Answer Key Problem Set 1 Francesco Nava

Microeconomic Principles II EC202 Lent Term 2010

Please give your answers to your class teacher by Friday of week 6 LT. If you not to hand in at your class,
make arrangements with your class teacher about where to bring it. Thank you!
1. Consider the following complete information strategic form game:
12L L C R
T 3; 4 1; 1 6; 2
M 2; 1 6; 4 0; 2
B 2; 2 2; 3 4; 2
(a) Find the pure strategy Nash equilibria.
Answer: PNE of this game are: (T; L) ; (M; C)
i) (T; L) is a PNE since:
u
1
(T; L) = 3 > 2 = u
1
(M; L) = u
1
(B; L)
u
2
(T; L) = 4 > 2 = u
2
(T; R) > 1 = u
2
(T; C)
ii) (M; C) is a PNE since:
u
1
(M; C) = 6 > 2 = u
1
(B; C) > 1 = u
1
(T; C)
u
2
(M; C) = 4 > 2 = u
2
(M; R) > 1 = u
2
(M; L)
(b) Are there any strictly dominated strategies if players can only play pure strategies?
Answer: NO.
For player 1: T is not dominated since it is best when player 2 chooses R; M is not dominated
since it is best when player 2 chooses C; and B is not dominated since it beats T when player 2
chooses C and it beats M when player 2 chooses R.
For player 2: L is not dominated since it is best when player 1 chooses T; C is not dominated
since it is best when player 1 chooses M; and R is not dominated since it beats L when player 1
chooses M and it beats C when player 1 chooses T.
(c) Are there any strictly dominated strategies if players can employ a mixed strategies?
Answer: Yes, (1=2)L+(1=2)C strictly dominates R and (3=4)T +(1=4)M strictly dominates B.
In particular (1=2)L + (1=2)C strictly dominates R, since:
1=2u
2
(T; L) + 1=2u
2
(T; C) = 5=2 > 2 = u
2
(T; R)
1=2u
2
(M; L) + 1=2u
2
(M; C) = 5=2 > 2 = u
2
(M; R)
1=2u
2
(B; L) + 1=2u
2
(B; C) = 5=2 > 2 = u
2
(B; R)
and (3=4)T + (1=4)M strictly dominates B, since:
3=4u
1
(T; L) + 1=4u
1
(M; L) = 11=4 > 2 = u
1
(B; L)
3=4u
1
(T; C) + 1=4u
1
(M; C) = 9=4 > 2 = u
1
(B; C)
3=4u
1
(T; R) + 1=4u
1
(M; R) = 9=2 > 4 = u
1
(B; R)
(d) Find the mixed strategy Nash Equilibrium.
Answer:
1
(T) =
1
(M) = 1=2,
2
(L) = 5=6,
2
(C) = 1=6 &
1
(B) =
2
(R) = 0.
Microeconomic Principles II F. Nava
Because strategies B and R are dominated we know that they cannot be played with positive
probability in a Nash equilibrium or else a protable deviation would exist (see slides). Thus we
can focus on the two player two action remaining game. To prove that the proposed strategies
constitute a MNE and to compute them simply verify that:
u
1
(T;
2
) = 3
2
(L) + (1
2
(L)) = 2
2
(L) + 6(1
2
(L)) = u
1
(M;
2
) > u
1
(B;
2
)
u
2
(
1
; L) = 4
1
(T) + (1
1
(T)) =
1
(T) + 4(1
1
(T)) = u
2
(
1
; C) > u
2
(
1
; R)
2. Consider an economy with two producers competing to supply a market. Suppose that the cost
function of the rst rm displays a constant marginal costs, while the second rm displays increasing
marginal costs. In particular assume that:
c
1
(q
1
) = 2q
1
c
2
(q
2
) = (q
2
+ 1=2)
2
Suppose that the inverse demand in this market is linear and satises:
p(q) = 4 2q
Assume that the two rms compete la Cournot.
(a) Derive the Cournot production levels, prots and the equilibrium price.
Answer: q
1
= 3=10, q
2
= 4=10, p = 13=5,
1
= 9=50,
2
= 23=100.
To nd the Cournot outputs, lets nd the best response functions by solving the problem of
each rm. Firm 1s problem is:
max
q
1
(4 2q
1
2q
2
)q
1
2q
1
4 4q
1
2q
2
= 2 [FOC]
q
1
=
1
2

q
2
2
[BR1]
Firm 2s problem is:
max
q
2
(4 2q
1
2q
2
)q
2
(q
2
+ 1=2)
2
4 2q
1
4q
2
= 2q
2
+ 1 [FOC]
q
2
=
1
2

q
1
3
[BR2]
The solution q
1
= 3=10, q
2
= 4=10 is obtained by solving the system of the two best response
functions (2 equations & 2 unknowns). The prots and prices are obtained by substituting the
equilibrium quantities in the relevant expressions.
(b) Assume that rms do not account for their market power, but simply equalize marginal costs
to prices. Derive the competitive production levels, prots and the equilibrium price. Compare
them to the Cournot outcomes.
Answer: q
1
= 1=2, q
2
= 1=2, p = 2,
1
= 0,
2
= 0.
The competitive production levels are obtained by equating prices to marginal costs:
4 2q
1
2q
2
= 2
4 2q
1
2q
2
= 2q
2
+ 1
The solution q
1
= 1=2, q
2
= 1=2 is obtained by solving the system of the two best response
functions (2 equations & 2 unknowns). The prots and prices are obtained by substituting the
equilibrium quantities in the relevant expressions.
2
Microeconomic Principles II F. Nava
(c) Assume that rms form a cartel to sell their output as a monopolist. Derive the cartel production
levels, prots and the equilibrium price. Compare them to the competitive and Cournot outcomes.
Answer: q
1
= 0, q
2
= 1=2, p = 3,
1
= 0,
2
= 1=2.
The cartel production levels are obtained by maximizing the joint prots:
max
q
1
;q
2
(4 2q
1
2q
2
)(q
1
+q
2
) 2q
1
(q
2
+ 1=2)
2
4 4q
1
4q
2
= 2 [FOC1]
4 4q
1
4q
2
= 2q
2
+ 1 [FOC2]
The solution q
1
= 0, q
2
= 1=2 is obtained by solving the system of the two best response functions
(2 equations & 2 unknowns). The prots and prices are obtained by substituting the equilibrium
quantities in the relevant expressions. Notice that the redistribution of prots among the two
producers in a cartel is undetermined and that I have simply computed the factory prots.
3. Consider an auction with two buyers participating and a single object for sale. Suppose that each
buyer knows the values of all the other bidders. Order players so that values decrease, x
1
> x
2
.
Consider a 2
nd
price sealed bid auction. In such auction: all players simultaneously submit a bid b
i
;
the object is awarded to the highest bidder; the winner pays the second highest submitted bid to the
auctioneer; the losers pay nothing. Suppose ties are broken in favor of player 1. That is: if b
1
= b
2
then 1 is awarded the object.
(a) Characterize the best response correspondence of each player.
Answer: Best responses are found simply by looking at the optimal bid holding xed the bid
of the other player, as we have done in the slides for the rst price auction. In a second price
auction with our tie-braking assumption they satisfy:

1
(b
2
) =
8
<
:
b
1
< b
2
if b
2
> x
1
b
1
[0; ) if b
2
= x
1
b
1
_ b
2
if b
2
< x
1

2
(b
1
) =
8
<
:
b
2
_ b
1
if b
1
> x
2
b
2
[0; ) if b
1
= x
2
b
2
> b
1
if b
1
< x
2
(b) Characterize all the Nash equilibria for a given prole (x
1
; x
2
).
Answer: All Nash Equilibria of the game satisfy one of the following:
b
2
_ x
1
and b
1
_ x
2
b
1
_ x
2
and b
2
_ minx
1
; b
1

To nd the PNE simply intersect the two best response correspondences in a plot. You may verify
that for each of the proposed strategies both players are best responding to their competitor.
(c) Is bidding above the value weakly dominated? and bidding below the value?
Answer: Yes both bidding above and below the value are weakly dominated, by bidding ones
value.
Bidding below your value is dominated by bidding your value. Consider player 1 bidding b
1
< x
1
and notice that:
u
1
(x
1
; b
2
) = (x
1
b
2
) = u
1
(b
1
; b
2
) if b
2
_ b
1
u
1
(x
1
; b
2
) = (x
1
b
2
) > 0 = u
1
(b
1
; b
2
) if b
1
< b
2
< x
1
u
1
(x
1
; b
2
) = 0 = u
1
(b
1
; b
2
) if b
2
_ x
1
3
Microeconomic Principles II F. Nava
Bidding above your value is dominated by bidding your value. Consider player 1 bidding b
1
> v
1
and notice that:
u
1
(x
1
; b
2
) = (x
1
b
2
) = u
1
(b
1
; b
2
) if b
2
_ x
1
u
1
(x
1
; b
2
) = 0 > (x
1
b
2
) = u
1
(b
1
; b
2
) if x
1
< b
2
_ b
1
u
1
(x
1
; b
2
) = 0 = u
1
(b
1
; b
2
) if b
2
> b
1
A similar argument works for player 2. Note that for player 2 inequalities need to be adjusted to
account for the tie-braking rule.
(d) Are there any dominant strategy equilibria
Answer: Yes, b
i
= x
i
for any i 1; 2.
This is an immediate consequence of part (c) since it has been shown that bidding the valuation
is a dominant strategy for both players.
(e) If so, what are the sellers revenues in such equilibrium?
Answer: The revenues are x
2
.
If both bid their value the highest value player wins the object and he pays the second highest
value, namely x
2
.
4. Consider two rms competing on prices to supply a market. Each rm can sell goods to the market
at one of three prices 2; 4; 6. Suppose that rm 1s marginal cost of production is zero. While the
cost of production of rm 2 is only known by rm 2 and is either 2 or 4 with equal probability. If
the lowest price charged is p, then assume that market demand for goods is 7 p. The rm oering
the lowest price captures the entire market. To keep payos simple establish the following convention
when rms choose the same price: if the rms marginal costs are less than or equal to the common
price, then the market is split evenly amongst them. Otherwise rm 1 captures the entire market at
the common price. Therefore payos in the game satisfy:
12L p
L
= 6 p
L
= 4 p
L
= 2 12H p
H
= 6 p
H
= 4 p
H
= 2
p
1
= 6 3; 2 0; 6 0; 0 p
1
= 6 3; 1 0; 0 0; 10
p
1
= 4 12; 0 6; 3 0; 0 p
1
= 4 12; 0 6; 0 0; 10
p
1
= 2 10; 0 10; 0 5; 0 p
1
= 2 10; 0 10; 0 10; 0
For this game of incomplete information:
(a) Characterize the set of possible pure strategies for each player.
Answer: S
1
= 2; 4; 6 & S
2
= p
2
: L; H 2; 4; 6
Equivalently S
2
can be dene as a list of pairs of actions:
S
2
= (2; 2); (2; 4); (2; 6); (4; 2); (4; 4); (4; 6); (6; 2); (6; 4); (6; 6)
(b) Find the dominated strategies of each player.
Answer: Strategies p
2
(L) 2; 6 are weakly dominated for player 2L; strategies p
2
(H) 2; 4
are weakly dominated for player 2H; strategy p
1
= 6 is strictly dominated for player 1. To check
these notice that:
u
2
(4; p
1
[L) _ u
2
(6; p
1
[L) _ u
2
(2; p
1
[L) for any p
1
(somewhere strict)
u
2
(6; p
1
[H) _ u
2
(4; p
1
[H) _ u
2
(2; p
1
[H) for any p
1
(somewhere strict)
u
1
(2; p
2
[x
2
) > u
1
(6; p
2
[x
2
) for any p
2
2; 4; 6 & x
2
T; L
4
Microeconomic Principles II F. Nava
(c) Find a pure strategy Bayes Nash equilibrium of this game.
Answer: A BNE satises p
2
(L) = 4, p
2
(H) = 6, p
1
= 2. The other pure strategy BN equilibria
satisfy p
1
= 2, for any (p
2
(L); p
2
(H)) ,= (6; 6). This is extra, but mixed strategy BNE satisfy

1
(2) = 1 and:
10(1 (1=2)
2L
(2)) + 5(1=2)
2L
(2) _ 12(1=2)(
2H
(6) +
2L
(6)) + 6(1=2)(
2H
(4) +
2L
(4))
Lets check that no player benets from a deviation in the rst BNE. Notice that the strategy used
by player two of either type is dominant and that therefore he cannot benet from a deviation.
All we have to check is the optimality of the strategy of player 1 which holds since:
U
1
(2; p
2
) = 10 > (1=2)6 + (1=2)12 = U
1
(4; p
2
) > U
1
(2; p
2
)
Similarly for the other pure strategy BN equilibria just notice that player 1 always prefers to
play p
1
= 2 so long as p
2
,= (6; 6) and that player 2s strategy is always optimal as he is always
indierent:
U
1
(2; p
2
) > U
1
(4; p
2
) > U
1
(2; p
2
)
u
2
(4; p
1
[L) = u
2
(6; p
1
[L) = u
2
(2; p
1
[L)
u
2
(4; p
1
[H) = u
2
(6; p
1
[H) = u
2
(2; p
1
[H)
where the rst inequality holds since:
10 > (1=2)6 + (1=2)12
(1=2)5 + (1=2)10 > (1=2)12
Finally to test for the mixed BNE notice that if the above condition holds, player 1 does not
benet from a deviation since:
U
1
(2;
2
) _ U
1
(4;
2
) _ U
1
(2;
2
)
(d) Is it a dominant strategy equilibrium?
Answer: No, p
1
= 2 is not weakly dominant, since:
u
1
(4; 6[L) = 12 > 10 = u
1
(2; 6[L)
5. Consider the following extensive form game:
5
Microeconomic Principles II F. Nava
(a) Find the unique Subgame Perfect equilibrium of this game
Answer:
1:1
(b) = 1,
2:1
(A) = 1,
2:2
(C) = 1 &
1:2
(e) = 1.
The proposed strategies constitute a SPE since:
u
1:2
(e) = 2 > u
1:2
(d) = 0
u
2:2
(C) = 1 > u
2:2
(D) = 0
u
2:1
(A;
1:2
) = 4 > u
2:1
(B;
1:2
) = 2
u
1:1
(b;
1:1
) = 5 > u
1:1
(c;
1:1
) = 3 > u
1:1
(a;
1:1
) = 2
(b) Find a pure strategy Nash equilibrium with payos (3; 5)
Answer:
1:1
(c) = 1,
2:1
(A) = 1,
2:2
(D) = 1 &
1:2
(e) = 1.
The proposed strategies constitute a NE since:
u
1
(c; e;
2
) = 3 = u
1
(c; d;
2
) > u
1
(a; e;
2
) = 2 >
> u
1
(a; d;
2
) = u
1
(b; e;
2
) = u
1
(b; d;
2
) = 0
u
2
(A; D;
1
) = 5 = u
2
(A; C;
1
) = u
2
(B; C;
1
) = u
2
(B; D;
1
)
(c) Find a pure strategy Nash equilibrium with payos (4; 2)
Answer:
1:1
(a) = 1,
2:1
(B) = 1,
2:2
(D) = 1 &
1:2
(d) = 1.
The proposed strategies constitute a NE since:
u
1
(a; d;
2
) = 4 = u
1
(a; e;
2
) > u
1
(c; d;
2
) = u
1
(c; e;
2
) = 3 >
> u
1
(b; d;
2
) = u
1
(b; e;
2
) = 0
u
2
(B; D;
1
) = 2 = u
2
(B; C;
1
) > u
2
(A; C;
1
) = u
2
(A; D;
1
) = 0
6