w0 |2|G(t, x, w, b)| ≤ K(1 + |x| + |w| + |b|)

3. U is Lipschitz continuous and bounded, that is, it satisfies|U (x) − U (x0 )| ≤ K(|x − x0 |)|U (x)| ≤ K.

Then there exists a unique solution (X, W, β) of the FBSDE. The solution takes the form
Wt = w(t, Xt ), βt = b(t, Xt ) for some function w : [0, T ] × Rd → Rn that is uniformly
Lipschitz continuous in x ∈ Rd , and some function b : [0, T ] × Rd → Rd×n .

B.2

Proof of Lemma 1

We note that the model is constructed from a canonical probability space (Ω, F, P) where
there is no drift in X and changes in the probability measure depend on A = (Ai )i∈N . We
denote this new probability space by (Ω, F, PA ; F X ), which has been augmented with thefiltration generated by X, and the the corresponding expectation operator by EA . This
construction is standard and (often implicitly) used by most continuous-time models thatfeature imperfect public monitoring.32
We begin with the following preliminary lemma.
Lemma 7. Fix a strategy profile A = (Ai )i∈N . Then W0i (A) ≥ W0i (Âi , (Aj )j6=i ) for any
strategy Âi of player i if and only if Ait = f i (βt (A), Xt ) for almost all t ∈ [0, T ] almost
32

Chapter 5 of Cvitanic and Zhang (2012) discusses the technical details more extensively in the context ofdynamic contracts.

29surely.
Proof. Fix any strategy profile A = (Ai )i∈N . As discussed in Section 3.1, player i’s
continuation payoff under A takes the form
Wti (A)

A

= E



Z T

i

U (XT ) −ic (Ais , Xs )ds|FtX



t

Z T

Z T

βsi (A) · dZs (A)



Z T
Z T
X
−1
i
i
i
i
j




= U (XT ) −c (As , Xs ) − βs (A) · Σβsi (A) · Σ−1 dXsµj As + µj (Xs )ds −i= U (XT ) −ic (Ais , Xs )ds −

t

t

t

t

j∈N

with WTi (A) = U i (XT ). The second equality follows by applying the extended martingale
representation theorem to the conditional expectation of the total payoff (see for example
Chapter 5 and Lemma 10.4.6 in Cvitanic and Zhang (2012)), and the third equality uses
P

j
dXt =
µ
A
+
µ
(X
)
dt + ΣdZt .
0
t
j j t
The pair (W i (A), β i (A)) is a solution to the one-dimensional BSDE (under the originalP
probability space) with driver −ci (Ait , Xt ) + β i · (Σ−1 j∈N µj Ajt + µ0 (Xt )) and terminal
condition UTi (XT ). Note that we treat (Aj )j6=i as exogenous processes in this BSDE
formulation.
Take another strategy profile Ã = (Ãj )j∈N in which player i uses strategy Ãit =f i (βt (A), Xt ) and where Ãj = Aj for every j 6= i. Using the same argument as above,
player i’s continuation value takes the form



Z T
Z T
X
ci (Ãis , Xs ) − βsi (Ã) · Σ−1 
Wti (Ã) = U i (XT )−µj Ãjs + µ0 (Xs ) ds−
βsi (Ã)·Σ−1 dXstjtwith WTi (Ã) = U i (XT ). Likewise, (W i (Ã), β i (Ã)) is a solution to the one-dimensional
P
BSDE with driver −ci (Ãit , Xt )+β i ·Σ−1 ( j µj Ãjt +µ0 (Xt )) and terminal condition U i (XT ).
Note that the driver term satisfies the quadratic growth condition, because f i is bounded
and Lipschitz continuous (Lemma 8). By the comparison theorem (Lemma 4), W0i (Ã) ≥W0i (A) holds. This proves the “if” direction.
To prove the “only if” direction, consider the case in which Ait 6= f i (βt , Xt ) for somestrictly positive measure dt ⊗ dP. Then by the strict inequality part of the comparison
theorem (Lemma 4), W0i (Ã) > W0i (A).

30

Proof of Lemma 1. To show the “if” direction, take any strategy profile A = (Ai )i∈N
under which conditions (1), (3), (4), and (5) hold for some F X -progressively measurableRTprocesses (W, β) such that E sup0≤t≤T |Wt |2 , E[ 0 |βt |2 dt] < ∞. As we have seen in the
proof of Lemma 7, for player i, the pair of processes (W i (A), β i (A)) is a unique solutionP
to one-dimensional BSDE with driver −ci (Ait , Xt ) + β i · (Σ−1 j∈N µj Ajt + µ0 (Xt )) andterminal condition UTi (XT ). Thus Wti = Wti (A) and βti = βti (A) (for almost all t almost
surely). By Lemma 7 and the incentive compatibility condition (5), each player maximizes
her expected total payoff. Thus A is a Nash equilibrium.
To show the “only if” direction, take any Nash equilibrium A = (Ai )i∈N . Then the
incentive compatibility condition (5) holds by Lemma 7. The remaining conditions follow
immediately by setting Wti = Wti (A) and βti = βti (A).

B.3

Proof of Theorem 1

Lemma 8. There is Cf > 0 such that |f i (β, X) − f i (β̃, X̃)| ≤ Cf (|β i − β̃ i | + |X − X̃|) for
all β, β̃, X, X̃.
Proof. Denote the control range by Ai = [Ai , Āi ]. Since β i · Σ−1 µi αi − ci (αi , X) is strictly
concave in αi , its unique maximizer Ai is continuous in β and X and satisfies the firsti

i(A ,X)
order condition β i · Σ−1 µi = ∂c ∂A
in the case of Ai ∈ (Ai , Āi ). Furthermore, thisimaximizer takes the form
i (Āi ,X)



Āi
if β i · Σ−1 µi ≥ ∂c ∂A
i



i
i
i
i
f i (β, X) = g i (β, X) if β i · Σ−1 µi ∈ ( ∂c (A i,X) , ∂c (Ā i,X) )
∂A
∂A




i (Ai ,X) iAif β i · Σ−1 µi ≤ ∂c ∂Aiii(A ,X)
where g i (β, X) is the unique value Ai ∈ Ai that is defined by the equality ∂c ∂A− βi ·i

Σ−1 µi = 0. Note that this value is uniquely determined, since ci is strictly convex in Ai .
By the implicit function theorem, for k = 1, . . . , d, he first-order partial derivatives of g isatisfy
∂g i
=
∂X k

∂ 2 ci∂Ai ∂X k∂ 2 ci(∂Ai )2,∂g i
ek · Σ−1 µi=,∂ 2 ci
∂β ik
i 2
(∂A )

where β ik denotes the kth element of the vector β i ∈ Rd , and ek is the kth unit vector in
Rd . Since we can choose constants M, M 0 > 0 uniformly in (β, X) such that31

∂ 2 ci(∂Ai )2>Mand∂ 2 ci∂Ai ∂X k< M 0 by Assumption 2.1, this establishes the Lemma.

Proof of Theorem 1. Take any solution (W, β) of BSDE (6) it one exists. This is a solution
to an FBSDE of the form
dWti = ci (f i (βt , Xt ))dt + βti · dZt , WTi = U i (XT ), i ∈ N
!
X
dXt =
µi f i (βt , Xt ) + µ0 (Xt ) dt + ΣdZt

(10)

i

under the probability space (Ω, G, Q) in which G = F X and the Zt -process is a ddimensional Brownian motion. The probability measure Q is constructed from the originalcanonical probability space (Ω, F X , P) by the Girsanov theorem, which ensures F Z ⊆ F X .
We apply Lemma 6 to show that a unique solution (X, W, β) to FBSDE (10) exists.
To check condition 1 in Lemma 6, first note that the drift term in the expression for theP
Xt process, namely i µi f i (β, Xt ) + µ0 (Xt ), is Lipschitz continuous in βt by Lemma 8,
which ensures the first inequality. The second inequality follows by the Cauchy-SchwartzPinequality and the Lipschitz continuity of i µi f i (βt , Xt ) + µ0 (Xt ) in X (Lemma 8), andthe boundedness of µ0 and Ai for each i ensures the third inequality. To check condition
2, note that the drift term in the expression for the Wti process, namely ci (f i (β, X), X),
is Lipschitz continuous in (X, β) by Lemma 8 and the assumptions on ci . This term isindependent of W , which ensures the second inequality. The third inequality follows fromthe boundedness of ci for each i. Condition 3 is satisfied by Assumption 2.2.
Thus if there is another solution (W 0 , β 0 ) to BSDE (6), this induces another solution(X 0 , W 0 , β 0 ) to FBSDE (10) that coincides with the solution (X, W, β). Thus (Wt , βt ) =(Wt0 , βt0 ) for almost all t almost surely. By Theorem 2.1 of Cheridito and Nam (2015),
the process (W, β) is a solution to BSDE (6). This shows existence of a unique Nashequilibrium by Lemma 1.
Finally, by Lemma 6, the unique solution (X, W, β) to the FBSDE with G = F Z takes
the form Wt = w(t, Xt ), βt = b(t, Xt ) for some function w : [0, T ] × Rd → Rn that is
uniformly Lipschitz continuous in x ∈ Rd and some function b : [0, T ] × Rd → Rd×n .

32

B.4

Details for Section 3.2

The continuation payoff for player i at time t = T − ∆ can be written asWti,∆ = −ci (Ait , Xt )∆ + E U i (XT ) |Xt = −ci (Ait , Xt )∆ + E U i Xt + 


X





µj Ajt  ∆ + t  Xt  .

j∈NNote that by convolution the second term on the right-hand side is smooth in At . Therefore, the first- and second-order partial derivatives of Wti,∆ are∂∂
W i,∆ = − i ci ∆ + ∆∂A∂Ait t

Z

∂ ∆
φ dt
∂
k
h 2i
−t
Z
exp
X
2∆ t
∂ i
i
k
√
µk At ∆ + t )dt
= − i c ∆ + ∆ U (Xt +∂A∆ 2π ∆
k
"Z
#
X
∂ i
i
k
= − ic ∆ + E
U (Xt +
µk At ∆ + t )t |Xt∂A
U i (Xt +Xµk Akt ∆ + t )

k

and
∂2

∂2
Wti,∆ = − i j ci ∆ + ∆j∂A ∂A∂Ait ∂At= −∂2ci ∆ + E∂Ai ∂AjZ

U i (Xt +Xµk Akt ∆ + t )tk"Z

U i,∆ (Xt +

X

∂ ∆
φ dt
∂
#

µk Akt ∆ + t )t t |Xt ,kwhere φ∆ denotes the density of t .
We show that the equilibrium action profile at period t is unique if ∆ is small. To
show this, we claim that the players’ best response in period t has a slope less than 1 if ∆is small enough; this ensures the uniqueness by the contraction mapping theorem. Notei,∆∂that the equilibrium action satisfies the first-order condition ∂A= 0 in the case ofi Wtt

an interior solution.
Because U i is Lipschitz continuous, there exists a constant L > 0 such that
|U i (x + ) − U i (x)| ≤ L||33

for any x, . The second-order partial derivatives are bounded in absolute value as follows:∂2∂Ait ∂Ajt

Wti,∆≤ E[|(U i (Xt +Xµk Akt ∆ + t ) − U i (Xt +Xµk Akt ∆ + t ) − U i (Xt +X

ki≤ E[((U (Xt +
≤
≤
=

X

µk Akt ∆))2t |] + E[U i (Xt +

k

k
2 1/2
E[L 2t ] (Var[t ]2 )1/2

1/2∆
L 2E[4t ]1/2

k

µk Akt ∆))2 ]1/2 E[4t ]1/2

k

2

√

2L∆3/2 ,which is based on E[t ] = 0 and Var[t ] = ∆; the Holder inequality was used on the secondand fourth lines.
Let K > 0 denote the lower bound of the second-order partial derivative of ci withrespect to Ai . Then
∂2
Wti,∆
i
2
∂(At )≥

K∆ − E[U i (Xt +≥ |K∆ −√X

µk Akt ∆ + t )2t ]

k

2L∆

3/2

|

for sufficiently small ∆. By the implicit function theorem applied to the first-order conditions, the slope of each player’s best response in period t is bounded as follows:∂2∂Ait ,∂Ajt

Wti,∆

∂2
Wti,∆
∂(Ait )2√≤

2L∆1/2√,K − 2L∆1/2

which establishes the claim.

B.5

Details for Example 3

We show that no player has an incentive to deviate from the prescribed strategy. Fix anyt and current state Xt .
• Case 1: Xt ≥ (T − t)θ.
If there is no deviation, the terminal state is XT = Xt + (T − t)N , which is strictly
positive. After an arbitrary deviation on the part of player i after time t, thestate variable Xt0 at any t0 > t is strictly greater than (T − t0 )θ because of θ <−N + 1. Thus, the terminal state after any deviation is still positive. Given this,34

Xµk Akt ∆)2t ]the optimization problem reduces to
Z T
max
Ai

(Ais − κc(Ais ))ds,t

and thus it is strictly optimal to choose Ait = 1 at any time t0 ≥ t.
• Case 2: Xt < (T − t)θ.
If there is no deviation, the terminal state is XT = Xt − (T − t)N , which is strictly
negative. By the same argument as in Case 1, under an arbitrary deviation on thepart of player i after time t, the terminal state is strictly negative. Given this, theoptimization problem reduces to
Z T
max
Ai

(−c(Ais ))ds,t

and thus it is strictly optimal to choose Ait = 0 at any time t0 ≥ t.

B.6

Proof of Lemma 2

Proof. By symmetry of the players, at the unique equilibrium A = (Ai )i∈N , every playerchooses the same action, namely Ait = f (βt (A)), where f (β) := arg maxα∈A {σ −1 βα − κc(α)}
at almost all t almost surely. Thus the equilibrium BSDE (6) reduces to a single dimensiondWt = − N f (βt )σ −1 βt − κc(f (βt )) dt + σ −1 βt dXt , WT = U (XT ).

(11)

Let Ŵt denote the continuation value process for this hypothetical single-agent problem
under the optimal policy Â = (Âi )i∈N . By construction, Âit = f (β̂t ) for each i ∈ N andalmost all t almost surely, where (Ŵ , β̂) follows the BSDEdŴt = −(N f (β̂t )σ −1 β̂t − N κĉ(f (β̂t )))dt + σ −1 β̂t dXt , ŴT = U (XT ).
By the assumption that c(·) ≥ 0, the comparison of the driver terms yields
N f (β)σ −1 β − κc(f (β)) ≥ N f (β)σ −1 β − N κc(f (b))
for almost all t almost surely. Because these BSDEs satisfy the quadratic growth condition,
the comparison theorem (Lemma 4) implies W0 ≥ Ŵ0 .
To show the remaining inequality, consider the modified version of the hypothetical35

single-agent problem in which the agent maximizes E[U (XT ) −

RT
0

κ(

i
i c(Ât ) − (N −P1)c̄)dt]. Let W̃t denote the continuation value process under the optimal policy. ThendW̃t = −(N f (β̃t )σ −1 β̃t − κ(N c(f (β̃t )) + (N − 1)c̄))dt + σ −1 β̃t dXt , W̃T = U (XT ),where β̃t is the corresponding sensitivity process. Comparing its driver to the driver termin (11), we obtainN f (β)σ −1 β − κ(N c(f (β)) − (N − 1)c̄) ≥ N f (β)σ −1 β − κc(f (β))
for almost all t almost surely. By the comparison theorem (Lemma 4), W̃0 ≥ W0 .

B.7

Proof of Proposition 1

Proof. We show that Ŵ0 is approximately greater than maxx∈[X0 −N AT,X0 +N ĀT ] U (x) if
both σ and κ are small. To see this, let x∗ ∈ arg maxx∈[X0 −N AT,X0 +N ĀT ] U (x). Then,the expected payoff in the hypothetical single-agent problem under the constant policy∗

0for each i ∈ N ) converges to maxx∈[X0 −N AT,X0 +N ĀT ] U (x) as σ, κ → 0.
(Âit = x N−X
TThis expected payoff is lower than Ŵ0 by definition, and thus the Proposition follows by
Lemma 1.

B.8

Proof of Proposition 2

Proof. First, we prove the following lemma, which restricts the sign of the βt process under
the unique equilibrium for any values of the parameters, assuming that U is increasing.
Lemma 9. Consider the team production game in which U is increasing, and let A =(Ai )i∈N be the unique Nash equilibrium. Then β(A)t ≥ 0 for almost all t almost surely.
Proof. Note that the driver term in (11) satisfies the quadratic growth condition, and thatthe terminal payoff U (x) is bounded, Lipschitz continuous, and increasing. Therefore, theclaim follows by Corollary 3.5 and Remark 3.8 in dos Reis and dos Reis (2013).
For any β ≥ 0, the term maxα Σ−1 βα − κc(α) is decreasing in κ by the envelope
theorem. Let f (β; κ) := arg maxα Σ−1 βα − κc(α). Thus, for each β ≥ 0, the driver termin the equilibrium BSDE (11),(N − 1)f (β; κ)Σ−1 β + max{Σ−1 βα − κc(α)},α

36

is decreasing in κ and increasing in N . By Lemmas 4 and 9, W0 (A(κ, N )) ≥ W0 (A(κ̃, N ))for any κ ≤ κ̃ and N , and W0 (A(κ, N )) ≤ W0 (A(κ, Ñ )) for any N ≤ Ñ and κ.

B.9

Proof of Proposition 3

In the proof of Proposition 8, we construct an equilibrium strategy profile for generalP
quadratic payoffs U i = k=1,2 (αik (xk )2 + βik xk ) + γi x1 x2 . This implies that the equilibrium actions and continuation values take the form ai (t, x1 , x2 ) = c̄1i (2αii (t)xi + βii (t) +Pγi (t)xj ) and wi (t, x1 , x2 ) = k=i,j αik (t)(xk )2 + βik (t)xk + γi (t)xi xj + δi (t), where thecoefficients are obtained by solving the system of ODEs (16) given in that proof. For thecurrent game, we can directly verify the solution
α11 (t) = α12 (t) = γ1 (t) = α22 (t) = 0,
T −t
(T − t)3β11 (t) =, β12 (t) = 1, δ1 (t) =,c̄23c̄1 c̄22
α21 (t) =

T −t
,
2c̄2

γ2 (t) = 1,β22 (t) =δ2 (t) =(T − t)2,2c̄1 c̄2β21 (t) =(T − t)3,2c̄1 c̄22

σ12 (T − t)2 3(T − t)5,+4c̄2
20c̄21 c̄32

where the boundary conditions (17) given in the proof of Proposition 8 take the form
β12 (T ) = γ2 (T ) = 1, α11 (T ) = α12 (T ) = α21 (T ) = α22 (T ) = β11 (T ) = β21 (T ) = β22 (T ) =γ1 (T ) = δ1 (T ) = δ2 (T ) = 0.
Therefore, the equilibrium strategies are
a1 (t, x1 , x2 ) =T −t(T − t)2 x1, a2 (t, x1 , x2 ) =+ .
c̄1 c̄22c̄1 (c̄2 )2c̄2

For the continuation value functions,w1 (t, x1 , x2 ) =w2 (t, x1 , x2 ) =(T − t)3
T −t 1x + x2 +,c̄2
3c̄1 c̄22

T − t 1 2 (T − t)3 1 (T − t)2 2
σ12 (T − t)2 3(T − t)5
1 2
x
+
.
(x ) +
x
+
x
x
+
+
2c̄2
2c̄1 c̄24c̄22c̄1 c̄2220c̄21 c̄32

37

Supplementary Appendix
C

Variations of the ModelIn this section, we consider several variations of the original model.

C.1

Multiplicity with an Infinite Horizon

We demonstrate that equilibrium may not be unique if there is no deterministic boundeddeadline T . To make this point, we assume that the deadline T is time of the first arrivalof a Poisson process with fixed intensity λ > 0. For simplicity, here we focus on theP
two-player case with one-dimensional state dXt = i=1,2 Ait dt + σdZt .
Focusing on Markov strategies that depend on only the current state Xt , we can derive
the following HJB equations:

0 = max −ci (x, Ai ) + (wi )0 (x)Ai ∈Ai

X

Ak +

k=1,2


σ i 00(w ) (x) + λ U i (x) − wi (x)  ,2

where wi (x) denote the continuation value of player i when the state Xt is equal to x.
These equations can be written as

λwi (x) = max λU i (x) − ci (x, Ai ) + (wi )0 (x)Ai ∈Ai

X

Ak +

k=1,2

σ i 00 (w ) (x) .
2

Therefore, the model is equivalent to the infinite-horizon model in which each player
receives flow payoff λU i (Xt ) − ci (Xt , Ai ) and has discount rate λ.
It is known in the literature that infinite-horizon differential games can have multiple
equilibria in Markov strategies even if flow payoffs are independent of opponents’ actions(e.g., Tsutsui and Mino (1990)). As a particularly simple example, consider the gamein which the terminal payoff U i is constantly zero and the flow payoff −ci is given by− 12 (Ait )2 + 4(Ajt )2 + γ(Xt )2 for some constant γ > 0. Note that the uniqueness resultin the main model still holds even if flow payoffs depend on opponents’ actions in an
additively separable manner (footnote 16). Based on Example 2 in Lockwood (1996), one
can verify that there are two possible values of θ > 0 such that the strategy profile of theform Ait = −θXt is a (Markov perfect) equilibrium of this game when γ is small.33
33

Lockwood (1996) analyzes a deterministic model, in which σ = 0. Under quadratic payoffs, any Markov

38

This multiplicity contrasts with the uniqueness result under the original model with afinite horizon. Because there is no terminal-value condition on the continuation value Wti ,the “backward induction” argument which drives the unique equilibrium in the originalmodel does not work here.

C.2

Discrete-Time ModelIn this subsection, we develop discrete-time models. Player i chooses a control action Ait
at only the times t = 0, ∆, 2∆, . . . , T − ∆, where ∆ > 0 is the period length and T /∆ isassumed to be a natural number.
Player i’s total payoff is given by
T /∆i

U (XT ) − ∆Xci (Ait ).

t=0

We retain Assumption 2 on U i and ci . In the first subsection, we consider a discretizedversion of the original model. In the second subsection, we consider a Poisson noise model.

C.2.1

Brownian Case

We consider the same environment as in the main model, except that player i’s action
Ait is assumed to remain constant in [t, t + ∆). To simplify the notation, we assume
that d = n and player i chooses a one-dimensional action Ait to influence the process
dXti = Ait dt + dZti . This assumption is not essential for any argument made here.
Note that the state evolves asiXt+∆= Xti + ∆Ait + itfor each i ∈ N and t = 0, ∆, ..., T − ∆, where it is i.i.d noise that follows the normal
distribution N (0, ∆).
We consider two cases: imperfect monitoring and perfect monitoring.
Let X̃t = (X0 , ..., Xt ) denote a public history at period t, a sequence of state variables
for all periods up to and including the one that begins at time t. We define player i’s
imperfect monitoring strategy Ai as a function that, for period t, maps the public public
history X̃t−∆ to some element o Ai . A Nash equilibrium under imperfect monitoring is
strategy equilibrium profile that is linear in the state constitutes an equilibrium of the stochastic model as longas the transversality condition is satisfied.

39

a profile (Ai )i∈N of imperfect monitoring strategies such that each player maximizes her
expected total payoff within the class of imperfect monitoring strategies. Note that the
distribution of public histories at every period t has full support. As usual, we do not
distinguish between two strategies if for each period t, they specify the same action withprobability 1.
Let X̂t = ((X0 , Ai0 )i∈N , ..., (Xt , Ait )i∈N ) denote a full history at period t, that is, asequence of the state variables and the actions chosen by the players for all periods up
to and including the one that begins at time t. We define player i’s perfect monitoring
strategy Âi as a function that, for each period t, maps the full history Ht−∆ to someelement of Ai . A Nash equilibrium under perfect monitoring is a profile (Âi )i∈N of perfectmonitoring strategies such that each player maximizes her expected total payoff within theclass of perfect monitoring strategies. We say that a profile (Âi )i∈N of perfect monitoring
strategies is outcome equivalent to a profile of imperfect monitoring strategies (Ai )i∈N if
the distributions of the Xt processes induced by the two strategy profiles coincide withprobability 1.
We first show that whenever there is a unique equilibrium under imperfect monitoring,then any equilibrium under perfect monitoring is essentially unique, that is, any equilibrium under perfect monitoring is outcome equivalent to the unique equilibrium underimperfect monitoring. This suggests that the monitoring imperfectness is not important
for the equilibrium uniqueness result in the original model.
Proposition 5. Consider the discrete-period model with period length ∆. Suppose that
there is a unique Nash equilibrium (Ai )i∈N under imperfect monitoring. Then a Nashequilibrium under perfect monitoring exists. Moreover, any Nash equilibrium under perfectmonitoring is outcome equivalent to (Ai )i∈N .
Proof. Let (Ai )i∈N denote the unique Nash equilibrium under imperfect monitoring.
Step 1: (Ai )i∈N is a unique Nash equilibrium in Markov strategies.
Given a strategy profile (Ai )i∈N , let W̃ i (X̃t ) denote the expected continuation payofffor player i at time t conditional on public history X̃t . ThenW̃ i (X̃t ) = −ci (Ait (X̃t ))∆ + E[W̃ i ((X̃t , Xt + At (X̃t )∆ + t ))](12)

for each t ∈ {0, ∆, . . . , T − ∆} and X̃t , with W̃ i (X̃T ) = U i (XT ).
Observe first that, at t = T − ∆ and for almost all realizations of X̃t , (Ai (X̃t ))i∈N

40

should be a unique control action profile At such thatii−ci (Ait )∆ + E[U i (Xt + At ∆ + t ))] ≥ −ci (Āit )∆ + E[U i (Xt + (Āit , A−it )∆ + t ))] ∀Āt ∈ A ,for every i. (If not, we can construct multiple Nash equilibria under imperfect monitoringby specifying the different action profiles at histories of positive measure at t = T −∆ and then solving backwards to determine the equilibrium actions at earlier periods.)
Furthermore, since U i depend on only the terminal state, if we take any two histories
X̃t , X̃t0 such that the state variables at t coincide, we must have Ai (X̃t ) = Ai (X̃t ) for
every i.
We iterate this argument backwards to earlier periods: Except for histories of measure0, the continuation value can be written as a function of time and state, Wt (Xt ), suchthat the equilibrium control action profile at period t is a unique action profile At withthe property thatiiii−ci (Ait )∆+E[Wt+∆(Xt +At ∆+t ))] ≥ −ci (Āit , Xt )∆+E[Wt+∆(Xt +(Āit , A−it )∆+t ))] ∀Āt ∈ A

for every i.

Step 2: Outcome equivalence
Next, we take any Nash equilibrium (Âi )i∈N under perfect monitoring. Let Ŵ i (X̂t )denote the expected continuation payoff for player i at time t conditional on history X̂t .
Note that at time t = T − ∆,ii−ci (Ai (X̂t ))∆+E[U i (Xt +At (X̂t )∆+t ))] ≥ −ci (Āit )∆+E[U i (Xt +(Āit , A−it (X̂t ))∆+t ))] ∀Āt ∈ Aholds with probability 1 for every i ∈ N . Thus, by the argument in Step 1, Âi (X̂t ) =Ai (X̃t ) holds with probability 1 for each i (Here we are comparing two strategy profiles
under the common probability space in which the distribution of (t )t=0,...,T is fixed.) Thisimplies W̃ i (X̃t ) = Ŵ i (X̂t ) with probability 1.
Based on the argument in Step 1, we iterate this argument backwards to earlier periods:
Except for histories of measure 0, the continuation value can be written as a function oftime and state, Ŵt (Xt ), such that the equilibrium control action profile at period t is a41

unique action profile At with the property thatiiii−ci (Ait )∆+E[Ŵt+∆(Xt +At ∆+t ))] ≥ −ci (Āit , Xt )∆+E[Ŵt+∆(Xt +(Āit , A−it )∆+t ))] ∀Āt ∈ A

for every i. This leads to Âi (X̂t ) = Ai (X̃t ) and W̃ i (X̃t ) = Ŵ i (X̂t ) with probability 1 foreach period t and i ∈ N . This completes the proof.

The next result provides a uniqueness result for small ∆ under a restriction on theequilibrium continuation value functions:
Proposition 6. Consider the discrete-time game described above. Assume that there
exist constants M > 0 and δ ∈ (0, 12 ) such that for each ∆, any equilibrium continuation
1

value W i,∆ (X̃t ) is Lipschitz continuous with coefficient less than M ∆δ− 2 . Then for smallenough ∆, there is a unique equilibrium.
The proof is based on repeating the argument in Appendix B.4 and thus is omitted.
The result is not entirely satisfactory, in that it restricts the asymptotic behavior of theslopes of the continuation value functions. While we conjecture that this assumption is
unnecessary, this conjecture has not yet been proved. In this paper, we have circumvented
this issue by formulating the game directly in continuous time.

C.2.2

Poisson CaseLet λi : Ai → R++ be a bounded, differentiable function with a bounded derivative, andsuppose that the state variable Xti follows a compound Poisson process
i

Xti =

Nt
X

Dli ,

l=1

where Nti is an inhomogeneous Poisson process with intensity λi (Ait ) > 0 at time t, and thejump sizes (Dli )l=1,2,...,Nti are i.i.d and follow cumulative distribution Gi . We approximate
this environment with the following discretized model: Choose ∆ sufficiently small so thatimaxi,Ai λi (Ai )∆ ≤ 1. At each period t, Xt+∆
= Xti holds with probability 1 − ∆λi (Ait ).
ii
Conditional on Xt+∆
6= Xti , the jump size Dti := Xt+∆
−Xti follows the distribution Gi . We

define a strategy (in imperfect monitoring) as a function that, for t = 0, ∆, 2∆, . . . , T − ∆,maps public history (X0 , X∆ , ..., Xt ) to some element of Ai as in the previous subsection.
The notion of Nash equilibrium is defined likewise.

42

Proposition 7. Consider the discrete-time model with Poisson noise. There is a unique
Nash equilibrium if ∆ is small enough.
We note that the analogue of Proposition 6 holds, so that the uniqueness result is
intact even if we consider the perfect monitoring case.

D

Quadratic GamesIn this subsection, we analyze a specific class of games in which the terminal payoffs
and adjustment costs are quadratic functions, and we show that equilibrium PDEs can be
simplified to ODEs. Because of the tractability of quadratic games, they have been widely
employed in applications. A drawback to this approach is that it involves unbounded
terminal payoffs and unbounded control ranges, which violate the assumptions for our
main theorems; the uniqueness of equilibrium is an open question. In this section, we
assume the two-player case as in Supplementary Appendix C.1 for simplicity.
We consider a quadratic game that has the following terminal payoff function and costfunction:U i (X) =

X 
k=1,2


c̄i
ᾱik (X k )2 + β̄ik X k + γ̄i X 1 X 2 , ci (a) = a2 ,2where ᾱik , β̄ik , γ̄i , c̄i are fixed constants such that c̄i > 0. We also allow for unbounded
controls: Ai = R. Proposition 8 states that an equilibrium is linear in the state variables,
where the coefficients follow ODEs.
Proposition 8. Consider a quadratic game. Let (αik (t), βik (t), γi (t), δi (t))i,k=1,2,t∈[0,T ] bea solution to the system of ordinal differential equations2(αii (t))2 γi (t)γj (t)γ 2 (t) 4αij (t)αjj (t)−, α̇ij (t) = − i
−
,
c̄i
c̄j
2c̄i
c̄j
2(αij (t)βjj (t) + αjj (t)βij (t))
2αii (t)βii (t) βjj (t)γi (t) + βij (t)γj (t)βii (t)β̇ii (t) = −−, β̇ij (t) = −γi (t) −
,
c̄i
c̄j
c̄i
c̄j
βij βjj
2αii (t)γi (t) 2(αij (t)γj (t) + αjj (t)γi (t))β2γ̇i (t) = −−, δ̇i (t) = −(σ1 )2 αi1 − (σ2 )2 αi2 − ii −
c̄i
c̄j
2c̄i
c̄j
α̇ii (t) = −(13)
associated with the boundary conditions
αik (T ) = ᾱik , β̄ik (T ) = βik , γ̄i (T ) = γi , δi (T ) = 0.

43

(14)

Then a Nash equilibrium strategy takes the formai (t, x1 , x2 ) =1(2αii (t)xi + βii (t) + γi (t)xj ).
c̄iEProofs of Results in the Appendix

E.1

Uniformly Parabolic PDEs

The lemma below on uniformly parabolic PDEs is taken directly from Theorem 7.1 on
p.596 in Ladyzenskaja, Solonnikov, and Ural’ceva (1995). It gives a set of sufficientconditions that ensures a unique solution to a system of second-order PDEs. In thestatement below, u = (ui )ni=1 : Rd × [0, T ] → Rn is the function to be determined, and
i

2 i

∂ u
n
n
the subscripts represent partial derivatives, that is, ut = ( ∂u∂t )i=1 , ukl = ( ∂xk ∂xl )i=1 ,
i

∂u n
d
uk = ( ∂xk )i=1 and ux = (uk )k=1 . Let H denote the set of n-dimensional functions u(x, t)that are continuous, together with all derivatives of the form Dtr Dxs with 2r + s < 3.
Lemma 10. Consider the following n-dimensional PDE system in u = (ui )ni=1 : Rd ×
[0, T ] → Rn :ut −X

αkl (x, t, u)ukl +k,lXδ k (x, t, u, ux )uk + γ(x, t, u, ux ) = 0, u(x, T ) = U (x),kwhere αkl : Rd × [0, T ] × Rn → R, δ k : Rd × [0, T ] × Rn × Rn×d → R, γ : Rd × [0, T ] × Rn ×
Rn×d → Rn , and U : Rd → Rn are exogenous functions, k, l = 1, . . . , d.
Then there exists a unique solution to the above system in H if the following conditions
are satisfied:
1. There exist M1 , M2 ≥ 0 such that
γ i (x, t, u, 0)ui ≥ −M1 |u|2 − M2 , i, j = 1, . . . , n

2. There exist constants M3 , µ, ν > 0 such that(a) (Uniform Parabolicity)ν≤

1 X klα (t, x, u)ξ k ξ l ≤ µ, k, l = 1, . . . , d
|ξ|2
k,l

44

(b)
|δ k (x, t, u, p)| ≤ µ(1 + |p|)2 , k = 1, . . . , d(c)|γ(x, t, u, p)| ≤M3(1 + |p|)2
|p|

(d)
∂αkl
∂αkl
(x,
t,
u,
p),
(x, t, u, p) ≤ µ, k, l = 1, . . . , d∂ui∂xk
3. The first-order partial derivatives of αkl , δ k , γ with respect to (t, x, u, p) are contin2 kl

2 kl

2 kl

2 kl

∂ α
∂ α
∂ α
∂ α
uous, as are the second-order partial derivatives ∂ui ∂uj , ∂ui ∂xk , ∂ul ∂t , ∂xk ∂un .

4. U (·) is C 3 and has bounded derivatives.

E.2

Proof of Proposition 4

The proof consists of two steps.

Step 1: Construction of a bounded sensitivity equilibrium
Lemma 11. The PDE system (8) with the terminal condition has a unique solution w̃
that is C 3,b .
Proof. Let us reproduce the PDE system:0=∂wi (t, x)
∂t

+

d
d
1 X X

2

σlk σmkl,m=1 k=1

∂ 2 wi (t, x)∂xl ∂xm+Xµj aj + µ0 (x) · ∇x wi (t, x) − ci (ai , x),j∈N

where ai (t, x) = f i (µi (x) · ∇x wi (t, x), x) for all (t, x), with a terminal condition wi (T, x) =U i (x). To see how the notations in Lemma 10 correspond to the current case, define thefollowing quantities for i = 1, ..., n and k, l, m = 1, ..., d:


d
X
X
1
αlm =
σlk σmk , δ k = µkj f j (∇x wj (t, x), x) + µk0 (x) , γ i = −ci (f i (∇x w, x), x).
2
k=1

j∈N

Note that f i is continuously differentiable and bounded, by Assumption 3 and the implicit
function theorem. We now verify that each of the conditions of Lemma 10 is satisfied.
Condition (1) holds because ci (f i , x) is bounded. Condition (2a) follows from the factthat Σ is invertible (see footnote 31). Condition (2d) is clearly satisfied, because the45

αlm are constants. If we take µ to be sufficiently large, then condition (2b) is satisfied
because f i is bounded. Likewise, with a sufficiently large M3 , (2c) is satisfied because
ci is bounded. The continuity assumptions in (3) follow from the continuity of the firstorder partial derivatives of ci and f i . Finally, (4) is satisfied because U i (·) is C 3 and hasbounded derivatives.
Based on the uniqueness of the solution, we construct a particular strategy profile Ã
defined asÃit = f i (∇x w̃(t, Xt ), Xt ).

(15)

Lemma 12. Ã is an equilibrium with bounded sensitivity strategies.
Proof. Treating ∇x wi as a column-vector-valued function, for each i define
βti (Ã) := Σ0 ∇x wi (t, Xt )0(equivalently ∇x wi (t, Xt ) = Σ−1 βti (Ã)).
By applying Ito’s formula, we can confirm that (W, β(Ã)) indeed solves the equilibrium
BSDE



X
dWti = ci (f i (∇x wi (t, X t ), Xt ), Xt ) − βti (Ã) · Σ−1µj f j (∇x wj (t, Xt ), Xt ) + µ0 (Xt ) dt+βti (Ã)·Σ−1 dXt
jwith WTi = U i (XT ).

Note that the first-order partial derivatives of wi with respect to x are uniformly
bounded. The results above verify that Ã is a regular equilibrium strategy.

Step 2: Uniqueness of a bounded sensitivity equilibrium
Suppose there exist two bounded sensitivity equilibrium strategy profiles, A and Ã. Let(W, β) and (W̃ , β̃) denote the corresponding equilibrium value and sensitivity processes.
Note that the driver terms of the BSDE take the formg i (t, w, b) = ci (f i (b, x), x) − bi · Σ−1 (

X
i

46

µi f i (b, x) + µ0 (x)),

which is continuously differentiable in b. Define a function h : Rn×n → Rn×n by



M



i,j
h (b) = bi,j





−M

if

bi,j ≥ M

ifbi,j ∈ (−M, M )ifbi,j ≤ −M.

for each i, j. By the boundedness of β and β̃, if we take a sufficiently large M > 0, (W, β)and (W̃ , β̃) are solutions to the modified BSDE with driver terms
Xḡ i (t, w, b) = ci (f i (h(b), x)) − hi (b) · Σ−1 (µi f i (h(b), x) + µ0 (x))
iand terminal condition U (XT ). This driver satisfies the uniform Lipschitz condition in
Lemma 3 (see Appendix B.1.1) and thus there is a unique solution to the modified BSDE.
Thus (W, β) = (W̃ , β̃), which implies A = Ã.

E.3

Proof of Proposition 7

Proof. To simplify the notation, we consider only the two-player case. By the boundednessof ci and U i , there is M > 0 such that any equilibrium continuation payoff is bounded in
2ii)(A ,X),
absolute value by M uniformly in ∆, A, t, and the history. Let M 0 := inf i,Ai ,X ∂ (c∂(Ai )2which is strictly positive. Also, let L := supi,Ai |(λi )0 (Ai )|.
Fix any ∆ and any Nash equilibrium strategy profile A. Take any t and history
ht = (X0 , ..., Xt ). Let (Ait , Ajt ) denote the action profile specified in the strategy profile.
Then Ait is a best-response against Ajt that maximizes−ci (ai , Xt )∆ + E[W i ((ht , Xt+∆ ))|Ajt , ai ]j= −ci (ai , Xt )∆ + (1 − ∆λi (ai ))E[W i ((ht , (Xti , Xt+∆)))|Ajt ]Z
j+∆λi (ai ) E[W i ((ht , (Xti + Dti , Xt+∆)))|Ajt ]dGi (Dti )over ai ∈ Ai , where W i (ht0 ) denotes the equilibrium continuation payoff at history ht0 .

47

The first derivative in Ait takes the formZ∂ci (Ait , Xt )
j
j
j
i 0
i
i
i
i
i
i
i
i
−
∆ + ∆(λ ) (At )E
W ((ht , (Xt + Dt , Xt+∆ )))dG (Dt ) − W ((ht , (Xt , Xt+∆ ))) At
∂Ai
Z

Z
∂ci (Ait , Xt )
j
i 0
i
j
i
i
j
i
j
∆
+
∆(λ
)
(A
)∆λ
(A
)
W
(+,
+)dG
dG
−
W
(0,
+)dG
=−
t
t
∂Ai
Z

j
i 0
i
j
i
i
i
+∆(λ ) (At )(1 − ∆λ (At ))W (+, 0)dG − W (0, 0) ,where we used the shorthand notation of the continuation value where + or 0 indicates
whether each state variable admits a jump within the period or not.
For j 6= i, the derivative of left hand side with respect to Ajt is∆(λ ) (Ait )∆(λj )0 (Ajt )
i 0

Z

i

i

j

Z

i

j



W (+, +)dG dG − W (0, +)dG
Z

j
i 0
i
j 0
i
i
i
−∆(λ ) (At )∆(λ ) (At ))W (+, 0)dG − W (0, 0) ,which is bounded by 4∆2 L2 M in the absolute value.

As in Appendix B.4, using the implicit function theorem, the best-response of i’s action
conditional on this history against the opponent’s choice Ajt has a slope less than 1 if ∆is sufficiently small. Because this bound on ∆ is uniform in all histories, we can apply
the contraction mapping argument from the last period to show that a Nash equilibriumis unique.

E.4

Proof of Proposition 8

Proof. We first solve (αik (t), βik (t), γi (t), δi (t))i,k=1,2,t∈[0,T ] by solving the system of ordinaldifferential equations2(αii (t))2 γi (t)γj (t)γ 2 (t) 4αij (t)αjj (t)−, α̇ij (t) = − i
−
,
c̄i
c̄j
2c̄i
c̄j
2(αij (t)βjj (t) + αjj (t)βij (t))
2αii (t)βii (t) βjj (t)γi (t) + βij (t)γj (t)βii (t)β̇ii (t) = −−, β̇ij (t) = −γi (t) −
,
c̄i
c̄j
c̄i
c̄j
βij βjj
2αii (t)γi (t) 2(αij (t)γj (t) + αjj (t)γi (t))β2γ̇i (t) = −−, δ̇i (t) = −(σ1 )2 αi1 − (σ2 )2 αi2 − ii −
c̄i
c̄j
2c̄i
c̄j
α̇ii (t) = −

(16)

48

associated with the boundary conditions:
αik (T ) = ᾱik , β̄ik (T ) = βik , γ̄i (T ) = γi , δi (T ) = 0.

(17)

Guess the functional form of value function byXwi (t, x1 , x2 ) =αik (t)(xk )2 + βik (t)xk + γi (t)xi xj + δi (t).

k=i,jSubstituting this into the HJB equations
0=

X
k=i,j


1
α̇ik (xk )2 + β̇ik xk + γ̇i xi xj + δ̇i + (σ1 )2 αi1 + (σ2 )2 αi2 +(2αii xi + βii + γi xj )22c̄i

1(2αij xj + βij + γi xi )(2αjj xj + βjj + γj xi )
c̄j






2
γi γj
4αij αjj
2αii
γi22αii γi
2
i 2
j 2
i j
=(x ) α˙ii +++ (x ) α˙ij +++ x x γ̇i ++ (αij γj + αjj γi )
c̄i
c̄j
2c̄j
c̄j
c̄i
c̄j




2αii βii βjj γi + βij γjβii γi 2(αij βjj + αjj βij )+++ xi β̇ii ++ xj β˙ij +
c̄i
c̄j
c̄i
c̄j


2
βij βjjβ+ δ̇i + (σ1 )2 αi1 + (σ2 )2 αi2 + ii +
2c̄i
c̄j
+

where we have omitted the argument t for coefficient functions. By the proposed ODE,
the right hand side becomes zero for every x1 and x2 . Also, the boundary condition holdswithwi (T, x1 , x2 ) =Xᾱik (xk )2 + β̄ik xk + γ̄i xi xj

k=i,jwhich verifies the solution.
Finally, by Theorem 1, the equilibrium action is given byai (t, x1 , x2 ) =1
wii (t, x1 , x2 )= (2αii (t)xi + βii (t) + γi (t)xj ).
c̄ic̄iReferences
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49

Battaglini, M., S. Nunnari, and T. R. Palfrey (2014): “Dynamic Free Riding with
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