Assignment 2 (Practice)

XLRI-GMP

January 14, 2020

1. Consider the following Bayesian game between Player 1 and Player 2. Player 1’s type
is known and Player 2 may be either an H type with probability p or an L type. The
payoffs to this simultaneous Bayesian game are given as follows:

L2 R2
L1 1,3 1,2
R1 3, 1 2, 5

Table 1: Player 2 H type

L2 R2
L1 3,2 1,3
R1 2, 1 0, 4

Table 2: Player 2 L type

Suppose p = 0.75. Find all pure strategy Bayes-Nash equilibria under this assumption.
Solution:
If Player 1 plays L1 . Then Player 2 will play L2 if he is high type and will play R2 if
he is low type. Thus, the expected payoff playing L1 is
3 1
L1 : 1 × + 1 × = 1.
4 4
If Player 1 plays R1 . Then Player 2 will play R2 if he is high type and will also play
R2 if he is low type. Thus, the expected payoff playing R1 is
3 1 6 3
R1 : 2 × + 0 × = = .
4 4 4 2
Thus, playing R1 , Player 1 can ensure more payoff than playing L1 . Thus, the pure
strategy Bayesian equilibrium is : Player 1 will play R1 and Player 2 will R2 when he
is high type and will also play R2 if he is low type.

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2. A buyer makes a price offer p ≥ 0 to a seller, who either accepts (a) or rejects (r) the
offer and the game ends. If the seller rejects, then they both receive a payoff of zero.
If he accepts, then the seller’s payoff is p − v and the buyer’s payoff is kv − p. Assume
that k > 1 is commonly known but v is uniformly distributed over [0, 1] and known
only to the seller. All of this is common knowledge. Find the (pure strategy) Bayesian
equilibria of this game as a function of k.
Solution:
The seller will accept any price p ≥ v. Thus, the seller’s strategy is s(v) ⊂ [[v, 1]].
If the buyer quotes any price p < v, then the payoff is zero. The expected payoff of the
buyer if he quotes a price p ≥ v is :
Z p  
2 k
(kv − p)dv = p −1 .
0 2

Looking at objective function, we can see the solution: p∗ = 1 if k > 2 and p∗ = 0 if

Table 5: A Moral Hazard Game

Low (e = 0) 0.3 0.7 1

High (e = 1) 0.1 0.9 1

(a) What would the agent’s effort choice and utility be if he owned the firm?
Solution: The agent gets everything in this case. His utility is either
√
U (High) = 0.1(0) + 0.9 100 − 1 = 8 (1)

or √
U (Low) = 0.3(0) + 0.7 100 − 0 = 7. (2)
So the agent chooses high effort and a utility of 8.

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(b) If agents are scarce and principals compete for them, what will the agent’s contract
be under full information? His utility?
Solution: The efficient effort level is High, which produces an expected output
of 90. The principal’s profit is zero, because of competition. Since the agent is
risk averse, he should be fully insured in equilibrium: w = w = 90 But he should
get this only if his effort is high. Thus, the contract is w=90 if effort is high, w=0
√
if effort is low. The agent’s utility is 8.5 (= 90 − 1, rounded).
(c) If principals are scarce and agents compete to work for them, what would the con-
tract be under full information? What will the agent’s utility and the principal’s
profit be in this situation?
Solution: The efficient effort level is high. Since the agent is risk averse, he
should be fully insured in equilibrium: w = w = w. The contract must satisfy a
√
participation constraint for the agent, so w − 1 = 3. This yields w = 16, and
a utility of 3 for the agent. The actual contract specified a wage of 16 for high
effort and 0 for low effort. This is incentive compatible, because the agent would
get only 0 in utility if he took low effort. The principal’s profit is 74 (= 90-16).
(d) Suppose that U = w − e. If principals are the scarce factor and agents compete to
work for principals, what would the contract be when the principal cannot observe
effort? (Negative wages are allowed.) What will be the agent’s utility and the
principal’s profit be in this situation?
Solution: The contract must satisfy a participation constraint for the agent, so
U = 3. Since effort is 1, the expected wage must equal 4. One way to produce
this result is to allow the agent to keep all the output, plus 4 extra for his labor,
but to make him pay the expected output of 90 for this privilege (“selling the
store”). Let w = 14 and w = −86 (other contracts also work). Then expected
utility is 3 (= 0.1(−86) + 0.9(14) − 1 = −8.6 + 12.6 − 1). Expected profit is 86
(= 0.1(0 − −86) + 0.9(100 − 14) = 8.6 + 77.4).