LONDON SCHOOL OF ECONOMICS Leonardo Felli

Department of Economics 32L.4.02; x7525

Solutions to Assignment 1
Contracts and Enforcement

1. The normal form of this game can be described as follows.

D ND
P 50, 40 −50, 50
NP 100, −10 0, 0

The set of players is: N = {B, S}. The buyer’s strategy space is AB =
{P, N P }, where P denotes the strategy choice ‘pay the price of 5’ and N P
the strategy choice ‘do not pay the price of 5’. The seller’s strategy space
is instead AS = {D, N D} where D denotes the strategy choice ‘deliver the
good at the cost -1’ and N D the strategy choice ‘do not deliver the good’.
The unique mixed strategy Nash equilibrium of this game is (N P, N D), with
associated payoffs: (0, 0) (The game has the same structure of the prisoners’
dilemma game).
The outcome (P, D) with payoffs (50, 40) strictly dominates the Nash equilib-
rium outcome for both players. Therefore the Nash equilibrium outcome is
inefficient.

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2. The extensive form of this new game is:

Ba
#c
# c
P # # c
c NP
# c
# c
# c
S ## c S
q cq
c
#

J
S
D1
J N D1 D2
S N D2

J
S
q

Jq q
Sq
(50, 40) (−50, 50) (100, −10) (0, 0)

Let Di denote the seller’d decision to deliver the good at the node i and N Di
the seller’s decision not to deliver the good at the same note, i ∈ {1, 2}.
Backward induction implies that the unique Subgame Perfect equilibrium of
this game is [N P, (N D1 , N D2 )], with payoffs (0, 0).
Consider now the alternative situation in which the seller moves first. The
extensive form of this game can be described using the following game tree:

Sa
#c
# c
D # # c
c ND
# c
# c
# c
B # # c B
q cq
c
#

J
S
P1
J N P 1 P2
S N P 2

J
S
q
Jq q
Sq
(40, 50) (−10, 100) (50, −50) (0, 0)

The unique Subgame Perfect equilibrium of this game is: [N D, (N P1 , N P2 )]

with payoffs (0, 0). In either case the outcome is still inefficient.

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3. The extensive form in the case B and S choose their strategies simultaneously
is:
B

P NP

S S

D ND D ND

J J J J

I1 N I1 I2 N I2 I3 N I3 I4 N I4

(50, 40, 0) (−50, 50, 0) (100, −10, 0)

(50 − K, 40 − K, −10) (100 − K, −10 − K, 10) (0, 0, 0)

(−50 − K, 50 − K, 10) (−K, −K, −10)

Solving this game backward it is clear that J’s best response to (P, D) is not
intervene N I1 , J’s best response to (P, N D) is intervene I2 , J’s best response
to (N P, D) is intervene I3 and J’s best response to (N P, N D) is not intervene
N I4 . Therefore the reduce form normal form trading game that players B and
S play is:

D ND
P 50, 40, 0 −50 − K, 50 − K, 10
NP 100 − K, −10 − K, 10 0, 0, 0

This normal form game has two pure strategy Nash equilibria (P, D) and

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(N P, N D) and a non-degenerate mixed strategy Nash equilibrium
 
10 + K 50 + K
,
2K 2K

Therefore we can construct three Subgame Perfect Equilibria of this three

players game:

[P, D, (N I1 , I2 , I3 , N I4 )], [N P, N D, (N I1 , I2 , I3 , N I4 )]

and  
10 + K 50 + K
p= ,q = , (N I1 , I2 , I3 , N I4 )
2K 2K
Clearly, one of this equilibria is efficient, the outcome is (50, 40, 0).
The extensive form in the case B and S choose their strategies sequentially

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 is:
B

P NP

S S

D ND D ND

J J J J

I1 N I1 I2 N I2 I3 N I3 I4 N I4

(50, 40, 0) (−50, 50, 0) (100, −10, 0)

(50 − K, 40 − K, −10) (100 − K, −10 − K, 10) (0, 0, 0)

(−50 − K, 50 − K, 10) (−K, −K, −1)

Solving this game backward it is clear that the unique Subgame Perfect equi-
librium of the three players trading game with Justice is:

[P, D, (N I1 , I2 , I3 , N I4 )]

Clearly this SPE corresponds to the efficient outcome.