ANSWER KEY 7

GAME THEORY, ECON 395

PROFESSOR A. JOSEPH GUSE

(1) (Gibbons 2.13) Recall the static Bertrand duopoly (with homogeneous products): the firms
name prices simultaneously; demand for firm i’s product is a − pi if pi < pj , is 0 if pi > pj
and is (a − pi )/2 if pi = pj . Marginal costs are c < a. Show that the firms can use trigger
strategies (that switch forever to the stage-game Nash equilibrium after any deviation) to
sustain the monopoly price level in a SPNE if and only if δ < 12 .
ANSWER. Let VNi E represent the value of playing the stage game NE in every period
for player i. Since the profit of each firm is zero in every stage where they play the stage
game NE, we have VN1 E = VN2 E = 0. Suppose that in a given stage, t, the two firms collude
to maximize total profit (which they split). The maximization problem is

max(a − p)(p − c)
p

where a − p is the total demand for both firms’ output at price p and p − c is the per unit
profit. find the first order condition on the profit-maximizing level of price, p∗M , by taking
the derivative of profit and setting it equal to zero:

a + c − 2p∗ = 0
"
#
a+c
2
⇒ p∗M =
5

Now use this to calculate the total profit the firms earn when they each set price at p∗M .
Call this level of profit πM :

πM = (a − p∗M ) (p∗M − c)
  
a+c a+c
= a− −c
2 2
(a − c)2
=
4
If both firms were to cooperatively set their price to, p∗M , they would split the demand
(a−c)2
in half (by assumption in the set-up) and therefore split this profit gaining 8 each.
Now consider the most a firm could gain in a single period by deviating from the coop-
a+c
erative price level. If the other firm set their price equal to p∗M = 2 , the other firm could
1
2 PROFESSOR A. JOSEPH GUSE

just undercut it, charging p∗M − ǫ and gain the entire profit. Making ǫ as small as possible,
(a−c)2
in words, a deviating firm could earn as much as 4 .
Suppose that both firms adopt the following grim trigger strategy:

(
p∗M if pjt−1 = pM AND pit−1 = pM
pit =
pB otherwise

In words, play the cooperative (total profit maximizing) price in each period as long as
both players set that same price in the previous period. Otherwise set price equal to the
one-shot Bertrand price, pB , which we know from earlier to be equal to c, the marginal
cost. To whether both firm adopting this strategy is a NE we need to ask whether either
(a−c)2
firm should deviate. By cooperating each firm will earn πm /2 = 8 in every period. By
(a−c)2
deviating a firm will earn 4 in the period they deviate followed by 0 ever after. Hence
deviation from the grim trigger stragegy profile is worthwhile if

P Vdev ≥ P Vcoop
(a − c)2 δ0 (a − c)2
⇒ + ≥
4 1−δ 8(1 − δ)
(a − c)2
⇒(a − c)2 ≥
2(1 − δ)
⇒2(1 − δ) ≥ 1
1
⇒ ≥δ
2

(2) (Gibbons 2.15) Suppose there are n firms in a Cournot oligopoly. Inverse demand is given
by P (Q) = a − Q, where Q = ni=1 = qi . Consider the infinitely repeated game based on
P

this stage game.

(a) What is the lowest value of δ such that the firms can use trigger strategies to sustain the
monopoly output level in a subgame-perfect Nash equilibrium? How does the answer
vary with n, and why?
ANSWER
We will be interested in the following three strategies (quantities) and associated profit
levels.
 ANSWER KEY 7 GAME THEORY, ECON 395 3

Strategy Profile Description Quantity Individual Profit

πM (a−c)2
All Firms Cooperate to Maximize Profit qM = a−c
2n n = 4n
a−c (a−c)2
All Firms Play Cournot Eqm in stage game qC = n+1 πC = (n+1)2
n+1 2
qD = (n+1)(a−c) − c)2


One firm deviates 4n πD = 4n (a

1 2 3

We need to ask whether for a given value of δ whether all firm playing grim trigger
is a Nash Equilibrium in the repeated game. In this case grim trigger would mean
each firm producing qM in every period as long as all firms did this in the preivous
period and producing qC in any period where it was observed in the previous period
that someone did something other than qM . This will be a NE if

P Vcollusion > P Vdeviation

πM δπC
⇒ ≥ πD +
n(1 − δ) (1 − δ)

where collusion here means playing the strategy encouraged by the grim trigger strategy
and deviatation means taking advantage of the other players by maximizing profit in
some period. The present value of collution is the present value of the infinite stream
of individual firm profits from playing the collusive strategy when all other firms play
it ( πnM ). The present value of deviation is the one-time profit of deviating (πD ) in
the stage game plus the infinite stream of subsequent profits from playing the non-
πM
cooperative cournot equilibrium, (πC ). Plugging the values we have for n , πC and
πD we get

1Deriving q : Maximize total profit, (a − Q − c)Q w.r.t to Q. F.O.C. is 2Q = a − c. So industry total quantity
M
a−c
to maximize industry total profit is QM = 2
. qM is just one firm’s share of QM .
2
Deriving qC : See AK 1 (Gibbons 1.4)
3
Deriving qD : Suppose n − 1 firms – all but firm i – cooperate by each producing qM ; qD is the
 output level
(n−1)(a−c)
that will maximize i’s profit in a single stage game. Hence it solves maxqi a − c − 2n
− qi qi . F.O.C is
(n−1)(a−c)
a−c− 2n
− 2qD = 0.
4 PROFESSOR A. JOSEPH GUSE

P Vcollusion > P Vdeviation

(a−c)2
2 δ (n+1)
(a − c)2

n+1 2
2
⇒ ≥ (a − c) +
4n(1 − δ) 4n (1 − δ)
16n2
4n δ (n+1)2
⇒ ≥ (n + 1)2 +
(1 − δ) (1 − δ)
16n2
⇒4n ≥ (1 − δ)(n + 1)2 + δ
(n + 1)2
⇒4n(n + 1)2 ≥ (1 − δ)(n + 1)4 + δ16n2
⇒4n(n + 1)2 − (n + 1)4 ≥ δ(16n2 − (n + 1)4 )
⇒δ(16n2 − (n + 1)4 ) ≤ 4n(n + 1)2 − (n + 1)4
4n(n + 1)2 − (n + 1)4
⇒δ ≥
16n2 − (n + 1)4
4n(n2 − 2n + 1)
⇒δ ≥ +1
16n2 − (n + 1)4

4n(n2 −2n+1)
Note that 16n2 −(n+1)4
is always negative for all n ≥ 1 since the denominator is always
negative and the numerator is always positive. Note also that the largest power in the
4n(n2 −2n+1)
numerative is O(n3 ) while the in the denominator we have O(n4 ). Hence 16n2 −(n+1)4
is a negative number approaching 0 as n grows large. Which means that the minimum
value of δ necessary in order to support collusion in equilibrium is less than 1 and
approaches 1 as n grows large.
(b) If δ is too small for the firms to use trigger strategies to sustain the monopoly output,
what is the most-profitable symmetric subgame-perfect Nash equilibrium that can be
sustained using trigger strategies? OPTIONAL.
(3) (Gibbons 3.2) Consider a Cournot duopoly operating in a market with inverse demand
P (Q) = a − Q, where Q = q1 + q2 is the aggregate quantity on the market. Both firms have
total costs ci (qi ) = cqi , but demand is uncertain: it is high (a = aH ) with probability θ and
low (a = aL ) with probability 1 − θ. Furthermore, information is asymetric: firm 1 knows
whether demand is high or lwo, but firm 2 does not. All of this is common knowledge. The
two firms simulataneously chooose quantities.
(a) What are the strategy spaces for the two firms.
ANSWER.
Firm 1: q1 : {aL , aH } → R
Firm 2: q2 ∈ R+
Since Firm 1 observes the demand parameter Firms 1’s strategy is a function, mapping
from the set of possible demand parameters, {aL , aH } to the positive real numbers
(feasible output levels). Since there are only two possible demand types, this boils
 ANSWER KEY 7 GAME THEORY, ECON 395 5

down to Firm 1’s strategy being a pair or positive numbers - one to be played if a = aL
and the other to be played if a = aH . Since Firm 2 observes neither the demand
parameter nor Firm 1’s action, there is nothing to make its choice of contingent on; its
strategy is simply a choice of output quantity, q2 .
(b) Make assumptions on aH , aL , θ, and c such that all equilibrium quantities are positive.
What is the Bayesian Nash equilibrium of this game?
ANSWER. If firm 1 is to playing a best response againt a strategy of q2 by firm 2,
then firm 1 should solve

max (a − c − q2 − q1 ) q1
q1

Firm 1’s best response function can be derived by writing down the F.O.C. and solving
for q1 in the usual way

a − c − q2
q1∗ (q2 , a) =
2
Firm 2’s best response function solves

max (aH − c − q2 − q1 (aH )) q2 θH + (aL − c − q1 (aL ) − q2 ) q2 (1 − θH )

q2

Note that the first group of terms in this objective function is the contribution to
F2’s expected profit when demand is high and F1 plays some strategy q1 (aH ). (Firm
2 won’t know whether demand is H or L, but will know that when it is H that F1
will plat q1 (aH ).) Hence this first group of terms is multiplied by the probability that
demand is H, θH . Differentiating w.r.t q2 gives us the following F.O.C.

(aH − 2q1 (aH )) θH + (aL − q1 (aL )) (1 − θH ) − c − 2q2 = 0

To solve for the equilibrium we can substitute the epression we derived for F1’s BR
funtion into this, which yields

   
a H − c − q2 a L − c − q2
aH − θH + a L − (1 − θH ) − c − 2q2 = 0
2 2
a  a  c 3q2
H L
⇒ θH + (1 − θH ) − − =0
2 2 2 2
⇒ (aH ) θH + (aL ) (1 − θH ) − c − 3q2 = 0
(aH ) θH + (aL ) (1 − θH ) − c
⇒q2 =
3
E(a) − c
⇒q2 =
3
6 PROFESSOR A. JOSEPH GUSE

(Surprisingly ?), this means that Firm 2’s equilibrium strategy is to produce an output
level as though it were in a Cournot Equilibrium and demand is the expected demand.
(note that E(a) = (aH )θH + aL (1 − θH ).) Since Firm 2 will always play the average
Cournot quantity, Firm 1 will want to produce above this quantity when a = aH and
below this quantity when a = aL . Specifically,

(aH )θH +(aL )(1−θH )−c

aL − c − 3
q1∗ (aL ) =
2
3a L − a θ
H H − aL (1 − θH ) − 2c
⇒q1∗ (aL ) =
6
3aL E(a)
3aL − E(a) − 2c 2 − 2 −c
⇒q1∗ (aL ) = =
6 3

Note that this is less then F2 will produce when a + aL since 3aL
2 − E(a)
2 − c < E(a) − c.
Similarly, F1’s output when it observes a = aH can be calculated:

(aH )θH +(aL )(1−θH )−c

aH − c − 3
q1∗ (aH ) =
2
3a H − a H θ H − aL (1 − θH ) − 2c
⇒q1∗ (aH ) =
6
3aH E(a)
3aH − E(a) − 2c 2 − 2 −c
⇒q1∗ (aH ) = =
6 3

Note that this is less then F2 will produce when a + aL since 3aH
2 − E(a)
2 − c > E(a) − c.
The answer to the question about what conditions the parameters have to meet in
order to guarantee that all quantities are positive is that we must have

3aL − E(a) − 2c > 0 AND E(a) − c > 0

Notice that if this condition hold then we see directly that q1∗ (aL ) > 0. Also since
aH > aL , we know that 3aL − E(a) − 2c > 0 ⇒ 3aH − E(a) − 2c > 0 so q1∗ (aH ) > 0 as
well. The second condition guarantees that q2∗ > 0
Ironically, perhaps, Firm 1, who knows more than Firm 2, will earn less profit when
demand is low. (Since they will face the same price and marginal cost and F2 will
produce more).
(4) (Gibbons 3.6) Consider a first-price sealed-bid auction in which the bidders’ valuations are
independently and uniformly distributed on [0, 1]. Show that if there are n bidders, then the
(n−1)
strategy of bidding n times one’s valuation is a symmetric Bayesian nash equilibrium
of this auction.
 ANSWER KEY 7 GAME THEORY, ECON 395 7

(n−1)vi
ANSWER. Let vi be the valuation of biider i. To show that n is a symmetric
BNE, we need to show that if all players except one employ this strategy then it is a best
(n−1)vj
response for the last one. Suppose that all bidders j 6= i bid n , bidder i’s problem is
to maximize expected utility.

max Eui (b) = Pr(win|b)(vi − b) + Pr(lose|b)0

b

Let’s look more closely at Pr(win|b)

Pr(win|b) = Pr(b > max {bj })

j6=i
  
(n − 1)vj
= Pr b > max
j6=i n
 
(n − 1)v1 (n − 1)vi−1 (n − 1)vi+1 (n − 1)vn
= Pr b > &...&b > &b > &...&b >
n n n n
 
nb nb nb nb
= Pr v1 < &...&vi−1 < &b > vi+1 < &...&b > vn <
n−1 n−1 n−1 n−1
 
Y nb
= Pr vj <
n−1
j6=i

Note the last step can be taken because each vj is an independently drawn value which
means the probability of the joint statement concening each vj is equal to the product of
each statement. Using the fact that each j is drawn from the uniform distribution, we know
that, in general Pr(vj < x) = x, so we can be even more precise about Pr(win|b):

Y  nb 
Pr(win|b) =
n−1
j6=i

nb n−1
 
=
n−1

Plugging this back into i’s objecive function and differentiating w.r.t b, we get the fol-
lowing first order condition.
8 PROFESSOR A. JOSEPH GUSE

nb∗i n−2 nb∗i n−1

     
n ∗
(n − 1) (vi − bi ) − =0
n−1 n−1 n−1
nb∗i n−2 nb∗i n−1
   
∗
⇒ (n)(vi − bi ) − =0
n−1 n−1
nb∗i (n−1)−(n−2)
 
⇒n(vi − b∗i ) − =0
n−1
nb∗i
 
∗
⇒n(vi − bi ) − =0
n−1
 ∗ 
∗ bi
⇒(vi − bi ) − =0
n−1
⇒(n − 1)(vi − b∗i ) − b∗i = 0
(n − 1)vi
⇒b∗i =
n

To be thorough, we should also check the second-order condition (SOC):

d2 Eui (b∗i )
<0
db∗i
d2 Eui (b∗i )
/(n − 1) < 0
db∗i
2 " # 
nb∗i n−3
n−2 
∗ nb∗i n−2
     
n ∗ nb i n n
⇐⇒ (n − 2) (vi − bi ) − − <0
n−1 n−1 n−1 n−1 n−1 n−1
" # 
nb∗i n−3 nb∗i n−2 nb∗i n−2
     
n ∗
⇐⇒ (n − 2) (vi − bi ) − − <0
n−1 n−1 n−1 n−1
" (n−2)−(n−3) # 
∗ nb∗i (n−2)−(n−3)
  
n ∗ nb i
⇐⇒ (n − 2) (vi − bi ) − − <0
n−1 n−1 n−1
"  #
nb∗i 1
 
n ∗
⇐⇒ (n − 2) (vi − bi ) − 2 <0
n−1 n−1
⇐⇒ (n − 2)(vi − b∗i ) − 2b∗i < 0
⇐⇒ (n − 2)vi − nb∗i < 0

(n−1)vi
Evaluating this last epresstion at b∗i = n we get
 ANSWER KEY 7 GAME THEORY, ECON 395 9

d2 Eui (b∗i )
<0
db∗i
(n − 1)vi
⇐⇒ (n − 2)vi − n <0
n
⇐⇒ (n − 2)vi − (n − 1)vi < 0
⇐⇒ − vi < 0

which is true by our assumption that vi is drawn on U (0, 1).