Closed-loop equilibria for Stackelberg games: a story about stochastic targets

TL;DR

This paper introduces a novel method to reformulate continuous-time stochastic Stackelberg differential games with closed-loop strategies as a single-level optimization problem with target constraints, enabling equilibrium characterization.

Contribution

It develops a new framework for analyzing Stackelberg games with closed-loop strategies by using second-order backward stochastic differential equations and Hamilton-Jacobi-Bellman equations.

Findings

Reformulation as a standard stochastic control problem with target constraints.

Characterization of equilibrium strategies via HJB equations.

Illustration through a simple example for theoretical and numerical comparison.

Abstract

We provide a general approach to reformulating any continuous-time stochastic Stackelberg differential game under closed-loop strategies as a single-level optimisation problem with target constraints. More precisely, we consider a Stackelberg game in which the leader and the follower can both control the drift and the volatility of a stochastic output process, in order to maximise their respective expected utility. The aim is to characterise the Stackelberg equilibrium when the players adopt 'closed-loop strategies', i.e. their decisions are based solely on the historical information of the output process, excluding especially any direct dependence on the underlying driving noise, often unobservable in real-world applications. We first show that, by considering the second-order backward stochastic differential equation associated with the continuation utility of the follower as a controlled state variable for the leader, the latter's unconventional optimisation problem can be reformulated as a more standard stochastic control problem with target constraints. Thereafter, adapting the methodology developed by Soner and Touzi (2002a) or Bouchard, Elie and Imbert (2010), the optimal strategies, as well as the corresponding value of the Stackelberg equilibrium, can be characterised through the solution of a well-specified system of Hamilton- Jacobi-Bellman equations. For a more comprehensive insight, we illustrate our approach through a simple example, facilitating both theoretical and numerical detailed comparisons with the solutions under different information structures studied in the literature.