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Navin Kumar
Delhi School of Economics
This is strictly a beta version. Two thirds of it are missing and there are errors aplenty. You have been warned.
On a more positive note, if you do find an error, please email me at
navin.ksrk@gmail.com, or tell me in person.
- Navin Kumar
a q1 ... 2 qi ... qn c = 0
a c = q1 + ... + 2 qi + ... + qn
For all i=1, ... ,n. We could solve this question using matrices and
Cramers rule, but a simpler method would be to observe that since
all firms are symmetric, their equilibrium quantity will be the same
i.e.
q1 = q2 = ... = qi = ... = qn
Which means the preceding equation becomes.
a c = (n + 1)qi qi =
ac
n+1
qm
ac
=
2
4
ac ac
( a c )2
=
= 0.13 ( a c)2
2
4
8
If both are playing the Cournot equilibrium quantity, than the profits earned by Firm 1 (and Firm 2) are: 1
1
cc
= ( P c) q1c = ( a
P = aQ
2( a c )
a + 2c
c) q1c = (
c) q1c
3
3
= a q1cc q2cc
ac
= a2
3
a+c
=
2
( a c )2
9
= 0.11 ( a c)2
=
What if one of the firms (say Firm 1) plays the Cournot quantity
and the other plays the Monopoly quantity? 2 Firm 1s profits are:
1
cm
= ( P c) q1c = (
5a
7c
ac
5
+
c)
=
( a c )2
12 12
3
36
= 0.14 ( a c)2
And Firm 2s profits are:
2
cm
= ( P c) q2m = (
5a
7c
ac
5
+
c)
=
( a c )2
12 12
4
48
= 0.10 ( a c)2
For notational simplicity, let
( a c )2
Their profits are reversed when their production is. Thus, the payoffs are:
Player 2
Player 1
qm
qc
qm
0.13, 0.13
0.10, 0.14
qc
0.14, 0.10
0.11, 0.11
= a q1c q2m
ac
ac
= a
3
4
7
= a
( a c)
12
5a
7c
=
+
12
12
a c2 q1
2
a c2 q1
2
a 2c1 + c2
3
a 2c2 + c1
3
Now,
2c2 > a + c1 0 > a 2c2 + c1 0 >
a 2c2 + c1
0 > q2
3
q2 = 0
Since quantities cannot be be negative. Thus, under certain conditions, a sufficient difference in costs can drive one of the firms to
shut down.
Answer 1.7 We know that,
a pi
qi = a2pi
if pi < p j ,
if pi = p j ,
if pi > p j .
( pi c ) ( a pi ) > ( pi c )
( a pi )
2
Si =
xi +
1
2
( x j xi )
1
2
if xi < x j ,
if xi = x j ,
1
2
(1 xi ) + ( xi x j ) if xi > x j .
Player 1
( p) Mum
(1 p) Fink
(q) Mum
1, 1
9, 0
(1 q) Fink
0, 9
6, 6
Prisoners Dilemma
In a mixed strategy equilibrium, Player 1 would choose q such that
Player 2 would be indifferent between Mum and Fink. The payoff
from playing Mum and Fink must be equal. i.e.
1 q + 9 (1 q) = 0 q + 6 (1 q) q = 3.5
This is impossible.
(b)
Player 2
Player 1
Le f t(q0 )
Middle(q1 )
Right(1 q0 q1 )
U p( p)
1, 0
1, 2
0, 1
Down(1 p)
0, 3
0,1
2, 0
Figure 1.1.1.
Here, Player 1 must set p so that Player 2 is indifferent between
Left, Middle and Right. The payoffs from Left and Middle, for
example, have to be equal. i.e.
p 0 + (1 p ) 3 = p 2 + (1 p ) 1
p = 0.5
Similarly, the payoffs from Middle and Right have to be equal
2 p + 1 (1 p ) = 1 p + 0 (1 p )
p = 0.5
Which, besides contradicting the previous result, is quite impossible.
(c)
Player 2
Player 1
L ( q0 )
C ( q1 )
R (1 q0 q1 )
T ( p0 )
0, 5
4, 0
5, 3
M ( p1 )
4, 0
0, 4
5, 3
B (1 p0 p1 )
3, 5
3, 5
6, 6
Figure 1.1.4.
In a mixed equilibrium, Player 1 sets p0 and p1 so that Player 2
would be indifferent between L, C and R. The payoffs to L and C
must, for example, be equal i.e.
4 p0 + 0 p1 + 5 (1 p0 p1 ) = 0 p0 + 4 p1 + 5 (1 p0 p1 )
p0 = p1
Similarly,
0 p0 + 4 p1 + 5 (1 p0 p1 ) = 3 p0 + 3 p1 + 6 (1 p0 p1 )
p1 = 2.5 p0
Which violates p0 = p1 .
10
C ( q1 )
R (1 q0 q1 )
T ( p0 )
2, 0
1, 1
4, 2
M ( p1 )
3, 4
1, 2
2, 3
B (1 p0 p1 )
1, 3
0, 2
3, 0
Player 1
0 p0 + 4 p1 + 3 (1 p0 p1 ) = 1 p0 + 2 p1 + 2 (1 p0 p1 )
p1 = 2 p0 1
Similarly,
E2 (C ) = E2 ( R)
1 p0 + 2 p1 + 2 (1 p0 p1 ) = 2 p0 + 3 p1 + 0 (1 p0 p1 )
2
p1 = p0
3
Combining these,
5
2
p0 p0 =
3
9
5
1
p1 = 2 p0 1 = 2 1 =
9
9
5 1
3
1 p0 p1 = 1 =
9 9
9
2 p0 1 =
Now we must calculate q0 and q1 . Player 2 will set them such that
E1 ( T ) = E1 ( M )
2 q0 + 1 q1 + 4 (1 q0 q1 ) = 3 q0 + 1 q1 + 2 (1 q0 q1 )
q1 = 1 1.5 q0
And
E1 ( M) = E1 ( B)
3 q0 + 1 q1 + 2 (1 q0 q1 ) = 1 q0 + 0 q1 + 3 (1 q0 q1 )
Qed
Answer 1.12
( q ) L2
(1 q ) R2
( p) T1
2, 1
0, 2
(1 p) B1
1, 2
3, 0
11
1 p + 2 (1 p ) = 2 p + 0 (1 p )
p=
2
3
2 q + 0 (1 q ) = 1 q + 3 (1 q )
q=
3
4
Answer 1.13
(q)Apply1 to Firm 1
(1 q)Apply1 to Firm 2
( p)Apply2 to Firm 1
1
1
2 w1 , 2 w1
w1 ,w2
(1 p)Apply2 to Firm 2
w2 ,w1
1
1
2 w2 , 2 w2
p=
2w1 w2
w1 + w2
2w1 w2
w1 + w2
dU ( IC + B) dV ( IP B)
+
=0
dB
db
dU ( IC + B) d( IC + B) dV ( IP B) IP B
=0
d( IC + B)
dB
d ( IP B )
dB
kU 0 ( IC + B) V 0 ( IP B) = 0
V 0 ( IP B ) = kU 0 ( IC + B )
Where B is the maximizing level of the bequest. We know it exists
because a) there are no restrictions on B and b) V() and U() are
concave and increasing
The childs utility function is given by U ( IC ( A) B ( A)). This is
maximized at
dU ( IC ( A) + B ( A))
=0
dA
U 0 ( IC ( A) + B ( A))
dIC ( A) dB ( A)
+
dA
dA
=0
dIC ( A) dB ( A)
+
= 0 IC0 ( A) = B0 ( A)
dA
dA
14
( IP ( A)B ( A))
dIP ( A) dB ( A)
dA
dA
=0
IP0 ( A) = B0 ( A)
Answer 2.2 The utility function of the parent is given by V ( IP
B) + k[U1 ( IC S) + U2 ( B + S)]. This is maximized at
d {V ( IP B) + k[U1 ( IC S) + U2 ( B + S)]}
=0
dB
= V ( I p B) + (1 + k)(U1 ( IC S) + U2 ( B + S))
This is maximized (w.r.t S) at:
V 0 ( BS0 ) + (1 + K ) [U10 (1) + U20 (1 + BS0 )] = 0
V 0 BS0
1+k
V ( R c1 )2 0 c1 R V
V ( R V )2
15
R
1
V
2
V
too high), c1 = R V and c2 = V. Otherwise, c2 = 0 and
c1 = 0.
Answer 2.5 Let the wage premium be p = w D wE , where
p (, ). In order to get the worker to acquire the skill, the
firm has to credibly promise to promote him if he acquires the skill
- and not promote him if he doesnt.
Lets say that he hasnt acquired the skill. The firm will not promote him iff the returns to the firm are such that:
y D0 w D y E0 wE y D0 y E0 w D wE = p
If he does acquire the skill, the firm will promote if the returns to
the firm are such that:
y DS w D y ES wE y DS y ES w D wE = p
Thus the condition which the firm behaves as it ought to in the
desired equilibrium is:
y D0 y E0 p y DS y ES
Given this condition, the worker will acquire the promotion iff he
acquires the skill. He will acquire the skill iff the benefit outweighs
the cost i.e.
wD C wE wE + p C wE p c
That is, the premium paid by the company must cover the cost of
training. The company wishes (obviously) to minimize the premium, which occurs at:
C
if C y D0 y E0 ,
wD wE = p =
y D0 y E0 if C < y D0 y E0
A final condition is that the wages must be greater than the alternative i.e. wE 0 and w D 0. The firm seeks to maximize yij wi ,
which happens at wE = 0 and w D = p.
Answer 2.6 The price of the good is determined by
P ( Q ) = a q1 q2 q3
The profit earned by a firm is given by i = ( p c) qi . For Firm 2,
for example
2 = ( a q1 q2 q3 c) q2
16
which is maximized at
d2
= ( a q1 q2 q3 c) + q2 (1) = 0
dq2
q2 =
a q1 q3 c
2
Symmetrically,
q3 =
a q1 q2 c
2
a q1
aq1 q2 c
2
q2 =
a c q1
3
ac
6
d ( a L1 . . . L i . . . L n w ) L i
=0
dLi
( a L1 . . . Li . . . Ln w) + Li (1) = 0
L1 + . . . + 2Li + . . . + Ln = a w i = 1, . . . , n
This generates a system of equation similar to the system in Question (1.4)
2 1 ... 1
L1
aw
1 2 . . . 1 L2 a w
.. .. ..
.. .. . .
. .
. .
. .
1
...
Ln
aw
a q1 c
3
q1
17
Which resolves to
Li =
aw
n+1
aw
aw
n
+...+
=
( a w)
n+1
n+1
n+1
n
n
( a w) =
( aw awa w2 + wwa )
n+1
n+1
a c 2t j
ac
= 0 tj =
3
2
hi =
a wi +
a wi + t i
=
3
3
a wi
2
a wi
2
Which is the monopoly amount. Now, in the monopoly-union bargaining model, the quantity produced equals the labor demanded.
Thus,
Lie=0 =
a wi
2
a wi
a wi
2
a wi
2
a wi
2
wi a wa wi2 + wi wa
2
a wi
2
2
18
The union sets wages to maximize utility with the following condition:
dU e=0
a + wa
a 2wi + wa
= 0 wi =
=
dwi
2
2
Now, tariffs decline to zero. In this situation, t j = 0 and therefore
h j = hi =
a wi
3
e j = ei =
a wi
3
and
a wi
a wi
a + 2wi
=
3
3
3
it=0
=2
a + 2wi
wi
3
a wi
3
2
a wi
3
a + 2wi
wi
3
= 2 ie=0
2
2
(w wa )( a wi ) = (wi a wa a wi2 + wa wi )
3 i
3
This is maximized at
2
a + wa
dU t=0
= ( a 2wi + wa ) = 0 wi =
dwi
3
2
Which is the same as before.
Answer 2.10 Note that ( P1 , P2 ), ( R1 , R2 ) and (S1 , S2 ) are Nash
Equilibrium.
P2
Q2
R2
S2
P1
2, 2
x, 0
-1, 0
0,0
Q1
0, x
4, 4
-1, 0
0, 0
R1
0, 0
0, 0
0, 2
0, 0
S2
0, -1
0, -1
-1, -1
2, 0
j
So what are player 1s payoff from playing the strategy? Let POi ( X1 , X2 )
denote player is payoff in round j when player 1 plays X1 and
a wi
3
19
3,1
0,0
5,0
2,1
1,2
3,1
1,2
0,1
4,4
Unfortunately, the payoff (4,4) - which comes from the actions (B,R)
- cannot be maintained. Player 2 would play R, if player 1 plays B player 1 however would deviate to T to earn a payoff of 5. Consider,
however, the following strategy for player 2:
In Round 1, play R.
In Round 2, if Round 1 was (B,R), play L. Else, play M.
Player 1s best response in Round 2 is obviously T or M, depending on what player 2 does. But what should he do in Round 1? If
he plays T, his playoff is: 3
PO11 ( T, R) + PO12 ( M, C ) = 5 + 1 = 6
If he plays B:
PO11 ( B, R) + PO12 ( T, L) = 4 + 3 = 7
Thus, as long as player 2 is following the strategy given above, we
can induce (B,R).
20
1
1
ac
ac
1
( a c )2
2
4
1
8
( a c )2
1
1
( a c )2
2
1
2
Q.E.D.
Answer 2.14 The monopoly quantity when demand is high is
a H c
which makes the monopoly price
2
aH c
a +c
pH = aH
= H
2
2
21
This is the price that the firms have to maintain when demand is
high. Conversely, when demand is low
aL + c
2
pL =
p
if ai = a H
H
pM =
pL
if ai = a L
Consider the following strategy for firm i:
In Round 1, set pi = p M .
In Round t 6= 1, if p j = p M in the previous round, play p M , else
play pi = c
The payoff received from deviating is the monopoly profit for
one round 4 and then zero profits in all future rounds:
deviate =
( a i c )2
( a c )2
+ 0 + 2 0 + . . . = i
4
4
( a H c )2
( a L c )2
( a i c )2
+
+ (1 )
+...
=
8
8
8
f ollow =
( a i c )2
( a c )2
( a c )2
+
H
+ (1 ) L
8
1
8
8
( a i c )2
( a c )2
( a c )2
( a c )2
i
+
H
+ (1 ) L
4
8
1
8
8
c
Answer 2.15 If the quantity produced by a monopolist is a
2 , the
quantity produced by a single company in a successful cartel is
qm
n =
ac
2n
( p c)qm
n
= (a
Q c)qm
n
ac
a
c
2
an
ac
1+ n
ac
2n
1
=
n
which means
ac
ac
ac 2
c
=
1+n
1+n
1+n
ac
2
5
2
22
ac
2
n+1
n+1
n+1
ac
( n 1)
( a c)
( a c) =
( a c)
2n
4n
4n
4n
If the firm deviates, it earns the cheating gain for one round and
Cournot profits for all future rounds i.e. the gain from deviating
from the strategy is
deviate =
n+1
( a c)
4n
"
deviate =
2
n+1
4n
2
ac
1+n
+
1+
2
+ 2
1
1+n
ac
1+n
2 #
2
+...
( a c )2
If the firm follows the strategy, its payoff is m for all rounds:
f ollow
1
=
n
ac
2
2
1
+
n
ac
2
2
1
+
n
2
ac
2
2
1
n+1
2 #
1
1
+... =
1 n
1 n
ac
2
"
2
n+1
4n
2
+
1
( a c )2
n2 + 2n + 1
n2 + 6n + 1
ac
2
2
23
game, if the two players cant agree, the game goes to the second
stage, at which point, player 2 gets 1 and player 1 gets 0. This payoff of 1 in the second round is worth to player 2 in the first round.
If player 1 offers to player 2 in the first round, player 2 will accept,
getting a payoff of 1 i.e. (1 , ).
In a three period game, if player 2 rejects the offer in the first
round, they go on to the second round, at which point it becomes
a two period game and player 2 gets a payoff of 1 and player 1
gets . This payoff (,1 ) is worth (2 ,[1 ]) to the players in
the first round. Thus, if player 1 makes an offer of (1 [1 ],[1
])=(1 + 2 , 2 ), player 2 would accept and player 1 would
secure a higher payoff.
1
Answer 2.21
Answer 2.22 In the first round, investors can either withdraw (w)
or not (d). A strategy can represented as x1 x2 where x1 is what the
investor does in the first round and x2 is what the investor does in
the second round. The game can be represented by the following
table:
ww
wd
dd
dw
ww
r,r
r,r
D,2r-D
D,2r-D
wd
r,r
r,r
D,2r-D
D,2r-D
dd
2r-D,D
2r-D,D
R,R
D,2R-D
dw
2r-D,D
2r-D,D
2R-D,D
R,R
24
Thus, the highest possible price that the buyer will pay at this point
is p = v + I. If, however, the buyer doesnt invest, the buyer will
buy if
vp 0 v p
Thus the buyer would be willing to pay p = v. Thus investment is
I {0, 21 }. The price is drawn from p {v, v + 12 }. There is no gain
from charging anything other than these prices.
v+
1
2
1
2, A
1
2, R
41 , v +
0, A
21 , v +
v
1
2
1
4, v
41 , 0
1
2
0, v
14 , 0
0, R
0, 0
0, 0
(1 q ) v
0, 0
0, 0
(q)v +
( p) I =
1
2 Accept
(1 p) I = 0Reject
1
4, v
The only pure Nash Equilibrium is for the buyer to not invest and
the
a H c q2
q1 = a c2q
2
L
if ai = a H
if ai = a L
a H + (1 ) a L c
a H +(1 ) a L cq2
2
q2 =
a H + (1 ) a L c
3
aH c
a H +(1 ) a L c
3
(3 ) a H (1 ) a L 2c
6
But what if ai = a L ?
q1L =
aL c
a H +(1 ) a L c
3
(2 + ) a L a H 2c
6
26
c aL
aH aL
(2 + ) a L a H 2c
c aL
0 2
6
aH aL
2c 3a H + a L
aH aL
a b H [ p H + (1 ) p L ]
a (1 ) b H p L
pH =
2
2 + b H
And if b1 = bL :
pL =
a bL p H
a b L [ p H + (1 ) p L ]
=
2
2 + b L (1 )
ab L p H
2+(1 )b L
2 + b H
pH =
a (1 [1 ] b H )
4 + 2(1 )bL + 2b H
Similarly,
pL =
a(1 bL )
4 + 2(1 )bL + 2b H
(q)T
1,1
0,0
(1-q)B
0,0
0,0
27
(q)T
0,0
0,0
(1-q)B
0,0
2,2
vi bi if bi > b j j = 1, 2, . . . , i 1, i + 1, . . . , n
ui =
vi b j
m
if bi = b j
n 1
bi a j
= ( v i bi ) P v j <
cj
This is maximized at
di
= (1)
dbi
bi a j
cj
bi a j
cj
! n 1
+ ( v i bi )
! n 2
n1
cj
a j + (n 1)vi nbi
cj
bi a j
cj
!
=0
! n 2
=0
!#n1
= ( v i bi )
bi a j
cj
! n 1
28
aj
a
a
an
a1 = 2 = 3 = . . . =
n
n
n
n
n1
vi
n
n 1
n
and
(1-q)R
4,1
0,0
3,0
0,1
2,2
2,2
1
2
M0
R0
1,3
1,2
4,0
4,0
0,2
3,3
2,4
2,4
2,4
30
2
>p
3
and
2 ( M0 ) > 2 ( R0 ) 2 > 3 3p p >
1
3
2
q2
3
2
5
q2 q2 >
3
12
(q) L0
(1 q ) R 0
( p) L
3,0
0,1
(1 p ) M
0,1
3,0
2,2
2,2
31
1
2
1
>p
2
2 ( L 0 ) = 2 ( R 0 ) 0 p + 1 (1 p ) = 1 p + 0 (1 p ) p =
And similarly, for player 1:
1 ( L ) = 1 ( M ) 3 q + 0 (1 q ) = 0 q + 3 (1 q ) q =
1
2
32
1
1
1
1+ 1+ 1 = 1
3
3
3
R ( L, d) =
1
1
1
0+ 0+ 0 = 0
3
3
3
There are two strategies: (u, u) and (u, d). Under (u, u):
1 ( L, u) = 1 and 1 ( R, u) = 0
2 ( L, u) = 2 and 2 ( R, u) = 1
3 ( L, u) = 1 and 3 ( R, u) = 0
None of the three types have an incentive to send R instead of L.
Thus, we have the following equilibrium:
1
[( L, L, L), (u, u), p = , 1 q 0]
3
Answer 4.4 (a) Lets examine pooling equilibrium ( L, L). p =
0.5. R ( L, u) = R ( L, d). Thus, it doesnt matter for the receiver
whether he/she plays u or d.
Under (u, u), 1 ( L, u) = 1 < 1 ( R, u) = 2, making it unsustainable.
Under (u, d), 2 ( L, u) = 0 < 2 ( R, d) = 1, making it unsustainable.
Under (d, d), 2 ( L, d) = 0 < 2 ( R, d) = 1, making it unsustainable.
Under (d, u), 2 ( L, u) = 0 < 2 ( R, d) = 1, making it unsustainable.
Thus, ( L, L) is not a sustainable equilibrium.
Lets examine separating equilibrium ( L, R). The best response
to this is (u, d)6 . Lets see if either of the types have an incentive to
deviate:
For type 1, 1 ( L, u) = 1 > 1 ( R, d) = 0 i.e. no reason to play R
instead of L.
For type 2, 2 ( L, u) = 0 < 2 ( R, d) = 1 i.e. no reason to play L
instead of R.
Lets examine pooling equilibrium ( R, R). R ( R, u) = 1 >
R ( R, d) = 0.5. Therefore, the two strategies that can be followed by
the receiver are (u, u) and (d, u).
Under (u, u), ( L, u) < ( R, u) for both types.
Under (d, u), ( L, d) ( R, u) for both types.
Lets examine pooling equilibrium ( R, L). The best response to
this is (d, u)7 .
For type 1, 1 ( L, d) = 2 1 ( R, u) = 2, i.e. will play L.
For type 2, 2 ( L, d) = 0 2 ( R, u) = 1, i.e. will play R.
33
34
Lets examine ( L, R). The best response to this is (u, d). In response to this,
For type 1, 1 ( L, u) = 1 < 1 ( R, d) = 3 i.e. type 1 will play R
which violates the equilibrium
For type 2, 2 ( L, u) = 0 < 2 ( R, d) = 2 i.e. type 2 will play R
which doesnt violate the equilibrium.
Lets examine ( R, L). The best response to this is (u, d). In response to this,
For type 1, 1 ( L, u) = 1 < 1 ( R, d) = 3, i.e. type 1 will play R.
For type 2, 2 ( L, u) = 0 < 2 ( R, d) = 2, i.e. type 2 will play R,
violating the equilibrium.
The perfect Bayesian Equilibrium is
8
Since R (3, R, u) = 0 < R (3, R, d) =
1 and 0.5 R (1, L, u) + 0.5
R (2, L, u) = 1 > 0.5 R (1, L, d) + 0.5
R (1, L, d) = 0
10
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L.
12
since R (2, L, u) = 1 > R (2, L, d) =
0 and 0.5 R (2, L, u) + 0.5
R (3, L, u) = 0.5 = 0.5 R (2, L, d) +
0.5 R (3, L, d) = 0.5
13
since R (3, L, u) = 1 > R (3, L, d) =
0 and 0.5 R (1, R, u) + 0.5
R (2, R, u) = 0.5 > 0.5 R (1, R, d) +
0.5 R (2, R, d) = 0
Answer 4.6 Type 2 will always play R since S (2, R, a) > S (2, R, u) and S (2, R, a) >
S (2, R, d). Thus if the Receiver gets the message L, he knows that
14
it can only be type 1. In such a case, the Receiver plays u14 , creating
in fact, R ( x, L, u) > R ( x, L, d) for
both types, so the Receiver will always
play u
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a payoff of (2, 1). This gives type 1 a higher payoff than if he played
R, which would have given him a payoff of 1. Thus, the perfect
Bayesian Equilibrium is