MSc.

IN ECONOMICS
GAMES AND CONTRACT THEORY
FINAL EXAM
18 December 2015
Time allowed for the exam: 2h00m
Teacher: Henrique Monteiro
This is a closed book exam.
Students not excluded from continuous evaluation must indicate on the answer sheet the
exam they are doing (final exam for 60% or 100% of the grade).
Group I 10 pts. (1h)
1. (2 pts.) Define and relate the following concepts: Iterative elimination of strictly
dominated strategies; Nash equilibrium.
2. (2 pts.) Define and relate the following concepts: History of the game;
Continuation game.
3. (2 pts.) State the revenue equivalence theorem. Does it hold for risk-averse
buyers?
4. (2 pts.) What is a situation of adverse selection? Give one example.
5. (2 pts.) What are the two types of constraints which are essential to design
optimal mechanisms? Explain their separate roles.
Group II 10 pts. (1h)
1. (7 pts.) Consider the following duopoly formed by firms 1 and 2, which produce
an homogenous product. The inverse aggregate demand for the good is
=
100 , where  =  + 
is the aggregate quantity traded in the market, i.e.,
the sum of the quantities produced by each firm ( and 
). The unit cost of
production is similar and constant and is  = 10.
a) (1 pt.) Define what is a subgame-perfect equilibrium.

b) (1.5 pts.) Find the subgame-perfect equilibrium of a Stackelberg game in this

duopoly in which the Firm 1 moves first.
c) (1 pt.) Prove that there is a first-mover advantage.
d) (2 pts.) Now, assume that in the duopoly described, firms act simultaneously.
Find the equilibrium quantities if firms behave as Cournot duopolists and the
quantity they should produce in order to maximize their combined profit if they
collude and replicate a monopoly situation.

e) (1.5 pts.) Consider an infinite repetition of the duopoly game described above.
For which values of a discount rate d (0 < < 1) can collusion last forever if
firms play trigger strategies in which they cooperate only if the other firm
always cooperated?

2. (3 pts.) Two players participate in a first-price sealed-bid auction. The value of

the good for each player is observed only by player i and independent of the
other players valuation. It is given by  = 0.5 +  , where  is uniformly
distributed over the interval [0, 1]. 1
a) (2 pts.) Show that there is a symmetric Bayesian Nash equilibrium in linear
strategies in which each bidder is bidding strategy is of the form  =  +  .
b) (1 pt.) What is the expected payoff of a player if his type is  ?

Tadelis, Steven. 2013. Game Theory: An Introduction. Princeton, New Jersey, USA: Princeton
University Press. Exercise 13.9.

Solutions
Group I
1) (2 pts.)

Iterative elimination of strictly dominated strategies is the process by which the

strategies that always results in a worst payoff than some other available strategy
(strictly dominated strategies) are eliminated from the game based on the assumption
that all players are rational, that a rational player will never choose a strictly dominated
strategy and that all of this is common knowledge. The process is iterative because, after
each elimination, a new game is considered.
Nash equilibrium: Situation where the strategies chosen by each player are best
responses, given the choices made by the other players, i.e., they maximize the payoff
function for the values of their opponents choices. In Nash equilibrium, no player
wants to individually change the chosen strategy.
In the an player strategic-form game if iterated elimination of strictly dominated
strategies eliminates all but the strategies  , ,  , then these strategies are the
unique Nash equilibrium of the game.
Relationship between both concepts:

In an player strategic-form game if the strategies  , ,   are a Nash equilibrium,

then they survive iterated elimination of strictly dominated strategies.
2) (2 pts.)

History of the game is the collection of actions played by all players in the previous
stages of the game.
A continuation game is the game starting at a given information set and including all
edges and vertices/nodes until the terminal nodes.
If the history of the game is known, the continuation game will starts at an information
set which is made of a single decision node. The continuation game is a subgame if the
history of the game is known.
3) (2 pts.)

Revenue equivalence theorem:

In a symmetric sealed-bid auction with independent private values, for symmetric and
monotonically increasing equilibriums for which the winner is the buyer with the
highest private value and the expected payment of each buyer with private value 0 is 0,
the sellers expected value is independent of the auction method.

The revenue equivalence theorem does not hold with risk-averse buyers. In that case the
revenue collected by the seller will be higher higher in a sealed-bid first-price auction
than in a sealed-bid second-price auction.
4) (2 pts.)

Adverse selection is a situation where an uninformed party (the principal) who offers a
contract is uncertain about the characteristics of the informed party (the agent) to whom
the contract is offered, which have an impact on the principals payoff from the
contract.
Potential examples:
-

Life insurance: the insured knows better his state of health (and the probability
of dying soon).

Banking: Borrowers know their credit default risk better.

Labor markets: Potential employees are more aware of their abilities than the
employers.

Regulated markets; Regulated firms have better information about their costs
and productivity than the regulator

5) (2 pts.)

The two types of constraints which are essential to design optimal mechanisms are the
participation or individual-rationality constraint and the incentive-compatibility
constraint.
The participation constraints impose that the agent should not have a negative net
payoff from the contract in order to be interested in it.
The incentive-compatibility constraints require that each agent is better-off choosing the
contract designed for him, thus truthfully revealing his type.

Group II
1) (7 pts.)
a. (1 pt.) Subgame-perfect equilibrium

A strategy vector combination of strategies is a subgame perfect equilibrium if for

every subgame, the restriction of the strategy vector to the subgame is a Nash
equilibrium of that subgame, i.e., its a Nash equilibrium in each subgame.

b. (1.5 pts.) Stackelberg game

Step 1: Find the best reply function of the follower firm.
max
= max
 
= max100  
10 
=
Firm 2s optimization problem:
,-

,-

= max90  
 

,-

,-

90 
= 0 90  2
= 0 
=
1q

2
First-order condition (FOC):

= 2 < 0
1

Second-order condition (SOC):

The objective function is concave throughout.

Step 2: Plug the best reply function of the follower firm into the objective function of
the leader firm and find its optimal quantity of production.

max  = max
  = max100  

  10 
=
,5

,5

= max 690 
,5

,-

90 
90 
7  = max 6
7 
,5
2
2

1
90 2
=0
= 0  = 45
1q
2

FOC:

1

= 1 < 0
1

SOC:

The objective function is concave throughout.

Step 3: Plug the quantity of the leader firm into the follower firms best reply function
to find the optimal quantity of the latter.

 = 45 =

90 45
= 22.5
2

The subgame-perfect equilibrium of the Stackelberg model is  = 45; 

= 22.5.
c. (1 pt.)
The goal of both firms is to maximize profit. Lets calculate the profits of the leader and
the follower firms.
 = 
  = 100  
  = 100 45 22.5 10 45 =

Leader firms profits:

= 22.5 45 = 1,012.5

= 
 
= 100  
 
= 100 45 22.5 10 22.5 =
Follower firms profits;

= 22.5^2 = 506.25

Firm 1 makes more profit because of the advantage it has in moving first.
Notice that given the similar costs and the homogeneous product they sell (i.e., the
market price is the same), as long as the profit is positive, the firm with the highest
production level will have the highest profit.
d. (2 pts.)
Cournot duopoly
Step 1: Find each firms best reply function.
max
= max
 
= max100  
10 
=
Firm 2s optimization problem (as seen in point b)):
,-

,-

= max90  
 

,-

,-

90 
= 0 90  2
= 0 
=
1q

2
FOC:

= 2 < 0
1

SOC:

The objective function is concave throughout.

90 

Firms are identical so, by an argument of symmetry, firm 1s best reply function is:
 =

90 

2
<
=2 = 90 690 
7 >4 = 180 90 + 
90 

2

=
2
90 30
 = 30
 =
@ 
B 
2

= 30

= 30

Step 2: Intersect both firms best reply functions to find the Nash equilibrium.
 =

max D
= max
  = max100  10  =
Monopoly
C

= max90  
C

1
= 0 90   = 0  = 45
1Q
FOC:

= 0 2 < 0
1Q

SOC:

The function is concave throughout.

Each firm should produce  = 

=

FG

= 22.5.

e. (1.5 pts.)
H
H
H
= 

= I100 2
10J  = 90 2 22.5 22.5 =
2
2
2
= 1,012.5
Profit from the one-stage game with collusion:

K = 
 K = 100 2 K 10  = 90 2 30 30 = 900

Profit from the one-stage game with Cournot duopoly:
Optimal one-stage deviation from the cartel:

max M = max
 M = max I100 M

,L

,L

H
= max I90 M J M
,L
2

,L

H
10J M =
2


90 2H
1M
H
90 22.5
= 0 90
2M = 0 M =
M =

1q M
2
2
2
FOC:

M = 33.75

Profit from the one-stage deviation from the cartel:

H
M = 
 M = I100 M
10J M =
2
= 90 33.75 22.5 33.75 = 33.75^2 = 1,139.0625
For the trigger strategy to be a Nash equilibrium with cooperation in the infinitely
repeated game we must have:

1
H

1

M +
K
1,012.5 1,139.0625 +
900
2
1
1
1
1
1,012.5 1,139.0625 + 1,139.0625 + 900
126.5625 239.0625 239.0625 126.5625

2)

126.5625
0.53
239.0625
(3 pts.)
a. (2 pts.)

0.5 +  
T
0.5 +  
Q =
2
S
0
R

UV

 > X

Each bidders payoff function is:

UV

UV

 = X
 < X

Expected payoff of bidder U:

0.5 +  
YZQ [ = 0.5 +   
\] > X ^ + 6
7
\] = X ^ +
2
+0
\] < X ^ = 0.5 +   
\] > X ^

With linear strategies of the form X =  + X and X ~`Z0; 1[ we have:

YZQ [ = 0.5 +   
\] >  + X ^ = 0.5 +   
\ IX <

 
J

Finding the bidders optimal strategy:
 
max0.5 +    I
J
ab

= 0.5 +    I

 
J=


c
 
 
1
d0.5 +    I
Je = 0 1 I
J + 0.5 +    = 0
c



FOC:

0.5 +    
 
=
0.5 +   =    = 0.25 + +

2 2

Bidders are homogeneous, so by an argument of symmetry we have also:

 X
+
2 2
Given that we have X =  + X , it must be that:


 = 0.25 + = 0.25  = 0.5
2
2
and
X = 0.25 +

=

1
2

 = 0.5 +
 X = 0.5 +
X form a symmetric Bayesian Nash equilibrium in linear
strategies.


b. (1 pt.)
YZQ [ = 0.5 +    I

 
J=


1
I0.5 + 2  J 0.5
1



= g0.5 +  60.5 +  7h i
k =  =
2
12
2
2