Economics 440/640 Problem Set III Answers

Gibbons 2.4
(Basic setup: P1 chooses c
1
, then P2 chooses c
2
, and if c
1
+ c
2
R, a project of value succeeds).
Applying backwards induction, in order to determine c
1
we must rst nd c
2
as a function of c
1
and R. In period 2, player 2 decides c
2
and has utility
U
2
=
_

_
0 if c
2
= 0 < R c
1
V c
2
2
if c
2
R c
1
c
2
2
if 0 < c
2
R c
1
There are two possibilities for optimal c
2
: either 0 or R c
1
. The latter is better if
U
2
(c
2
= R c
1
) U
2
(c
2
= 0)
V (R c
1
)
2
0

V R c
1
c
1
R

V
Now consider period 1. There are three possible optimal c
1
: 0, R (if benets are high and is
low), or R

V .
U
1
(c
1
= 0) = 0
U
1
(c
1
= R) = V R
2
U
1
(c
1
= R

V ) = V (R

V )
2
Investing c
1
(0, R) is better than investing R if
U
1
(c
1
= R

V ) U
1
(c
1
= R)
V (R

V )
2
V R
2
R
2
(R

V )
2
(1 )V
R
2
R
2
+ 2R

V V
2
(1 )V
2R

V (1 + V )V
R
(1 + V )V
2

V
R
(1 + V )

V
2
When investing c
1
= R is better than c
1
between 0 and R, c
1
= 0 might be better still. For
1
c
1
= R to be preferred,
U
1
(c
1
= R) U
1
(c
1
= 0)
V R
2
0
R

V
Likewise, when c
1
(0, R) is better than c
1
= R, c
1
= 0 might be better than a higher c
1
. For
investment to occur,
U
1
(c
1
= R

V ) U
1
(c
1
= 0)
V (R

V )
2
0
V (R

V )
2
_
(V ) R

V
R

V +

V
Putting all of these calculations together, the SPNE is
c
1
=
_

_
0 if R

V
R if

V R
(1+V )

V
2
R

V if
(1+V )

V
2
R

V +

V
(for high enough ) and
c
2
=
_
0 if R > c
1
+

V
R c
1
otherwise.
A diagram would probably help in understanding the solution better, but I leave it to you to draw
one.
Gibbons 2.7
(Basic setup: labor union in oligopolistic industry)
In period 2, the rms maximize prots given w. For rm i,

i
= q
i
(a Q)q
i
w
= L
i
(a w
n

j=1
L
j
)
d
i
dL
i
= 0 = a 2L
i

j=i
L
j
2
d
i
dL
i
= 0 = a w 2L
i

j=i
L
j
2Li = a w
n

j=i
L
j
2L

= a w (n 1)L

(n + 1)L = a w
L

=
a w
n + 1
where L

is the labor demand of each rm.

In period one, the union knows L

(w) =
aw
n1
, so L = nL

=
n(aw)
n1
. The union maximizes
U
u
= (w w
a
)L
=
_
n
n + 1
_
(w w
a
)(a w)
dU
u
dw
= 0 =
_
n
n + 1
_
(a + w
a
2w)
w =
a + w
a
2
The number of rms n does not affect w, because it just scales U
u
proportionally.
Gibbons 2.15
(Basic setup: n rm Counrnot collusion)
Consider n identical producers of identical homogenous goods, who compete as Cournot oligopolists
with P = a Q. Dene a collusive q strategy as a stratey in which if all rms set q
i
= q they
continue to do so next period. The punishment for deviation is that all rms subsequently play
the static equilibrium forever, a grim trigger strategy. The static NE is given by q =
a
n+1
and

P
=
_
a
n+1
_
2
.
W
C
w
0 W
P
q
i
= q
q
i
< q
q
i
R
Let
C
(q) be prots in cooperative subgame,
P
be prots in punishment subgame, and
D
(q)
the prots from defecting.
3
Perfect collusion: Best collusive outcome is acting like a joint monopolist and setting q =
a
2n
(since monopolist would produce a/2 units total). Then

C
=
a
2
4n
.
What would a rm do if it deviated? Other rms set q
i
= q so

i
(q
i
, q
i
= q) = q
i
(a (n 1)q q
i
)
q
D
=
a (n 1)q
2

D
=
_
a (n 1)q
2
_
_
a (n 1)q q
D
_
=
_
a (n 1)q
2
_
2
=
_
a
(n1)a
2n
2
_
2
=
(n + 1)
2
a
2
16n
2
=
(n + 1)
2
4n

C
In order to determine whether it is a NE to play q in w
C
states, we construct a game using (1
)(current payoffs)+(continuation values) and check whether q is a NE in this game:
U
g
C
i
(q
i
= q, q
i
= q) U
g
C
i
(q
i
= q
D
, q
i
= q)
(1 )

C
+

C
(1 )
D
+
P

C
(1 )
_
(n + 1)
2
4n
_

C
+
_
4n
(n + 1)
2
_

C
1 (1 )
_
(n + 1)
2
4n
_
+
_
4n
(n + 1)
2
_
4n(n + 1)
2
(1 )(n + 1)
4
+ 16n
2
[(n + 1)
4
16n
2
] (n + 1)
4
4n(n + 1)
2

(n + 1)
4
4n(n + 1)
2
(n + 1)
4
16n
2
For instance, n = 2 cooperation requires 0.53 while n = 8 cooperation requires 0.72. As
n , 1.
Imperfect collusion: If the rms are too impatient to satisfy that condition, then they can still
collude to get positive prots, but not full monopoly ones. The rms will increase q from a/(2n)
until their incentives are satised.
4
Now

C
(q) = q(a nq)
so the prot-maximizing deviation is

i
(q
i
, q
i
= q) = q
i
(a (n 1)q q
i
)
q
D
(q) =
a (n 1)q
2

D
(q) =
_
a (n 1)q
2
_
_
a (n 1)q q
D
_
=
_
a (n 1)q
2
_
2
The incentive-compatibility condition is
U
g
C
i
(q
i
= q, q
i
= q) = U
g
C
i
(q
i
= q
D
, q
i
= q)
(1 )
C
(q) +
C
(q) = (1 )
D
(q) +
P
q(a nq) = (1 )
_
a (n 1)q
2
_
2
+
_
a
n + 1
_
2
4(n + 1)
2
q(a nq) = (1 )(n + 1)
2
(a (n 1)q)
2
+ 4a
4(n + 1)
2
q(a nq) =
(1 )(n + 1)
2
(a
2
2(n 1)q+
(n 1)
2
q
2
)
2
+ 4a
so q is dened implicitly by a quadratic function
q
2
_
4n(n+1)
2
(n1)
2
(n+1)
2
_
+q
_
4(n+1)
2
a+2(n1)(n+1)
2
+4
_

_
(1)(n+1)
2
a
2
]
D
_
= 0.
Question 4. Repeated Movie-Watching
Consider a simple game where in each time period, a couple simultaneously choose whether to see
a horror movie or a romantic comedy. Player 1 loves romantic comedies and gets > 1 utility
from seeing them but dislikes horror movies. Unfortunately player 2 has the opposite preferences.
If they do choose different movies, they get into an an argument and instead decide to stay home,
but this outcome is better than seeing the disliked movie genre.
5
C H
C , 1 0, 0
H 0, 0 1,
A) Consider the strategy of alternating (C, C), (H, H), (C, C), and so on, as long as the other
player follows it, supported by a grim-trigger strategy in which they play (C, H) forever.
Draw an automaton representing this strategy.
B) Find the minimum necessary for the strategy in (A) to be a subgame-perfect Nash equilib-
rium.
C) It is not very nice for a couple to threaten each other with a grim-trigger strategy. What if
they engage in one period of (C, H) as punishment if either deviates? Draw an automaton
representing this strategy.
D) Find the minimum necessary for the strategy in (C) to be a subgame-perfect Nash equilib-
rium.
Answer (A): The automaton is below.
W
HH
w
0
W
HC
W
CC
HC, CH, CC
HH
CC
HC, CH, HH
HH, HC, CH, HH
with
f(w
CC
) = (C, C), and
f(w
HH
) = (H, H), and
f(w
HC
) = (H, C).
6
Answer (B): We only need to analyze one of the players because they are playing a symmetric
game. Lets consider player 2, who has some incentivee to deviate in w
CC
subgames.
V
i
(w
HC
) = 0
V
2
(w
HH
) = (1 ) + V
2
(w
CC
)
V
2
(w
CC
) = (1 )(1) + V
2
(w
HH
)
= (1 )(1) + [(1 ) + V
2
(w
CC
)
V
2
(w
CC
) = (1 )(1 + ) +
2
V
2
(w
CC
)
V
2
(w
CC
) =
(1 )( 1)
1
2
=
(1 )( 1)
(1 )(1 + )
=
1
1 +
V
2
(w
HH
) = (1 ) + V
2
(w
CC
)
=
(1
2
) + ( 1)
1 +
=

1 +
Now using the standard automaton technique, we construct a game g
w
CC
equal to
g
w
CC
= (1 )
, 1 0, 0
0, 0 1,
+
V
1
(w
HH
), V
2
(w
HH
) V (w
HC
), V (w
HC
)
V (w
HC
), V (w
HC
) V (w
HC
), V (w
HC
)
and in g
w
CC
for the cooperative strategy to be a SPNE, f(w
CC
) = (C, C) must be a NE. For it to
be a NE,
U
g
w
CC
2
(C, C) U
g
w
CC
2
(C, H)
(1 )(1) + V
2
(w
HH
) (1 )0 + V
2
(w
HC
)
(1 )(1) + V
2
(w
HH
) 0
7
V
2
(w
HH
) 1
V
2
(w
HH
)
1

1 +

1

2
1
2

1

Answer (C): This part is ambiguous because it is not clear exactly what one period on punish-
ment means. In particular, what is (w
P
)? There are two approaches that are acceptable as answers
for (c):
1. After punishment the system returns back to w
0
.
2. There are two kinds of punishment.
Automatons for either choice are below.
W
HH
w
0 W
CC
W
P2
HH, HC, CH, HH
HC, CH, CC
HH
CC
HC, CH, HH
W
HH
w
0
W
P1
W
CC
W
P2
HC, CH, CC
HH
CC
HC, CH, HH
with
f(w
CC
) = (C, C), and
f(w
HH
) = (H, H), and
f(w
P1
) = (H, C), and
f(w
P2
) = (H, C).
The interpretation of w
Pi
is that it is a state that implicitly punishes player i.
8
Answer (D): First, note that the strategy represented by the automaton of the left above cannot
be a SPNE. Player 1 actually likes this punishment, which allows him to skip a horror movie,
wait one week, and then see a comedy. So player 1 will always deviate in state w
HH
.
Hence we turn to the more complicated automaton above. V
i
(w
CC
) and V
i
(w
HH
) are un-
changed from (b) because the punishment continuation values do not affect the cooperative con-
tinuation values.
V
2
(w
P2
) = V (w
HH
)
=

2
1 +
For (C, C) to be a NE in w
CC
subgames,
U
g
w
CC
2
(C, C) U
g
w
CC
2
(C, H)
(1 )(1) + V
2
(w
HH
) (1 )0 + V
2
(w
P2
)
(1 )(1) + V
2
(w
HH
)

2

3
1 +
(1
2
)
1 +
+ V
2
(w
HH
)

2

3
1 +
V
2
(w
HH
)
1
2
+
2

3
1 +

2
1 +

1
2
+
2

3
1 +

2
+ 1 0
Cubic equations are hard to solve, so this solution is acceptable. Wolfram Alpha says that
( 1

2
2 3)/2. For < 3, no allows cooperation; at = 4, 0.38 allows
cooperation.
Repeated Games Problem Set version 1.0 (4/5/13)
9