Game Theory
Game Theory
Game Theory
Faculty
Professor: Muhamet Yildiz [email protected] (Office hours: M 4:00-5:30, E52-251a, 253-5331)
TA: Kenichi Amaya [email protected] (Office hours: T 4:00-6:00, E52-303, 253-3591)
TA: Astrid Dick [email protected]
Schedule
Class: Room E51-372
Recitation: F10 or F3, Room E51-085
Handouts
● syllabus
● Lecture notes 1
● Lecture notes 2
● Lecture notes 3
● Lecture notes 4
● Lecture notes 5
● Lecture notes 6
● Review notes 1
● Review notes 2
● Review notes 3 (11/30)
Lecture Slides
Some of the slides for lectures 1,2, and 6 are not included, as they are made by another program.
● Slides 1
● Slides 2
● Slides 3
● Slides 4
● Slides 5
● Slides 6
● Slides for lecture 8
● Slides for lecture 9
● Slides for lecture 10
● Slides for lecture 12
● Slides for lecture 13
● Slides for lecture 15-18
● Slides for lecture 19-21
Homeworks
● Homework 1 (due 9/26)
● Solutions for homework 1
● Homework 2 (due 10/3)
● Solutions for homework 2
● Homework 3 (due 10/29)
● Solutions for homework 3 Revised
● Homework 4 (due 11/7)
● Solutions for homework 4
● Homework 5 (due 12/7)
● Solutions for homework 5 Revised
Exams
● Midterm 1 (10/10)
● Midterm 1 solutions
● Midterm 1 Grade Distribution
● Midterm 2
● Midterm 2 Solutions New!
● Midterm 2 Grade Distribution New!
● Grade distribution of the average of midterm 1 and 2 New!
● Mock Final New!
● Mock Final solutions New!
● Final exam solutions New!
● Final exam grade distribution New!
● Final grade+quiz distribution New!
Midterm 2
● 1996
● 1997
● 1999 Mock Midterm
● 2000 (11/16)
● 2000 (11/17)
● Some previous midterm questions (including some questions from files above)
● Solutions for Question 7 (or 8)
Final
● 2000
● 2000 solutions
● 2000 make-up
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(0,2) (-1,-1)
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1 Enter 2 Acc. 1 Enter 2 Acc.
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1 Enter 2 Acc.
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1 Enter 2 Acc.
(2,2)
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1 Enter 2 Acc. 1 Enter 2 Acc.
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<
14.12 Review Notes 1
Kenichi Amaya∗
September 14, 2001
max pq − c(q)
q
⇒ FOC p = c0 (q) = M C.
Monopoly A monopolist choose the price, and the quantity to sell is deter-
mined by the demand curve D(p).
In the examples above, the firm is the only decision maker and everything
other than the choice variables (q in perfect competition and q in monopoly) are
exogenously given. Therefore we can solve for the optimal value of the choice
variable.
Consider the Cournot Duopoly. Firm 1 chooses the quantity to sell q1 , and
Firm 2 chooses q2 . Let P (q) be the inverse demand curve, where q = q1 + q2 .
Firm 1 maximizes its profit:
1
Firm 2 maximizes its profit:
To solve for the optimal q1 , we need to know what q2 is. But to know the
optimal q2 , we need to know what q1 is. This goes forever and we can never
solve it mathematically. We need some theory to solve it: Game theory.
Game theory is a tool to analyze people’s behavior under strategic environ-
ment: An agent’s payoff depends not only on his decisions but also other agents’
decisions.
Other examples includes:
• Employer — Employee (Wage scheme — Effort)
• Government — Firm (Regulation — Business strategy)
• U.S. Government — Japanese government (Trade policy)
U (lottery 1) ≥ U (lottery 2)
lottery 1 lottery 2.
The basic theory of choice implies there exists such a utility function if is a
preference relationship, i.e., it is complete and transitive
2
But thinking directly about this function U is too messy! It is more conve-
nient if we have a function u such that
1 1
U (lottery 1) = u(beer) + u(chocolate),
2 2
1 2
U (lottery 2) = u(beer) + u(cof f ee).
3 3
But can we really find such an convenient function u? Actually, it is known that
we can find u if the agent’s preference over lotteries satisfies the following
condition, in addition to completeness and transitivity.
ap + (1 − a)r aq + (1 − a)r ⇔ p q.
ap + (1 − p)r q bp + (1 − b)r.
3
4 Modelling games
When we write down a game which represents some economic environment,
the payoffs of the game are vNM utilities of the players, not the actual money
amount received. In this way, we can assume the players maximize their ex-
pected payoffs. The only case where the payoffs of a player is equal to the
actual money amount received is the case where the player is risk neutral. Ac-
tually, in many textbook modelling we find the players are assumed to be risk
neutral and therefore maximize expected revenue.
4
14.12 Review Notes
Dynamic games with incomplete information
Kenichi Amaya∗
November 30, 2001
Note 1: When you are asked to describe a PBE, you need to show not only
the strategy profile but also the belief system. (However, you usually don’t need
to describe the belief at a singleton information set because it is obvious).
Note 2: PBE is a stronger concept than subgame perfect Nash equilibrium.
Therefore, the strayegy profile of a PBE is a subgame perfect Nash equilibrium.
∗ E52-303, [email protected]
1
2 How do we find PBE?
Here is an abstract procedure of looking for PBE.
1. Using sequential rationality and Bayes rule, determine strategies and be-
liefs wherever possible. If you can determine strategies and beliefs every-
where, that’s it.
2. When you can’t do more, make an assumption about a strategy at any
information set. Then, using sequential rationality and Bayes rule, deter-
mine strategies and beliefs wherever possible.
3. You may be able to determine strategies and beliefs everywhere, i.e., to
find an equilibrium. Then, change your assumption and look for another
equilibrium.
4. You may reach a contradiction. In this case, the assumption was wrong.
Change your assumption.
5. When you can’t do more only with the assumption you made, make a
further assumption.
The idea we use in finding a mixed strategy Nash equilibrium applies here
too: The mixing probability must be such that the other player is indifferent
between the strategies he is mixing.
2
14.12 Economic Applications of
Game Theory
Professor: Muhamet Yildiz
Lecture: MW 2:30-4:00 @4-153?
Office Hours: M 4-5:30 @E52-251a
TA: Kenichi Amaya
F 10,3 @E51-85
Office Hours:TBA
Web: http://web.mit.edu/14.12/www/
1
Hawk-Dove game
V − c V − c (V,0)
,
2 2
(0,V) (V/2,V/2)
Chicken
(-1,-1) (1,0)
(0,1) (1/2,1/2)
2
Stag Hunt
(2,2) (4,0)
(0,4) (6,6)
Quiz Problem
• Without discussing with anyone, each student
is to write down a real number xi between 0
and 100 on a paper and submit it to the TA.
• The TA will then compute the average
x1 + x2 + + xn
x= .
n
• The students who submit the number that is
closest to x / 3 will share 100 points equally;
the others will get 0.
3
14.12 Game Theory
Road Map
1. Basic Concepts (Alternatives, preferences,…)
2. Ordinal representation of preferences
3. Cardinal representation – Expected utility
theory
4. Applications: Risk sharing and Insurance
5. Quiz
1
Basic Concepts: Alternatives
• Agent chooses between the alternatives
• X = The set of all alternatives
• Alternatives are
– Mutually exclusive, and
– Exhaustive
• Example: Options = {Tea, Coffee}
X = {T, C, TC, NT} where
T= Tea, C = Coffee, TC = Tea and Coffee,
NT = Neither Tea nor Coffee
2
Examples
• Define a relation among the students in this
class by
– x T y iff x is at least as tall as y;
– x M y iff x’s final grade in 14.04 is at least as
high as y’s final grade;
– x H y iff x and y went to the same high school;
– X Y y iff x is strictly younger than y;
– x S y iff x is as old as y;
Exercises
• Imagine a group of students sitting around a
round table. Define a relation R, by writing
x R y iff x sits to the right of y. Can you
represent R by a utility function?
• Consider a relation } among positive real
numbers represented by u with u ( x ) = x .
2
3
• TeX – OR Theorem
• TeX – Cardinal representation
• VNM Axioms
• Theorem
A Lottery
4
Two Lotteries
$1M
$1000 .00001
.3
.3
$10
.99999
.4 $0
$0
Exercise
• Consider an agent with VNM utility
function u with u ( x ) = x .
2
5
Attitudes towards Risk
p x
• A fair gamble: px+(1-p)y = 0.
1-p y
A utility function
EU
u
A
u(pW1+(1- p)W2)
C
EU(Gamble)
B
W1 pW1+(1-p)W2 W2
6
• An agent is risk-neutral iff he has a linear
utility function, i.e., u(x) = ax + b.
• An agent is risk-averse iff his utility
function is concave.
• An agent is risk-seeking iff his utility
function is convex.
Risk Sharing
• Two agents, each having a utility function u
with u ( x ) = x and an “asset:” .5
$100
.5 $0
• For each agent, the value of the asset is
7
• If they form a mutual fund so that each
agent owns half of each asset, each gets
$100
1/4
1/2 $50
1/4
$0
Insurance
• We have an agent with u(x ) = x and
.5 $1M
.5 $0
• And a risk-neutral insurance company with
lots of money, selling full insurance for
“premium” P.
8
Lecture 3
Decision Theory/Game Theory
Road Map
1. Basic Concepts (Alternatives, preferences,…)
2. Ordinal representation of preferences
3. Cardinal representation – Expected utility theory
4. Applications: Risk sharing and Insurance
5. Quiz
6. Representation of games in strategic
and extensive forms
7. Quiz?
1
A Lottery
Two Lotteries
$1M
$1000
.00001
.3
.3
$10
.99999
.4 $0
$0
2
Exercise
• Consider an agent with VNM utility
function u with u ( x ) = x .
2
3
A utility function
EU
u
A
u(pW1+(1- p)W2)
C
EU(Gamble)
B
W1 pW1+(1-p)W2 W2
4
Risk Sharing
• Two agents, each having a utility function u
with u ( x ) = x and an “asset:” .5
$100
.5 $0
• For each agent, the value of the asset is
1/4
$0
5
Insurance
• We have an agent with u(x ) = x and
.5 $1M
.5 $0
• And a risk-neutral insurance company with
lots of money, selling full insurance for
“premium” P.
Quiz Problem
• Without discussing with anyone, each student
is to write down a real number xi between 0
and 100 on a paper and submit it to the TA.
• The TA will then compute the average
x1 + x2 + + xn
x= .
n
• The students who submit the number that is
closest to x / 3 will share 100 points equally;
the others will get 0.
6
Multi-person Decision Theory
• Who are the players?
• Who has which options?
• Who knows what?
• Who gets how much?
Knowledge
Common Knowledge: x is
1. If I know something, it
common knowledge iff
must be true.
2. If I know x, then I know •Each player knows x
that I know x. •Each player knows that each
3. If I don’t know x, then I player knows x
know that I don’t know x.
• Each player knows that each
4. If I know something, I
player knows that each player
know all its logical
knows x
implications.
•Each player knows that each
player knows that each player
knows that each player knows x
•… ad infinitum
7
Representations of games
Normal-form representation
Definition (Normal form): A game is any list
G = (S1 , l , S n ; u1 , l , u n )
8
Chicken
(-1,-1) (1,0)
(0,1) (1/2,1/2)
Extensive-form representation
Definition: A tree is a set of nodes connected with
directed arcs such that
1. For each node, there is at most one incoming
arc;
2. each node can be reached through a unique path;
9
A tree?
A tree??
B B
A
A
D
C
C
10
A tree
Non-terminal
Terminal Nodes
nodes
11
Information set
An information set is a collection of nodes
such that
1. The same player is to move at each of
these nodes;
2. The same moves are available at each of
these nodes.
An informational partition is an allocation
of each non-terminal node of the tree to an
information set.
A game
1
L R
(2,2) 2
l r u
1 (0,0)
1
λ Ρ
ρ Λ
12
Another Game
1 x
T B
2
L R L R
T B
L R
R L
13
Strategy
A strategy of a player is a complete
contingent-plan, determining which action
he will take at each information set he is to
move (including the information sets that
will not be reached according to this
strategy).
14
Matching pennies with perfect information
2
1
HH HT TH TT
Head
Tail
15
A game with nature
Left (5, 0)
1
Head
1/2 Right (2, 2)
Nature
(3, 3)
1/2 Left
Tail 2
Right
(0, -5)
A centipede game
1 A 2 α 1 a
(1,-5)
D δ d
16
Lecture 4
Representation of Games &
Rationalizability
14.12 Game Theory
Muhamet Yildiz
Road Map
1. Representation of games in strategic
and extensive forms
2. Dominance
3. Dominant-strategy equilibrium
4. Rationalizability
1
Normal-form representation
Definition (Normal form): A game is any list
G = (S1 , l , S n ; u1 , l , u n )
Chicken
(-1,-1) (1,0)
(0,1) (1/2,1/2)
2
Extensive-form representation
Definition: A tree is a set of nodes connected with
directed arcs such that
1. For each node, there is at most one incoming
arc;
2. each node can be reached through a unique path;
A tree
Non-terminal
Terminal Nodes
nodes
3
Extensive form – definition
Definition: A game consists of
– a set of players
– a tree
– an allocation of each non-terminal node to a
player
– an informational partition (to be made precise)
– a payoff for each player at each terminal node.
Information set
An information set is a collection of nodes
such that
1. The same player is to move at each of
these nodes;
2. The same moves are available at each of
these nodes.
An informational partition is an allocation
of each non-terminal node of the tree to an
information set.
4
A game
1
L R
(2,2) 2
l r u
1 (0,0)
1
λ Ρ
ρ Λ
Another Game
1 x
T B
2
L R L R
5
The same game
1 x
T B
L R
R L
Strategy
A strategy of a player is a complete
contingent-plan, determining which action
he will take at each information set he is to
move (including the information sets that
will not be reached according to this
strategy).
6
Matching pennies with perfect information
2’s Strategies:
HH = Head if 1 plays Head,
1 Head if 1 plays Tail;
HT = Head if 1 plays Head,
Head Tail Tail if 1 plays Tail;
2 TH = Tail if 1 plays Head,
2 Head if 1 plays Tail;
head tail head tail TT = Tail if 1 plays Head,
Tail if 1 plays Tail.
(-1,1) (1,-1) (1,-1) (-1,1)
2
1
HH HT TH TT
Head
Tail
7
Matching pennies with Imperfect
information
1 2
1
Head Tail
Head Tail
2 Head (-1,1) (1,-1)
head tail head tail
Tail (1,-1) (-1,1)
(-1,1) (1,-1) (1,-1) (-1,1)
1
Head
1/2 Right (2, 2)
Nature
(3, 3)
1/2 Left
Tail 2
Right
(0, -5)
8
Mixed Strategy
Definition: A mixed strategy of a player is a
probability distribution over the set of his strategies.
How to play
9
Dominance
s-i =(s1,…, si-1,si+1,…,sn)
Definition: A pure strategy si* strictly
dominates si if and only if
u i ( si* , s − i ) > u i ( si , s − i ) ∀ s−i .
Prisoners’ Dilemma
2
1 Cooperate Defect
10
A game
2
1 L m R
Weak Dominance
Definition: A pure strategy si* weakly dominates si
if and only if
u i ( si* , s − i ) ≥ u i ( si , s − i ) ∀ s−i .
and at least one of the inequalities is strict. A mixed
strategy σi* weakly dominates si iff
σ i ( si1 )ui ( si1 , s−i ) + + σ i ( sik )ui ( sik , s−i ) > ui ( si , s−i ) ∀si
and at least one of the inequalities is strict.
If a player is rational and cautious (i.e., he assigns
positive probability to each of his opponents’
strategies), then he will not play a weakly
dominated strategy.
11
Dominant-strategy equilibrium
Definition: A strategy si* is a dominant
strategy iff si* weakly dominates every
other strategy si.
Prisoners’ Dilemma
2
1 Cooperate Defect
12
Second-price auction
• N = {1,2} buyers;
• The value of the house
for buyer i is vi;
• Each buyer i
simultaneously bids bi;
• i* with bi* = max bi gets
the house and pays the
second highest bid
p = maxj≠ibj.
Question
What is the probability that an nxn game has a
dominant strategy equilibrium given that the
payoffs are independently drawn from the
same (continuous) distribution on [0,1]?
13
(2n-2)
(1/n)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1 2 3 4 5 6 7 8 9 10
14
Rationalizability
Eliminate all the strictly
dominated strategies.
No
Rationalizable strategies
Simplified price-competition
Firm 2
High Medium Low
Firm 1
Dutta
15
A strategy profile is rationalizable when …
16
Lecture 5
Nash equilibrium & Applications
Road Map
1. Rationalizability – summary
2. Nash Equilibrium
3. Cournot Competition
1. Rationalizability in Cournot Duopoly
4. Bertrand Competition
5. Commons Problem
6. Quiz
7. Mixed-strategy Nash equilibrium
1
Dominant-strategy equilibrium
s-i =(s1,…, si-1,si+1,…,sn)
Definition: si* strictly dominates si iff
u i ( si* , s − i ) > u i ( si , s − i ) ∀ s−i ;
si* weakly dominates si iff u i ( s , s − i ) ≥ u i ( si , s − i ) ∀s−i
*
i
and at least one of the inequalities is strict.
Definition: A strategy si* is a dominant strategy iff
si* weakly dominates every other strategy si.
Definition: A strategy profile s* is a dominant-
strategy equilibrium iff si* is a dominant strategy
for each player i.
Examples: Prisoners’ Dilemma; Second-Price auction.
Question
What is the probability that an nxn game has a
dominant strategy equilibrium given that the
payoffs are independently drawn from the
same (continuous) distribution on [0,1]?
2
(2n-2)
(1/n)
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1 2 3 4 5 6 7 8 9 10
Rationalizability
Eliminate all the strictly
dominated strategies.
No
Rationalizable strategies
3
Simplified price-competition
Firm 2
High Medium Low
Firm 1
Dutta
4
Stag Hunt
(2,2) (4,0)
(0,4) (6,6)
A summary
• If players are rational (and cautious), then they
play the dominant-strategy equilibrium whenever
it exists
– But, typically, it does not exist
• If it is common knowledge that players are
rational, then they will play a rationalizable
strategy-profile
– Typically, there are too many rationalizable strategies
• Now, a stronger assumption: The players are
rational and their conjectures are mutually known.
5
Nash Equilibrium
Definition: A strategy-profile s* =(s1*,…,sn*) is a
Nash Equilibrium iff, for each player i, and for
each strategy si, we have
Stag Hunt
(2,2) (4,0)
(0,4) (6,6)
6
Economic Applications
1. Cournot (quantity) Competition
1. Nash Equilibrium in Cournot duopoly
2. Nash Equilibrium in Cournot oligopoly
3. Rationalizability in Cournot duopoly
2. Bertrand (price) Competition
3. Commons Problem
Cournot Oligopoly
• N = {1,2,…,n} firms;
• Simultaneously, each firm i P
produces qi units of a good at
marginal cost c, 1
• and sells the good at price
P = max{0,1-Q}
where Q = q1+…+qn.
• Game = (S1,…,Sn; π1,…,πn)
Q
where Si = [0,∞∞),
1
πi(q1,…,qn) = qi[1-(q1+…+qn)-c] if q1+…+qn < 1,
-qic otherwise.
7
Cournot Duopoly -- profit
qj=0.2
Profit c=0.2
0
qi(1-qj-c)
-cqi
-0.2
0 1
(1-qj-c)/2 1-qj-c
q1* = (1-q2*-c)/2;
q2* = (1-q1*-c)/2; q*
1− c
• q1* = q2* = (1-c)/3 2 q2=q2B(q1)
q1
1-c
8
Cournot Oligopoly --Equilibrium
• q>1-c is strictly dominated, so q ≤ 1-c.
• πi(q1,…,qn) = qi[1-(q1+…+qn)-c] for each i.
• FOC: ∂π ( q , , q ) ∂[ qi (1 − q1 − − qn − c )]
i 1 n
=
∂qi q=q * ∂qi q = q*
n=1
n=2
n=3
n=4
Q
c
1
9
Rationalizability in Cournot Duopoly
q2
1-c
Assume that
players are
rational. 1− c
2
q1
1− c
2
1-c
1-c
Assume that
players know
this.
1− c
2
q1
1− c
2
1-c
10
Players are rational and know
that players are rational
q2
1-c
Assume that
players know
this.
1− c
2
q1
1− c
2
1-c
1-c
Assume that
players know
this.
1− c
2
q1
1− c
2
1-c
11
Rationalizability in Cournot duopoly
• If i knows that qj ≤ q, then qi ≥ (1-c-q)/2.
• If i knows that qj ≥ q, then qi ≤ (1-c-q)/2.
• We know that qj ≥ q0 = 0.
• Then, qi ≤ q1 = (1-c-q0)/2 = (1-c)/2 for each i;
• Then, qi ≥ q2 = (1-c-q1)/2 = (1-c)(1-1/2)/2 for each i;
• …
• Then, qn ≤ qi ≤ qn+1 or qn+1 ≤ qi ≤ qn where
qn+1 = (1-c-qn)/2 = (1-c)(1-1/2+1/4-…+(-1/2)n)/2.
• As n→∞, qn → (1-c)/3.
12
Bertrand duopoly -- Equilibrium
Theorem: The only Nash equilibrium in the “Bertrand
game” is p* = (0,0).
Proof:
1. p*=(0,0) is an equilibrium.
2. If p = (p1,p2) is an equilibrium, then p = p*.
1. If p = (p1,p2) is an equilibrium, then p1 = p2...
• If pi > pj= 0, for sufficiently small ε>0, pj’ = ε is a better
response to pi for j. If pi > pj> 0, pi’ = pj is a better response
for i.
2. Given any equilibrium p = (p1,p2) with p1 = p2, p = p*.
• If p1 = p2>0, for sufficiently small ε>0, pj’ = pj - ε is a better
response to pj for i.
Commons Problem
• N = {1,2,…,n} players, each with unlimited
money;
• Simultaneously, each player i contributes xi
≥ 0 to produce y = x1+…xn unit of some
public good, yielding payoff
Ui(xi,y) = y1/2 – xi.
13
Quiz
Each student i is to submit a real number xi.
We will pair the students randomly. For
each pair (i,j), if xi ≠ xj, the student who
submits the number that is closer to
(xi+xj)/4 gets 100; the other student gets 20.
If xi = xj, then each of i and j gets 50.
14
Lectures 6-7
Nash Equilibrium
&
Backward Induction
Road Map
1. Bertrand Competition
2. Commons Problem
3. Mixed-strategy Nash equilibrium
4. Bertrand competition with costly search
5. Backward Induction
6. Stackelberg Competition
7. Sequential Bargaining
1
Bertrand (price) competition
• N = {1,2} firms.
• Simultaneously, each firm i sets a price pi;
• If pi < pj, firm i sells Q = max{1 – pi,0}
unit at price pi; the other firm gets 0.
• If p1 = p2, each firm sells Q/2 units at price
p1, where Q = max{1 – p1,0}.
• The marginal cost is 0.
p1 (1 − p1 ) if p1 < p2
π 1 ( p1 , p2 ) = p1 (1 − p1 ) / 2 if p1 = p2
0 otherwise.
Proof:
1. p*=(0,0) is an equilibrium.
2. If p = (p1,p2) is an equilibrium, then p = p*.
1. If p = (p1,p2) is an equilibrium, then p1 = p2...
• If pi > pj= 0, for sufficiently small ε>0, pj’ = ε is a better
response to pi for j. If pi > pj> 0, pi’ = pj is a better response
for i.
2. Given any equilibrium p = (p1,p2) with p1 = p2, p = p*.
• If p1 = p2>0, for sufficiently small ε>0, pj’ = pj - ε is a better
response to pj for i.
2
Commons Problem
• N = {1,2,…,n} players, each with unlimited
money;
• Simultaneously, each player i contributes xi
≥ 0 to produce y = x1+…xn unit of some
public good, yielding payoff
Ui(xi,y) = y1/2 – xi.
Stag Hunt
(2,2) (4,0)
(0,4) (5,5)
3
Equilibrium in Mixed Strategies
What is a strategy?
– A complete contingent-plan of a player.
– What the others think the player might do under
various contingency.
What do we mean by a mixed strategy?
– The player is randomly choosing his pure
strategies.
– The other players are not certain about what he
will do.
Stag Hunt
(2,2) (4,0)
(0,4) (5,5)
4
Mixed-strategy equilibrium in Stag-Hunt game
5
play Rabbit?
2.5 4 - 2p
Rabbit: 1 5(1-p)
0.5
U2(R;p) = 2p + 4(1-p) 0
0 0.2 0.4 0.6 0.8 1
= 4-2p.
• From Stag:
U2(R;p) = 5(1-p) 0 if p < 1/3
• She is indifferent iff q ( p ) = q ∈ [0,1] if p = 1/3
BR
1/3
p
1/3
5
Bertrand Competition with costly search
• N = {F1,F2,B}; F1, F2 Game:
are firms; B is buyer 1. Each firm i chooses price
• B needs 1 unit of good, p i;
worth 6; 2. B decides whether to
• Firms sell the good; check the prices;
Marginal cost = 0. 3. (Given) If he checks the
• Possible prices P = prices, and p1≠p2, he buys
{1,5}. the cheaper one;
• Buyer can check the otherwise, he buys from
prices with a small cost any of the firm with
c > 0. probability ½.
High High
Low Low
6
Mixed-strategy equilibrium
• Symmetric equilibrium: Each firm charges
“High” with probability q;
• Buyer Checks with probability r.
• U(check;q) = q21 + (1-q2)5 – c = 5 - 4 q2 – c;
• U(Don’t;q) = q1 + (1-q)5 = 5 - 4 q;
• Indifference: 4q(1-q) = c; i.e.,
• U(high;q,r) = 0.5(1-r(1-q))5;
• U(low;q,r) = qr1 + 0.5(1-qr)
• Indifference = r = 4/(5-4q).
7
Definitions
Perfect-Information game is a game in which all
the information sets are singleton.
Sequential Rationality: A player is sequentially
rational iff, at each node he is to move, he
maximizes his expected utility conditional on that
he is at the node – even if this node is precluded
by his own strategy.
In a finite game of perfect information, the common
knowledge of sequential rationality gives
“Backward Induction” outcome.
A centipede game
1 A 2 α 1 a
(1,-5)
D δ d
8
Backward Induction
Take any pen-terminal node
T B
2 2
L R L R
9
Note
Head
Tail
2
2
head tail head tail
10
Stackelberg Duopoly
Game:
N = {1,2} firms w MC = 0; P
1. Firm 1 produces q1 units
1
2. Observing q1, Firm 2 produces
q2 units
3. Each sells the good at price
P = max{0,1-(q1+q2)}.
Q
1
πi(q1, q2) = qi[1-(q1+q2)] if q1+ q2 < 1,
0 otherwise.
“Stackelberg equilibrium”
P
• If q1 > 1, q2*(q1) = 0.
• If q1 ≤ 1, q2*(q1) = (1-q1)/2. 1
• Given the function q2*, if q1 ≤ 1
π1(q1;q2*(q1)) = q1[1-(q1+ (1-q1)/2)]
= q1 (1-q1)/2;
0 otherwise.
• q1* = ½. 1
• q2*(q1*) = ¼.
11
Sequential Bargaining
D • N = {1,2}
1
• X = feasible
expected-utility
pairs (x,y ∈X )
• Ui(x,t) = δitxi
• d = (0,0) ∈ D
disagreement
payoffs
1
Timeline – 2 period
At t = 1, At t = 2,
– Player 2 offers some (x2,y2),
– Player 1 offers some (x1,y1),
– Player 1 Accept or Rejects the
– Player 2 Accept or Rejects the
offer
offer
– If the offer is Accepted, the
– If the offer is Accepted, the
game ends yielding payoff
game ends yielding (x1,y1),
δ(x2,y2).
– Otherwise, we proceed to date
– Otherwise, the game end
2.
yielding d = (0,0).
1 (0,0)
2 2 (x2,y2)
1 (x1,y1) Reject
Reject
Accept (δx2,δy2)
Accept (x1,y1)
12
1 (0,0)
2 2 (x2,y2)
1 (x1,y1) Reject
Reject
Accept (δx2,δy2)
Accept (x1,y1)
At t = 2,
•Accept iff y2 ≥ 0.
•Offer (0,1).
At t = 1,
•Accept iff x2 ≥ δ.
•Offer (1−δ,δ).
Timeline – 2n period
T = {1,2,…,2n-1,2n} If t is even
If t is odd, – Player 2 offers some
(xt,yt),
– Player 1 offers some
(xt,yt), – Player 1 Accept or Rejects
the offer
– Player 2 Accept or
Rejects the offer – If the offer is Accepted,
the game ends yielding
– If the offer is Accepted, payoff (xt,yt),
the game ends yielding
– Otherwise, we proceed to
δt(xt,yt),
date t+1, except at t = 2n,
– Otherwise, we proceed when the game end
to date t+1. yielding d = (0,0).
13
Equilibrium
• Scientific Word
14
Lectures 8
Subgame-perfect Equilibrium
&
Applications
Road Map
1. Subgame-perfect Equilibrium
1. Motivation
2. What is a subgame?
3. Definition
4. Example
2. Applications
1. Bank Runs
2. Tariffs & Intra-industry trade
3. Quiz
1
A game
1
E X
1
(2,6)
T
B
2
L R L R
(0,1) (3,2) (-1,3) (1,5)
Sequential Bargaining
D • N = {1,2}
1
• X = feasible
expected-utility
pairs (x,y ∈X )
• Ui(x,t) = δitxi
• d = (0,0) ∈ D
disagreement
payoffs
1
2
Timeline – ∞ period
T = {1,2,…, n-1,n,…}
If t is odd, If t is even
– Player 1 offers some – Player 2 offers some
(xt,yt), (xt,yt),
– Player 2 Accept or – Player 1 Accept or Rejects
Rejects the offer the offer
– If the offer is Accepted, – If the offer is Accepted,
the game ends yielding the game ends yielding
δt(xt,yt), payoff (xt,yt),
– Otherwise, we proceed – Otherwise, we proceed to
to date t+1. date t+1.
Backward induction
• Can be applied only in perfect information
games of finite horizon.
3
A subgame
A subgame is part of a game that can be
considered as a game itself.
• It must have a unique starting point;
• It must contain all the nodes that follow the
starting node;
• If a node is in a subgame, the entire
information set that contains the node must
be in the subgame.
A game
1 A 2 α 1 a
(1,-5)
D δ d
4
And its subgames
1 a 2 α 1 a
(1,-5) (1,-5)
d δ d
A game
1
E X
1
(2,6)
T
B
2
L R L R
(0,1) (3,2) (-1,3) (1,5)
5
Definitions
A substrategy is the restriction of a strategy to
a subgame.
A subgame-perfect Nash equilibrium is a
Nash equilibrium whose substrategy profile
is a Nash equilibrium at each subgame.
Example
1
E X
1
(2,6)
T
B
2
L R L R
(0,1) (3,2) (-1,3) (1,5)
6
A “Backward-Induction-like” method
Take any subgame with no proper subgame
Theorem
7
A subgame-perfect equilibrium?
X
1 (2,6)
T
B
2
L R L R
(0,1) (3,2) (-1,3) (1,5)
Bank Run
1
R > D > r > D/2
W DW
2
W DW
DW W
1
(r,r) (D,2r-D) (2r-D,D)
W DW
2
W DW
DW W
8
Lectures 9
Applications of Subgame-perfect
Equilibrium
&
Forward Induction
Road Map
1. Applications
1. Tariffs & Intra-industry trade
2. Infinite horizon bargaining – Single-
deviation principle
2. Forward Induction – Examples
3. Finitely Repeated Games
4. Quiz
1
Single-Deviation principle
Definition: An extensive-form game is continuous at
infinity iff, given any ε > 0, there exists some t such
that, for any two path whose first t arcs are the same,
the payoff difference of each player is less than ε.
Theorem: Let G be a game that is continuous at infinity.
A strategy profile s = (s1,s2,…,sn) is a subgame-perfect
equilibrium of G iff, at any information set, where a
player i moves, given the other players strategies and
given i’s moves at the other information sets, player i
cannot increase his conditional payoff at the
information set by deviating from his strategy at the
information set.
Sequential Bargaining
D • N = {1,2}
1
• D = feasible
expected-utility
pairs (x,y ∈D )
• Ui(x,t) = δitxi
• d = (0,0) ∈ D
disagreement
payoffs
1
2
Timeline – ∞ period
T = {1,2,…, n-1,n,…}
If t is odd, If t is even
– Player 1 offers some – Player 2 offers some
(xt,yt), (xt,yt),
– Player 2 Accept or – Player 1 Accept or Rejects
Rejects the offer the offer
– If the offer is Accepted, – If the offer is Accepted,
the game ends yielding the game ends yielding
δt(xt,yt), payoff δt(xt,yt),
– Otherwise, we proceed – Otherwise, we proceed to
to date t+1. date t+1.
3
Forward Induction
Strong belief in rationality: At any history
of the game, each agent is assumed to be
rational if possible. (That is, if there are two
strategies s and s’ of a player i that are
consistent with a history of play, and if s is
strictly dominated but s’ is not, at this
history no player j believes that i plays s.)
min 1 2 3
bid
1 60 - -
2 40 80 -
3 20 60 100
4
Nash equilibria of bidding game
• 3 equilibria: s1 = everybody plays 1; s2 = everybody
plays 2; s3 = everybody plays 3.
• Assume each player trembles with probability ε < 1/2,
and plays each unintended strategy w.p. ε/2, e.g., w.p.
ε/2, he thinks that such other equilibrium is to be played.
– s3 is an equilibrium iff
– s2 is an equilibrium iff
– s1 is an equilibrium iff
0.8
0.6
0.4
0.2
0.047
0
-0.2
n
(1-ε/2) -1/2
-0.4
-0.6
-0.8 n n
(1-ε) +(1-ε/2) -1
-1
0 0.032 0.05 0.1 0.15 0.2
5
Bidding game with entry fee
Each player is first to decide min 1 2 3
whether to play the Bid
bidding game (E or X); if 1 60 - -
he plays, he is to pay a fee 2 40 80 -
p > 60.
3 20 60 100
Burning Money
1
0 D BB BS SB SS
B S B S 0B
B 3,1 0,0 B 2,1 -1,0 0S
S 0,0 1,3 S -1,0 0,3 DB
DS
O T H E R
6
Repeated Games
Entry deterrence
1 Enter 2 Acc.
(1,1)
X Fight
(0,2) (-1,-1)
7
Entry deterrence, repeated twice
X Fight X Fight
Acc. 2 Enter 1
(1,3) (1,3) (0,0)
1 Enter 2 Acc.
Fight X (0,0)
X Fight
(-1,1) (0,4)
(-1,1) (-2,-2)
8
Lectures 10 -11
Repeated Games
B S B S 0B
B 3,1 0,0 B 2,1 -1,0 0S
S 0,0 1,3 S -1,0 0,3 DB
DS
O T H E R
Repeated Games
Entry deterrence
1 Enter 2 Acc.
(1,1)
X Fight
(0,2) (-1,-1)
Entry deterrence, repeated twice,
many times
1 Enter 2 Acc. 1 Enter 2 Acc.
(2,2)
X Fight X Fight
Acc. 2 Enter 1
(1,3) (1,3) (0,0)
1 Enter 2 Acc.
Fight X (0,0)
X Fight
(-1,1) (0,4)
(-1,1) (-2,-2)
What would happen if repeated n times?
Prisoners’ Dilemma, repeated twice,
many times
• Two dates T = {0,1};
• At each date the prisoners’ dilemma is played:
C D
C 5,5 0,6
D 6,0 1,1
1 1 1 1
D C D C
C C D D
2 2 2 2
C D C D C D C D D C D
D C D C C
10 5 11 6 5 0 6 1 11 6 12 7 6 1 7 2
10 11 5 6 11 12 6 7 5 6 0 1 6 7 1 2
1 Enter 2 Acc.
(1,1) Strategy of Entrant:
Enter iff
X Fight
Accomodated before.
Strategy of Incumbent:
(0,2) (-1,-1)
Accommodate iff
accomodated before.
Incumbent: Entrant:
• V(Acc.) = VA = 1/(1−δ); • Accommodated
• V(Fight) = VF = 2/(1−δ); – Enter => 1+VAE
• Case 1: Accommodated before. – X => 0 +VAE
– Fight => -1 + δVA • Not Acc.
– Acc. => 1 + δVA. – Enter =>-1+VFE
• Case 2: Not Accommodated – X => 0 +VFE
– Fight => -1 + δVF
– Acc. => 1 + δVA
– Fight Ù -1 + δVF ≥ 1 + δVA
ÙVF − VA = 1/(1−δ) ≥ 2/δ
Ùδ ≥ 2/3.
Infinitely-repeated PD
C D • VD = 1/(1−δ);
C 5,5 0,6 • VC = 5/(1−δ) = 5VD;
D 6,0 1,1 • Defected before (easy)
• Not defected
A Grimm Strategy: – D =>
Defect iff someone – C =>
defected before. –CÙ
Tit for Tat
• Start with C; thereafter, play what the other
player played in the previous round.
• Is (Tit-for-tat,Tit-for-tat) a SPE?
0.95
0.9
0.85
0.8
0.75
0.7
0.65
0.6
0.55
0.5
0 20 40 60 80 100
1
0.95
0.9
0.85
0.8
0.75
0.7
0.65
0.6
0.55
0.5
0 200 400 600 800 1000
IRCD (n=2)
• Strategy: Each firm is to produce q*; if any one
deviates, each produce 1/(n+1) thereafter.
• VC = q*(1-2q*)/(1-δ);
• VD = 1/(9(1-δ));
δ
• VD|C = max q(1-q*-q) +δVD = (1 − q *) / 4 +
2
9(1 − δ )
• Equilibrium iff
q * (1 − 2q *) ≥ (1 − δ )(1 − q *) / 4 + δ / 9
2
• Ù 9 − 5δ
q* ≥
3(9 − δ )
x = δ, y = (3-5/3 δ)/(9-δ )
0.4
0.3
0.2
y
0.1
0
0 0.2 0.4 0.6 0.8 1
x
Carrot and Stick
Produce ¼ at the beginning; at ant t > 0, produce ¼ if both
produced ¼ or both produced x at t-1; otherwise, produce
x.
Two Phase: Cartel & Punishment
VC = 1/8(1-δ). Vx = x(1-2x) + δVC.
VD|C = max q(1-1/4-q) + δVX = (3/8)2 + δVX
VD|x = max q(1-x-q) + δVX = (1-x)2/4 + δVX
VC ≥ VD|C Ù VC ≥ (3/8)2 + δ2VC + δ x(1-2x)
Ù (1-δ2) VC - (3/8)2 ≥ δ x(1-2x) Ù(1+δ)/8 - (3/8)2 ≥ δ x(1-2x)
VX ≥ VD|C Ù (1-δ)Vx ≥ (1-x)2/4 Ù (1-δ)(x(1-2x) + δ/8(1-δ)) ≥ (1-x)2/4
Ù (1-δ)x(1-2x) + δ/8 ≥ (1-x)2/4
2x2 – x + 1/8 – 9/64δ ≥ 0
(9/4-2δ)x2 – (3-2δ)x +δ/8(1-δ) ≤ 0
Lectures 12-13
Incomplete Information
Static Case
Road Map
1. Examples
2. Bayes’ rule
3. Definitions
1. Bayesian Game
2. Bayesian Nash Equilibrium
4. Mixed strategies, revisited
5. Economic Applications
1. Cournot Duopoly
2. Auctions
3. Double Auction
1
Incomplete information
An Example
W ork (1, 2)
W
Firm H ire
Shirk
H igh p (0, 1)
2
The same example
Work (1, 2)
W
High p (0, 1)
Nature Shirk
Hire hire
p Don’t
Seller (0, 0)
p’ (p’,2-p’)
High 0.5 Buy
Nature B
Don’t (0, 0)
Buy (p, 1-p)
B
Low .5 p
What would you ask Don’t (0,0)
if you were to choose
p’ Buy (p’, 1-p’)
p from [0,4]?
B
Don’t (0, 0)
3
Same “Another Example”
Buy (p, 2-p)
B
High 0.5
Don’t
Nature (0, 0)
Buy (p’,2-p’)
p
Low .5
B
Seller Don’t (0, 0)
Buy (p, 1-p)
B
p’ Nature High 0.5
What would you ask Don’t (0,0)
if you were to choose
Buy (p’, 1-p’)
p from [0,4]? Low .5
B
Don’t (0, 0)
Bayes’ Rule
Prob(A and B)
• Prob(A|B) =
Prob(B)
• Prob(A and B) = Prob(A|B)Prob(B) = Prob(B|A)Prob(A)
Prob(B|A)Prob(A)
• Prob(A|B) =
Prob(B)
4
Example
p • Prob(Work|Success) =
Work Success
µ µp/[µp + (1−µ)(1-p)]
1-p • Prob(Work|Failure) =
1-p (1-µ)p/[µ(1−p) + (1−µ)p]
Shirk Failure
1−µ p
0.9
P(W|S)
0.8
0.7
P (w|S ),P (W|F)
0.6
0.5
P(W|F)
0.4
0.3
0.2
0.1
0
0 0.2 0.4 0.6 0.8 1
µ
5
Bayesian Game (Normal Form)
A Bayesian game is a list
G = {A1,…,An;T1,…,Tn;p1,…,pn;u1,…,un}
where
• Ai is the action space of i (ai in Ai)
• Ti is the type space of i (ti)
• pi(t-i|ti) is i’s belief about the other players
• ui(a1,…,an;t1,…,tn) is i’s payoff.
An Example
Work (1, 2)
W TFirm={tf};
Firm Hire TW = {High,Low}
Shirk AFirm = {Hire, Don’t}
High p (0, 1) AW = {Work,Shirk}
Nature Do not (0, 0) pF(High) = p
hire pF(Low) = 1-p
Work (1, 1)
W
Low 1-p Hire
Shirk
(-1, 2)
Do not
hire (0, 0)
6
Bayesian Nash equilibrium
A Bayesian Nash equilibrium is a Nash equilibrium of
a Bayesian game.
Given any Bayesian game G =
{A1,…,An;T1,…,Tn;p1,…,pn;u1,…,un}
a strategy of a player i in a is any function si:Ti → Ai;
A strategy profile s* = (s1*,…, s1*) is a Bayesian Nash
equilibrium iff si*(ti) solves
max ∑ u (s (t ),..., s (t ), a , s (t ),..., s (t ); t )p (t | ti )
* * * *
i 1 1 i −1 i −1 i i +1 i +1 n n i −i
ai ∈Ai t− i ∈T− i
An Example
Work (1, 2)
W TFirm={tf};
Firm Hire TW = {High,Low}
Shirk AFirm = {Hire, Don’t}
High p (0, 1) AW = {Work,Shirk}
Nature Do not (0, 0) pF(High) = p >1/2
hire pF(Low) = 1-p
Work (1, 1)
W sF* = Hire,
Low 1-p Hire
sF* (High) = Work
Shirk sF* (Low) = Shirk
(-1, 2)
Do not
hire (0, 0) Another equilibrium?
7
Stag Hunt, Mixed Strategy
(2,2) (4,0)
(0,4) (6,6)
Mixed Strategies
• t and v are iid with uniform
distribution on [−ε,ε].
• t and v are privately known by
1 and 2, respectively, i.e., are
types of 1 and 2, respectively.
2+t,2+v 4+t,0 • Pure strategy:
– s1(t) = Rabbit iff t > 0;
0,4+v 6,6 – s2(v) = Rabbit iff t > 0.
• p = Prob(s1(t)=Rabbit|v) =
Prob(t > 0) = 1/2.
U1(R|t) = t +2q+4(1-q) = t + 4 – 2q • q = Prob(s2(v)=Rabbit|t) =
U1(S|t) = 6(1-q); 1/2.
U1(R|t) > U1(S|t) t+4–2q > 6(1-q)
t > 6-6q+2q-4 = 2 – 4q = 0.
8
Economic Applications
with Incomplete
Information
14.12 Game Theory
Muhamet Yildiz
Road Map
1. Cournot duopoly with Incomplete Informa-
tion
2. A ¿rst price auction
3. A double auction
4. Quiz
1
1 Cournot duopoly with
Incomplete Information
Demand:
E' ' @ '
where ' ' ^ n ^2.
The marginal cost of Firm 1 = S common
knowledge.
Firm 2’s marginal cost:
SM with probaility w,
Su with probaility w
its private information.
Each ¿rm maximizes its expected pro¿t.
2
1.1 Bayesian Nash Equilibrium
Firm 2 of high type:
4@ E SM ^2 ' 4@ d@ ^ ^2 SM o ^2
^5 ^5
@ ^ SM
^2ESM
' (*)
2
Firm 2 of low type:
4@ w d@ ^ ^2ESM So ^
^4
n E w d@ ^ ^2ESu So ^
w d@ ^2ESM So n E w d@ ^2ESu So
^ '
2
(***)
3
Solve *, **, and *** for ^c ^2ESuc ^2ESM .
3 4 5 6 3 4
^ 2 w w @S
C ^2ESM D ' 7 2 f 8 C @ SM D (
^2ESu f 2 @ Su
4
2 A First-price Auction
One object, two bidders
' Valuation of bidder i iid with uniform
distribution over dfc o.
Simultaneously, each bidder submits a bid
K, then the highest bidder wins the object
and pays her bid.
The payoffs: ;
? K if K : K c
EKc K2c c 2 ' lK l
if K ' K c
= 2
f if K K
Objective of :
4@ . dEKc K2c c 2o
Kl
where
. do ' E K hiK : K E j
n E K hiK ' K E j
2
5
2.1 Symmetric, linear equilib-
rium
K ' @ n S
Then,
hiK ' K E j ' f
Equilibrium condition: @ K .
Hence,
K '
2
6
2.2 Any symmetric equilibrium
K ' K E
Hence,
7
3 Double Auction
1. Simultaneously, Seller names Rr and Buyer
names RK.
a. If RK Rr, then no trade
Re nRv
b. if RK Rr, trade at price R ' 2
.
2. Valuations are private information: K, r
iid w/ uniform on dfc o.
3. Payoffs:
K RenR v
if RK Rr
K ' 2
f otherwise
RenRv
r if RK Rr
r ' 2
f otherwise
4. The buyer’s
problem:
RK n RrEr
4@ . K G RK RrEr
Re 2
5. The seller’s
problem:
Rr n RKEK
4@ . r G RKEK Rr
Rv 2
8
An Equilibrium:
f if K f
RK ' c
f otherwise
f if r f
Rr '
otherwise
vb
v b /v s
Trade
Efficient
X
not to trade
0 vS
Inefficient
lack of trade
9
Equilibrium with linear strategies:
RK ' @K n SKK
Rr ' @r n Srr
RK @r
RK Rr Er ' @r n Srr +, r
Sr
Rr @K
Rr RK EK ' @K n SKK +, K
SK
10
RK n RrEr
. dKo ' . K G RK RrEr
2
] e v
s d
fv RK n RrEr
' K _r
f 2
] e vk
RK n @r n Srr l
s d
fv
' K _r
f 2
] sedv
RK @r RK n @r Sr fv
' K r_r
Sr 2 2 f
2
RK @r RK n @r Sr RK @r
' K
Sr 2 e Sr
RK @r RK n @r RK @r
' K
Sr 2 e
RK @r RK n @r
' K
Sr e
F.O.C. (4@ Re . dKo):
RK n @r ERK @r
K 'f
Sr e eSr
i.e.,
2
RK ' K n @r (2)
11
Similarly,
Rr n RKEK
. dro ' . r G RKEK Rr
2
] k l
Rr n @K n SKK
' r _K
sv de 2
fe k l ]
Rr @K Rr n @K SK
' r n K_K
SK 2 2 f e
sv d
k l
e
Rr @K Rr n @K
' r
# SK 2 $
2
SK Rr @K
n
e SK
Rr @K Rr n @K SK Rr @K
' r n n
SK 2 e e
Rr @K Rr n @K SK
' r n
SK e e
12
F.O.C.
(4@ Rv . dro):
Rr n @K Rr @K
r n n 'f
SK e e e SK
Rr n @K SK
r n n ESK ERr @K ' fc
e e e
Rr @K SK @K n SK
' n r n ESK n @K ' r n
2 e e e 2
i.e.,
2 @K n SK
Rr ' r n (3)
@K ' @r*
@r ' @K* n 2*b
Hence, b@r ' @r n 2,
@r ' *e @K ' *2.
2
RK ' K n (4)
2
2
Rr ' r n (5)
e
13
We have trade iff
RK Rr
iff
2 2
K n r n
2 e
iff
K r ' '
2 e 2 2S e
3/4
ps
1/4
pb
1/12
14
Lectures 15-18
Dynamic Games with
Incomplete Information
Road Map
1. Examples
2. Sequential Rationality
3. Perfect Bayesian Nash Equilibrium
4. Economic Applications
1. Sequential Bargaining with incomplete
information
2. Reputation
1
An Example
Work (1, 2)
W
Firm Hire
Shirk
High 0.7 (0, 1)
Nature Do not (0, 0)
hire
Work (1, 1)
W
Low 0.3 Hire
Shirk
(-1, 2)
Do not
hire (0, 0)
2
What is wrong with this equilibrium?
X
1 (2,6)
T
B
2
L R L R
(0,1) (3,2) (-1,3) (1,5)
Beliefs
X
• Beliefs of an agent at a given
1 (2,6)
information set is a
probability distribution on T
the information set. B
• For each information set, we
µ 1−µ
must specify the beliefs of 2
the agent who moves at that
L R L R
information set.
(0,1) (3,2) (-1,3) (1,5)
3
Sequential Rationality
A player is said to be sequentially rational
iff, at each information set he is to move, he
maximizes his expected utility given his
beliefs at the information set (and given that
he is at the information set) – even if this
information set is precluded by his own
strategy.
An Example
Work (1, 2)
W
Firm Hire
Shirk
High 0.7 (0, 1)
Nature Do not (0, 0)
hire
Work (1, 1)
W
Low 0.3 Hire
Shirk
(-1, 2)
Do not
hire (0, 0)
4
Another example
X
1 (2,6)
T
B
2
L R L R
(0,1) (3,2) (-1,3) (1,5)
Example
T
B
.1 .9
2
L R L R
(0,10) (3,2) (-1,3) (1,5)
5
“Consistency”
Definition: Given any (possibly mixed)
strategy profile s, an information set is said
to be on the path of play iff the
information set is reached with positive
probability if players stick to s.
Definition: Given any strategy profile s and
any information set I on the path of play of
s, a player’s beliefs at I is said to be
consistent with s iff the beliefs are derived
using the Bayes’ rule and s.
Example
T
B
2
L R L R
(0,10) (3,2) (-1,3) (1,5)
6
Example
1
E X
2
2
T 0
B 0
3
L R L R
1 3 0 0
2 3 1 1
1 3 2 1
“Consistency”
• Given s and an information set I, even if I is
off the path of play, the beliefs must be
derived using the Bayes’ rule and s
“whenever possible,” e.g., if players tremble
with very small probability so that I is on
the path, the beliefs must be very close to
the ones derived using the Bayes’ rule and
s.
7
Example
1
E X
2
2
T 0
B 0
3
L R L R
1 3 0 0
2 3 1 1
1 3 2 1
8
Example
1
E X
2
2
T 0
B 0
3
L R L R
1 3 0 0
2 3 1 1
1 3 2 1
Beer – Quiche
0 1
1 du l 1
el e
beer quiche du
2 t {.1} don 3
’
0 don tw
’t
0
1 0
0 ts
0
el
du
du
el
9
Example
1 2 1
(1,-5)
.9
Sequential Bargaining
1. 1-period bargaining – 2 types
2. 2-period bargaining – 2 types
3. 1-period bargaining – continuum
4. 2-period bargaining – continuum
10
Sequential bargaining 1-p
• A seller S with valuation 0
H L
• A buyer B with valuation v; S
– B knows v, S does not
– v = 2 with probability π
– = 1 with probability 1-π p p
• S sets a price p ≥ 0; N
Y N Y
• B either
– buys, yielding (p,v-p) 0
p 0 p
– or does not, yielding (0,0). 2-p 0 1-p 0
Solution
1. B buys iff v ≥ p;
1. If p ≤ 1, both types buy:
S gets p. 1
2. If 1 < p ≤ 2, only H-type
buys: S gets πp.
3. If p > 2, no one buys. 1 2
2. S offers
• 1 if π < ½,
• 2 if π > ½.
11
Sequential bargaining 2-period
1. At t = 0, S sets a price
• A seller S with valuation p0 ≥ 0;
0 2. B either
• A buyer B with valuation – buys, yielding (p0,v-p0)
v; – or does not, then
– B knows v, S does not 3. At t = 1, S sets a price
– v = 2 with probability π p0 ≥ 0;
– = 1 with probability 1-π 4. B either
– buys, yielding (δp0,δ(v-p0))
– or does not, yielding (0,0)
Solution, 2-period
1. Let µ = Pr(v = 2|history at t=1).
2. At t = 1, buy iff v ≥ p;
3. If µ > ½, p1 = 2
4. If µ < ½, p1 = 1.
5. If µ = ½, mix between 1 and 2.
6. B with v=1 buys at t=0 if p0 ≤ 1.
7. If p0 > 1, µ = Pr(v = 2|p0,t=1) ≤ π.
12
Solution, cont. π <1/2
1. µ = Pr(v = 2|p0,t=1) ≤ π <1/2.
2. At t = 1, buy iff v ≥ p;
3. p1 = 1.
4. B with v=2 buys at t=0 if
(2-p0) ≥ δ(2−1) = δ Ù p0 ≤ 2−δ.
5. p0 = 1:
π(2−δ) + (1−π)δ = 2π(1−δ) + δ < 1−δ+δ = 1.
13
Mixed-strategy equilibrium, π >1/2
1. For p0 > 2−δ, µ(p0) = ½;
2. β(p0) = 1- Pr(v=2 buys at p0)
β ( p0 )π 1 1−π
µ= = ⇔ β ( p0 )π = 1 − π ⇔ β ( p0 ) = .
β ( p0 )π + (1 − π ) 2 π
3. v = 2 is indifferent towards buying at p0:
2- p0 = δγ(p0) Ù γ(p0) = (2- p0)/δ
where γ(p0) = Pr(p1=1|p0).
14
Sequential bargaining, v in [0,1]
• 2 periods: (p0,p1)
– At t = 0, B buys at p0 iff v ≥ a(p0);
– p1 = a(p0)/2;
– Type a(p0) is indifferent:
a(p0) – p0 = δ(a(p0) – p1 ) = δa(p0)/2
Ùa(p0) = p0/(1-δ/2)
• S gets p p
2
1 − 0
p0 + 0
1 − δ / 2 2 −δ
• FOC: 2 p0 2 p0 (1 − δ / 2 )
2
1− + = 0 ⇒ p0 =
1−δ / 2 2 −δ 2(1 − 3δ / 4 )
Reputation
15
Centipede Game
1 2 1 1 2 1 2 100
100
…
1 0 2 98 97 99 98
1 3 2 98 100 99 101
1 0 96 98 97 99 98
1 3 99 98 100 99 101
1 2 2 1 2 1 2 0
{.001} 100
…
-1 0 0 -1 0 -1 0
1 3 99 98 100 99 101
16
Facts about the Centipede
• Every information set of 2 is reached with positive
probability.
• 2 always goes across with positive probability.
• If 2 strictly prefers to go across at n, then
– she must strictly prefer to go across at n+1,
– her posterior at n is her prior.
• For any n > 2, 1 goes across with positive
probability. If 1 goes across w/p 1 at n, then 2’s
posterior at n-1 is her prior.
17
0.5
0.45
0.4
0.35
0.3
0.25
Go Across
0.2
0.15
0.1
0.05
Mix
0
0 20 40 60 80 100
18
Lecture 19-21
Road Map
• Market for Lemons (Adverse Selection)
• Insurance Market (Screening)
• Signaling – theory
• Job Market Signaling
1
Example for Adverse selection
• A buyer and a seller, who owns an object.
• The value of the object is
– v for the seller,
– v+b for the buyer.
• v is uniformly distributed on [0,1]. Seller
knows v. b > 0 is a known constant.
• Buyers offers a price p; seller decides on
whether to sell.
Solution
• Seller sells at p iff p ≥ v;
• Buyer’s payoff:
p
1 p
U ( p ) = ∫ (v + b − p )dv = p 2 + p (b − p ) = p b −
0
2 2
• Buyer offers p = 2b.
2
Example for Adverse selection
• A buyer and a seller, who owns an object.
• The value of the object is
– v for the seller,
– 3v/2 for the buyer.
• v is uniformly distributed on [0,1]. Seller
knows v.
• Buyers offers a price p; seller decides on
whether to sell.
Solution
• Seller sells at p iff p ≥ v;
• Buyer’s payoff:
p
3 3 p
U ( p ) = ∫ v − p dv = p − p = − p2 / 4
0
2 2 2
• Buyer offers p = 0.
3
Market for Lemons
• Two types of cars: Lemons and Peaches.
– A Peach is worth $2500 to seller, $3000 to buyer;
– A lemon is worth $1000 to seller, $2000 to buyer;
• Each seller knows whether his car is a Peach
or Lemon; buyers cannot tell.
• There are 200 Lemons and 100 Peaches.
• Equilibrium: a market clearing price p.
2000
1000
200 300 Q
4
Quiz
• The students are grouped in pairs;
• In each pair, one is assigned to be seller, the other one
is buyer. The buyer is given a valuation v, an integer
between 20 and 40 with uniform distribution.
– Buyer offers a price p;
– seller accepts or rejects;
– If seller accepts, seller gets p, buyer gets 20+v-p.
– If seller rejects, w/probability 0.1 each gets 20; w/p
0.95 we proceed to next date, and
– Seller offers a price p;
– If buyer accepts, seller gets p, buyer gets 20+v-p;
otherwise each gets 20.
5
High-risk Agent
Y2
Y1
Low-risk Agent
Y2
Y1
6
High- and Low-risk Agent
Y2
Y1
Optimal menu
Y2
Y1
7
Signaling Games
Beer – Quiche
0 1
1 du l 1
el e
beer quiche du
2 t {.1} don 3
’
0 don tw
’t
0
1 0
0 ts
0
el
du
du
el
8
Signaling Game -- Definition
• Two Players: (S)ender, (R)eceiver
1. Nature selects a type ti from T = {t1,…,tI}
with probability p(ti);
2. Sender observes ti, and then chooses a
message mj from M = {m1,…,mI};
3. Receiver observes mj (but not ti), and then
chooses an action ak from A = {a1,…,aK};
4. Payoffs are US(ti,mj,ak) and US(ti,mj,ak).
Beer – Quiche
0 1
1 du l 1
el e
beer quiche du
2 t {.1} don 3
’
0 don tw
’t
0
1 0
0 ts
0
el
du
du
el
9
Types of Equilibria
• A pooling equilibrium is an equilibrium in
which all types of sender send the same
message.
• A separating equilibrium is an equilibrium in
which all types of sender send different
messages.
• A partially separating/pooling equilibrium is
an equilibrium in which some types of sender
send the same message, while some others
sends some other messages.
A Pooling equilibrium
0 1
1 du l 1
el e
beer quiche du
2 t {.1} don 3
’
0 don tw
’t
0
1 0
0 ts
0
el
du
du
el
10
A Separating equilibrium
0 1
1 du l 1
el e
beer quiche du
1 0
0 ts
0
el
du
du
el
A Mixed equilibrium
0 1
1 du l 1
el e
beer quiche du
2 ’ t {.1} don 3
0 don tw
’t
0
1 0
0 ts
0
el
du
du
el
11
Job Market Signaling
Model
• A worker
– with ability t = H or t = L (his private information)
– Pr(t = H) = q,
– obtains an observable education level e,
– incurring cost c(t,e) where c(H,e) < c(L,e), and
– finds a job with wage w(e), where he
– produces y(t,e).
• Firms compete for the worker: in equilibrium,
w(e) = µ(H|e)y(H,e) + (1– µ(H|e))y(L,e).
12
Equilibrium
(eH, eL, w(e), µ(H|e)) where
• et = argmaxe w(e) – c(t,e) for each t;
• w(e) = µ(H|e)y(H,e) + (1– µ(H|e))y(L,e);
qPr(eH = e)
• µ(H|e) =
qPr(eH = e) + (1-q)Pr(eL = e)
whenever well-defined.
)
y (t,e
) =
w (e
e
e*(t)
13
No need to imitate
w , e)
y (H
(L,e)
y
e
e*(L) e*(H)
w H, e)
y (
(L,e)
y
e
e*(L) e*(H)
14
want to imitate
w , e)
y (H
(L,e)
y
e
e*(L) e*(H)
A pooling equilibrium , e)
y( H
w ,e)
(L
q) y
(1-
e)+
qy (H ,
(L,e)
y
e
e*(L) e*(H)
15
A separating equilibrium
w , e)
y (H
(L,e)
y
e
eL=e*(L) e*(H) eH
(L,e)
y
e
eL=e*(L) eH
16
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L
R
(2,2)
2
r
l
(0,0)
u
1
1
Ρ
λ ρ Λ
5
14.12 Solutions for Homework 1
Kenichi Amaya1
September 28, 2001
Question 1
(a)
(b)
xy
⇔ x ≥ y − 1/2 and y < x − 1/2
⇔ x > y + 1/2
Suppose x y and y z. Then, x > y + 1/2 and y > z + 1/2. This implies
that
x > y + 1/2 > (z + 1/2) + 1/2 > z + 1/2.
Therefore is transitive.
We can show that ∼ is not transitive by using the same counterexample used
in (a). Suppose x = 0, y = .5, and z = 1. Since x = 0 = y − 12 , x y and
y x, therefore x ∼ y. Since y = 12 = z − 12 , y z and z y, therefore y ∼ z.
However, we don’t have x z because x = 0 < 12 = z − 12 . Therefore x ∼ z is
not satisfied.
(c)
x y ⇔ x ≥ y − 1/2 ⇔ x ≥ y.
1
Question 2
Since the agent is risk neutral, his von-Neuman Morgenstern utility function is
represented by the amount of money he receives (or any affine transformation
of it).
(a)
If he doesn’t buy the security, the amount of money he has at date 1 is 0 for
sure, so the expected utility is 0. If he buys the security at price p, the amount
of money he has at date 1 is 100 − p, 50 − p, or −p, each with probability 1/3,
and thus the expected utility is
1 1 1
(100 − p) + (50 − p) + (−p).
3 3 3
He wants to buy this security if and only if this expected utility is higher than
or equal to 0, the expected utility from not buying.
1 1 1
(100 − p) + (50 − p) + (−p) ≥ 0 ⇔ p ≤ 50.
3 3 3
Therefore πS = 50.
(b)
If the agent exercises the option, he will pay K and receive the dividend d,
so he will receive net payment of d − K. If he doesn’t exercise the option, he
receives 0. Therefore he will excercise if and only if d − K ≥ 0. His utility is
represented by
u(d) = max{0, d − K} − p,
where p is the price of the option.
(c)
Case 1 K > 100
In this case, the agent will never exercise the option, so he ends up with
receiving 0 no matter what the dividend is. Therefore he wants to pay for
this option no more than 0.
Case 2 50 < K ≤ 100
If d = 100, the agent will exercise the option and receive net payment of
100 − K. However, if d = 0 or 50, he won’t exercise the option and receive
0. Therefore, he wants to buy this option if
1 2
(100 − K − p) + (−p) ≥ 0
3 3
1
⇔ p ≤ (100 − K).
3
2
Case 3 0 ≤ K ≤ 50
If d = 50 or 100, the agent will exercise the option and receive net payment
of d − K. However, if d = 0, he won’t exercise the option and receive 0.
Therefore, he wants to buy this option if
1 1 1
(100 − K − p) + (50 − K − p) + (−p) ≥ 0
3 3 3
2
⇔ p ≤ 50 − K.
3
To summarise,
0 if K > 100
1
πO = 3 (100 − K) if 50 < K ≤ 100
50 − 23 K if 0 ≤ K ≤ 50
Question 3
Here is an example.
L R
s 4,0 0,0
s’ 0,0 6,0
s” 1,1 1,1
Question 4
The intuition tells us only 0 would be selected, but actually, all strategies
except 100 are rationalizable! The reason is that a player’s objective is just
to win the game, i.e., to name closer number to one third of the average than
everyone else, and not to name exactly one third of the average. For example,
if everybody else is naming 100, you can win by naming any number below 100,
even 99 wins. The proof is given in the answer 1.
But if, not like this game, a player’s objective is to name exactly one third
of the average, our first intuition works. The proof for this case is given in the
answer 2.
Answer 1
If 0 ≤ x < 100, x is the best response to all other players’ playing x0 , where
x < x0 < 100 and x0 is close enough to x. To see this, if a player plays x and all
others plays x0 , x̄/3 < x (because x0 is close enough to x), therefore she is the
3
only winner. Since she can do no better than being the only winner, x is the
best response.
For any 0 ≤ x < 100, we can find a sequence x < x1 < x2 < · · · < 100 such
that x is a best response to everyone else’s playing x1 , x1 is a best response to
everyone else’s playing x2 , and so on.
Naming 100 is not a best response to anything. The only case a player wins
is when everyone is naming 100, but even in this case, she can be the only winner
by naming a smaller number.
To conclude, x is rationalizable if and only if 0 ≤ x < 100.
Answer 2
Suppose the award is 100 − |x − x̄3 |, so that a player always want to name
exactly x̄3 .
Given that 0 ≤ xi ≤ 100 for all i, x̄3 always lies between 0 and 33.33 · · ·. So
x > 33.33 · · · is never best response, i.e., it is not rationalizable.
As long as everyone is naming 0 ≤ xi ≤ 33.33 · · ·, x̄3 always lies between 0
and 11.11 · · ·. So x > 11.11 · · · is never best response, i.e., it is not rationalizable.
Repeating this procedure forever, any number greater than 0 is not ratio-
nalizable.
If everyone else is naming 0, the best response is to name 0 as well. Therefore
0 is rationalizable.
To conclude, x = 0 is the only rationalizable strategy.
Bonus: In the discussion above, the number of players played no role at all.
Question 5
(a)
l r
LλΛ 2,2 2,2
LλP 2,2 2,2
Lλu 2,2 2,2
LρΛ 2,2 2,2
LρP 2,2 2,2
Lρu 2,2 2,2
RλΛ 1,3 3,3
RλP 1,3 1,1
Rλu 1,3 0,0
RρΛ 3,1 3,3
RρP 3,1 1,1
Rρu 3,1 0,0
(b)
4
First, RρΛ weakly dominates all other strategies of player 1. We eliminate them
and then we have the following game.
l r
RρΛ 3,1 3,3
Now, l is weakly dominated by r, so we eliminate l and we have
r
RρΛ 3,3
5
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14.12 Solutions for Homework 2
Kenichi Amaya1
October 5, 2001
Question 1
(a)
L R
T 1,1 1,0
B 0,1 0,10000
(b)
1
L R
T .999, 1.009
B
In the same way, we can calculate expected payoffs for the remaining of the
payoff matrix and we have
L R
T .999, 1.009 .999, 9.991
B .001, 10.999 .001, 9980.01
For player 1, B is strictly dominated by T, and for player 2, L is strictly
dominated by R. Now we have
R
T .999, 9.991
Therefore, the rationalizable strategies are T for player 1 and R for player
2.
(c)
For player 1, the possibility that opponent trembles doesn’t affect her optimal
choice because T gives higher payoff than B no matter what the opponent is
doing.
For player 2, in the case of (a), the large payoff differnce between (B,L)
and (B,R) didn’t matter because he was sure B is never played. However,
when we introduce trembles, this large payoff difference matters with positive
probability even though player 2 knows that player 1 never intends to play B.
In this situation, the payoff difference between (T,L) and (T,R) is so small that
it is outweighed by the payoff differnce between (B,L) and (B,R).
Question 2
Fact All the Nash equilibrium strategies are rationalizable, and therefore
survives iterated elimination of strictly dominated strategies. When we look for
Nash equilibria, we can first eliminate strictly dominated strategies and then
find Nash equilibria of the game left.
L M R
A 3,1 0,0 1,0
B 0,0 1,3 1,1
C 1,1 0,1 0,10
Step 1 For player 1, C is strictly dominated by 12 A + 12 B. Now we have
L M R
A 3,1 0,0 1,0
B 0,0 1,3 1,1
2
Step 2 For player 2, R is stricly dominated by 12 L + 12 M . Now we have
L M
A 3,1 0,0
B 0,0 1,3
Step 3 In the game left, (A,L) and (B,M) are pure strategy Nash equilibria,
because players are taking best response to each other.
Step 4 We want to find the mixed strategy equilibrium. Let (pA + (1 −
p)B, qL + (1 − q)M ) be the equilibrium. First, player 1 must be indifferent
between playing A and B, which implies
3q = 1(1 − q),
where the LHS is the expected payoff of playing A and the RHS is that of B,
when player 2 is playing the equilibrium strategy. This implies
1
q= .
4
Next, player 2 must be indifferent between playing L and M, implying
1p = (1 − p)3
3
p= .
4
To conclude, the Nash equilibria are; (A,L), (B,M), and ( 34 A+ 14 B, 14 L+ 34 M ).
Question 3
3
First, consider the equilibrium where all firms are producing q ∗ . What we
need is that q ∗ is a best response to all other firms choosing q ∗ . The profit of
firm i when it is producing qi and all other firms are producing q ∗ is
In the equilibrium all firms must be getting positive revenue (because there is
fixed cost), so it must be 1 − (qi + (n − 1)q ∗ ) > 0. Therefore
1 − (n − 1)q ∗ − c
qi = . (3)
2
In the symmetric equilibium, we must have qi = q ∗ , thus
1−c
q∗ = . (4)
n+1
For this quantity to be actually construct equilibrium, each firm must be getting
nonnegative profit. Plugging this into (2),
1 − c 2
πi = − F. (5)
n+1
Therefore there exists an equilibrium where all firms are producing q ∗ = n+1
1−c
if
1−c 2
and only if ( n+1 ) ≥ F and c ≤ 1.
Next consider an equilibrium where only k < n firms are producing q ∗ . We
need to check incentives of firms which are producing and incentives of firms
which are not producing.
For a firm which is producing, qi = q ∗ must be a best response to k − 1 of
other firms producing q ∗ and the rest producing zero. The firm’s profit when
producing qi is
Notice this is same as equation (1), n being replaced by k. Therefore the same
argument as above holds.
1−c
q∗ = , (7)
k+1
1−c 2
For this to be an equilibrium, we need ( k+1 ) ≥ F and c ≤ 1.
However, this is not a sufficient condition. It must also be true that for non-
producing firms, not producing is actually the best response. From the point
4
of view of a non-producing firm i, k other firms are producing q ∗ . By the same
argument above, if this firm does choose to produce, the optimal amount is
1 − kq ∗ − c
qi∗ = , (8)
2
and the payoff is
1 − kq ∗ − c 2
πi = − F. (9)
2
∗
If this profit is positive, the firm wants to produce qi rather than producing
∗
2
nothing. Therefore, we need 1−kq2 −c ≤ F , i.e.,
1 − c 2
≤ F. (10)
2(k + 1)
Finally, consider an equilibrium where no firm produces. This is the case
where c ≥ 1 or where even the monopoly profit is less than the fixed cost. That
is,
1 − c 2
≤ F. (11)
2
Question 4
Each player i = 1, · · · , n chooses his price of meal pi . The payoff of player i
is
Pn
√ j=1 pj
ui = pi −
P n
√ pi j6=i pj
= pi − − .
n n
Taking first order condition,
1 1
√ =
2 pi n
n2
pi = .
4
This gives the best response, but actually this optimum does not depend on
what other players are doing, which means that it is the dominant strategy.
To conclude, the Nash equilibrium is
n2
pi = ∀i.
4
Notice if n = 1 then p = 12 . This is the efficient choice, because there is no
externality. If n → ∞, then pi → ∞. This is because every marginal increase
in the price of the meal will splitted by all the people and the marginal increase
of the payment of the player herself converges to 0.
5
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14.12 Solutions for Homework 3
Kenichi Amaya1
November 2, 2001
Question 1
We solve this problem by backward induction. First, we solve for the quan-
tity choice (stage 2) given the entrance decision, and then we solve for the
entrance decision (stage 1).
Stage 2 Suppose m firms has entered in stage 1. Assuming 1 − Q ≥ 0 in
equilibrium (we check this is actually true later), each firm i maximizes
πi = qi (1 − Q)
X
= qi (1 − qj − qi ).
j6=i
Notice, since the fixed cost F was payed in stage 1 already, i.e., it is
already sunk, the firm doesn’t care about it any more. Taking first order
condition, P
1 − j6=i qj
qi = .
2
Assuming the equilibrium is symmetric (qi is same for all i),
1 − (m − 1)qi
qi = ,
2
implying
1
qi = .
m+1
(It is not hard to prove the equilibrium is actually symmetric.) Now we
can confirm that our assumption 1 − Q ≥ 0 is actually satisfied because
m
Q = mqi = < 1.
m+1
The equilibrium payoff of each firm is
1
π= .
(m + 1)2
Stage 1 Let π(m) be the profit (gained in stage 2) of each firm when m firms
are entering. As we solved above,
1
π(m) = .
(m + 1)2
There are three possible classes of equilibria:
1 E52-303, [email protected], 253-3591
1
1. All n firms enter.
2. No firm enters
3. k firms enter, where 0 < k < n.
The first class of equilibrium exists if it is better to enter and gain π(n)−F
than to exit and gain 0. That is,
π(n) − F ≥ 0,
1
≥ F.
(n + 1)2
The second class of equilibrium exists if it is better to exit and get 0 than
to enter to be the only entering firm and gain π(1) − F . That is,
π(1) − F < 0,
1
≤ F.
4
To see when the third class of equilibrium exists, we need to check the
incentives of the firms which are entering and the firms which are not
entering.
Let’s consider the incentive of an entering firm first. It gets π(k) − F if it
enters, and gets 0 if it exits. Therefore, there is no incentive to deviate if
π(k) − F ≥ 0,
1
≥ F.
(k + 1)2
π(k + 1) − F ≤ 0,
1
≤ F.
(k + 2)2
Notice, the argument above says nothing about which k firms enter. If
the condition above is satisfied, any selection of k firms constitutes an
equilibrium.
2
1. • All firms enter in stage 1.
1
• If m firms enter in stage 1, each entering firm produces m+1 in stage
2.
1
The equilibrium payoff is (n+1) 2 −F for every firm. This equilibrium exists
1
if and only if (n+1)2 ≥ F .
Question 2
(a)
1
A
X A N
A
U2
A
(2,2) @
x @ n
@
R1
@
(2,2) @
L @ R
@
R2
@
A A
l A r l A r
A A
U
A
AU
(3,3) (0,0) (0,0) (1,1)
3
2’s first decision node, and a subgame starting from player 1’s second decision
node.
First we look at the subgame starting from player 1’s second decision node.
This subgame is equivalent to the following nomal form game:
l r
L 3,3 0,0
R 0,0 1,1
(b)
4
Question 3
(a)
pm (1 − pm ) 1
= ,
2 8
and the present discounted sum of the profit sequence from today is
1 1 1 1 1
+ δ + δ2 + · · · = .
8 8 8 1−δ8
If the firm is to deviate, the best it can do today is to set a price slightly less
than pm and get the whole monopoly profit
1
pm (1 − pm ) = .
4
If the firm does deviate, everyone will be playing 0 from the next period, yielding
per period payoff of zero. Therefore, the present discounted sum of the profit
sequence from today is
1 1
+ δ0 + δ 2 0 + · · · = .
4 4
The firm has no incentive to deviate if and only if
1 1 1
≥
1−δ8 4
1
δ≥ .
2
Secondly, check the incentive when somebody has ever deviated from pm
before. In this case, a firm’s action today doesn’t affect it’s future payoff because
everyone will be playing 0 in future no matter what happens today. Therefore
it is sufficient to check if the firm can increase the present period profit by
deviating. If it plays p = 0, as suggested by the strategy, it gets a payoff of 0.
5
If it deviates and plays p > 0, it gets a payoff of 0 again because all consumers
buy from the other firm which is choosing p = 0. Therefore it can’t benefit from
deviating.
To conclude, the trigger strategy constitutes a subgame perfect Nash equi-
librium if δ ≥ 21 .
(b)
When there are n firms, we can use the trigger strategy constructed in part
(a) again. As we did in part (a), we check incentives to deviate before and after
any deviation.
Firstly, check the incentive when nobody has deviated from pm before. If a
firm plays pm , as suggested by the strategy, then everyone will be playing pm
all the time in future, and a firm’s profit per period is
pm (1 − pm ) 1
= ,
n 4n
and the present discounted sum of the profit sequence from today is
1 1 1 1 1
+δ + δ2 + ··· = .
4n 4n 4n 1 − δ 4n
If the firm is to deviate, the best it can do today is to set a price slightly less
than pm and get the whole monopoly profit
1
pm (1 − pm ) = .
4
If the firm does deviate, everyone will be playing 0 from the next period, yielding
per period payoff of zero. Therefore, the present discounted sum of the profit
sequence from today is
1 1
+ δ0 + δ 2 0 + · · · = .
4 4
The firm has no incentive to deviate if and only if
1 1 1
≥
1 − δ 4n 4
n−1
δ≥ .
n
To check the incentive when somebody has ever deviated from pm before,
the same argument as in part (a) holds.
To conclude, the trigger strategy constitutes a subgame perfect Nash equi-
librium if δ ≥ n−1
n .
Question 4
(a)
6
To begin with, let’s find the subgame perfect Nash equilibrium of the stage
game. We do this by backward induction. The long run firm, observing the
short run firm’s quantity xt , chooses its quantity yt to maximize its profit
7
(b)
Keep playing this strategy as long it has not deviated from it.
1−xt
• Play yt∗ (xt ) = 2 if it has deviated from (*) at least once.
Short run firms • Play xt = 1/4 if the long run firm has not deviated from
(*) before.
1
• Play xt = 2 if the long run firm has deviated from (*) at least once.
To see this is actually a subgame perfect Nash equilibrium, let’s check in-
centives to deviate.
Firstly, consider the long run firm’s incentive when it has never deviated
from (*) before.
Case 1: xt ≤ 1/2 If it follows the strategy and choose yt = 1/2, the present
period profit of the long run firm is
1 1
(1 − ( + xt )).
2 2
Starting from the next period, the outcome will be xt = 1/4 and yt = 1/2
every period, and the long run firm’s per period profit is 1/8 and therefore
the present discounted value of the profit sequence is
1 1 δ
(1 − ( + xt )) + .
2 2 8(1 − δ)
If it is to deviate, the best it can do today is to play
1 − xt
yt =
2
and get payoff of
(1 − xt )2
.
4
However, starting from next period, the outcome will be xt = 1/2 and
yt = 1/4 and the long run firm’s per period profit is 1/16. Therefore the
present discounted value of the profit sequence is
(1 − xt )2 δ
+ .
4 16(1 − δ)
8
If δ = 0.99,
1 1 δ (1 − xt )2 δ
(1 − ( + xt )) + > + ,
2 2 8(1 − δ) 4 16(1 − δ)
(1 − xt )2 δ
+ .
4 16(1 − δ)
1 δ
+ .
16 16(1 − δ)
Secondly, consider the long run firm’s incentive when it has deviated from
(*) before. According to the strategy strategy profile, future outcomes don’t
depend on today’s behavior. Therefore the long run firm cares only about its
payoff today. Actually, by following the strategy, it is taking best response to
the short run firm.
Finally, consider the short run firm’s incentives. Since they never care about
future payoff, it must be playing a best response to the long run firm’s strategy,
which is actually true. (Check it!)
(c)
In the equilibrium we saw in part (b), the per period profit on the equilibrium
path were 1/8 for the long run firm and 1/16 for the short run firms.
9
If there is a subgame perfect Nash equilibrium where xt = yt − 1/4 on th
eequilibrium path, then the per period profit on the equilibrium path are 1/8
for the long run firm and 1/8 for the short run firms.
Construct the following trigger strategy, which is different from (b) only in
(*) where xt = 1/4:
Keep playing this strategy as long it has not deviated from it.
1−xt
• Play yt∗ (xt ) = 2 if it has deviated from (*) at least once.
Short run firms • Play xt = 1/4 if the long run firm has not deviated from
(*) before.
1
• Play xt = 2 if the long run firm has deviated from (*) at least once.
The incentive of the long run firm when it is supposed to play (*) and
xt = 1/4 is satisfied because it gets current payoff of 1/8, which is same as part
(b), and what it can get by deviating is same as in part (b). The incentive
problem of the long run firm is same as in (b).
The incentives of the short run firms are also satisfied because the payoff
from following the strategy is larger than part (b) and payoff when deviating is
same as in (b).
10
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14.12 Solutions for Homework 4
Kenichi Amaya1
November 9, 2001
Question 1
(a)
vNM utility function ui (a1 , a2 , t1 , t2 ) is the vNM utility when player 1’s ac-
tion is a1 , player 2’s action is a2 , player 1’s type is t1 and player 2’s type
is t2 .
u1 (B, B, α, β1 ) = 2, u2 (B, B, α, β1 ) = 1,
u1 (B, S, α, β1 ) = 0, u2 (B, S, α, β1 ) = 0,
u1 (S, B, α, β1 ) = 0, u2 (S, B, α, β1 ) = 0,
u1 (S, S, α, β1 ) = 1, u2 (S, S, α, β1 ) = 2,
u1 (B, B, α, β2 ) = 2, u2 (B, B, α, β2 ) = 0,
u1 (B, S, α, β2 ) = 0, u2 (B, S, α, β2 ) = 2,
u1 (S, B, α, β2 ) = 0, u2 (S, B, α, β2 ) = 1,
u1 (S, S, α, β2 ) = 1, u2 (S, S, α, β2 ) = 0.
(b)
First consider player 1’s incentive. Since she doesn’t know the game which
is being played, she maximizes her expected payoff.
If she plays B, with probability 1/2 the top game is being played and player
2 chooses B and thus she gets a payoff of 2, and with probability 1/2 the bottom
game is being played and player 2 chooses S and thus she gets a payoff of 0.
1 E52-303, [email protected], 253-3591
1
Therefore her expected payoff is 1. If she plays S, with probability 1/2 the top
game is being played and player 2 chooses B and thus she gets a payoff of 0,
and with probability 1/2 the bottom game is being played and player 2 chooses
S and thus she gets a payoff of 1. Therefore her expected payoff is 1/2.
Therefore B is actually player 1’s best response against player 2’s strategy.
Next consider player 2’s incentive. When he knows that the top game is
being played, B is the best response given player 1 is choosing B. When he
knows that the bottom game is being played, S is the best response given player
1 is choosing B.
Therefore choosing B when the top game is being played and choosing S when
the bottom game is being played is actually player 2’s best response against
player 1’s strategy.
Since both players are taking a best response to each other, the strategy
profile constitutes a Bayesian Nash equilibrium.
Question 2
Each player’s action is the choice of price. A price can take any nonnegative
real number. Therefore the action space is R+ for both players.
Player i’s type is her private information. In this model, bi is player i’s type.
bi is either bH or bL . Therefore, the type space of each player is {bH , bL }.
Player i’s belief µi (bj |bi ) is the probability that player j’s type is bj condi-
tional on that player i’s type is bi . In this model, since it is assumed that the
types are independent,
θ if bj = bH
µi (bj |bi ) = .
1 − θ if bj = bL
(von Neuman Morgenstern) utility in this model is the profit of each player
(assuming the firms are risk neutral) as a function of the actions and types of
both players:
ui (pi , pj , bi , bj ) = pi (a − pi − bi pj ).
Player i’s strategy specifies what action to take for any realization of her
type. In this model, it is a two dimensional vector (pi (bH ), pi (bL )), where pi (bH )
is the price when its type is bH and pi (bL ) is the price when its type is bL . The
2
strategy space is R+ for each i.
A strategy profile {(p∗1 (bH ), p∗1 (bL )), (p∗2 (bH ), p∗2 (bL ))} constitutes a Bayesian
Nash equilibrium if each p∗i (bi ) is a best response, i.e., a maximizer of player i’s
expected payoff, conditional on that her type is bi and the opponent is choosing
strategy (p∗j (bH ), p∗j (bL )). That is:
p∗1 (bH ) = argmaxp1 θp1 (a − p1 − bH p∗2 (bH )) + (1 − θ)p1 (a − p1 − bH p∗2 (bL )),
p∗1 (bL ) = argmaxp1 θp1 (a − p1 − bL p∗2 (bH )) + (1 − θ)p1 (a − p1 − bL p∗2 (bL )),
p∗2 (bH ) = argmaxp2 θp2 (a − p2 − bH p∗1 (bH )) + (1 − θ)p2 (a − p2 − bH p∗1 (bL )),
p∗2 (bL ) = argmaxp2 θp2 (a − p2 − bL p∗1 (bH )) + (1 − θ)p2 (a − p2 − bL p∗1 (bL )).
2
Taking first order conditions,
a − bH (θp∗2 (bH ) + (1 − θ)p∗2 (bL ))
p∗1 (bH ) = ,
2
a − bL (θp∗2 (bH ) + (1 − θ)p∗2 (bL ))
p∗1 (bL ) = ,
2
a − bH (θp∗1 (bH ) + (1 − θ)p∗1 (bL ))
p∗2 (bH ) = ,
2
∗ ∗
a − bL (θp1 (bH ) + (1 − θ)p1 (bL ))
p∗2 (bL ) = .
2
Since the game is symmetric, let’s look for a symmetric equilibrium where
p∗1 (bH ) = p∗2 (bH ) = p∗H and p∗1 (bL ) = p∗2 (bL ) = p∗L . Then the conditions are
reduced to
a − bH (θp∗H + (1 − θ)p∗L )
p∗H = ,
2
a − bL (θp∗H + (1 − θ)p∗L )
p∗L = .
2
Solving these, we get
a bH
p∗H = (1 − ),
2 2 + θbH + (1 − θ)bL
a bL
p∗L = (1 − ).
2 2 + θbH + (1 − θ)bL
Question 3
Consider the following incomplete information game.
H T
H 1 + α, −1 + β −1 + α, 1
T −1, 1 + β 1, −1
Here, α is player 1’s type, β is player 2’s type, α and β are independent draw
from uniform distribution in the interval [0, 1], and > 0 is a constant.
The interpretation is like this: Player 1 (2) can get an extra payoff of α
(β) by playing head, in addition to the payoff generated from the original game.
This extra payoff is her private information.
Notice, as we converge to 0, the game converges to the original game.
From the construction, player 1 (2) is more tempted to play H if she has a
higher value of α (β). Observing this, try to find the pure strategy Bayesian
Nash equilibrium of the following form.
• Player 1 chooses H if α ≥ ᾱ and chooses L if α ≤ ᾱ, where ᾱ ∈ [0, 1] is a
constant.
3
• Player 2 chooses H if β ≥ β̄ and chooses L if β ≤ β̄, where β̄ ∈ [0, 1] is a
constant.
This strategy profile is actually a Bayesian Nash equilibrium if player 1 with
cutoff type ᾱ and player 2 with cutoff type β̄ are indifferent between choosing
H and T.
According to the strategy, the probability that player 2 plays H is 1 − β̄, and
the probability that player 2 plays L is β̄. Therefore, if player 1 of type ᾱ plays
H, her expected payoff is
Therefore, we need
We do the same thing for player 2 with type β̄. According to the strategy,
the probability that player 1 plays H is 1 − ᾱ, and the probability that player 1
plays L is ᾱ. Therefore, if player 2 of type β̄ plays H, his expected payoff is
Therefore, we need
Question 4
4
Let i = 1, · · · , n be the index of bidders, vi be bidder i’s valuation of the
good, and bi be player i’s bid. We denote player i’s strategy by a function xi (vi ),
meaning that player i bids bi = xi (vi ) when her valuation is vi .
We want to show that the strategy profile
(n − 1)vi
xi (vi ) = for all i
n
constitutes a Bayesian Nash equilibrium. Since the game is symmetric and strat-
egy profile is symmetric, it is sufficient to check one player’s incentive because
every player is facing the same incentive problem.
We are going to show that if player i’s valuation is vi and all other players
are taking the strategy
(n − 1)vj
xj (vj ) = ,
n
then the bid which maximizes her expected payoff is
(n − 1)vi
bi = xi (vi ) = .
n
First consider the probability of winning the auction by bidding bi . She wins
if and only if all other players’ bids are less than bi , i.e.,
(n − 1)vj
xj (vj ) = ≤ bi for all j 6= i.
n
This is equivalent to
nbi
vj ≤ for all j 6= i.
n−1
Since
nbi nbi
P rob(vj ≤ )=
n−1 n−1
for all j because vj is uniformly distributed in [0.1],
nbi
P rob(win) = P rob(vj ≤ for all j 6= i)
n−1
nbi n−1
= P rob(vj ≤ )
n−1
nbi n−1
= .
n−1
Therefore, the expected payoff from bidding bi is
nbi n−1
Ui = (vi − bi )P rob(win) = (vi − bi ) .
n−1
5
Taking first order condition,
∂Ui nbi n−2 n nbi n−1
= (vi − bi )(n − 1) − = 0,
∂bi n−1 n−1 n−1
nbi
(vi − bi )n = ,
n−1
(n − 1)vi
bi = .
n
Therefore, the strategy of player i
(n − 1)vi
bi = xi (vi ) =
n
is actually the best response to other player’s playing
(n − 1)vj
xj (vj ) = .
n
Q.E.D.
6
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14.12 Game Theory
Fall 2001
Problem Set 5 Solutions
1
If the game is repeated 100 times a similar structure applies.
5. Part a.
2
• Pooling on R: Beliefs on the equilibrium path: µ(t1 |R) = .5
Receiver’s best response: u2 (u|R) = .5(2) = 1 > u2 (d|R) = .5(1) = .5
Sender’s payoff: ut1 (R) = 2,ut2 (R) = 1.
Any play by Receiver after observing L sustains (R, R).
PBE: [(R, R), (u, u), q > 1/2], [(R, R), (u, d), q < 1/2], [(R, R), (u, αu +
(1 − α)d), q = 1/2]
• Pooling on L: Not an equilibrium, since t2 will always want to play R.
• t1 plays R, t2 plays L: Then both of the Receiver’s information sets are
on the equilibrium path, so both beliefs are determined by Bayes’ rule
and the Sender’s strategy: µ(t1 |R) = 1, µ(t2 |L) = 1.
Receiver’s best response: (u, d)
t2 , however, will always play R.
• t1 plays L, t2 plays R: µ(t1 |L) = 1, µ(t2 |R) = 1.
Receiver’s best response: (u, d)
Sender’s payoff: ut1 (L) = 1,ut2 (R) = 1.
PBE: [(L, R), (u, d)]
Part b.
3
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Grade Distribution For Midterm 1
Average = 67.96 Std.Dev.= 18.05
100
Assuming that you will exhibit similar performance in the future,
if you got above 70, you will probably get A(+/-);
90 if you got above 50, you will probably get B(+/-) or above;
if you got below 40, you should reconsider ...
80
70
60
grade
50
40
30
20
10
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46
rank
14.12 Game Theory — Midterm II
10/10/2001
X E
1
5/2 L R
5/2
2
l r
r l
3 0 2 2
3 2 0 2
2. Below, there are pairs of stage games and strategy profiles. For each pair, check whether
the strategy profile is a subgame-perfect equilibrium of the game in which the stage
game is repeated infinitely many times. Each agent tries to maximize the discounted
sum of his expected payoffs in the stage game, and the discount rate is δ = 0.99.
1
3. Consider the following first-price, sealed-bid auction where an indivisible good is sold.There
are n ≥ 2 buyers indexed by i = 1, 2, . . . , n. Simultaneously, each buyer i submits a
bid bi ≥ 0. The agent who submits the highest bid wins. If there are k > 1 play-
ers submitting the highest bid, then the winner is determined randomly among these
players – each has probability 1/k of winning. The winner i gets the object and pays
his bid bi , obtaining payoff vi − bi , while the other buyers get 0, where v1 , . . . , vn are
independently and identically distributed with probability density function f where
½ 2
3x x ∈ [0, 1]
f (x) =
0 otherwise.
4. This question is about a thief and a policeman. The thief has stolen an object. He
can either hide the object INSIDE his car on in the TRUNK. The policeman stops the
thief. He can either check INSIDE the car or the TRUNK, but not both. (He cannot
let the thief go without checking, either.) If the policeman checks the place where the
thief hides the object, he catches the thief, in which case the thief gets -1 and the police
gets 1; otherwise, he cannot catch the thief, and the thief gets 1, the police gets -1.
b1 < b2 < · · · < b50 < 0 < b51 < · · · < b100 ,
d1 < d2 < · · · < d50 < 0 < d51 < · · · < d100 .
Policemen cannot distinguish the thieves from each other, nor can the thieves
distinguish the policemen from each other. Each thief has stolen an object, hiding
it either in the TRUNK or INSIDE the car. Then, each of them is randomly
matched to a policeman. Each matching is equally likely. Again, a policeman
can either check INSIDE the car or the TRUNK, but not both. Compute a
pure-strategy Bayesian Nash equilibrium of this game.
2
The game for problem 1.
X E
1
5/2 L R
5/2
2
l r
r l
3 0 2 2
3 2 0 2
X E
1
5/2 L R
5/2
2
l r
r l
3 0 2 2
3 2 0 2
3
14.12 Game Theory — Midterm II
10/10/2001
X E
1
5/2 L R
5/2
2
l r
r l
3 0 2 2
3 2 0 2
2 2
X E X E
1 1
5/2 L R 5/2 L R
5/2 5/2
2 2
l r l r
r l r l
3 0 2 2 3 0 2 2
3 2 0 2 3 2 0 2
For player 2, Er is strictly dominated by Xr, while El is not dominated. Hence, if player
1 keeps believing that 2 is rational whenever it is possible, then when he sees that 2
played E, he ought to believe that 2 plays strategy El – not the dominated strategy
Ex. In that case, 1 would play L, and 2 would play E. Therefore, the equilibrium on
the left is eliminated.
1
2. Below, there are pairs of stage games and strategy profiles. For each pair, check whether
the strategy profile is a subgame-perfect equilibrium of the game in which the stage
game is repeated infinitely many times. Each agent tries to maximize the discounted
sum of his expected payoffs in the stage game, and the discount rate is δ = 0.99.
2 + 0 < 98
(when he plays B). The only possible profitable deviation for player 2 is to play
R when he is supposed to play left. In that contingency, if he follows the strategy
he gets V1R = 98; if he deviates, he gets 2 + 0 < V1R .
(b) Stage Game:
1\2 A B
A 2,2 1,3
B 3,1 0,0
Strategy profile: The play depends on three states. In state S0 , each player
plays A; in states S1 and S2 , each player plays B. The game start at state S0 . In
state S0 , if each player plays A or if each player plays B, we stay at S0 , but if a
player i plays B while the other is playing A, then we switch to state Si . At any
Si , if player i plays B, we switch to state S0 ; otherwise we state at state Si .
Answer: It is not subgame-perfect. At state S2 , player 2 is to play B, and we
will switch to state S0 no matter what 1 plays. In that case, 1 would gain by
deviating and playing A (in state S2 ).
2
3. Consider the following first-price, sealed-bid auction where an indivisible good is sold.
There are n ≥ 2 buyers indexed by i = 1, 2, . . . , n. Simultaneously, each buyer i
submits a bid bi ≥ 0. The agent who submits the highest bid wins. If there are k > 1
players submitting the highest bid, then the winner is determined randomly among
these players – each has probability 1/k of winning. The winner i gets the object and
pays his bid bi , obtaining payoff vi − bi , while the other buyers get 0, where v1 , . . . , vn
are independently and identically distributed with probability density function f where
½ 2
3x x ∈ [0, 1]
f (x) =
0 otherwise.
bi = a + cvi
where c > 0. Then, the expected payoff from bidding bi with type vi is
3
(b) What happens as n → ∞?
Answer: As n → ∞,
bi → vi .
In the limit, each bidder bids his valuation, and the seller extracts all the gains
from trade.
4. This question is about a thief and a policeman. The thief has stolen an object. He
can either hide the object INSIDE his car on in the TRUNK. The policeman stops the
thief. He can either check INSIDE the car or the TRUNK, but not both. (He cannot
let the thief go without checking, either.) If the policeman checks the place where the
thief hides the object, he catches the thief, in which case the thief gets -1 and the police
gets 1; otherwise, he cannot catch the thief, and the thief gets 1, the police gets -1.
4
14.12 Midterm 2 Grade Distribution
100
90
80
70
60
grade
50
40
30
20
10
0
1
11
13
15
17
19
21
23
25
27
29
31
33
35
37
39
41
43
45
Rank
14.12 Grade Distribution (Midterm 1 + Midterm 2)/2
100
90
80
70
grade
60
50
40
30
20
1
11
13
15
17
19
21
23
25
27
29
31
33
35
37
39
41
43
45
rank
14.12 Game Theory — Final
12/10/2001
O I
2 2
2 L R
1
L R L R
3 0 0 1
1 0 0 3
2. This question is about a milkman and a customer. At any day, with the given order,
• Milkman puts m ∈ [0, 1] liter of milk and 1 − m liter of water in a container and
closes the container, incurring cost cm for some c > 0;
• Customer, without knowing m, decides on whether or not to buy the liquid at
some price p. If she buys, her payoff is vm − p and the milkman’s payoff is p − cm.
If she does not buy, she gets 0, and the milkman gets −cm. If she buys, then she
learns m.
1
(a) Assume that this is repeated for 100 days, and each player tries to maximize the
sum of his or her stage payoffs. Find all subgame-perfect equilibria of this game.
(b) Now assume that this is repeated infinitely many times and each player tries to
maximize the discounted sum of his or her stage payoffs, where discount rate is
δ ∈ (0, 1). What is the range of prices p for which there exists a subgame perfect
equilibrium such that, everyday, the milkman chooses m = 1, and the customer
buys on the path of equilibrium play?
3. For the game in question 3.a, assume that with probability 0.001, milkman strongly
believes that there is some entity who knows what the milkman does and will punish
him severely on the day 101 for each day the milkman dilutes the milk (by choosing
m < 1). Call this type irrational. Assume that this is common knowledge. For
v > p > c, find a perfect Bayesian equilibrium of this game.
Bonus: [10 points] Discuss what would happen if the irrational type were known to
dilute the milk by accident with some small but positive probability.
-1 1
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2
• Then, entrepreneur decides whether to borrow ($100,000) and invest.
• Then, uncertainty is resolved.
(a) Compute the subgame perfect equilibrium for the case when the wealth is common
knowledge.
(b) Now assume that the bank does not know the wealth of the entrepreneur. The
probability that the entrepreneur is rich is 1/4. Compute the perfect Bayesian
equilibrium.
3
14.12 Game Theory — Final
12/10/2001
O I
2 2
2 L R
1
L R L R
3 0 0 1
1 0 0 3
L R
OL 2,2 2,2
OR 2,2 2,2
IL 3,1 0,0
L R
OL 2,2 2,2
OR 2,2 2,2
IL 3,1 0,0
1
(d) Which strategies are consistent with all of the following assumptions?
(i) 1 is rational.
(ii) 2 is sequentially rational.
(iii) at the node she moves, 2 knows (i).
(iv) 1 knows (ii) and (iii).
ANSWER: By (i) 1 does not play IR. Hence, by (iii), at the node she moves, 2
knows that 1 does not play IR, hence he knows IL. Then, by (ii), 2 must play L.
Therefore, by (i) and (iv), 1 must play IL. The answer is (IL,L).
2. This question is about a milkman and a customer. At any day, with the given order,
• Milkman puts m ∈ [0, 1] liter of milk and 1 − m liter of water in a container and
closes the container, incurring cost cm for some c > 0;
• Customer, without knowing m, decides on whether or not to buy the liquid at
some price p. If she buys, her payoff is vm − p and the milkman’s payoff is p − cm.
If she does not buy, she gets 0, and the milkman gets −cm. If she buys, then she
learns m.
(a) Assume that this is repeated for 100 days, and each player tries to maximize the
sum of his or her stage payoffs. Find all subgame-perfect equilibria of this game.
ANSWER: The stage game has a unique Nash equilibrium, in which m = 0 and
the customer does not buy. Therefore, this finitely repeated game has a unique
subgame-perfect equilibrium, in which the stage equilibrium is repeated.
(b) Now assume that this is repeated infinitely many times and each player tries to
maximize the discounted sum of his or her stage payoffs, where discount rate is
δ ∈ (0, 1). What is the range of prices p for which there exists a subgame perfect
equilibrium such that, everyday, the milkman chooses m = 1, and the customer
buys on the path of equilibrium play?
ANSWER: The milkman can guarantee himself 0 by always choosing m = 0.
Hence, his continuation value at any history must be at least 0. Hence, in the
worst equilibrium, if he deviates customer should not buy milk forever, giving the
milkman exactly 0 as the continuation value. Hence, the SPE we are looking for
is the milkman always chooses m=1 and the customer buys until anyone deviates,
and the milkman chooses m=0 and the customer does not buy thereafter. If the
milkman does not deviate, his continuation value will be
p−c
V = .
1−δ
The best deviation for him (at any history on the path of equilibrium play) is to
choose m = 0 (and not being able to sell thereafter). In that case, he will get
Vd = p + δ0 = p.
In order this to be an equilibrium, we must have V ≥ Vd ; i.e.,
p−c
≥ p,
1−δ
2
i.e.,
c
p≥ .
δ
In order that the customer buy on the equilibrium path, we must also have p ≤ v.
Therefore,
c
v≥p≥ .
δ
3. For the game in question 2.a, assume that with probability 0.001, milkman strongly
believes that there is some entity who knows what the milkman does and will punish
him severely on the day 101 for each day the milkman dilutes the milk (by choosing
m < 1). Call this type irrational. Assume that this is common knowledge. For some
v > p > c, find a perfect Bayesian equilibrium of this game. [If you find it easier,
take the customers at different dates different, but assume that each customer knows
whatever the previous customers knew.]
ANSWER: [It is very difficult to give a rigorous answer to this question,
so you would get a big partial grade for an informal answer that shows
that you understand the reputation from an incomplete-information point
of view.] Irrational type always sets m = 1. Since he will be detected whenever he
sets m < 1 and the customer buys, the rational type will set either m = 1 or m = 0.
We are looking for an equilibrium in which early in the relation the rational milkman
will always set m = 1 and the customer will always buy, but near the end of the relation
the rational milkman will mix between m = 1 and m = 0, and the customer will mix
between buy and not buy.
In this equilibrium, if the milkman sets m < 1 or the customer does not buy at any
t, then the rational milkman sets m = 0 at each s > t. In that case, if in addition the
costumer buys at some dates in the period {t + 1, t + 2, . . . , s − 1} and if the milkman
chooses m = 1 at each of those days, then the costumer will assign probability 1 to
that the milkman is irrational and buy the milk at s; otherwise, he will not buy the
milk. On the path of such play, if the milkman sets m < 1 or the customer does not
buy at any t, then the rational milkman sets m = 0 and the costumer does not buy at
each s > t. In order this to be an equilibrium, the probability µt that the milkman is
irrational at such history must satisfy
µt (100 − t) (v − p) − (1 − µt ) p ≤ 0,
where the first term is the expected benefit from experimenting (if the milkman happens
to be irrational) and the second term is the cost (if he is rational). That is,
p
µt ≤ .
p + (100 − t) (v − p)
Now we determine what happens if the milkman has always been setting m = 1,
and the customer has been buying. In the last date, the rational type will set m = 0,
and the rational type will set m = 1; hence, the buyer will buy iff
µ100 (v − p) − (1 − µ100 ) p ≥ 0,
3
i.e.,
p
µ100 ≥ .
v
Since we want him to mix, we set
p
µ100 = .
v
We derive µt for previous dates using the Bayes’ rule and the indifference condition
necessary for the customer’s mixing. Let’s write αt for the probability that the rational
milkman sets m = 1 at t, and at = µt + (1 − µt ) αt for the total probability that m = 1
at date t. Since the customer will be indifferent between buying and not buying at
t + 1, his expected payoff at t + 1 will be 0. Hence, his expected payoff from buying at
t is
at (v − p) + (1 − at ) (−p) .
For indifference, this must be equal to zero, thus
p
at = .
v
On the other hand, by Bayes’ rule,
µt
µt+1 = .
at
Therefore,
p
µt = at µt+1 = µt+1 .
v
That is,
p
µ100 =
v
³ p ´2
µ99 =
v
³ p ´3
µ98 =
v
..
.
Note that p
p v
− µt
at = = µt + (1 − µt ) αt ⇒ αt = .
v 1 − µt
Assume that (p/v)100 < 0.001. Then, we will have a date t∗ such that
³ p ´101−t∗ ³ p ´100−t∗
< 0.001 < .
v v
At each date t > t∗ , we will have µt = (p/v)101−t and the players will mix so that
at = vp . At each date t < t∗ , the milkman will set m = 1 and the customer will buy.
At date t∗ , the rational milkman will mix so that
³ p ´100−t∗ µ∗ 0.001
= µt∗ +1 = t = ,
v at∗ at∗
4
hence
0.001
at∗ = ¡ p ¢100−t∗ .
v
Note that at∗ > p/v, hence the customer will certainly buy at t∗ .
Let’s write β t for the probability that the customer will buy at day t. In the day
99, if the rational milkman sets m = 1, he will get
U = β 99 (p − c) + β 99 β 100 p + (1 − β 99 ) (−c) ,
where the first term is the profit from selling at day 99, the second term is the profit
from day 100 (when he will set m = 0), and the last term is the loss if the customer
does not buy at day 99. If he sets m = 0, he will get β 99 p (from the sale at 99, and
will get zero thereafter). Hence, he will set m = 1 iff
β 99 (p − c) + β 99 β 100 p + (1 − β 99 ) (−c) ≥ β 99 p
i.e.,
c
β 99 β 100 ≥ .
p
We are looking for an indifference, hence we set
c
β 99 β 100 = .
p
Similarly, at day 98 the rational milkman will set m = 1 iff
β 98 (p − c) + β 98 β 99 p + (1 − β 98 ) (−c) ≥ β 98 p,
where the second term is due to the fact that at date 99 he will be indifferent between
choosing m = 0 and m = 1. For indifference, we set
c
β 98 β 99 = .
p
We will continue on like this as long as we need the milkman to mix. That is, we will
have
c
β t∗ β t∗ +1 = ,
p
c
β t∗ +1 β t∗ +2 = ,
p
..
.
c
β 98 β 99 = ,
p
c
β 99 β 100 = .
p
5
As we noted before, β t∗ = 1. Hence, β t∗ +1 = pc . Hence, β t∗ +2 = 1, ... That is,
β t∗ = 1,
c
β t∗ +1 = ,
p
β t∗ +2 = 1,
c
β t∗ +3 = ,
p
..
.
Bonus: [10 points] Discuss what would happen if the irrational type were known to
dilute the milk by accident with some small but positive probability.
-1 1
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beer quiche d
{.1} don
0 ’t 3
0 don tw
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1 0
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du
el
ANSWER:
6
-1 1
1 du 1
el uel
beer quiche d
1 0
0 ts
0
el
du
du
el
(a) Compute the subgame perfect equilibrium for the case when the wealth is common
knowledge.
ANSWER: The rich entrepreneur is always going to pay back the loan in full
amount, hence his expected payoff from investing (as a change from not investing)
is
(0.5)(300, 000) − 100, 000 (1 + π) .
Hence, he will invest iff this amount is non-negative, i.e.,
π ≤ 1/2.
π R = 1/2.
7
The poor entrepreneur is going to pay back the loan only when the project suc-
ceeds. Hence, his expected payoff from investing is
π ≤ 2.
π P = 2.
(b) Now assume that the bank does not know the wealth of the entrepreneur. The
probability that the entrepreneur is rich is 1/4. Compute the perfect Bayesian
equilibrium.
ANSWER: As in part (a), the rich type will invest iff π ≤ π R = .5, and the poor
type will invest iff π ≤ π P = 2. Now, if π ≤ πR , the bank’s payoff is
· ¸
1 3 1 1
U (π) = 100, 000 (1 + π) + 100, 000 (1 + π) + 0 − 100, 000
4 4 2 2
5
= 100, 000 (1 + π) − 100, 000
8
5
≤ 100, 000 (1 + π R ) − 100, 000
8
5 1
= 100, 000 (1 + 1/2) − 100, 000 = − 100, 000 < 0.
8 16
If π R < π ≤ π P , the bank’s payoff is
· ¸
3 1 1
U (π) = 100, 000 (1 + π) + 0 − 100, 000
4 2 2
3
= 100, 000 (π − 1) ,
8
which is maximized at πP , yielding 38 100, 000. If π > π P , U (π) = 0. Hence, the
bank will choose π = πP .
8
14.12 Game Theory — Final
12/21/2001
1 A 2 α 1 a
(1,4)
D δ d
1\2 α δ
Aa 1,4 0,3
Ad 2,2 0,3
Da 1,1 1,1
Dd 1,1 1,1
(b) Find all rationalizable pure strategies.
1\2 α δ
Ad 2,2 0,3
Da 1,1 1,1
Dd 1,1 1,1
1\2 α δ
Ad 2,2 0,3
Da 1,1 1,1
Dd 1,1 1,1
(d) Which strategies are consistent with all of the following assumptions?
(i) 1 is rational.
(ii) 2 is sequentially rational.
(iii) at the node she moves, 2 knows (i).
(iv) 1 knows (ii) and (iii).
1
ANSWER: By (i) 1 does not play Aa. Hence, by (iii), at the node she moves, 2
knows that 1 does not play Aa, hence he knows that 1 plays Ad. Then, by (ii), 2
must play δ. Therefore, by (i) and (iv), 1 must play Ad or Aa. The answer is 1
plays A, given chance 2 would play δ.
(-10,-10)
Apply Accept
{0} Reject
Don’t (-1,0)
.9
Hate
(0,0) (20,20)
Love {1}
Apply Accept
.1
Reject
Don’t (-1,0)
(0,0)
A pooling equilibrium:
2
(-10,-10)
Apply Accept
{.9} Reject
Don’t (-1,0)
.9
Hate
(0,0) (20,20)
Love {.1}
Apply Accept
.1
Reject
Don’t (-1,0)
(0,0)
3. Consider a bargaining problem where two risk-neutral players are trying to divide a
dollar they own, which they cannot use until they reach an agreement. The players
do not discount the future, but at the end of each rejection of an offer the bargaining
breaks down with probability 1 − δ ∈ (0, 1) and each player gets 0.
(a) Consider the following bargaining procedure. Player 1 makes an offer (x, 1 − x),
where x is player 1’s share. Then, player 2 decides whether or not to accept the
offer. If she accepts, they implement the offer, yielding division (x, 1 − x). If she
rejects the offer, then with probability 1 − δ, the bargaining breaks down an each
gets 0; with probability δ, player 1 makes another offer, which will be accepted or
rejected by player 2 as above. (If player 2 rejects the offer, bargaining will break
down with probability 1 − δ again.) If the offer is rejected and the bargaining
did not break down, now player 2 makes a counter offer, and player 1 accepts
or rejects this counter offer as above. If the offer is rejected, this time the game
will end, and each will get 0. Find the subgame-perfect Nash equilibrium of this
game. Compute the expected payoff of each player at the beginning of the game
in this equilibrium.
ANSWER: On the last day, 1 accepts any offer, so 2 offers (0,1). Hence, on the
previous day, 2 accepts an offer iff she gets at least δ. Hence, 1 offers (1 − δ, δ) –
accepted.
¡ Thus, in¢ the first day, 2 accepts an offer iff she gets
¡ at least¢ δ 2 . Hence,
1 offers 1 − δ 2 , δ 2 – accepted. The expected payoffs are 1 − δ 2 , δ 2 .
(b) Compute the subgame-perfect equilibrium of the game in which the procedure in
part (a) is repeated 2 times. (The probability of bargaining breakdown after each
rejection is 1 − δ, except for the end of the game.)
ANSWER: The last period as above. Let’s look at the first period.
¡ ¢On the last
2
day of the first period, 1 accepts an offer iff he gets at least δ 1 − δ , so 2 offers
3
¡ ¡ ¢ ¡ ¢¢
δ 1 − δ2 , 1 − ¡ δ 1 −¡ δ 2
. ¢¢
Hence, on the previous day, 2 accepts an offer iff she
2
gets at least δ 1 − δ 1 − δ . Hence, 1 offers
¡ ¡ ¡ ¢¢ ¡ ¡ ¢¢¢ ¡ ¡ ¢ ¡ ¡ ¢¢¢
1 − δ 1 − δ 1 − δ2 , δ 1 − δ 1 − δ2 = 1 − δ + δ2 1 − δ2 , δ 1 − δ 1 − δ2
–¡accepted.
¡ Thus,
¢¢ in the first day, 2 accepts an offer iff she gets at least
2 2
δ 1 − δ 1 − δ . Hence, 1 offers
¡ ¡ ¡ ¢¢ ¡ ¡ ¢¢¢ ¡ ¡ ¢ ¡ ¡ ¢¢¢
1 − δ2 1 − δ 1 − δ2 , δ 1 − δ 1 − δ2 = 1 − δ2 + δ3 1 − δ2 , δ2 1 − δ 1 − δ2
– accepted.
(c) Find the subgame-perfect equilibrium of the game in which this procedure is
repeated until they reach an agreement. Note that player 1 makes two offers,
then 2 makes one offer, then 1 makes two offers, and so on. You need to show
that the proposed strategy profile is in fact a subgame-perfect equilibrium. (The
probability of bargaining breakdown after each rejection is 1 − δ.)
[Hint: One way is to compute the SPE for the game in which the procedure
is repeated n times and let n → ∞. A somewhat easier way is to consider
an alternating offer bargaining procedure with some effective discount rates –
different for a different player.]
ANSWER: If you compare the calculations above with the calculations with the
alternating offer case with asymmetric discount rates, you should realize that
the first offer player 1 makes and the offer player 2 makes are identical to the
offers players 1 and 2 make, respectively, if the discount rates were δ1 = δ and
δ 2 = δ 2 . Intuitively, in his second offer player 1 makes player 2 indifferent between
accepting 1’s second offer and making an offer next day, and in his first offer he
makes her indifferent between accepting the offer and waiting for the second offer.
Therefore, 2 is indifferent between accepting 1’s first offer and waiting two days
two make an offer, as in the the alternating offer case when her discount rate
is δ 2 . Now conjecture that the subgame-perfect equilibrium would be as in the
alternating offer game with above discount rates. That is,
• in his first offer, player 1 offers
µ ¶ µ ¶ µ ¶
1 − δ2 1 − δ2 1 − δ 2 δ 2 (1 − δ 1 ) 1 − δ 2 δ2 (1 − δ)
,1 − ≡ , ≡ ,
1 − δ1δ2 1 − δ1δ2 1 − δ1 δ2 1 − δ1 δ2 1 − δ3 1 − δ3
µ ¶
1+δ δ2
≡ , ;
1 + δ + δ2 1 + δ + δ2
• in his secon offer, he will offer
µ ¶ µ ¶
δ (1 − δ 1 ) δ (1 − δ1 ) 1 + δ2 δ
1− , ≡ , ;
1 − δ1δ2 1 − δ1δ2 1 + δ + δ2 1 + δ + δ2
• player 2 will offer
µ ¶ µ ¶ µ ¶
1 − δ1 1 − δ1 δ 1 (1 − δ 2 ) 1 − δ 1 δ + δ2 1
1− , ≡ , ≡ , .
1 − δ1 δ2 1 − δ1 δ2 1 − δ1δ2 1 − δ1δ2 1 + δ + δ2 1 + δ + δ2
4
Player 1’s first offer and player 2’s offer are by formula for alternating offer, player
1’s second offer is calculated by backward induction using the player 2’s offer in
the next period. Using single deviation property, you need to check that this is
an equilibrium.
4. We have an employer and a worker, who will work as a salesman. The worker may be
a good salesman or a bad one. In expectation, if he is a good salesman, he will make
$200,000 worth of sales, and if he is bad, he will make only $100,000. The employer
gets 10% of the sales as profit. The employer offers a wage w. Then, the worker accepts
or rejects the offer. If he accepts, he will be hired at wage w. If he rejects the offer,
he will not be hired. In that case, the employer will get 0, the worker will get his
outside option, which will pay $15,000 if he is good, $8,000 if he is bad. Assume that
all players are risk-neutral.
(a) Assume that the worker’s type is common knowledge, and compute the subgame-
perfect equilibrium.
ANSWER: A worker will accept a wage iff it is at least as high as his outside
option, and the employer will offer the outside option – as he still makes profit.
That is, 15,000 for the good worker 8,000 for the bad.
(b) Assume that the worker knows his type, but the employer does not. Employer
believes that the worker is good with probability 1/4. Find the perfect Bayesian
Nash equilibrium.
ANSWER: Again a worker will accepts an offer iff his wage at least as high as
his outside option. Hence if w ≥ 15, 000 the offer will be accepted by both types,
yielding
U (w) = (1/4) (.1) 200, 000 + (3/4) (.1) 100, 000 − w = 12, 500 − w < 0
as the profit for the employer. If 8, 000 ≤ w < 15, 000, then only the bad worker
will accept the offer, yielding
as profit. If w < 0, no worker will accept the offer, and the employer will get 0. In
that case, the employer will offer w = 8, 000, hiring the bad worker at his outside
option.
(c) Under the information structure in part (b), now consider the case that the em-
ployer offers a share s in the sales rather than the fixed wage w. Compute the
perfect Bayesian Nash equilibrium.
ANSWER: Again a worker will accept the share s iff his income is at least as high
as his outside option. That is, a bad worker will accept s iff
5
i.e.,
8, 000
s ≥ sB = = 8%.
100, 000
A good worker will accept s iff
15, 000
s ≥ sG = = 7.5%.
200, 000
In that case, if s < sG no one will accept the offer, and the employer will get 0; if
sG ≤ s < sB , the good worker will accept the offer and the employer will get
and if s ≥ sB , each type will accept the offer and the employer will get
(10% − s) [(1/4) 200, 000 + (3/4) 100, 000] = 125, 000 (10% − s) .
Since 125, 000 (10% − sB ) = 2%125, 000 = 2, 500 is larger than 50, 000 (10% − sG ) =
2.5%50, 000 = 1, 250, he will offer s = sB , hiring both types.
(a) Assume that whether the market is good or bad is common knowledge, and com-
pute the subgame-perfect equilibrium.
ANSWER: A worker will accept a wage iff it is at least as high as his outside
option 12,000. If the market is good, the employer will offer the outside option
w = 12, 000, and make 20, 000 − 12, 000 = 8, 000 profit. If the market is bad, the
return 10,000 is lower than the worker’s outside option, and the worker will not
be hired.
(b) Assume that the employer knows whether the market is good or bad, but the
worker does not. The worker believes that the market is good with probability
1/4. Find the perfect Bayesian Nash equilibrium.
ANSWER: As in part (a). [We will have a separating equilibrium.]
(c) Under the information structure in part (b), now consider the case that the em-
ployer offers a share s in the sales rather than the fixed wage w. Compute a
perfect Bayesian Nash equilibrium.
ANSWER: Note that, since the return is 10% independent of whether the market
is good or bad, the employer will make positive profit iff s < 10%. Hence, except
6
for s = 10%, we must have a pooling equilibrium. Hence, at any s, the worker’s
income is
[(1/4) 200, 000 + (3/4) 100, 000] s = 125, 000s.
This will be at least as high as his outside option iff
12, 000
s ≥ s∗ = = 9.6% < 10%.
125, 000
Hence an equilibrium: the worker will accept an offer s iff s ≥ s∗ , and the employer
will offer s∗ . The worker’s beliefs at any offer s is that the market is good with
probability 1/4. [Note that this is an inefficient equilibrium. When the market is
bad, the gains from trade is less than the outside option.]
There are other inefficient equilibria where there is no trade (i.e., worker is
never hired). In any such equilibrium, worker take any high offer as a sign that the
market is bad, and does not accept an offer s unless s ≥ 12, 000/100, 000 = 12%,
and the employer offers less than 12%. When the market is good, in any such
pure strategy equilibrium, he must in fact be offering less than s∗ . (why?) For
instance, employer offers s = 0 independent of the market, and the worker accept
s iff s > 12%.
7
14.12 Final Exam Grade Distribution
Average = 73.82 Std. Dev = 20.74
120
100
80
grade
60
40
20
0
1
11
13
15
17
19
21
23
25
27
29
31
33
35
37
39
41
43
45
rank
Final Grade, Final Grade + Quiz
100
A+
90
88
A
80
76
70
A-
60
B+
52
50
B
45
B-
40
30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45
Series1 Series2
Final Grade (.25M1+.25M2+.4F+.1PS)
100
A+
90
88
80 A
76
70
A-
60
B+
52
50 B
45
B-
40
C
30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45
rank
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5
14.12 Game Theory – Midterm I
10/19/2000
Prof. Muhamet Yildiz
Instructions. This is an open book exam; you can use any written material. You have one hour and
20 minutes. Each question is 33 points. Good luck!
1. Consider the following game.
1\2 L M R
T 3,2 4,0 1,1
M 2,0 3,3 0,0
B 1,1 0,2 2,3
a. Iteratively eliminate all the strictly dominated strategies.
b. State the rationality/knowledge assumptions corresponding to each elimination.
c. What are the rationalizable strategies?
d. Find all the Nash equilibria. (Don’t forget the mixed-strategy equilibrium!)
2. Consider the following extensive form game.
X
1 (2,2)
T
B
2 2
L R L R
(3,1) (0,0) (5,0) (0,1)
4q5 O P U
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Dqvzhu= Lq htxloleulxp/ rq wkh odvw gd|/ wkh| zloo dfw dv lq sduw +d,1 Khqfh/ rq
wkh uvw gd|/ li d sod|hu uhmhfwv wkh rhu/ wkh h{shfwhg sd|r ri hdfk sod|hu zloo
eh B *2 ' B*21 Wkxv/ kh zloo dffhsw dq rhu li dq rqo| li lw jlyhv klp dw ohdvw
B*21 Wkhuhiruh/ wkh vhohfwhg sod|hu rhuv B*2 wr klv rssrqhqw/ nhhslqj B*2
iru klpvhoi/ zklfk lv pruh wkdq B*2/ klv h{shfwhg sd|r li klv rhu lv uhmhfwhg1
Wkhuhiruh/ lq dq| vxejdph shuihfw htxloleulxp/ wkh rxwfrph lv E B*2c B*2 li
lw frphv Khdg/ dqg EB*2c B*2 li lw frphv Wdlo1 Wkh h{shfwhg sd|r ri hdfk
sod|hu ehiruh wkh uvw frlq wrvv lv
E B*2 n EB*2 '
2 2 2
+f, Zkdw lv wkh vxejdph shuihfw htxloleulxp iru ? 1 ^46`
Dqvzhu= Sduw +e, vxjjhvwv wkdw/ li h{shfwhg sd|r ri hdfk sod|hu dw wkh ehjlqqlqj
ri gdwh | n lv B |n *2/ wkh h{shfwhg sd|r ri hdfk sod|hu dw wkh ehjlqqlqj ri |
zloo eh B | *21 ^Qrwh wkdw lq whupv ri grooduv wkhvh qxpehuv fruuhvsrqg wr B*2 dqg
425/ uhvshfwlyho|1` Wkhuhiruh/ wkh htxloleulxp lv iroorzv= Dw dq| gdwh | ? /
wkh vhohfwhg sod|hu rhuv B*2 wr klv rssrqhqw/ nhhslqj B*2 iru klpvhoi> dqg
klv rssrqhqw dffhswv dq rhu l kh jhwv dw ohdvw B*2> dqg dw gdwh ? / d sod|hu
dffhswv dq| rhu/ khqfh wkh vhohfwhg sod|hu rhuv f wr klv rssrqhqw/ nhhslqj 4 iru
klpvhoi1 ^\rx vkrxog eh deoh wr suryh wklv xvlqj pdwkhpdwlfdo lqgxfwlrq dqg wkh
dujxphqw lq sduw +e,1`
6
Hfrqrplf Dssolfdwlrqv ri Jdph Wkhru|= 47145
Vhfrqg Plgwhup
41 Frqvlghu wkh lqqlwh krul}lrq edujdlqlqj jdph1 Mrkq dqg Ehwk duh wu|lqj
wr vsolw d slh ri vl}h 41 Wkh| erwk jhw olqhdu xwlolw| iurp wkh vkduh ri wkh
fdnh wkh| rewdlq +{M iru Mrkq dqg {E iru Ehwk,1 Erwk sod|huv glvfrxqw
hyhu| shulrg ri edujdlqlqj zlwk glvfrxqw idfwru +wkxv wkh zkroh fdnh
qh{w shulrg lv htxlydohqw wr d vkduh ri wkh fdnh wklv shulrg,1 Dovr/ hdfk
sod|hu fdq vwrs edujdlqlqj dw dq| srlqw dqg jhw klv ru khu rxwvlgh rswlrq
Dw wkh ehjlqqlqj ri hyhu| shulrg Qdwxuh ghflghv zklfk sod|hu zloo pdnh
wkh rhu lq wkdw shulrg1 Erwk sod|huv kdyh d suredelolw| 45 ri ehlqj vhohfwhg
4
Frrshudwh Fkhdw
Vxssrvh wkdw wklv jdph lv uhshdwhg ryhu wlph/ dqg zh duh wu|lqj wr pdlq0
+d, Ilqg wkh wuljjhu vwudwhjlhv wkdw zloo vxssruw +Frrshudwh/ Frrshudwh,
dv dq htxloleulxp1
+e, Qh{w/ vxssrvh wkdw cqrq0irujlylqj* vwudwhjlhv duh qrw doorzhg1 Lqvwhdg
frqvlghu wkh iroorzlqj Wuljjhu vwudwhj|= %Li |rx fkhdw L zloo fkhdw iru
wkh qh{w W shulrgv/ dqg wkhq L zloo frrshudwh djdlq xqwlo |rx fkhdw
rqh pruh wlph%1 Zulwh wkh sd|r wr fkhdwlqj lq wkh uvw shulrg/ dqg
qrz dqg wkhq frrshudwlqj iurp W.4 rqzdugv udwkhu wkdq fkhdwlqj
fdq eh kljk ru orz w|sh zlwk suredelolw| 45 1 Wkhvh gudzv duh lqghshqghqw1
D kljk w|sh kdv pdujlqdo frvw 4 dqg d orz w|sh kdv pdujlqdo frvw 31 Wkhuh
5
lv rqh xqlw ri ghpdqg lq wkh pdunhw iru doo sulfhv ohvv wkdq U+A 4,1 Wkxv/
wkh surw ri d up zkr fkdujhv sulfh s ? U zkloh wkh rwkhu up fkdujhv
+d, Vkrz wkdw wkhuh h{lvwv qr sxuh vwudwhj| Ed|hvldq Qdvk Htxloleulxp1
vkrz wkdw wkh kljk w|shv zloo vhw s @ 41 Vxssrvh wkdw sod|hu
s1 Ohw I +s, eh wkh fgi1 H{sodlq zk| lq wklv fdvh wkh surw ri
erwk sod|huv sod|lqj I +s, zkhq wkh| duh orz w|sh dqg s @ 4
6
Hfrqrplf Dssolfdwlrqv ri Jdph Wkhru|1 Vhfrqg Plgwhup H{dp1
Qryhpehu 53wk1
\rx kdyh rqh dqg d kdoi krxuv1 Dqvzhu doo wkuhh txhvwlrqv1 ^Qrwh= wkh txhv0
wlrqv gr qrw kdyh htxdo zhljkw`1
4, ^Wrwdo= 63 srlqwv` Frqvlghu wkh iroorzlqj dowhuqdwlqj rhu edujdlqlqj jdph
ehwzhhq wzr sod|huv D dqg E1 D kdv d glvfrxqw idfwru B dqg E kdv B 1 Lqlwldoo|/
wkh| kdyh d fdnh ri vl}h htxdo wr 21 Lq wkh uvw shulrg/ D pdnhv dq rhu1 E fdq
hlwkhu dffhsw ru uhmhfw1 Li kh uhmhfwv wklv rhu/ wkhq E jhwv wr pdnh dq rhu lq
wkh vhfrqg shulrg1 D fdq dffhsw ru uhmhfw1 Li D uhmhfwv/ krzhyhu/ lq wkh wklug
shulrg/ wkh fdnh vkulqnv wr vl}h 4 +wklv vkulqndjh lv dgglwlrqdo wr wkh xvxdo glv0
frxqwlqj ehwzhhq shulrgv,1 Iurp wkhq rq/ wkh fdnh uhpdlqv ri vl}h 4 +exw wkhuh
lv vwloo glvfrxqwlqj, dqg wkh wzr sod|huv dowhuqdwh lq pdnlqj rhuv xqwlo dq rhu
lv dffhswhg1
Gudz wkh jdph wuhh dqg qg wkh xqltxh vxejdph shuihfw htxloleulxp ^Klqw=
uvw vroyh wkh vxejdph zklfk vwduwv lq shulrg 6 xvlqj vwdqgdug whfkqltxhv/ dqg
wkhq xvh edfnzdug lqgxfwlrq wr qg wkh htxloleulxp ehkdylru lq wkh uvw wzr
shulrgv1`
5, ^Wrwdo= 73 srlqwv` Frqvlghu wkh iroorzlqj vwdjh jdph ehwzhhq sod|huv dqg
=
q , 6 o
u Efc e Efc f Ec
Efc f Ec Ec
- Eec f Ec E2c 2
61 Qrz frqvlghu C" EB zklfk lv rewdlqhg e| uhshdwlqj wklv vwdjh jdph dq
lqqlwh qxpehu ri wlphv zlwk glvfrxqw idfwru B iru erwk sod|huv1 Ilqg dq
htxloleulxp zklfk lv suhihuuhg wr sod|lqj wkh Qdvk Htxloleulxp ri wkh vwdjh
jdph1 ^63 srlqwv`
5
Hfrqrplf Dssolfdwlrqv ri Jdph Wkhru|= 47145
Prfn Plgwhup
41 Frqvlghu wkh lqqlwh krul}lrq edujdlqlqj jdph1 Mrkq dqg Ehwk duh wu|lqj
wr vsolw d slh ri vl}h 41 Wkh| erwk jhw olqhdu xwlolw| iurp wkh vkduh ri wkh
fdnh wkh| rewdlq +{M iru Mrkq dqg {E iru Ehwk,1 Erwk sod|huv glvfrxqw
hyhu| shulrg ri edujdlqlqj zlwk glvfrxqw idfwru +wkxv wkh zkroh fdnh
qh{w shulrg lv htxlydohqw wr d vkduh ri wkh fdnh wklv shulrg,1 Dovr/ hdfk
sod|hu fdq vwrs edujdlqlqj dw dq| srlqw dqg jhw klv ru khu rxwvlgh rswlrq
Dw wkh ehjlqqlqj ri hyhu| shulrg Qdwxuh ghflghv zklfk sod|hu zloo pdnh
wkh rhu lq wkdw shulrg1 Erwk sod|huv kdyh d suredelolw| 45 ri ehlqj vhohfwhg
4
Frrshudwh Fkhdw
Vxssrvh wkdw wklv jdph lv uhshdwhg ryhu wlph/ dqg zh duh wu|lqj wr pdlq0
+d, Ilqg wkh wuljjhu vwudwhjlhv wkdw zloo vxssruw +Frrshudwh/ Frrshudwh,
dv dq htxloleulxp1
+e, Qh{w/ vxssrvh wkdw cqrq0irujlylqj* vwudwhjlhv duh qrw doorzhg1 Lqvwhdg
frqvlghu wkh iroorzlqj Wuljjhu vwudwhj|= %Li |rx fkhdw L zloo fkhdw iru
wkh qh{w W shulrgv/ dqg wkhq L zloo frrshudwh djdlq xqwlo |rx fkhdw
rqh pruh wlph%1 Zulwh wkh sd|r wr fkhdwlqj lq wkh uvw shulrg/ dqg
qrz dqg wkhq frrshudwlqj iurp W.4 rqzdugv udwkhu wkdq fkhdwlqj
5
47145 Jdph Wkhru| Plgwhup LL
4424925333
{0.5} D d
(-1,4)
(0,2) (-1,3)
1 A 2 a
(-1,-5)
D d
51 Frqvlghu wkh iroorzlqj sulydwh0ydoxh dxfwlrq ri d vlqjoh remhfw/ zkrvh ydoxh iru wkh
vhoohu lv 31 wkhuh duh wzr ex|huv/ vd| 4 dqg 51 Wkh ydoxh ri wkh remhfw iru hdfk ex|hu
5 ic 2j lv vr wkdw/ li ex|v wkh remhfw sd|lqj wkh sulfh R/ klv sd|r lv R> li kh
grhvq*w ex| wkh remhfw/ klv sd|r lv 31 Zh dvvxph wkdw dqg 2 duh lqghshqghqwo|
dqg lghqwlfdoo| glvwulexwhg zlwk wkh suredelolw| ghqvlw| ixqfwlrq s G dfc 4 $ dfc 4/
zkhuh
% li % 5 dfc 2o
s E% '
f rwkhuzlvh1
+d, Zh xvh vhdohg0elg uvw0sulfh dxfwlrq/ zkhuh hdfk ex|hu vlpxowdqhrxvo| elgv
K / dqg wkh rqh zkr elgv wkh kljkhvw elg ex|v wkh remhfw sd|lqj klv rzq elg1
Frpsxwh wkh v|pphwulf Ed|hvldq Qdvk htxloleulxp lq olqhdu vwudwhjlhv/ zkhuh
K ' @ n S 1 Frpsxwh wkh h{shfwhg xwlolw| ri d ex|hu iru zkrp wkh ydoxh ri wkh
remhfw lv 1
+e, Zkdw lv wkh Ed|hvldq Qdvk htxloleulxp iru wkh vhdohg0elg vhfrqg0sulfh dxfwlrq/
zkhuh wkh zlqqhu sd|v rqo| wkh rwkhu ex|hu*v elg1 Zkdw lv wkh h{shfwhg xwlolw|
ri d ex|hu iru zkrp wkh ydoxh ri wkh remhfw lv B
4
47145 Jdph Wkhru| Plgwhup LL
4424:25333
Lpsruwdqw Qrwh= Ilqdo H{dp lv rq Ghfhpehu :wk1
Suri1 Pxkdphw \logl}
Lqvwuxfwlrqv1 Wklv lv dq rshq errn h{dp> |rx fdq xvh dq| zulwwhq pdwhuldo1 \rx kdyh rqh
krxu dqg 53 plqxwhv1 Hdfk txhvwlrq lv 66 srlqwv1 Jrrg oxfn$
41 Frqvlghu wkh lqqlwho| uhshdwhg jdph zlwk revhuydeoh dfwlrqv zkhuh B ' fbb dqg wkh
iroorzlqj Sulvrqhuv* Glohppd jdph lv uhshdwhg1
F G
F 8/8 09/;
G ;/09 3/3
51 Frqvlghu wkh iroorzlqj sulydwh0ydoxh dxfwlrq ri d vlqjoh remhfw/ zkrvh ydoxh iru wkh
vhoohu lv 31 wkhuh duh wzr ex|huv/ vd| 4 dqg 51 Wkh ydoxh ri wkh remhfw iru hdfk ex|hu
5 ic 2j lv vr wkdw/ li ex|v wkh remhfw sd|lqj wkh sulfh R/ klv sd|r lv R> li kh
grhvq*w ex| wkh remhfw/ klv sd|r lv 31 Zh dvvxph wkdw dqg 2 duh lqghshqghqwo|
dqg lghqwlfdoo| glvwulexwhg xqlirupo| rq dc o zkhuh f 1
+d, Zh xvh vhdohg0elg uvw0sulfh dxfwlrq/ zkhuh hdfk ex|hu vlpxowdqhrxvo| elgv
K / dqg wkh rqh zkr elgv wkh kljkhvw elg ex|v wkh remhfw sd|lqj klv rzq elg1
Frpsxwh wkh v|pphwulf Ed|hvldq Qdvk htxloleulxp lq olqhdu vwudwhjlhv/ zkhuh
K ' @ n S 1 Frpsxwh wkh h{shfwhg xwlolw| ri d ex|hu iru zkrp wkh ydoxh ri wkh
remhfw lv 1
+e, Qrz dvvxph wkdw dqg 2 duh lqghshqghqwo| dqg lghqwlfdoo| glvwulexwhg xql0
irupo| rq dfc o1 Qrz/ lq rughu wr hqwhu wkh dxfwlrq/ d sod|hu pxvw sd| dq hqwu|
ihh 5 Efc 1 Iluvw/ hdfk ex|hu vlpxowdqhrxvo| ghflghv zkhwkhu wr hqwhu wkh dxf0
wlrq1 Wkhq/ zh uxq wkh vhdohg0elg dxfwlrq dv lq sduw +d,> zklfk sod|huv hqwhuhg lv
4
qrz frpprq nqrzohgjh1 Li rqo| rqh sod|hu hqwhuv wkh dxfwlrq dq| elg K f lv
dffhswhg1 Frpsxwh wkh v|pphwulf shuihfw Ed|hvldq Qdvk htxloleulxp zkhuh wkh
ex|huv xvh wkh olqhdu vwudwhjlhv lq wkh dxfwlrq li erwk ex|hu hqwhu wkh dxfwlrq1
Dqwlflsdwlqj wklv htxloleulxp/ zklfk hqwu| ihh wkh vhoohu pxvw fkrrvhB ^Klqw= Lq
wkh hqwu| vwdjh/ wkhuh lv d fxwr ohyho vxfk wkdw d ex|hu hqwhuv wkh dxfwlrq l klv
ydoxdwlrq lv dw ohdvw dv kljk dv wkh fxwr ohyho1`
61 Frqvlghu wkh hqwu| ghwhuuhqfh jdph/ zkhuh dq Hqwudqw ghflghv zkhwkhu wr hqwhu wkh
pdunhw> li kh hqwhuv wkh Lqfxpehqw ghflghv zkhwkhu wr Iljkw ru Dffrprgdwh1 Zh
frqvlghu d jdph zkhuh Lqfxpehqw*v sd|r iurp wkh Iljkw lv sulydwh lqirupdwlrq/ wkh
hqwu| ghwhuuhqfh jdph lv uhshdwhg wzlfh dqg wkh glvfrxqw udwh lv B ' fb1 Wkh sd|r
yhfwruv iru wkh vwdjh jdph duh +3/5, li wkh Hqwudqw grhv qrw hqwhu/ Ec @ li kh hqwhuv
dqg wkh Lqfxpehqw Iljkwv> dqg +4/4, li kh hqwhuv dqg wkh Lqfxpehqw dffrprgdwhv/
zkhuh wkh uvw hqwu| lq hdfk sdudqwkhvlv lv wkh sd|r iru wkh hqwudqw1 Khuh/ @ fdq eh
hlwkhu 04 ru 5/ dqg lv sulydwho| nqrzq e| wkh Lqfxpehqw1 Hqwudqwv eholhyhv wkdw @ '
zlwk suredelolw| Z( dqg hyhu|wklqj ghvfulehg xs wr khuh lv frpprq nqrzohgjh1
5
Vrph suhylrxv h{dp txhvwlrqv
41 Frqvlghu wkh lqqlwho| uhshdwhg jdph zlwk revhuydeoh dfwlrqv zkhuh @ 3=<< dqg wkh iroorzlqj Sulv0
rqhuv* Glohppd jdph lv uhshdwhg1
F G
F 8/8 09/;
G ;/09 3/3
Fkhfn li dq| ri wkh iroorzlqj vwudwhj| surohv lv d vxejdph0shuihfw Qdvk htxloleulxp1
51 Frqvlghu wkh iroorzlqj sulydwh0ydoxh dxfwlrq ri d vlqjoh remhfw/ zkrvh ydoxh iru wkh vhoohu lv 31 wkhuh duh
wzr ex|huv/ vd| 4 dqg 51 Wkh ydoxh ri wkh remhfw iru hdfk ex|hu l 5 i4> 5j lv yl vr wkdw/ li l ex|v wkh
remhfw sd|lqj wkh sulfh s/ klv sd|r lv yl s> li kh grhvq*w ex| wkh remhfw/ klv sd|r lv 31 Zh dvvxph
wkdw y4 dqg y5 duh lqghshqghqwo| dqg lghqwlfdoo| glvwulexwhg xqlirupo| rq ^y> 4` zkhuh 3 y ? 41
+d, Zh xvh vhdohg0elg uvw0sulfh dxfwlrq/ zkhuh hdfk ex|hu l vlpxowdqhrxvo| elgv el / dqg wkh rqh zkr
elgv wkh kljkhvw elg ex|v wkh remhfw sd|lqj klv rzq elg1 Frpsxwh wkh v|pphwulf Ed|hvldq Qdvk
htxloleulxp lq olqhdu vwudwhjlhv/ zkhuh el @ d . fyl 1 Frpsxwh wkh h{shfwhg xwlolw| ri d ex|hu iru
zkrp wkh ydoxh ri wkh remhfw lv y1
+e, Qrz dvvxph wkdw y4 dqg y5 duh lqghshqghqwo| dqg lghqwlfdoo| glvwulexwhg xqlirupo| rq ^3> 4`1
Qrz/ lq rughu wr hqwhu wkh dxfwlrq/ d sod|hu pxvw sd| dq hqwu| ihh ! 5 +3> 4,1 Iluvw/ hdfk ex|hu
vlpxowdqhrxvo| ghflghv zkhwkhu wr hqwhu wkh dxfwlrq1 Wkhq/ zh uxq wkh vhdohg0elg dxfwlrq dv lq
sduw +d,> zklfk sod|huv hqwhuhg lv qrz frpprq nqrzohgjh1 Li rqo| rqh sod|hu hqwhuv wkh dxfwlrq
dq| elg e 3 lv dffhswhg1 Frpsxwh wkh v|pphwulf shuihfw Ed|hvldq Qdvk htxloleulxp zkhuh wkh
ex|huv xvh wkh olqhdu vwudwhjlhv lq wkh dxfwlrq li erwk ex|hu hqwhu wkh dxfwlrq1 Dqwlflsdwlqj wklv
htxloleulxp/ zklfk hqwu| ihh wkh vhoohu pxvw fkrrvhB ^Klqw= Lq wkh hqwu| vwdjh/ wkhuh lv d fxwr
ohyho vxfk wkdw d ex|hu hqwhuv wkh dxfwlrq l klv ydoxdwlrq lv dw ohdvw dv kljk dv wkh fxwr ohyho1`
61 Frqvlghu wkh iroorzlqj uhshdwhg Vwdfnhoehuj gxrsro|/ zkhuh d orqj0uxq up sod|v djdlqvw pdq|
vkruw0uxq upv/ hdfk ri zklfk lv lq wkh pdunhw rqo| iru rqh gdwh/ zkloh wkh orqj0uxq up uhpdlqv lq
wkh pdunhw wkurxjkrxw wkh jdph1 Dw hdfk gdwh w/ uvw/ wkh vkruw uxq up vhwv lwv txdqwlw| {w > wkhq/
nqrzlqj {w / wkh orqj0uxq up vhwv lwv txdqwlw| |w > dqg hdfk vhoov klv jrrg dw sulfh sw @ 4 +{w . |w ,1
Wkh pdujlqdo frvwv duh doo 31 Wkh vkruw0uxq up pd{lpl}hv lwv surw/ zklfk lqfxuv dw w1 Wkh orqj0uxq
up pd{lpl}hv wkh suhvhqw ydoxh ri lwv surw vwuhdp zkhuh wkh glvfrxqw udwh lv @ 3=<<1 Dw wkh
ehjlqqlqj ri hdfk gdwh/ wkh dfwlrqv wdnhq suhylrxvo| duh doo frpprq nqrzohgjh1
+d, Zkdw lv wkh vxejdph shuihfw htxloleulxp li wkhuh duh rqo| qlwho| pdq| gdwhv/ l1h1/ w 5 i3> 4> = = = > W j1
+e, Qrz frqvlghu wkh lqqlwho| uhshdwhg jdph1 Ilqg d vxejdph shuihfw htxloleulxp/ zkhuh {w @ 4@7
dqg |w @ 4@5 dw hdfk w rq wkh sdwk ri htxloleulxp sod|/ qdpho| lq wkh frqwlqjhqflhv wkdw kdsshq
zlwk srvlwlyh suredelolw| jlyhq wkh vwudwhjlhv1
+f, Fdq |rx qg d vxejdph shuihfw htxloleulxp/ zkhuh {w @ |w @ 4@7 iru hdfk w rq wkh sdwk ri
htxloleulxp sod|B
4
71 Frqvlghu wkh iroorzlqj sulydwh0ydoxh dxfwlrq ri d vlqjoh remhfw/ zkrvh ydoxh iru wkh vhoohu lv 31 Wkhuh
duh q ex|huv1 Wkh ydoxh ri wkh remhfw iru hdfk ex|hu l 5 i4> 5> = = = > qj lv yl vr wkdw/ li l ex|v wkh remhfw
sd|lqj wkh sulfh s/ klv sd|r lv yl s> li kh grhvq*w ex| wkh remhfw/ klv sd|r lv 31 Zh dvvxph wkdw
+y4 > = = = > yq , duh lqghshqghqwo| dqg lghqwlfdoo| glvwulexwhg xqlirupo| rq ^3> 4`1
+d, Zh xvh vhdohg0elg uvw0sulfh dxfwlrq/ zkhuh hdfk ex|hu l vlpxowdqhrxvo| elgv el / dqg wkh rqh zkr
elgv wkh kljkhvw elg ex|v wkh remhfw sd|lqj klv rzq elg1 Frpsxwh wkh v|pphwulf Ed|hvldq Qdvk
htxloleulxp lq olqhdu vwudwhjlhv/ zkhuh el @ d . fyl 1
+e, Frpsxwh wkh h{shfwhg xwlolw| ri d ex|hu iru zkrp wkh ydoxh ri wkh remhfw lv y1
+f, Zkdw kdsshqv dv q $ 4B Fdq vhoohu kdyh d ehwwhu phfkdqlvp +iru klpvhoi, lq wkh olplw +q @ 4,B
81 Frqvlghu wkh iroorzlqj sulydwh0ydoxh dxfwlrq ri d vlqjoh remhfw/ zkrvh ydoxh iru wkh vhoohu lv 31 wkhuh
duh wzr ex|huv/ vd| 4 dqg 51 Wkh ydoxh ri wkh remhfw iru hdfk ex|hu l 5 i4> 5j lv yl vr wkdw/ li l
ex|v wkh remhfw sd|lqj wkh sulfh s/ klv sd|r lv yl s> li kh grhvq*w ex| wkh remhfw/ klv sd|r lv 31
Zh dvvxph wkdw y4 dqg y5 duh lqghshqghqwo| dqg lghqwlfdoo| glvwulexwhg zlwk wkh suredelolw| ghqvlw|
ixqfwlrq i = ^3> 4, $ ^3> 4,/ zkhuh
{ li { 5 ^3> 5`
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5
14.12 Solutions for Question 7 (or 8)
Kenichi Amaya1
November 9, 2001
(a)
Let’s denote firm 2’s by c2 , i.e., c2 ∈ {cL , cH }. Let p1 and p2 be each firm’s
price (action). Then, each firm’s payoff functions can be written as
p1 − c if p1 < p2
p1 −c
π1 (p1 , p2 ) = if p1 = p2 ,
2
0 if p1 > p2
p2 − c2 if p2 < p1
p2 −c2
π2 (p1 , p2 ; c2 ) = 2 if p2 = p1
0 if p2 > p1
(b)
A pure strategy profile {p∗1 , (p∗2L , p∗2H )} is a Bayesian Nash equilibrium if
p∗1 = argmaxp1 θπ1 (p1 , p∗2L ) + (1 − θ)π1 (p1 , p∗2H ),
p∗2L = argmaxp2 π2 (p∗1 , p2 ; cL ),
p∗2H = argmaxp2 π2 (p∗1 , p2 ; cH ),
(c)
If there exists a pure strategy Bayesia Nash equilibrium, it must be true that
p∗1 = min{p∗2L , p∗2H }.
To see this, if p∗1 < min{p∗2L , p∗2H }, firm 1 is always selling to the whole market.
If it increases the price slightly, it still sells the whole market. So it can increase
the payoff. If p∗2k < p∗1 , where k is either L or H, firm 2 is selling to the whole
market when its type is k. If it increases the price slightly, it still sells the whole
market. So it can increase the payoff.
Next, if there exists a pure strategy Bayesia Nash equilibrium, it must be
true that
p∗1 = min{p∗2L , p∗2H } = c.
To see this, if p∗1 < c, firm 1 is selling positive amount and losing money.
Therefore it’s better to charge a price higher than R and not to sell to get zero
profit. On the other hand, if p∗1 < c, firm 1 can increase it’s profit by slightly
reducing its price.
Finally, p∗1 = min{p∗2L , p∗2H } = c can not be an equilibrium because firm 2
of type L can increase its profit by choosing a price slightly smaller than c.
1 E52-303, [email protected], 253-3591
1
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5
14.12 Game Theory
Fall 2000
Final Exam Solutions
2. (a) Let the separating equilibrium be one where top plays R, bottom plays L.
The beliefs are µ(top|R) = 1 and µ(bottom|R) = 1. Player 2, the receiver,
plays up in the information set on the right-hand side, and down, on the
information set on the left-hand side. Now it is easy to check that player
1’s types do not want to deviate: if top type plays L instead, she gets
0 as opposed to 3, while bottom type, if she plays R instead, gets 1 as
opposed to 2.
(b) Pooling on R: player 2 plays down when sees R since EU (up|R) =
0.4(1) + 0.6(0) = 0.4 < EU (down|R) = 0.4(0) + 0.6(1) = 0.6. Any
beliefs about types given L actually support this equilibrium.
(c) Mixed strategies equilibrium: Bottom mixes αR + (1 − α)L. Player 2
mixes 1/2up+1/2down when sees R. By applying Bayes’ rule and forcing
it to be equal to 1/2, because this is the value that would make the
bottom type want to mix, we have µ(top|R) = 0.4(1)/(0.4+0.6(α)) = 1/2.
In particular, for player 2, EU (up|R) = P (top|R) and EU (down|R) =
1 − P (top|R). Setting these two equal, because we need player 2 to mix
1
after observing R in order for bottom type to want to mix, we obtain that
P (top|R) = 1/2. From the Bayes’ rule equation we solve for α above, such
that bottom type’s strategy is 2/3R + 1/3L. Top type always plays R.
Player 2 plays 1/2up + 1/2down when sees R and plays down when sees
L. Beliefs are µ(bottom|L) = 1 and µ(top|R) = 1/2.
3. Given no discounting, and the fact that the plaintiff gets to make the first offer,
the game ends in the first day, with the plaintiff making an offer w and the
defendant accepting the offer. In particular, taking into account the legal fees
both parties must pay until court day, and the amount the defendant must pay
then, which is certain and common knowledge, the plaintiff will offer 1, 110K
and the defendant will accept all offers less than or equal to this amount, and
reject all others.
4. One pooling equilibrium of this game would be for the firm to reject all offers
w0 > 5 and accept all others, for both types of workers to offer w0 = 5, and to
offer w1 = 5 in the following period if reached. Beliefs: µ(type = 0|w 6= 5) = 1.
Workers do not want to deviate because that would lead to a rejection and a
wage of 5 in the following period, which is what they can get now (so they are
indifferent).
2
(2,1)
(3,1)
L 1 R
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(0,0) (2,0)
{0.4}
L 1 R
(1,1) (3,1)
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