ECND: Advanced Microeconomics Hee Yeul Woo

Spring 2020 [email protected]

Practice problems 3

1. Amy and Bill simultaneously write a bid on a piece of paper. The bid can only be either 2 or 3.

A referee then looks at the bids, announces the amount of the lowest bid (without revealing who

submitted it) and invites Amy to either pass or double her initial bid. The outcome is determined by

comparing Amy’s final bid to Bill’s bid: if one is greater than the other then the higher bidder gets

the object and pays his/her own bid; if they are equal then Bill gets the object and pays his bid.

(a) Represent this situation by means of two alternative extensive frames.

ˆ When there are simultaneous moves we have a choice as to which player we select as moving

first: the important thing is that the second player does not know what the first player did.

Select Amy as the first mover.

ˆ When representing, by means of information sets, what a player is uncertain about, we

typically assume that a player is smart enough to deduce relevant information, even if that

information is not explicitly given to him/her.

Amy

2 3

Bill

2 3 2 3
Amy Amy
Amy

pass 4 pass 4 pass 6 pass 6

Bill, 2 Amy, 4 Bill, 3 Amy, 4 Amy, 3 Amy, 6 Bill, 3 Amy, 6

ˆ Each outcome (x, y) should be read “x wins and pays y”.

(b) Write the associated strategic form game frame.

(c) Assume that Amy and Bill are selfish and greedy, are interested in their own net gain, Amy values

the object at 5 and Bill at 4.

ˆ There are two proper subgames: the ones after Amy chose 3 and whatever are chosen by Bill.

ˆ After reducing the game by replacing associated payoffs with the two proper subgames,
2 3
2, P 0, 2 0, 1
2, 4 1, 0 1, 0
3, P 2, 0 0, 1
3, 4 2, 0 0, 1

1
ECND: Advanced Microeconomics Hee Yeul Woo
Spring 2020 [email protected]

ˆ This game has one Nash equilibrium: ((2, 4), 3)).

ˆ Thus the initial extensive-form game has one subgame-perfect equilibrium: Amy’s strategy is

(2, 4, P ass, P ass) (at the root, 2 is chosen and 4, pass, and pass are chosen at her information

sets from left to right) and Bill’s strategy is 3.

2. Consider the following situation. An incumbent monopolist decides at date 1 whether to build a small

plant or a large plant. At date 2 a potential entrant observes the plant built by the incumbent and

decides whether or not to enter.

ˆ If she does not enter then her profit is 0 while the incumbent’s profit is 25 with a small plant and

20 with a large plant.

ˆ If the potential entrant decides to enter, she pays a cost of entry equal to K.

ˆ At date 3 the two firms simultaneously decide whether to produce high output or low output.

ˆ The profits of the firms are as shown in the following table, where Entrant is a row player,

Incumbent is a column player, ‘L’ means ‘low output’, and ‘H’ means ‘high output’ (these figure

do not include the cost of entry for the entrant).

ˆ In each cell, the first number is the profit of the entrant and the second is the profit of the

incumbent.

ˆ Since the players are selfish and greedy, take a players’ utility of an outcome to be the profit of

that player at that outcome

L H L H
L 10, 10 7, 7 L 10, 7 5, 9

H 7, 6 4, 3 H 7, 3 4, 5

Incumbent has a small plant Incumbent has a large plant

(a) Draw an extensive-form game assuming that each player cares about its own profits and prefers

more money to less. Since the players are selfish and greedy, take a players’ utility of an outcome

to be the profit. of that player at that outcome

2
ECND: Advanced Microeconomics Hee Yeul Woo
Spring 2020 [email protected]

Incumbent

small large
out out
0, 25 Entrant Entrant 0, 20

in in

Incumbent Incumbent

low high low high

Entrant Entrant

low high low high low high low high

10-k, 10 7-k, 6 7-k, 7 4-k, 3 10-k, 7 7-k, 3 5-k, 9 4-k, 5

(b) How many strategies does the potential entrant have?

ˆ 16 strategies

(c) How many strategies does the incumbent entrant have?

ˆ 8 strategies.

3. Find the subgame perfect equilibrium of Care game 1 (Example 2 in the lecture note titled General

Dynamic Games). See the reproduced game tree below with payoffs attached.

ˆ Since one subgame exists, which is the entire game, all Nash equilibria of the associated strategic

form game are SPE.

ˆ Ann has 2 strategies, Bob four, and Carla four.

ˆ No pure strategy Nash equilibrium exists.

ˆ Discussed later: if mixed strategies are allowed, there exists at least one Nash equilibrium.

-1, -1, 2 -1, -1, 2

Carla Ann Carla

1, 1, -2 Red 1, 1, -2
B B
Red Black
Bob
-1, -1, 2 R R -1, -1, 2

4. Find the Nash equilibria and the subgame-perfect equilibria of the game shown below.

3
ECND: Advanced Microeconomics Hee Yeul Woo
Spring 2020 [email protected]

A B
3 2

E F C D
2
G H G H 1, 4, 3 4, 3, 2

2, 2, 4 2, 0, 1 4, 5, 3 0, 6, 0

ˆ Two Nash equilibria: (A, (G, C), E) and (B, (H, C), F )

ˆ One SPE: (A, (G, C), E)