Midterm 1 ECON 201 Section D 15 November 2006 SOLUTIONS

1. (15 Points) Romeo and Juliet have run away together and they live in a tiny apartment in Rome. They have very little money, just enough to buy food. Romeo has an old watch, but its belt is broken so he cannot use it. If he were to have a watch belt he would use it and be happy(a payo of 2). Juliet, on the other hand, have long hair but unfortunately does not have a comb. If she were to have a comb, she would comb her hair every day which makes her really happy (a payo of 2). Soon, it is February 14ththe Valentines day, so they would like to buy gifts for each other and surprise the other person. Since they love each other so much, each enjoys making the other happy. Juliet can get enough money to buy Romeo a watch belt, if she sold her hair. Even after giving up her hair, giving a gift to Romeo makes her happy(a payo of 1). If Romeo sold his watch, he can get enough money to buy a comb for Juliet. Even after loosing his watch, giving a gift makes Romeo happy (a payo of 1). If neither one of them buys a gift to each other, they are neither unhappy nor happy( a payo of zero for both). On the other hand, if they both buy gifts for each other, neither of them have any use for the gift: Juliet has no hair to comb, and Rome has no watch for the watch belt(a payo of zero for both). Interpret this situation as a strategic game. (a) (5 points) Write the set of players and their strategy sets. (b) (10 points) Write the game table, and nd the pure strategy Nash equilibria. Answer. Part a. Players:{Romeo, Juliet} Strategy set of Romeo: {BuyGif t, DoN otBuyGif t} Strategy set of Juliet: {BuyGif t, DoN otBuyGif t} Part b. The game table is below: Juliet DoN otBuyGif t 1, 2 0, 0

Romeo

BuyGif t DoN otBuyGif t

BuyGif t 0, 0 2, 1

Figure 1: Game table for question 1. There are two pure strategy equilibria: (BuyGif t, DoN otBuyGif t), (DoN otBuyGif t, BuyGif t)

2. (8 points) Ali is facing a choice between three options. Option 1: Ali has to pay 1YTL to play. Then a die is rolled. If it shows an odd number (1 or 3 or 5) he gets 18YTL. If it shows an even number (2 or 4 or 6) he has to pay 14YTL. Option 2: Ali has to pay 1YTL to play. Then a die is rolled. If it shows 1 or 6, he gets 18YTL. If it shows 2 or 5, he gets 12YTL. If it shows 3 or 4, he has to pay 21YTL. Option 3: He does not take option 1 or option 2. He neither gets anything nor pays anything. Assuming that Ali wants to maximize his expected payo, which option should Ali select? [Note: When a die is rolled, each face shows with equal probability.] Answer. A die shows an odd number with probability 1/2 and an even number with probability 1/2. A die shows 1 or 6 with probability 1/3, 2 or 5 with probability 1/3, 3 or 4 with probability 1/3. Expected payo of rst option: 1 1 1 + 18 14 = 1 + 9 7 = 1 2 2 Expected payo of second option: 1 1 1 1 + 18 + 12 21 = 1 + 6 + 4 7 = 2 3 3 3 Expected payo of third option is zero. Therefore, Ali would maximize his expected payo by choosing option 2.

3. (8 points) In the game presented in gure 2, (a) (2 points) Write the strategy sets of each player. (b) (2 points) Describe a mix strategy for the Row player. (c) (4 points) Describe a mix strategy for the Column player. Column L M R 2, 2 2, 0 0, 3 3, 0 0, 9 1, 1

Row

T B

Figure 2: Game table for question 3. Answer. Part a. Strategy set of Row:{T, B} Strategy set of Column:{L, M, R} Part b. A mix strategy of the row player assigns probabilities to each of his pure strategies. A mixed strategy is (pT , pB ) such that 0 pT 1, 0 pB 1, and pT + pB = 1. Hence, (pT , 1 pT ) would do. Part c. A mix strategy of the column player assigns probabilities to each of his pure strategies. A mixed strategy is (pL , pM , pR ) such that 0 pL 1, 0 pM 1, 0 pR 1, and pL + pM + pR = 1. Hence, (pL , pM , 1 pL pM ) would do.

4. (21 points) Alice and Bob are facing a strategic situation as shown in the game table presented in gure 3. (a) (7 points) For what values of (x, y, z) Alice playing Up and Bob playing Left is a dominant strategy equilibrium? (You are asked to write just three numbers so that (U p, Lef t) is a dominant strategy equilibrium.) (b) (7 points) For what values of (x, y, z) Alice playing Up and Bob playing Left as well as Alice playing Down and Bob playing Right are pure strategy Nash equilibria? (c) (7 points) For what values of (x, y, z) this game has no pure strategy Nash equilibrium? Bob Right 2, x y, z

Alice

Up Down

Lef t 4, 3 1, 2

Figure 3: Game table for question 4. Answer. Part a. x < 3, z < 2 and y < 2 implies (U p, Lef t) is a dominant strategy equilibrium. So any three number satisfying these conditions would do: e.g. (x = 1, z = 1, y = 1). Part b. any x, z > 2 and y > 2 implies (U p, Lef t) and (Down, Right) are pure strategy equilibria. Any numbers satisfying these conditions would do, e.g. (x = 1, z = 3, y = 3). Part c. any x > 3, y > 2 and z < 2 implies that there is no pure strategy Nash equilibrium. Any numbers satisfying these conditions would do, e.g. (x = 4, z = 1, y = 3).

5. (24 points) Alice and Bob are facing a strategic situation as shown in the game table presented in gure 4. Bob Lef t Right 4, 3 2, 1 3, 1 4, 2

Alice

Up Down

Figure 4: Game table for question 5. (a) (6 points) Find all pure strategy Nash Equilibria. (b) (18 points) Find best responses of Alice and Bob, plot them, and nd the mixed strategy Nash Equilibrium. Answer. Part a. There are two pure strategy Nash equilibria: (U p, Lef t) and (Down, Right). Part b. Let us rst assume that the Bob uses Bob = (q, 1 q). Expected payo of the Alice when she plays U p against this mixed strategy is
Alice EPU p,(q,1q) = (4)q + (2)(1 q) = 2 + 2q

and her expected payo playing Down is given by

Alice EPDown,(q,1q) = (3)q + (4)(1 q) = 4 q

Figure 5: Best responses of Alice and Bob in question 5

Alice Alive When EPU p,(q,1q) > EPDown,(q,1q) , best response of Alice is to play U p, i.e. whenever 2 + 2q > 4 q or 3q > 2 or q > 2/3, Alice should play U p or select a degenerate mixed strategy Alice Alive (p = 1, 1 p = 0). When EPU p,(q,1q) < EPDown,(q,1q) , which happens when q < 2/3, the Alive Alice should play Down or select a degenerate mixed strategy (p = 0, 1 p = 1). When EPU p,(q,1q) = Alice EPDown,(q,1q) , or q = 2/3, any mixed strategy (p, 1 p) delivers Alice the same expected payo. We can write the best response correspondence of the Alice as follows: 0, q < 2/3 p = BAlice (q) = p [0, 1], q = 2/3 1, q > 2/3

Now let us compute the best response of Bob when Alice uses Alice = (p, 1 p). Expected payo of the Bob when he plays Lef t against this mixed strategy is
Bob EP(p,1p),Lef t = (3)p + (1)(1 p) = 1 + 2p

and his expected payo playing Right is given by

Bob EP(p,1p),Right = (1)p + (2)(1 p) = 2 p Bob Bob When EP(p,1p),Lef t > EP(p,1p),Right , best response of Bob is to play Lef t, i.e. whenever 1 + 2p > 2 p or 3p > 1 or p > 1/3, Bob should play Lef t or select a degenerate mixed strategy Bob Bob (q = 1, 1 q = 0). When EP(p,1p),Lef t > EP(p,1p),Right , which happens when p < 1/3, Bob Bob should play Right or select a degenerate mixed strategy (q = 0, 1q = 1). When EP(p,1p),Lef t = Bob EP(p,1p),Right , or p = 1/3, any mixed strategy (q, 1 q) delivers Bob the same expected payo. We can write the best response correspondence of the Bob as follows: 0, p < 1/3 q = BColumn (p) = q [0, 1], p = 1/3 1, p > 1/3

The best responses are plotted in gure 5. As can be seen the only mixed strategy equilibrium is (p = 1/3, 1 p = 2/3), (q = 2/3, 1 q = 1/3)).

6. (24 Points) Puma and Gola are two sport shoe brands. They have paid market research rms to gure out how much they can sell at each price, i.e. they obtained the relationship between their sales and market prices. According to these analysis, the demand function for Puma is given by QP uma = 300 8pP uma + 6pGola , while the demand function for Gola is given by QGola = 300 10pGola + 6pP uma . [Here, pP uma is the price of a pair of Puma shoes, pGola is the price of a pair of Gola shoes, QP uma is the quantity sold by Puma and QGola is the quantity sold by Gola.] A pair of Puma shoes costs 25YTL to produce, while it costs 40YTL to produce one pair of Golas. Both rms select their prices in order to maximize their prots simultaneously. (a) (6 points) Write down the payo functions for both rms. (b) (18 points) Find the best response function of each rm, and prices charged by both rms in a Nash equilibrium. Answer. Part a. The prot function of Puma is P uma (pP uma , pGola ) = (pP uma 25)(300 8pP uma + 6pGola ) and it is quadratic concave in pP uma . This implies solving the rst order condition yields maximizer. The prot function of Puma is Gola (pP uma , pGola ) = (pGola 40)(300 10pGola + 6pP uma ) and it is quadratic concave in pGola . This implies solving the rst order condition yields maximizer. Part b. To nd the best response of Puma, we need to solve the rst order condition: pP P uma (pP uma , pGola ) = uma 0, or P uma (pP uma , pGola ) = (300 8pP uma + 6pGola ) 8(pP uma 25) = 0 pP uma which yields the best response function for Puma as pP uma = BP uma (pGola ) = 125 3 + pGola . 4 8

To nd the best response of Gola, we need to solve the rst order condition: pGola Gola (pP uma , pGola ) = 0, or Gola (pP uma , pGola ) = (300 10pGola + 6pP uma ) 10(pGola 40) = 0 pGola which yields the best response function for Puma as

pP uma = BP uma (pGola ) = 35 +

3 pP uma . 10

In Nash equilibrium both prices are best responses to each other hence solve the following two equation simulateneously: p uma = P p Gola 125 3 + pGola 4 8 3 = 35 + pP uma 10

which yields (pP uma = 50, pGola = 50) as the Nash equilibrium prices.