Midterm Examination

Fall 2004 Economics 703

There are 3 questions. All parts of all questions count equally. Justify all answers and show all work. Write legibly. If you need to make additional assumptions, state them clearly. BE CONCISE. 1. Consider a continuous action variation of the eort example we discussed in class. There are two players who choose eort levels e1 and e2 , ei [0, ). For a pair of eort levels (e1 , e2 ), the total output is e1 + e2 + e1 e2 , which is split equally between the two. The cost to player i of eort level ei is e2 , and hence, the payo to player i when eort levels e1 and e2 are chosen is i i (e1 , e2 ) = 1/2(e1 + e2 + e1 e2 ) e2 . However, unlike the example in class, the players do not choose i their eort levels simultaneously. Instead, player 1 chooses his eort level rst, and player 2 chooses his eort level after seeing player 10 s eort choice. a. Describe precisely the strategy sets for the two players. b. What is the subgame perfect Nash equilibrium of this game? c. Suppose that the game is played a nitely number of times. Players payos are the sum of the payos for the stage game without discounting. What are the subgame perfect equilibria of the repeated game? Explain briey. d. Suppose that the game is played innitely many times with players payos the discounted sum of the stage game payos. Is there a subgame perfect equilibrium in which player 1s payo is higher than player 2s payo? Explain.

2. a. Which of the following games can be solved by dominance or iterated dominance? b. Find the pure strategy Nash equilibria for the games. L R U 3,3 2,0 D 4,1 8,-1 L U 5,9 M 3,2 D 2,8 W U 3,6 M 2,6 D 1,5 M 1,1 0,9 0,1 X 4,10 3,3 2,9 R 4,3 1,1 8,4 Y 5,0 4,10 3,0 Z 0,8 1,1 4,6

c. Consider a two stage game in which the rst game with two strategies for each player is played twice, and in which the payos to the players are the sum of the payos from each stage without discounting. Can the game be solved by dominance or iterated dominance? 1

3. Suppose that two people can invest in a project that would be valuable to both of them if it is completed. The project requires 2 units of investment and will give a value of 25 to each person if undertaken. Person 1 can only invest in odd period while person 2 can only invest in even periods. There are four periods, with the cost of investment in period t equal to 2t per unit of investment. That is, an investment of 1 costs 2 in period 1, 4 in period 2, 6 in period 3 and 8 in period 4. If there are at least 2 units of investment at the end of period 4 each person receives a payo of 25 minus the cost of the investments that player has made. If there are 0 or 1 units of investment at the end of period 4 each person just loses the cost of her investment, if any. Suppose that in each period that a player can make an investment, either 0 or 1 can be invested. a. Write down the extensive form for the game. b. Describe precisely the strategy sets for the two players. c. What is the subgame perfect equilibrium for the game? (Be sure to describe precisely the strategies in the equilibrium.) d. Is there a Nash equilibrium of the game that is not subgame perfect? Explain. e. Suppose now that in each period that a player can make an investment, each player can invest 0, 1, or 2. What is the subgame perfect equilibrium? (Be sure to describe precisely the strategies in the equilibrium.) f. Suppose now that as before, in each period that a player can make an investment, that player can invest 0 or 1, but that there are six periods instead of four periods. Also as before, the cost of making an investment of 1 is 2t, where t is the period the investment is made. Thus, the cost of investing 1 in period 5 is 10 and the cost in period 6 is 12. What is the subgame perfect equilibrium outcome in this case? (You do not need to specify fully the equilibrium strategies in this case, but you should explain the logic briey. You also should not write out the extensive form tree for the game.)