ECON 440/640 Problem Set 2 Answers

Worker

Invest

Not Invest

Firm

Firm

Promote

Not Promote

Promote

Not Promote

Wd - C Yds - Wd

We - C Yes - We

Wd Yd0 - Wd

We Ye0 - We

Figure 1: Game Tree for Problem 2.5

Problem 2.5
Period 2. because The rm will not promote the worker without investment on the workers part (0, E ) = YE 0 WE > YD0 WD = (0, D) as long as WD WE , since YD0 < YE 0 . The rm will promote the worker if the worker invests as long as (S, E ) = YDS WD <YES WE = (S, D) YDS YES >WD WE .

(1)

Period 1. Assuming (??) holds, the worker will invest if WD C > WE , or WD WE > C.

Wage setting. Lower wages are good for the rm, so it makes sense to consider two possibilities 1. WD = WE = 0 = the workers reservation utiity, and 2. WD = C , WE = 0, the minimum wages that induce investment. 1

Equilibrium prots under option i are (0, E ) = YE 0 and under the second option are (S, D) = YSD C . By assumption investment is efcient (YSD YE 0 > c, so the rm makes the second set of offers.

Problem 2.10
The second-stage outcome increases the payoffs to the rst-stage strategy combinations by (Q1 , Q2 ): leads to (P1 , P2 ), so an additional 2 for each player. (y, Q2 ): leads to (R1 , R2 ), so an additional 2 for player 2. (Q1 , z ): leads to (S1 , S2 ), so an additional 2 for player 1. Any other combination: leads to (P1 , P2 ) so an additional 2 for each player. Adding these payoffs to the rst-stage payoffs, we get P2 4,4 2, x 2, 2 2, 1 Q2 x, 2 6, 6 2, 2 2, 1 R2 1, 2 1, 2 2, 4 1, 1 S2 2, 2 2, 2 2, 2 4, 2

P1 Q1 R1 S1

As long as x 6, Qi is a best response to Qj , i.e., (Q1 , Q2 ) in stage 1 is a subgame-perfect Nash equilibrium of the twice-repeated game.

Problem 2.13
Collusion. Colluding rms will charge the same price pC > c. Each rms prot from the arrangement is a pC = D ( p C c) = (pC c) 2 The prot-maximizing price level is pC = (a + c)/2. Hence the current and discounted future value of this arrangement is ( a c) 2 (a c)2 (a c)2 (a c)2 + + 2 + = . 4 4 4 4(1 ) 2

Deviation. A rm can deviate and charge pD = pC , providing a one-time payoff of (a c)2 /2. Comparing this payoff to the value of maintaining the collusive agreement, collusion is supportable if (a c)2 (a c)2 > 4(1 ) 2 2 > 4(1 ) 1 > . 2

Problem 2.14
As in the previous problem, pH = aH + c 2 aL + c pL = . 2

Colluding in period t leads to expected prots in t + 1 to of discounted value V = = (aH c)2 (aL c)2 (aL c)2 (aH c)2 + (1 ) + (1 ) + 2 + ... 4 4 4 4 (aL c)2 (aH c)2 + (1 ) . 1 4 4

The incentives for each rm to deviate are going to be greatest when a = aH and the benets of cheating are large. The payoff to defecting and pricing at pH is (aH c)2 /2. Firms are only better off colluding if (aH + c)2 (aH + c)2 (aH + c)2 (aL + c)2 < + + (1 ) 2 4 1 4 4 2 2 2 (aH + c) (aH + c) (aL + c) (1 ) < + (1 ) 4 4 4 (aH + c)2 < ( + 1)(aH + c)2 + (1 )(aL + c)2

so (if Ri prots from collusion when a = ai ) = (aH c)2 ( + 1)(aH c)2 + (1 )(aL c)2 RH . = RH + RL + (RH RL ) 3

As a rudimentary check of whether this answer is correct, note that when = 1, = 0.5 as it should. Reducing pH will reduce the incentive to deviate, so when 0.5 < < , setting some intermediate price between pL and pH will allow credible collusion. Let p( ) be the maximum price that can be charged in aH periods if collusion is going to be successful. Let R( ) prots(p( )) = (aH p( ))(p( ) c)/4. Then p( ) is dened by the equation 2R( ) = R( ) + Solving for R( ), p2 R( ) = R( ) + (1 ) L 4 2 p (1 )R( ) = R( ) + (1 ) L 4 2 p (1 )R( ) = (1 ) L 4 (1 ) p2 L . R( ) = 1 4 1 Substituting in the denition of R( ), (aH p( ))(p( ) c) = 4 p( )2 + p( )(aH c) aH c = (1 ) 1 (1 ) 1 p2 L 4 p2 L 1 R( ) + (1 ) p2 L . 4

and solving the quadratic equation gives p( ).

Problem 2.17
Let et {0, c} be the tth workers effort choice and wt be the wage the rm pays to that worker. Consider the following strategies: wt = e1 = c et = 0 if et1 = c and wt1 < c c otherwise 4 0 if et = 0 c if et = c

Conditional on the rm following this wage-setting strategy, workers who put in effort get c + c > 0 so et = c is optimal. For the rm, offering wt = c gives 1 1 ( y c)

and paying 0 gives y . Hence the rm will prefer to not deviate if 1 1 (y c) > y y c > (1 )y y > c c > . y

Pirates
The point of this problem is to use backwards induction to nd a surprising subgameperfect equilibrium of the loot division game. We start with 2 pirates, numbers 1 and 2, remaining. If 1 and 2 are left, 2 will propose that he keeps all of it. Payoffs are (0, 0, 0, 0, 0, 0, 100, 0). If 1, 2, and 3 are left, 3 cannot make it worth 2s while to vote for any division, but 1 will vote for any division that leaves him 1. 3 proposes giving 1 to pirate 1 and keeping 99 for himself. Payoffs are (0, 0, 0, 0, 0, 99, 0, 1). If 1, 2, 3, and 4 are left, 4 knows that 2 will vote for anything that gives him at least one, so 4 proposes to keep 99 and give 1 to 2. Payoffs are (0, 0, 0, 0, 99, 0, 1, 0). If 1, 2, 3, 4, and 5 are left, similar logic leads to payoffs of (0, 0, 0, 98, 0, 1, 0, 1). If 1 to 6 are left, similar logic leads to payoffs of (0, 0, 98, 0, 1, 0, 1, 0). If 1 to 7 are left, similar logic leads to payoffs of (0, 97, 0, 1, 0, 1, 0, 1). If 1 to 8 are left, similar logic leads to payoffs of (97, 0, 1, 0, 1, 0, 1, 0).

The unique subgame-perfect Nash equilibrium calls for pirate 8 to keep 97 for himself and offer one coin each to pirates 6, 4, and 2. Pirates 2, 4, 6, and 8 vote in favor of this; the other pirates vote in favor or against it (it does not matter). 5