No Folk Theorem in Repeated Games with Costly Observations - a Draft∗

The hallmark of the theory of repeated games with full monitoring is the Folk Theorem, which states that the set of subgame-perfect discounted equilibrium payoffs converges to the set of feasible and individually rational payoffs as the discount factor goes to 1. In practice, more often than not players do not observe each other’s actions, but rather some signal that depends on the vector of chosen actions. For example, firms do not observe the quantity of products manufactured by other firms or the production cost of other firms, but rather the market price; countries do not observe the investment of other countries in new weapons or the new technologies that other countries develop, but only those weapons and technologies that are actually used. Games with imperfect monitoring have been studied, e.g., by Fudenberg, Levine, and Maskin (1994), who pro-