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1. Suppose two computer firms, A and B, are planning to market network systems for office

information management. Each firm can develop either a fast, high-quality system (H), or

a slower, low-quality system (L). Market research indicates that the resulting profits to each

firm for the alternative strategies are given by the following payoff matrix:

H L

H 50, 40 60, 45

L 55, 55 15, 20

(b) Suppose now that firm A can move first. Draw the extensive form of the game. What

will be the outcome of the game? What will be the outcome if Firm B can move first?

(12)

3. Suppose two firms are engaged in Cournot competition. The market demand curve is

P = 100 − Q1 − Q2 .

(a) What are the profit maximizing output levels of the two firms if they decide on quantity

independently? Find the associated profit levels. (5)

(b) Now suppose the two firms collude. What is the profit maximizing output level and the

associated profit? (5)

(c) Suppose the two firms interact only once. Can such collusion be sustained? Why or why

not? Give a precise quantitative answer. (7)

(d) Suppose the two firms interact repeatedly. In this situation, can collusion be sustained?

Describe in words the nature of a strategy that can sustain the collusion. (3)

4. BW, Exercise 20.4, Page 766. (Read Section 20.2 to answer this question). (20)

1

5. Suppose there are two types of workers, one high quality (H) and the other low quality (L).

The H type’s marginal product is 5 and the low type’s marginal product is 2. Suppose the

proportion of H type workers is 0.4. So, the proportion of L type is 0.6.

(a) Assume lots of firms compete for workers. If firms know the type of a worker, what

would be wages paid to a high type worker and a low type worker? (3)

(b) If firms cannot tell the type of the worker, what would be the wage rate paid to a worker?

(4)

(c) Suppose firms cannot tell the type of the worker. Workers can now choose to acquire

education to signal its type to the firms. Suppose the cost of acquiring an unit of

education for the high type worker is cH = 1 and cost for the low type worker is cL = 2.

cL > cH because the high type worker can work harder and so has a lesser effort cost.

Assume that the minimum possible level of education is zero. How many units of edu-

cation would the high type and the low type workers choose to acquire respectively in

order to signal their types to firms? (Hint: Since the minimum possible level of educa-

tion is zero, low ability workers in any separating equilibrium will choose to acquire zero

education.) (8)

(d) Would the H type workers prefer to acquire education as a signal or would they prefer

not to acquire education? What would your answer be if the proportion of H type is 0.6

and the proportion of L type is 0.4? (5)

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