ECON-459: Applied Game Theory Problem Set 1 - Solutions

1. Problems 1.5, 1.7 and 1.8 from Gibbons. Gibbons #1.5 The question asks you to express the Cournot duopoly game as a Prisoners Dilemma where the only two available quantities are the monopoly quantity, qm and the Cournot equilibrium quantity qc . To do this, you will need to calculate the payos to each player under each combination of these strategies. That is for each player i we know that the prot function is i (qi , qj ) = qi [a c (qi + qj )] So for player 1, the following values must be calculated.

m = 1 (

(a c)2 qm qm , )= 2 2 8 (a c)2 c = 1 (qc , qc ) = 9 qm 5(a c)2 t = 1 (qc , )= 2 36 5(a c)2 qm s = 1 ( , q c ) = 2 48

It can be veried that t > m > c > s which corresponds to the payos for the Prisoners Dilemma game. These payos and strategies can be represented in matrix form as below.
qm 2 qm 2

qc

m , m t , s

qc s , t c , c

The second part of the questions asks you to extend the game by adding a third possible quantity, q . The game must be such that the Cournot output is still the unique Nash equilibrium, and there are no strictly dominant strategies. There is no single solution to this problem, but one way to proceed is as follows. First set up a hypothetical matrix of this game as below.

qm 2

qm 2

qc q where

m , m t , s B, A

qc s , t c , c D, C

q A, B C, D E, E

qm ,q ) 2 qm B = 1 (q , ) 2 C = 1 (qc , q ) A = 1 ( D = 1 (q , qc ) E = 1 (q , q )

Next, note that in order for (qc , qc ) to be a Nash equilibrium, c > D. Then, in order for (qc , qc ) to be a unique Nash equilibrium q cannot be a best response for either player, when the other is playing q [otherwise (q , q ) is also a NE]. So either A > E or C > E or both. For there to be no strictly dominant strategies, q must either be a best response for one of m m to be a best response to q . Let us assume that q2 is a best the other strategies, or allow q2 response to q for both players. Then A > C > E . Consequently, for (qc , qc ) to be a unique Nash equilibrium it must be the case that B < t . Using this information, we can now calculate a value for q and then verify that it satises all the requirements above.
1 The best response function for rm 1 in the Cournot duopoly game is R1 (q2 ) = 2 (a c q2 ). qm So for 2 to be a best response to q , q must satisfy

R1 (q ) = This yields q =
ac 2 ,

1 qm = (a c q ) 2 2

which implies A = 1 ( B C D E qm (a c)2 ,q ) = 2 16 qm (a c)2 = 1 (q , )= 2 8 (a c)2 = 1 (qc , q ) = 18 (a c)2 = 1 (q , qc ) = 12 = 1 (q , q ) = 0

All of which satisfy the requirements above.

Page 2

Gibbons #1.7 Firm i s payo function is (pi c)(a pi ) if pi < pj , 1 2 (pi c)(a pi ) if pi = pj for i = j, 0 if pi > pj ,

i (pi , pj ) =

To show that p 1 = p2 = c is the unique Nash equilibrium, rule out all other possibilities. First, neither rm will charge a price below c. If pi pj and pi < c, then i < 0, and rm i is better o if it raises its price. Second, if both rms prices are above c, then the rm with the higher price wants to undercut its rival. That is, if c < pi pj , then rm j would increase its prots by setting its price equal to pi . Third, if one rms price equals c while the other rm charges a price above c, then the rm charging c wants to increase its price. That is, if c = pi < pj , then rm i wants to increase its price to pj . The only possibility left is p1 = p2 = c. At this point, neither rm has any incentive to deviate, and we have our Nash equilibrium.

Gibbons #1.8 You are given a population of voters, uniformly distributed over the ideological spectrum, which you can take to be the interval [0,1]. Strategies (platforms) are points in [0,1], and payos are probabilities of being elected. Consider rst the model with two candidates. Let x1 denote candidate 1s strategy and x2 1 denote candidate 2s strategy. The pure-strategy Nash equilibrium is x 1 = x2 = 2 . At 1 1 x 1 = x2 = 2 , each candidate wins the election with probability 2 . Any deviation from this strategy combination causes the deviator to lose the election. This ideological blandness is the unique pure-strategy Nash equilibrium. To show this, consider 1 the other possibilities, x 1 = x2 = x = 2 and x1 = x2 . You should be able to convince yourself that neither of these possibilities constitutes a Nash equilibrium. In both cases, one or both of the candidates would have an incentive to deviate. The case with three candidates is more complicated there is an innity of pure-strategy Nash equilibria. Consider x 1 = .3, x2 = .4, x3 = .6. Candidate 3 gets 50% of the vote .4 (.5 = (1 0.6) + .6 2 ) and wins the election. She obviously has no incentive to deviate. Candidate 2, even though she gets only 15% of the vote and loses the election, also has no incentive to deviate. It is true that she can increase her vote total by changing position but, given the positions of the other two candidates, there is no move she can make that will give her any chance of winning the election. Similarly, candidate 1 has no incentive to deviate. Thus, x 1 = .3, x2 = .4, x3 = .6 is a pure-strategy Nash equilibrium. You should be able to nd many, many more.

Page 3

Please print your name HERE: .............................................

1. Find all the pure and mixed strategy Nash equilibria of the following game in normal form C R I \II L T 3, 0 0, 3 0, 2 M 0, 3 3, 0 0, 0 B 2, 0 0, 0 0, 0
2. Find all the Nash equilibria of the following game.

2. (a) Which strategies survive the process of iterated deletion of dominated strategies in the following game in normal form? (show the deletion process This game has one pure strategy Nash Equilibrium (B, R). if any) Economics 459 Theory R To check if this game has any equilibrium, start by assuming that player 1 uses I \mixed II strategy LGame C Professor Luca Anderlini 7,p7 7 For 7 , 1 2 to randomize, he (she) must the mixed strategy p1 = (p11T , p12 , 1 p,12 ). player 11 7 Fall 2004 M , 7 7, 7 player 7, 1 be indierent between playing L, C 7 and R. Hence 2s expected payo playing all three B 1, 2 1, 2 1, 7 must be equal. That is, (b) Now suppose that we consider the possibility that a pure strategy Final Examination may be dominated by a mixed strategy. How does your answer to (a) above p 0 + p12 3 + (1 p11 p12 ) 0 (1) change in this case (if at 11 all)? Explain.
=p11 3 + p12 0 + (1 p11 p12 ) 0 (2)

This is a closed book Please all questions (3) =p11 examination. 2 + p12 0 + (1 p 0 11 p12 )answer This test is worth 50% of your nal grade Comparing expressions (1), (2) and (3), it is 1 obvious that the expected payo playing R is
strictly less than playing both L and C . That means that there are no beliefs about player 1s strategies that player 2 could have, that would cause player 2 to play R with positive Please print your name HERE: ............................................. probability. By a similar reasoning, we can show that player 1 will never place a positive probability on 1. Find all the pure and mixed Nash equilibria of the following game playing B . This means that 1 p11 pstrategy 12 = 0 or p11 + p12 = 1. Therefore, we need to calculate in normal form p11 and p12 such that p12 3 = p11 3 and p11 + p12 = 1, which gives p11 = p12 = 1 2. By the same calculation for player that p21 = p22 = 1 2 , where p21 is the T2 we3can , 0 calculate 0, 3 0, 2 probability that player 2 places onM L, and that player 2 places on C . 22 is 0,p3 3,the 0 probability 0, 0
1 1 The mixed strategy Nash equilibrium for this game is therefore (p 1 , p2 ) such that p1 = ( 2 , 2 , 0) 1 1 = (Which and 2.p (a) 2 2 , 2 , 0). strategies survive the process of iterated deletion of dominated

I \II

2, 0 0, 0 0, 0

strategies in the following game in normal form? (show the deletion process
3. Consider the normal form game below if any)

I \II L C R T 7, 7 7, 7 7, 1 M 7, 7 7, 7 7, 1 B 1, 2 1, 2 1, 7 (b) Now suppose that we consider the possibility that a pure strategy
(a) Which survive process of iterated deletion strictly dominated strategies? may be strategies dominated by athe mixed strategy. How does of your answer to (a) above

change in this case (if at all)? Explain. All strategies survive iterated deletion of strictly dominated strategies.
Page 4

(b) Now suppose that we consider the possibility that a pure strategy may be dominated by a mixed strategy. How does your answer to part (a) change in this case (if at all)? Explain.
1 The mixed strategy p1 = ( 1 2 , 2 , 0) strictly dominates playing B for player 1. After elimi1 1 , 2 , 0) strictly dominates playing R for player 2. nation of B , the mixed strategy p2 = ( 2 Therefore when considering mixed strategies, the strategies that survive iterated deletion of strictly dominated strategies are (T, M ) for player 1 and (L, C ) for player 2.

4. Consider a Cournot game with n identical rms and a linear inverse demand function p(Q) = n Q where Q = i=1 is total industry output. Each rm has constant marginal cost c of producing output. (a) Solve for the unique Nash equilibrium of the game. When you derive the best response function for each rm i you should get: Ri (qi ) = c 1 2 2 qj
j =i

Exploiting symmetry between the rms you can set qi = q for all i, and solving for q c you obtain q = (n +1) for each rm i which is the unique NE. (b) How much prot does each rm make in equilibrium? What happens to total industry prots as n increases? Substituting q = prot of
c (n+1)

into the prot function, you should get that each rm makes a

i = The total industry prot is then

( c)2 (n + 1)2

=n

( c)2 (n + 1)2

Industry prot goes to zero as n goes to innity. (c) Assume that there are three rms (n = 3). Show that all rms would want to merge to form a monopoly. Before the merger each rm receives prots of i = ( c)2 16
(c)2 4

After the merger, the prots of the joint rm would be i =

a third of which equals

Page 5

i =

( c)2 12

This is greater than the prots of each rm acting independently, so they would like to merge. (d) Assume again that there are three rms playing a Cournot game. The FTC prohibits monopoly in this industry but is worried about a merger of two rms such that the industry would become a duopoly. Show that the FTCs worries are unfounded. Prior to a merge the two rms would have joint prots of i = ( c)2 8

However, the merged rm cannot commit to keep output at the pre-merger level because it is o its best response curve. It would do better by decreasing output slightly to increase prices. The remaining rm realizes this and increases its output slightly. This will tempt the merged rm to decrease output even more etc. Eventually we are back at the 2-rm Cournot solution which will give the merged rm a prot of i = ( c)2 9

Which is lower than their pre-merger prots. 5. Two employees work together in a team. Worker i = 1, 2 contributes some positive eort ei to the team output y = e1 + e2 (the output is measured in dollar terms) which is equally divided 1 2 up between both workers. This eort causes the worker a disutility of 2 ei . (a) Assume that you are a social planner whose aim is to maximize the total utility of both workers (i.e. the sum of their utilities). How much eort should both workers choose? The social planner will choose eort levels to maximize social welfare. Social welfare, is the joint welfare of both players which is given by 1 1 u1 + u2 = e1 + e2 e2 e2 2 1 2 2 A rst order condition with respect to each players eort level will yield e1 = e2 = 1. (b) Find the pure strategy Nash equilibrium of the game. Compare your result to the social planners solution. Each player will respond to its own private incentives. Each player gets utility ui = 1 1 [e1 + e2 ] e2 2 2 i

Page 6

for i = 1, 2. Therefore each of them has a best response function of ei = other players eort level. This is the pure strategy Nash equilibrium.

1 2

regardless of the

The Nash equilibrium is clearly suboptimal. The problem is that players do not enjoy the full social benet of their actions. If they exert more eort ei they generate additional social surplus ei but they themselves get only half of it. Therefore, the incentive to work hard is reduced and since the marginal cost of exerting eort increases with ei (due to convex eort costs) workers will exert less eort than is socially optimal.

6. Consider the following game-theoretic model of the equilibrium determination of the cleanliness (and eort distribution) of an apartment shared by two roommates. In the game, the two roommates simultaneously choose the eort, e1 and e2 , to spend on apartment cleaning. They each get utility from the cleanliness of the apartment (which is a function of the sum of the eorts) and disutility from the eort they personally expend. Player 1 places a higher valuation on cleanliness. Specically, assume that e1 and e2 are chosen from the set of nonnegative real numbers and that

u1 (e1 , e2 ) = k log(e1 + e2 ) e1 u2 (e1 , e2 ) = log(e1 + e2 ) e2 where k > 1. (a) Find the two players best response functions. In this problem it is important to specify the best response function for all eort levels of the other player : k e2 0 1 e1 0 for 0 e2 k, for e2 > k for 0 e1 1, for e1 > 1

R1 (e2 ) =

R2 (e1 ) =

(b) Find the pure strategy Nash equilibrium of the game. How does the equilibrium distribution of eort reect the dierences in the players tastes. Hint: Your BR function should be dened for each positive eort level and has to be non-negative everywhere. A graphical solution for this Nash equilibrium is the simplest. The graph below represents the two best response functions.

Page 7

e2

k 1

R1(e2) R2(e1) 1 k e1

The dot indicates the unique intersection of the two best response functions at e 1 = k and e2 = 0. This is the unique Nash equilibrium of the game. In this Nash equilibrium the person who values cleanliness more does all the work. (c) Try to write down a modication of the model above in which the outcome seems more fair. There is no single answer to this question. A possible answer would modify the utility functions so that they are

u1 (e1 , e2 ) = k [log(e1 ) + log(e2 )] e1 u2 (e1 , e2 ) = log(e1 ) + log(e2 ) e2

In this case, e 1 = k and e2 = 1. That is, both players exert some eort.

Page 8