Assignment 1 (Solution)

XLRI-GMP

January 2, 2020

1. A banana cake costs 50 rupees and a piece of chocolate costs 25 rupees at the local
cafeteria. You have 125 rupees in your pocket and you value money. The money-
equivalent value (payoff ) you get from eating your first banana cake is 120 rupees, and
that of each additional banana cake is half the previous one (the second banana cake
gives you a value of 60 rupees, the third 30 rupees, and so on). Similarly the payoff you
get from eating your first piece of chocolate is 40 rupees, and that of each additional
piece is half the previous one (20 rupees, 10 rupees, and so on). Your value from eating
banana cakes is not affected by how many pieces of chocolate you eat and vice versa.

(a) What is the set of possible actions you can take given your budget of 125 rupees?
(b) Draw the decision tree that is associated with this decision problem.
(c) Should you spend all your money at the cafeteria? Justify your answer with a
rational choice argument.
(d) Now imagine that the price of a piece of chocolate increases to 30 rupees. How
many possible actions do you have? Does your answer to (c) change?

2. You are in city X and there is horse-race betting going on. You would like to decide
what to do at the horse-racing betting window. You may choose not to participate or
you may bet on one of two horses as follows. Betting on Horse 1 costs 100 rupees, and
you will be paid 200 rupee if he wins. Betting on Horse 2 costs 100 rupees, and you will
be paid 1100 rupees if she wins. You believe that Horse 1 has probability 0.7 of winning
and that Horse 2 has probability 0.1 of winning (there are other horses on which you
are not considering betting). Your goal is to maximize the expected monetary return
of your action.

(a) Draw the decision tree for this problem.

(b) What is your best course of action, and what is your expected value?

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 (c) Someone offers you gambler’s “anti-insurance,” which you may accept or decline.
If you accept it, you get paid 200 rupees up front and you agree to pay back 50%
of any winnings you receive. Draw the new decision tree and find the optimal
action.

3. Consider a two-player game in which player 1 can choose A or B. The game ends if he
chooses A while it continues to player 2 if he chooses B. Player 2 can then choose C or
D, with the game ending after C and continuing again with player 1 after D. Player
1 can then choose E or F , and the game ends after each of these choices.

(a) Depict this game on a game tree.

Answer:
Player 1

A B

Player 2
C D

Player 1

E F

(b) How many pure strategies does each player have?

Answer:
Player 1 has four pure strategies and Player 2 has two.
(c) Imagine that the payoffs following choice A by player 1 are (2, 0), those following C
by player 2 are (3, 1), those following E by player 1 are (0, 0), and those following
F by player 1 are (1, 2). What are the backward induction equilibria of this game?
Does one strike you as more “appealing” than the other? If so, explain why.
Answer:

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 Player 1

A B

Player 2
2,0 C D

Player 1
3, 1
E F

0,0 1,2

The normal of this game is

C D
AE 2,0 2,0
AF 2,0 2,0
BE 3,1 0,0
BF 3,1 1,2

It is easy to see that there are three pure strategy Nash equilibria, namely
(AE, D), (AF, D), (BE, C). The backward induction equilibrium is (AF, D).

4. Consider the following model of price competition. Two firms set prices in a market
whose demand curve is given by the equation Q = 6 − p where p = min(p1 , p2 ).
If firm 1 is lower priced firm, then it is firm 1 that meets all of the demand; the same
applies to firm 2 if it is the lower priced firm. If the two firms post the same price p,
then they each get half the market, that is, they each get 6−p 2
. Suppose that prices can
only be quoted in rupee units, such as 0, 1, 2, 3, 4, 5, or 6 rupees. Suppose, furthermore,
that costs of production are zero for both firms.

(a) Write down the strategic form of this game assuming that each firm cares only
about its own profits.
Answer:
There are two players N = {1, 2}.
Their set of strategies are to charge any price from the set {0, 1, 2, 3, 4, 5, 6}.
Their payoff functions are given as:

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 
p1 (6 − p1 ) if p1 < p2


p1 (6−p1 )
u1 (p1 , p2 ) = if p1 = p2
 2

0 if p1 > p2

p2 (6 − p2 ) if p2 < p2


p2 (6−p2 )
u2 (p1 , p2 ) = if p1 = p2
 2

0 if p2 > p1
We can represent the game by the following game matrix:

0 1 2 3 4 5 6
0 0,0 0,0 0,0 0,0 0,0 0,0 0,0
1 0,0 2.5,2.5 5,0 5, 0 5,0 5,0 5,0
2 0,0 0,5 4,4 8,0 8,0 8,0 8,0
3 0,0 0,5 0,8 4.5,4.5 9,0 9,0 9,0
4 0,0 0,5 0,8 0,9 4,4 8,0 8,0
5 0,0 0,5 0,8 0,9 0,8 2.5,2.5 5,0
6 0,0 0,5 0,8 0,9 0,8 0,5 0,0

(b) Show that the strategy of posting a price of rupees 5 (weakly) dominates the
strategy of posting a price of rupees 6. Does it strictly dominate as well?
Answer:
This is clear from the game matrix that a price of rupees 5 weakly dominates a
price of 6.
It does not strictly dominates.
(c) Are there any other (weakly) dominated strategies for firm 1? Explain.
Answer:
Price of 0 is weakly dominated by any other price.
(d) Is there a dominant strategy for firm 1? Explain.
Answer:
There is no dominant strategy. It is clear from the game matrix.

5. Consider the following game. Two players drive their cars down the center of the
road directly at each other. Each player chooses Swerve or Stay. Staying wins you
admiration of your peers only if the other player swerves. Swerving loses face if the
other player stays. However, clearly the worst outcome is for both players to stay.

(a) Write the strategic form of this game.

(b) Show that no player has dominant strategies in this game.

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 (c) Suppose that Player 1 has adopted the strategy of Staying with probability of 15
and Swerving with probability 54 . Show that Player 2 is indifferent in Swerving
and Staying.
(d) If both Player 1 and Player 2 use this probability mix, what is the chance that
they crash?

6. Consider the situation represented by the following matrix:

L M R
U 1,0 2,5 -2,-1
D 2,1 2,1 -1,0

(a) Write down the strategic form of this game.

(b) Is there a strictly dominant strategy equilibrium of this game? Explain.
(c) Is there a weakly dominant strategy equilibrium of this game? Explain.

7. Two people are engaged in a joint project. If each person i puts in the effort ei , a
non-negative number equal to at most 1, which costs her c(ei ), the outcome of the
project is worth f (e1 , e2 ). The worth of the project is split equally between the two
people, regardless of their effort levels.

(a) Formulate this situation as a strategic form.

Answer:
This problem is like a tragedy of commons. People tends to exert less effort when
the outcome depends on others’ effort too when the effort is costly individually.
Strategic Form: N = {1, 2}, strategy space is S1 = S2 = [0, 1] and the payoff
functions are given as
1
u1 (e1 , e2 ) = f (e1 , e2 ) − c(e1 )
2
1
u2 (e1 , e2 ) = f (e1 , e2 ) − c(e2 )
2

(b) Find the Nash equilibrium of this problem when

i. f (e1 , e2 ) = 3e1 e2 , c(ei ) = e2i , for i = 1, 2.
Answer:
The utility functions are:
1
u1 (e1 , e2 ) = 3e1 e2 − e21
2
1
u2 (e1 , e2 ) = 3e1 e2 − e22
2

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 Let us find the best response function of the players. The best response
function of Player 1 will also depend on the effort of Player 2.
3
max u1 (e1 , e2 ) = e1 e2 − e21
e1 2
From the first order condition, we have
3
e1 (e2 ) = e2
4
Since the problem is symmetric, we have e2 (e1 ) = 43 e1 . Solving these equation,
we get e∗1 = e∗2 = 0.
Since the function is concave, this is the Nash equilibrium. Check yourself
that the payoff function is concave.
ii. f (e1 , e2 ) = 4e1 e2 , c(ei ) = ei , for i = 1, 2.
Answer:
We have the payoff function for this as below:
1
u1 (e1 , e2 ) = 4e1 e2 − e1
2
1
u2 (e1 , e2 ) = 4e1 e2 − e2
2
Let us derive the best response function of players.

max u1 (e1 , e2 ) = 2e1 e2 − e1 = e1 (2e2 − 1) subject to e1 ∈ [0, 1].

e1

We cannot use calculus because the payoff function is linear unlike in the
earlier case. But we have compact domain for the payoff function, we can
still maximize it.
Note that if e2 > 21 , then the slope of the function is positive. We can take
the maximum value for e1 to maximize the function in this case.
Similarly, if e2 < 21 , the the slope of payoff function is negative, then we can
choose the lowest value for e1 to maximize the function in this case.
For e2 = 21 , the payoff for Player 1 is u1 (e1 , e2 ) = 0 · e1 = 0. Thus, whatever
Player 1 does, his payoff is zero. Thus, we can summarize the best response
function of Player 1 as

1

 if 21 < e2 ≤ 1
B1 (e2 ) = [0, 1] if e2 = 12

 1
0 if 0 ≤ e2 < 2

Since we have symmetric case, the best response function for Player 2 is

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 
1
1

 if 2
< e1 ≤ 1
B2 (e1 ) = [0, 1] if e1 = 12

 1
0 if 0 ≤ e1 < 2

We can plot the best response function as

e2

1
2

e1
1
2

1 1


We see that there are three Nash equilibria (0, 0), (1, 1) and ,
2 2
.
(c) In each case, is there a pair of effort levels that yields both player higher payoffs
than the Nash equilibrium payoffs?
Answer:
1
In this first case, we know that if e1 = e2 = 1, then we have u1 = u2 = 2
while
the Nash equilibrium payoff was 0.
In the second case, one Nash equilibrium gives the highest payoff, that is, e∗1 =
e∗2 = 1 and the payoff is 1 for both the players.