Answers to Chapter 7 Exercises

Review and practice exercises

7.1. Dominant and dominated strategies. What are the assumptions regarding player
rationality implicit in solving a game by elimination of dominated strategies? Contrast this
with the case of dominant strategies.
Answer: See the discussion on pages 3 and following.

7.2. The movie release game. Consider the example at the beginning of the chapter.
Suppose that there are only two blockbusters jockeying for position: Warner Bros.’s Harry
Porter and Fox’s Narnia. Suppose that blockbusters released in November share a total of
$500 million in ticket revenues, whereas blockbusters released in December share a total of
$800 million.
(a) Formulate the game played by Warner Bros. and Fox.
Answer: The game in normal form is as follows, where payo↵s are in $ million:
Warner Bros.
November December
250 800
November
250 500
Fox
500 400
December
800 400

(b) Determine the game’s Nash equilibrium(a).

Answer: There are two Nash equilibrium in this game: (N,D) and (D,N). See also the
discussion on page 5.

7.3. Ericsson v Nokia. Suppose that Ericsson and Nokia are the two primary competitors
in the market for 4G handsets. Each firm must decide between two possible price levels:
$100 and $90. Production cost is $40 per handset. Firm demand is as follows: if both firms
price at 100, then Nokia sells 500 and Ericsson 800; if both firms price at 90, then sales
are 800 and 900, respectively; if Nokia prices at 100 and Ericsson at 90, then Nokia’s sales
drop to 400, whereas Ericsson’s increase to 1100; finally, if Nokia prices at 90 and Ericsson
at 100 then Nokia sells 900 and Ericsson 700.
(a) Suppose firms choose prices simultaneously. Describe the game and
solve it.
Answer: First, it may help to write the demand curve as a matrix. (Notice this is not the
game firms are playing.)

Ericsson
100 90
800 1110
100
500 400
Nokia
700 900
90
900 800

Now, based on price, marginal cost and demand, we can write the payo↵ corresponding to
each strategy pair. This is now the normal form game played by firms

Ericsson
100 90
48 55
100
30 24
Nokia
42 45
90
45 40

Pricing at 90 is a dominant strategy for Nokia and Ericsson alike. The Nash equilibrium is
therefore given by (90,90). Equilibrium profits are given by (40,45).
(b) Suppose that Ericsson has a limited capacity of 800k units per quarter.
Moreover, all of the demand unfulfilled by Ericsson is transferred to
Nokia. How would the analysis change?
Answer: The new demand matrix is given by

Ericsson
100 90
800 800
100
500 700
Nokia
700 800
90
900 900

The new game is given by

2
 Ericsson
100 90
48 40
100
30 42
Nokia
42 40
90
45 45

It is now a dominant strategy for Ericsson to price at $100. It is still a dominant strategy
for Nokia to price at $90.
(c) Suppose you work for Nokia. Your Chief Intelligence Officer (CIO) is
unsure whether Ericsson is capacity constrained or not. How much
would you value this piece of info?
Answer: Nokia has a dominant strategy: price at 90. Therefore, it has no value for the
information of whether Ericsson is or is not capacity constrained (as far as the present game
is concerned).

7.4. ET. In the movie E.T., a trail of Reese’s Pieces, one of Hershey’s chocolate brands,
is used to lure the little alien out of the woods. As a result of the publicity created by
this scene, sales of Reese’s Pieces trebled, allowing Hershey to catch up with rival Mars.
Universal Studio’s original plan was to use a trail of Mars’ M&Ms, but Mars turned down
the o↵er. The makers of E.T. then turned to Hershey, who accepted the deal.
Suppose that the publicity generated by having M&Ms included in the movie would
increase Mars’ profits by $800,000 and decrease Hershey’s by $100,000. Suppose moreover
that Hershey’s increase in market share costs Mars a loss of $500,000. Finally, let b be the
benefit for Hershey’s from having its brand be the chosen one.
Describe the above events as a game in extensive form. Determine the equilibrium as a
function of b. If the equilibrium di↵ers from the actual events, how do you think they can
be reconciled?
Answer: The game’s extensive form is the following (payo↵s in millions of dollars):

............................................................................................
.....
.....
-.5, b - 1
.
..
......
.
.....
....
.....
.....
.
......
............................................................................................
.....
.....
.....
.....
.....
.
.
H
..... .....
.
..
..... .....
.....
.
..... .....
..... .....
..... .....
.....
[reject][accept][reject][accept]M
..... .....
.....
.....
...........................................................................................
0, 0
.....
.....
.....
.....
.....
.....
.....
.....
...........................................................................................
-.2, -.1

If b > 1, then Hershey is better o↵ by accepting Universal’s o↵er, were it ever asked to make
that choice; in which case Mars is better o↵ by accepting Universal’s o↵er. If b < 1, then
Hershey is better o↵ by rejecting Universal’s o↵er, were it ever asked to make that choice;
in which case Mars is better o↵ by rejecting Universal’s o↵er.

3
 7.5. ET (continuation). Return to Exercise 7.4. Suppose now that Mars does not know
the value of b, believing that either b =$1,200,000 or b =$700,000, each with probability
50%. Unlike Mars, Hershey knows the value of b. Draw the tree for this new game and
determine its equilibrium.
Answer: The game’s extensive form is now given by the following (payo↵s in millions of
dollars):

..................................................................... -500 -500, 2

......
......
......
......
................................................................... ...... ......
... 500 ⇥ 50% ...... +H
... ...... 0 ⇥ 50% =
..... ......
......
... = 250 ......................................................................
0, 0
...
...
...
...
.
................................................................... . ... N
... ...
... ...
... ...
..... ...
...
... ...................................................................... -500, -300
...
... ......
...
... ......
...
... ......
[reject][buy][bl][7pt][0pt]M[ ... ......
... ... b= 1200 (50%)][b = 700 (50%)][accept][reject][accept] .................[reject]
.......................[l]
.......[l]
......[l]
.......[l]
......[l]
. ...... ...... H
... ......
... ......
... ......
... ......
......................................................................
... 0, 0
...
...
0
...
...
...
...
...
...
.................................................................. -200, -100

where M and H refers to Mars and Hershey, whereas N refers to the player Nature. The
values next to the H nodes correspond to M ’s expected payo↵ if we ever get to that
node. Nature is not a strategic player: it simply chooses di↵erent branches according
to predetermined probabilities. In the present case, Nature flips a fair coin and chooses
b =$1,200,000 or b =$700,000 with equal probability. This implies that, from M ’s point of
view, the expected value given that we are in the N node is given by
500 ⇥ 50% + 0 ⇥ 50% = 250
It follows that M ’s optimal choice is to accept Universal’s o↵er. To summarize, the equi-
librium strategies are given by
• Mars: accept Universal’s o↵er
• Hershey: accept Universal’s o↵er if b is high, reject otherwise.

7.6. Hernan Cortéz. In a message to the king of Spain upon arriving in Mexico,
Spanish navigator and explorer Hernan Cortéz reports that, “under the pretext that [our]
ships were not navigable, I had them sunk; thus all hope of leaving was lost and I could
act more securely.” Discuss the strategic value of this action knowing the Spanish colonists
were faced with potential resistance from the Mexican natives.
Answer: By eliminating the option of turning back, Hernan Cortéz established a credible
commitment regarding his future actions, that is, to fight the Mexican natives should they
attack. Had Cortéz not made this move, natives could have found it better to attack,
knowing that instead of bearing losses the Spaniards would prefer to withdraw.

7.7. HDTV standards. Consider the following game depicting the process of standard
setting in high-definition television (HDTV).4 The US and Japan must simultaneously de-
cide whether to invest a high or a low value into HDTV research. If both countries choose

4
a low e↵ort than payo↵s are (4,3) for US and Japan, respectively; if the US chooses a low
level and Japan a high level, then payo↵ are (2,4); if, by contrast, the US chooses a high
level and Japan a low one, then payo↵s are (3,2). Finally, if both countries choose a high
level, then payo↵ are (1,1).
(a) Are there any dominant strategies in this game? What is the Nash
equilibrium of the game? What are the rationality assumptions im-
plicit in this equilibrium?
Answer: The game in matrix form looks like the following:
E↵ort by Japan
Low High
3 4
Low
4 2
E↵ort by US
2 1
High
3 1

It is a dominant strategy for the US to choose Low. Given that the US chooses Low, Japan’s
best response is to choose High. (Low, High) is thus the only Nash equilibrium of the game.
(b) Suppose now the US has the option of committing to a strategy ahead
of Japan’s decision. How would you model this new situation? What
are the Nash equilibria of this new game?
Answer: The most natural way to model this situation is by writing an extensive form
game as follows:

............................................................................................
......
......
..
..
.......
.....
......
......................................................................................... ...... ...... Japan
... ......
... ......
.
.... ......
......
.. ......
... ......
... ...........................................................................................
...
.....
...
...
[H][L][H][br][0pt][+2pt][L][tr][0pt][-2pt][H][br][0pt][+2pt][L][tr][0pt][-2pt]
...
... ...
... US
...
...
...
...
...
... .............................................................................................
... ......
... ......
...
... ..
..
.......
... .....
... ......
........................................................................................ ...... ...... Japan
......
......
......
......
......
......
...........................................................................................

Japan’s optimal strategy is to choose H if the US choses L and to choose L if the US chooses
H. Anticipating that strategy, the US optimal strategy is to choose H. The equilibrium is
therefore (H,L).
(c) Comparing the answers to (a) and (b), what can you say about the
value of commitment for the US?
Answer: In the simultaneous move game, US and Japan choose (L,H), respectively, which
gives the US a payo↵ of 2. In the sequential move game (with the US moving first), US
and Japan choose (H,L), respectively, which gives the US a payo↵ of 3. It follows that the

5
value of commitment for the US is 3 2 = 1.
(d) “When pre-commitment has a strategic value, the player that makes
that commitment ends up ‘regretting’ its actions, in the sense that,
given the rivals’ choices, it could achieve a higher payo↵ by choosing
a di↵erent action.” In light of your answer to (b), how would you
comment this statement?
Answer: In the sequential choice game (with the US moving first), Japan ends up choosing
L. Given that Japan chooses L, the payo↵ for the US would be higher if it chose L instead
of H. In this sense, there is ex-post regret. However, the sole reason for Japan choosing
L is precisely the fact the US commits to H. Were such commitment not credible, that is,
were the US able to change its choice easily, then Japan should anticipate that change and
accordingly chose H. In this sense, the US should not regret having committed to H in the
first place.

7.8. Finitely repeated game. Consider a one-shot game with two equilibria and suppose
this game is repeated twice. Explain in words why there may be equilibria in the two-period
game which are di↵erent from the equilibria of the one-shot game.
Answer: When the game is repeated twice the strategy space for each player becomes more
complex. Each player’s strategy specifies the action to be taken in period 1 as well as the
action to be taken in period 2 as a function of the outcome in period 1. The possibility of
linking period 2’s actions to past actions allows for equilibrium outcomes that would not be
attainable in the corresponding one-shot game (for example, the use of a ’punishment’ action
in period 2 if one of the players deviates from the designated period 1 payo↵-maximizing
action).

7.9. American Express’s spino↵ of Shearson. In 1993, American Express sold Shearson
to Primerica (now part of Citigroup). At the time, the Wall Street Journal wrote that

Among the sticking points in acquiring Shearson’s brokerage operations would

be the firm’s litigation costs. More than most brokerage firms, Shearson has
been socked with big legal claims by investors who say they were mistreated,
though the firm has made strides in cleaning up its backlog of investor cases. In
1992’s fourth quarter alone, Shearson took reserves of $90 million before taxes
for “additional legal provisions.”5

When the deal was completed, Primerica bought most of Shearson’s assets but left the legal
liabilities with American Express. Why do you think the deal was structured this way?
Was it fair to American Express?

7.10. Sale of business. Suppose that a firm owns a business unit that it wants to
sell. Potential buyers know that the seller values the unit at either $100m, $110m, $120,
. . . $190m, each value equally likely. The seller knows the precise value, but the buyer
only knows the distribution. The buyer expects to gain from synergies with its existing
businesses, so that its value is equal to seller’s value plus $10m. (In other words, there are

6
Table 7.1
Sale of business
Probability Exp. value Expected
Price of sale if accepted profit
100 10 110 1
110 20 115 1
120 30 120 0
130 40 125 -2
140 50 130 -5
150 60 135 -9
160 70 140 -14
170 80 145 -20
180 90 150 -27
190 100 155 -35

gains from trade.) Finally, the buyer must make take-it-or-leave-it o↵er at some price p.
How much should the buyer o↵er?
Answer: We can write down Table 7.1, which summarizes, for each o↵er that the buyer
makes, the probability that the o↵er gets accepted, the expected value (to the buyer)
conditional on having the o↵er accepted, and the overall expected profit from any given
o↵er. From this we see that the seller should thus o↵er either $100m or $110m.
Suppose the buyer o↵ers p = 100 (in $m). Then, in most cases the o↵er is rejected.
Specifically, 90% of the times the o↵er is rejected. O↵ering more would imply a higher
probability of sale, but the expected value of the unit would increase by less than the price
paid. The intuition for this result is the force of adverse selection: the seller will only sell
the unit if its value is relatively low.

Challenging exercises

7.11. First-price auction. Consider the following auction game. There are two bidders
who simultaneously submit bids bi for a given object. Bidder i values the object at vi ;
it knows its own value but not the other bidder’s value. It is common knowledge that
valuations vi are uniformly drawn from the unit interval, that is, vi ⇠ U [0, 1].
(a) Suppose that Bidder 1 expects Bidder 2’s bid to be uniformly dis-
tributed between 0 and 12 . What is Bidder 1’s optimal bid function
(that is, bid as a function of valuation v1 )?
Answer: Suppose Bidder 1 believes that Bidder 2’s bid, b2 , is some number between 0 and
1
2 , with all numbers equally likely (that is, Bidder 2’s bid is uniformly distributed in the [0

7
and 12 ] interval. By bidding b1 , Bidder 1’s expected profit is given by

⇡1 = (v1 b1 ) P(b1 > b2 )

The higher b1 , the lower then net gain from winning the auction, v1 b1 ; but the higher the
probability of winning the auction, P(b1 > b2 ). Specifically, if b1 = 0, then P(b1 > b2 ) = 0;
whereas, if b1 = 12 , then P(b1 > b2 ) = 1. More generally, for b1 2 [0, 12 ],

P(b1 > b2 ) = 2 b1

It follows that
⇡1 = (v1 b 1 ) 2 b1
Taking the derivative with respect to b1 and equating to zero, we get the first-order condition
for profit maximization (see Section 3.2):

2( b1 + v 1 b1 ) = 0

or simply
v1
b1 = (7.1)
2
(b) If Bidder 2 expects Bidder 1 to follow the strategy derived in part (a),
what is Bidder 2’s belief about Bidder 1’s bid levels?
Answer: Since Bidder 2 knows that v1 is uniformly distributed in [0,1], (7.1) implies that
b1 is uniformly distributed in the [0, 12 ] interval.
(c) Determine the bidding game Nash equilibrium (assuming there is only
one).
Answer: From part (a), we know that the bidding function (7.1) is optimal given the belief
that the other bidder’s bid is uniformly distributed in [0, 12 ]. From part (b), we know that, if
bidders bid according to (7.1), then, from the other bidder’s perspective, bids are uniformly
distributed in the [0, 12 ] interval. Together this implies that strategies and beliefs form a
Nash equilibrium.

7.12. Ad games. Two firms must simultaneously choose their advertising budget; their
options are H or L. Payo↵s are as follows: if both choose H, then each gets 5; if both
choose L, then each gets 4; if firm 1 chooses H and firm 2 chooses L, then firm 1 gets 8 and
firm 2 gets 1; conversely, if firm 2 chooses H and firm 1 chooses L, then firm 2 gets 8 and
firm 1 gets 1.
(a) Determine the Nash equilibria of the one-shot game.
Answer: H is a dominant strategy, so the unique Nash equilibrium is (H, H).
(b) Suppose the game is indefinitely repeated and that the relevant dis-
count factor is = .8. Determine the optimal symmetric equilibrium.
Answer: The condition that (L, L) is an equilibrium is that
5 4
8+
1 1

8
 3
which is equivalent to 4. Since = .8, it follows that (L, L) is indeed an equilibrium.
(c) (challenge question) Now suppose that, for the first 10 periods, firm
payo↵s are twice the values represented in the above table. What is
the optimal symmetric equilibrium?
Answer: From the analysis in the previous answer, we conclude that, after t = 10, (L, L)
is an equilibrium. Consider the situation at t = 9. Current payo↵s are doubled. It follows
that the no-deviation constraint is
5 4
10 + 16 +
1 1
6
which implies 7 ⇡ .86. If follows that (L, L) is not an equilibrium. By induction and
a fortiori, we also conclude that (L, L) is not an equilibrium for any earlier t. It follows
the best symmetric equilibrium is for firms to choose H during the first 10 periods and L
thereafter.

7.13. Finitely repeated game. Suppose that the game depicted in Figure 7.1 is repeated
T times, where T is known. Show that the only subgame perfect equilibrium is for players
to choose B in every period.
Answer: Suppose we are in period T , the last period of the finitely-repeated game. Subgame
perfection implies that we look for a Nash equilibrium of this subgame. As we saw earlier,
there exists a unique Nash equilibrium of this one-shot game: (B, R).
Now consider the subgame starting in period T 1. This is e↵ectively a two-period
game. Players correctly anticipate that, regardless of what happens in period T 1, (B, R)
will be played in period T . For this reason, they should treat choices in period T 1 as
if they were playing a one-shot game: nothing in the past or in the future depends on the
outcome of what takes place in period T 1. Since there exists a unique equilibrium in the
one-shot game, players choose (B, R) in period T 1.
By induction, we conclude that, in a subgame perfect Nash equilibrium, players must
choose (B, R) in every period.

7.14. Centipede. Consider the game in Figure 7.13.6 Show, by backward induction, that
rational players choose d at every node of the game, yielding a payo↵ of 2 for Player 1 and
zero for Player 2. Is this equilibrium reasonable? What are the rationality assumptions
implicit in it?
Answer: Starting from the right-most node, we observe that Player 2’s strategy, if that
node is reached, is to play d, in which case its gets 101, whereas Player 1 gets 99. This
implies that, in the second to last node, Player 1 is better o↵ choosing d. In fact, by choosing
r, Player 1 expects to get 99 (see sentence above) instead of 100 from d. And so forth. We
conclude that the unique sub-game perfect Nash equilibrium is for each player to play d
whenever it is called upon to make a move. The outcome of this equilibrium is Player 1
getting 2 and Player 2 getting 0.
Obviously, one might question whether this result is reasonable or not. Here, the implicit
assumption is that each player is rational, believes that the other player is rational, believes
that the other player believes that the first player is rational, and so forth.

9
 To see how important this assumption is, suppose that Player 1 chooses r in the first
period. Since this is not according to the equilibrium, Player 2 may not conjecture that
Player 1 is not rational. But then choosing d may no longer be in Player 2’s best interest.
But then choosing r may be, after all, a rational strategy by Player 1 in the first place.

7.15. Advertising levels. Consider an industry where price competition is not very
important: all of the action is on advertising budgets. Specifically, total value S (in dollars)
gets splits between two competitors according to their advertising shares. If a1 is firm 1’s
advertising investment (in dollars), then its profit is given by
a1
S a1
a1 + a2
(The same applies for firm 2). Both a1 and a2 must be non-negative. If both firms invest
zero in advertising, then they split the market.
(a) Determine the symmetric Nash equilibrium of the game whereby firms
choose ai independently and simultaneously.
Answer: Firm i’s profit is given by
ai
⇡i = S ai
ai + aj
where i 6= j. The first order condition for profit maximization with respect to ai is given by
(ai + aj ) ai
S 1=0
(ai + aj )2

In a symmetric equilibrium, we have a1 = a2 = b

a. Thus
a+b
(b a) b a
2
S 1=0
a+b
(b a)
or simply
1
b
a= S
4
Each player’s payo↵ is then given by
1 1 1
b=
⇡ S S= S
2 4 4
For aficionados: Note that in deriving the above solution I “cut some corners” by assuming
the solution is symmetric. I next follow a more complete line of reasoning. From the
first-order condition, we can derive firm i’s best response mapping. From the first-order
condition we get
aj S = (ai + aj )2
or simply p
ai = aj S aj
Solving the system, and imposing that ai 0, we get ai = aj , as assumed in the earlier
derivation.

10
Figure 7.13
The centipede game. In the payo↵ vectors, the top number is Player 1’s payo↵, the bottom
one Player 2’s.
" #
................ r ................. r ................. r ................. r ................. r ................ r ................. r ................. r 100
... ...
..... 1
..... ......
...............................
. ... 2
..... ......
...............................
. ... 1
..... ......
...............................
. ... 2
..... ......
...............................
. ... 1
..... ......
...................
. ... .....................
... 2
................
...............................
.. ... 1
..... ......
...............................
. ... 2
..... ......
............................
.
.........
...
.........
...
.........
...
.........
...
.........
... .
....
....
.
....
..
.. .........
... 100
.... .... ... ... ... ... ... ...
... ... ... ....
d ...
... d ...
... d .... d ...
...
d ...
...
d ...
... d ...
... d ...
... ... ... . ... ... ...
.
" # " # " # " # " # " # " #" #
2 1 4 3 6 97 100 99
0 3 2 5 4 99 98 101

(b) Determine the jointly optimal level of advertising, that is, the level a⇤
that maximizes joint profits.
Answer:
⇡1 + ⇡2 = S a1 a2
It follows that a1 = a2 = a⇤ = 0 maximizes joint profits.
(c) Given that firm 2 sets a2 = a⇤ , determine firm 1’s optimal advertising
level.
Answer: Given a2 = 0, any positive a1 gives firm 1 100% of the market. Since advertising
is costly, firm 1’s best response is to set an arbitrarily small but strictly positive value of a1
(similarly to price undercutting under Bertrand competition).
(d) Suppose that firms compete indefinitely in each period t = 1, 2, ..., and
that the discount factor is given by 2 [0, 1]. Determine the lowest
value of such that, by playing grim strategies, firms can sustain an
agreement to set a⇤ in each period.
Answer: By choosing a⇤ each period, each firm gets S/2. The optimal deviation yields ap-
proximately S. Finally, the static Nash equilibrium yields S/4 for each firm. The condition
for a grim strategy equilibrium whereby firms set a = 0 in each period is then given by
1 1 1
S S+ S
1 2 1 4
or simply
2
3

Applied exercises

7.16. Laboratory experiment. Run a laboratory experiment to test a specific prediction

from game theory. First, convene a group of willing subjects (you may need to clear the
experiment with the human subject review board at your institution). Second, write detailed
instructions to explain subjects what they are supposed to do. To the extent that it is

11
possible, attach a financial reward to the subjects’ performance in the experiment. Third,
run the experiment and carefully keep track of all of the subjects’ decisions. Finally, compare
the observed results with the theoretical predictions, and discuss any di↵erences there might
exist between the two. (If a dedicated laboratory does not exist in your institution, use the
classroom and your colleagues as a subject pool.)

12