14.

12 Game Theory - Midterm I

10/13/2011

Prof. Muhamet Yildiz

Instructions. This is a closed book exam. You have 90 minutes. You need to show your
work when it is needed. All questions have equal weights. You may be able to receive partial
credit for stating the relevant facts, such as the defnition of the solution concept, towards
the correct solution. Also, if you leave the answer for a part blank or just write "I don't
know the answer", you will receive 10% of the full grade for that part. Good luck!

1. Consider the following game.

w x y z
a 3,3 2,1 0,2 2,1
b 1,1 1,2 1,0 1,4
c 0,0 1,0 3,2 1,1
d 0,0 0,5 0,2 3,1

(a) Compute the set of all rationalizable strategies.

Solution: b is strictly dominated by a mixed strategy that plays with a with
probability � and c with � . Hence, b is eliminated. Then, z is strictly dominated
by y and eliminated. Next, d is strictly dominated by a mixed strategy that
plays with a with probability � and c with � and eliminated. Lastly, x is strictly
dominated by y and eliminated. For remaining strategies, we cannot eliminate
any more as a is a BR (best response) to w, c is BR to y, w is BR to a, and y is
BR to c. The set of all rationalizable strategies is {a, c} X {w, y}.
(b) Compute the set of all Nash equilibria.
Solution: Pure strategy Nash Equilibria are (a, w) and (c, y). To fnd a mixed
strategy NE, note that any such equilibrium puts positive probability only on
rationalizable strategies. Hence, player 1 can mix between a and c, and player 2
can mix between w and y. Suppose player 2 plays w with probability p and y
with probability 1 - p. To make player 1 indiferent, 3p = 3 (1 - p), so p = � .
Similarly, if player 1 plays a with probability q and c with probability 1 - q, to
make player 2 indiferent, 3q = 2q + 2 (1 - q) should hold. This gives q = .

2. Consider the following extensive form game.

 (a) Apply backward induction to fnd an equilibrium.

Solution: We start from the bottom cases. For the bottom left node, player 1
will choose X and for the bottom right node, players 2 will choose y. Then, for
the middle left node, player 2 will choose a and for the middle right node, player
1 will choose /. Lastly, at the top node, player 1 will choose A. Thus, NE is
(AX/, ay) .
(b) Write this game in normal form.
Solution:
ax ay bx by
AXa 3,0 3,0 1,-1 1,-1
AX/ 3,0 3,0 1,-1 1,-1
AY a 0,3 0,3 1,-1 1,-1
AY / 0,3 0,3 1,-1 1,-1
BXa 3,0 0,3 3,0 0,3
BX/ 1,-1 1,-1 1,-1 1,-1
BY a 3,0 0,3 3,0 0,3
BY / 1,-1 1,-1 1,-1 1,-1
GXa 2,-2 2,-2 2,-2 2,-2
GX/ 2,-2 2,-2 2,-2 2,-2
GY a 2,-2 2,-2 2,-2 2,-2
GY / 2,-2 2,-2 2,-2 2,-2
(c) Find a Nash equilibrium that leads to a diferent outcome than that of the solution
in (a).

Solution: (GXa, by) is another NE, as player 2 has no incentive to deviate if

player 1 plays G and player 1 also has no incentive to deviate since if he plays A

then he gets 1 and plays B then he gets either 0 or 1. The coutcome of (GXa, by)

is player 1 plays G, while the outcome in part (a) was that Player 1 plays A,

Player 2 plays a and fnally Player 1 plays X.

3. In a pirate ship, n 2 2 pirates are to determine the amount y of gunpowder for the ship
as follows. Simultaneously, each pirate i submits a real number Si 2 0. The amount
of gunpowder is determined to be

y = m.n {S� , . . . , Sn } ,

and each pirate i pays his share y/n of the cost. The payof of a pirate i is
�
�i (y) = y - y/n.

Everything above is commonly known. (You will get 75% of the points if you solve
this problem for n = 2.)

(a) Write this formally as a normal-form game.

Solution: Players: {1, 2, ..., n}. Strategies: each pirate i (call Pi ) chooses Si E
[0, 0). Payofs: [i (S� , . . . , Sn ) = m.n {S� , . . . , Sn } - min{Sln,...,Sn } .

 (b) Check whether there is a dominant-strategy equilibrium. If there is one, compute

it and verify that it is indeed a dominant-strategy equilibrium. Otherwise, explain
why there cannot be a dominant strategy equilibrium.
Solution: Note that Ui is a concave function maximized at y = n2 /4. By concav-
ity, Ui increases in y for y < n2 /4 and decreases in y for y > n2 /4. The strategy
profle (n2 /4, . . . , n2 /4) is a dominant strategy equilibrium. To show this, take
any player i and any Si < n2 /4. For any S-i , writing y (S-i ) minj=i Sj , we have
Ui (n2 /4, S-i ) = Ui (y (S-i )) = Ui (Si , S-i ) if y (S-i ) : Si
Ui (n2 /4, S-i ) = Ui (min {y (S-i ) , n2 /4}) > Ui (Si ) = Ui (Si , S-i ) if y (S-i ) > Si .

Therefore, n2 /4 weakly dominates Si . Similarly, n2 /4 weakly dominates any Si >

n2 /4 because for any S-i
Ui (n2 /4, S-i ) = Ui (y (S-i )) = Ui (Si , S-i ) if y (S-i ) : n2 /4
Ui (n2 /4, S-i ) = Ui (n2 /4) > Ui (min {y (S-i ) , Si }) = Ui (Si , S-i ) if y (S-i ) > n2 /4.

4. Apply backward induction to compute an equilibrium in the following game. Alice

sues a large corporation (defendant) for damages. At date 2n + 1, the judge will
decide whether the defendant is guilty. If the judge decides that the defendant is
guilty, then the defendant will be ordered to pay 1 to Alice; otherwise there will be
no payment between the parties. (Here, the unit of money is million US dollars.) The
probability that the judge decides guilty is p E (0, 1). Before the court date, Alice
and the defendant can settle out of court, in which case they do not go to court. The
settlement negotiation is as follows. In each date t E {1, . . . , 2n}, one of them is to
make a settlement ofer St , and the other party is to decide whether to accept it. If
the ofer is accepted, the game ends and the defendant pays St to Alice. Alice makes
the ofers on odd dates 1, 3, . . . , 2n - 1, and the defendant makes the ofers on even
dates 2, . . . , 2n. Alice's payof from receiving payment x is xl/a for some a > 1. She
does not discount the payofs and does not pay any cost for negotiation or for going to
court. On the other hand, the defendant is risk neutral and it needs to pay a small fee
c > 0 to the lawyers for every day the case has not settled (paying ct if they settle at
date t and c (2n + 1) if they go to court). (You will get 50% of the points if you can
solve it for n = 1.)
Solution: If they cannot settle, at date 2n + 1, judge orders the defendant to pay 1
to Alice with probability p, and hence the expected payofs of Alice and the defendant
are
VA,2n+l = p1l/a + (1 - p) 0l/a = p
VD,2n+l = -p - (2n + 1) c,
respectively. Now at date 2n, Alice must accept an ofer S if and only if
Sl/a 2 VA,2n+l = p,
i.e., S 2 pa . Hence, the payof of the defendant from an ofer S is
-S - 2nc if S 2 pa ,
UD,2n (S) =
-p - (2n + 1) c otherwise.

3
Since pa < p + c, [D, n (S) is maximized at S = pa , and the defendant ofers

S n = pa .

Consequently, at date 2n - 1, the defendant accepts an ofer S if S : S n + c. Since

Alice will get only S n for sure if the ofer is rejected, she ofers

S n-� =S n + c.

For any date t = 2� < 2n, suppose that if the parties do not settle at t or before they
will settle for S �+� at 2� + 1 (as above). Then, at t, Alice accepts an ofer S if S 2 S �
where
S � = S �+� ,
and the defendant ofers S � . At date 2� - 1, the defendant accepts an ofer S if
S : S �-� , and Alice ofers S �-� where

S � -1=S � + c.

Note that the solution to the above diference equations is

S � =S �+� = pa + (n - �) c. (1)

The resulting equilibrium is: at any even date t, Alice accepts an ofer S if S 2 St , and
the defendant ofers St ; at any odd date t, Alice ofers St and the defendant accepts an
ofer S if S : St , where St is as in (1). �You will lose 5 points if you get the last part
wrong and reveal that you don't know the defnition of a strategy or an equilibrium.�

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14.12 Economic Applications of Game Theory

Fall 2012

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