Advanced Microeconomics: Game Theory and

Information Economics
Problem Set 1
Prof. Dr. Heiner Schumacher
KU Leuven

Problem 1: Weakly Dominant Strategies

1. Argue that if a player has two weakly dominant strategies, then for every strategy
choice by his opponents, the two strategies yield him equal payo¤s.

2. Provide an example of a two-player game in which a player has two weakly dominant
pure strategies, but his opponent prefers that he plays one of them rather than the
other.

Problem 2: Auctions
There are two bidders in an auction on a used bike. The seller does not value the bike,
but Bidder 1 would pay up to DKK 20,000 for it, while Bidder 2 would pay no more than
DKK 1,000. Both submit sealed bids, which can be for any of the following amounts:
DKK 0, DKK 500, DKK 1000, DKK 10,000, DKK 20,000 or DKK 25,000. In case of a
tie, a coin is ‡ipped to see who will get the bike.

1. Write this game in normal form.

2. Identify all strongly dominated strategies.

Problem 3: The Traveler’s Dilemma

Lone and Michael, returning from a remote Paci…c island, …nd that the airline has dam-
aged their identical antiques that each of them has purchased. An airline manager says
that he is happy to compensate them, but is handicapped by being clueless about the
value of these strange objects. He also explains to them that the airline is liable for a

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maximum of DKK 1,000 per item. Simply asking the travelers for the price is hopeless,
he …gures out, for they will in‡ate it. Instead he devises a more complicated scheme.

He asks each of them to write down the price of the antique as any amount in 10s of
DKK between 20 and 1000 without conferring together. If both write the same number,
he will take that to be the true price, and he will pay each of them that amount. But if
they write di¤erent numbers, he will assume that the lower one is the actual price and
that the person writing the higher number is cheating. In that case, he will pay both
of them the lower number along with a bonus and a penalty: the person who wrote the
lower number will get DKK 20 more as a reward for honesty, and the one who wrote the
higher number will get DKK 20 less as a punishment. For instance, if Lone write 460 and
Michael writes 1,000, Lone will get DKK 480 and Michael will get DKK 440.

1. What would Lone and Michael like to report if they could commit to a certain
strategy?

2. Derive the Nash equilibrium for the Traveler’s Dilemma (assume that Lone and
Michael only maximize their own payo¤).

3. Provide a brief discussion of why the answers in (1.) and (2.) di¤er.

Problem 4: Cournot Duopoly

Consider the Cournot model of duopoly as discussed in class. There are two …rms si-
multaneously choosing their production quantities q1 and q2 . The inverse demand in the
market is P (Q) = a Q (with Q = q1 + q2 ) and …rms have identical marginal costs c.
Additionally, suppose that each …rm is run by a manager and the manager’s compensa-
tion depends on how much better his own …rm does relative to the other. In particular,
assume that the salary of the manager of …rm 1 is 1 2 and that of the manager of
…rm 2 is 2 1 (where i is the pro…t of …rm i). Determine the Nash equilibrium.

Problem 5: Two Markets

Imagine a market setting with three …rms. Firms 2 and 3 are already operating as
monopolists in two di¤erent industries (they are not competitors). Firm 1 decides whether
to enter …rm 2’s industry and compete with …rm 2, or enter …rm 3’s industry and thus
compete with …rm 3. Production in …rm 2’s industry occurs at zero cost, while the cost
of production in …rm 3’s industry is 2 per unit. Demand in …rm 2’s industry is given by
P2 (Q) = 9 Q, while demand in …rm 3’s industry is given by P3 (Q) = 14 Q (where P
is the price and Q the total quantity produced in the corresponding industry).

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 The game runs as follows. First, …rm 1 chooses between “enter …rm 2’s industry”(E2)
and “enter …rm 3’s industry” (E3). This choice is observed by …rms 2 and 3. Then, if
…rm 1 chose E2, …rms 1 and 2 compete as Cournot duopolists (they select their quantities
q1 and q2 simultaneously). In this case, …rm 3 automatically gets the monopoly pro…t in
its own industry. If …rm 1 chose E3, then …rm 1 and 3 compete as Cournot duopolists
and …rm 2 gets its monopoly pro…t.

1. Draw the game tree corresponding to this problem.

2. Calculate and report the subgame-perfect Nash equilibrium of this game. Does …rm
1 enter …rm 2’s or …rm 3’s industry?

3. Is there a Nash equilibrium (not necessarily subgame-perfect) in which …rm 1 enters

the other industry? If so, describe it. If not, brie‡y explain why.

Problem 6: The Rotten Kid Theorem

In a three person household (father, mother, child) the parents not only care about their
own well-being, but also about the happiness of their child. The child, on the other hand,
is completely egoistic. With its work e¤ort the child can increase the family income. An
e¤ort a increases the family income by 20a whereas the child incurs a disutility of a2 . The
parents observe the child’s e¤ort and decide about the child’s pocket money of amount b.
The child’s preferences are given by the utility function

UC (a; b) = ln(100 a2 + b):

The parent’s utility function is

VP = ln(400 + 20a b) + UC (a; b):

1. Write this game in an extensive form.

2. Show that in the unique subgame-perfect equilibrium the egoistic child chooses its
e¤ort a such that the family income minus the child’s disutility is maximized (This
is the Rotten Kid Theorem). Note that the total family income is 100 + 400 + 20a.
[Hint: Solve for the equilibrium value of a and compare it with the value of a
maximizing the family income minus the child’s disutility].

3. Now assume that the parents are completely egoistic:

VP = ln(400 + 20a b):

Find the subgame-perfect equilibrium. Does the equilibrium e¤ort a still maximize
the family income minus the child’s disutility of e¤ort?

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Problem 7: Pirates’Game
Ten pirates (ranked 10 to 1 from the oldest to the youngest) jointly own 100 gold coins.
They have to decide on an allocation which gives each pirate a non-negative number of
coins and exhausts all the coins. They have agreed on the following decision rule: The
oldest pirate is the …rst to propose an allocation. If at least half of the pirates (including
the proposer) approve of this allocation, it is enforced. Otherwise, pirate 10 is executed.
The nine-pirate version of the game is then played, where pirate 9 makes a proposal. For
approval of this allocation, the vote of at least four pirates among the other eight pirates
is needed. If the proposal is accepted, it is enforced, otherwise pirate 9 is executed. And
so on. (If the number of pirates in the game is odd, a strict majority is necessary; if the
number is even, the proposer breaks ties).

1. What are all the subgame-perfect equilibria described in terms of what pirate 10
gets?

2. Restricting attention to the subgame-perfect equilibria, what are the minimum and
maximum payo¤s that pirate 10 obtains?