CB2041 – Mock Midterm Exam

Not For Distribution Beyond The Class

February 8, 2023

1. You may bring one double-sided A4-sized sheet of paper with anything you like written on
both sides. Your cheat sheet must be hand-written by you, not photocopied or printed.
You will turn in the cheat sheet with your exam. If any cheat sheet violates the
guidelines above, it will be confiscated, AND your final grade will be reduced by 10%.

2. You may use a calculator.

3. This is a 120 minute exam that consists of 4 questions, with a maximum of 100 points.
Please check this before commencing.

4. Answer each of the questions ONLY on the front side of the pages of the exam. You can use
the back sides of the pages as the scrap paper, but whatever you write there or anywhere
else outside of the front sides of the pages of the exam will not be graded.

5. Make sure to PRINT your name and your student ID.

6. Write your answers into the exam itself. To receive full credit, answers should be neat,
coherent AND legible. To receive full credit you should justify your answers where
directed to. Clearly label all diagrams (if you decide to draw any).

YOUR NAME _______________________

STUDENT ID _______________________

1
1. Consider the following extensive form game:

(1, 1, 1)
t
L (2, 3, 2)
TINMAN
N b
SCARECROWR
SCARECROW (0, 0, 2)

S u (3, 3, 3)
LION W (1, 2, 4)
d
SCARECROWE
(0, 2, 0)

In each triple of payoffs, the first number is Scarecrow’s payoff, the second number is Tin-
man’s payoff and the third number is Lion’s payoff.

(a) List out all of the pure strategies for each player. [8 points]
Answer:

(b) Identify the backward induction equilibrium. [8 points]

Answer:

Justification:

Page 2
Solution:

(a) Answer:
Scarecrow has 8 pure strategies: NLW, NLE, NRW, NRE, SLW, SLE, SRW, SRE.
Tinman has 2 pure strategies: t, b
Lion has 2 pure strategies: u, d

(b) Answer: The game has a unique backwards induction equilibrium. Scarecrow’s
equilibrium strategy is NLW, Tinman’s equilibrium strategy is b, and Lion’s equi-
librium strategy is d.
Justification: The backwards induction procedure can be illustrated by the fol-
lowing figure:

(1, 1, 1)
t
L (2, 3, 2)
TINMAN
N b
SCARECROWR
SCARECROW (0, 0, 2)

S u (3, 3, 3)
LION W (1, 2, 4)
d
SCARECROWE
(0, 2, 0)

Step 1: For scarecrow, L is a conditional best reply since 2 > 0, W is a conditional

best reply since 1 > 0.
Step 2: For tinman, b is a conditional best reply since 3 > 1. For Lion, d is a
conditional best reply since 4 > 3.
Step 3: For scarecrow, N is a conditional best reply since 2 > 1.

Page 3
2. Consider the following game table:

a b c d e f
T −1, 1 −1, 1 −1, 1 1, −1 1, −1 1, −1
M 1, −1 0, 0 1, −1 1, −1 0, 0 1, −1
B −1, 1 −1, 1 0, 0 −1, 1 −1, 1 0, 0

(a) Use iterated elimination of strictly dominated strategies to reduce the game as much
as possible. Give the order in which the eliminations occur. [9 points]
Answer:

(b) Is this game dominance solvable? [3 points]

Answer:

Justification:

(c) State the Nash equilibrium (or equilibria) of this game. [8 points]
Answer:

Justification:

Page 4
Solution:

(a) Answer:
Step 1: eliminate B (strictly dominated by M) and f (strictly dominated by b)
Step 2: eliminate d (strictly dominated by b)

(b) Answer: No, the game is not dominance solvable.

(c) Answer: The unique Nash equilibrium is (M,b).

Justification:
The truncated game that survives IESDS is given as follows:

a b c e
T −1,1 −1,1 −1,1 1,−1
M 1,−1 0,0 1,−1 0,0

The unique Nash equilibrium is (M,b), which can be found via the best-reply
analysis shown above.
Alternatively, one can find the Nash equilibrium by analyzing the original game
directly.

Page 5
3. Rosa and Ernesto are going to split $ 10. They have agreed to the following rules. Rosa
first divides the money into two piles, $x in one pile and $10 − x in the other pile, where
x = 0, 1, 2, 3, 4, or 5. Ernesto observes Rosa’s division and chooses which one of the two
piles he will get; Rosa gets the remaining pile.

(a) Model this situation as an extensive form game and draw a game tree to represent the
extensive form game. [8 points]
Answer:

(b) Use your game tree in part (a) to find all the backwards induction equilibrium (or
equilibria) of the game. [8 points]
Answer:

Justification:

Page 6
Solution:

(a) Answer: The game tree is given in the following figure

Ernesto 0
(10,0)
10 (0,10)
Ernesto 1
(9,1)
0
9 (1,9)
1
Ernesto 2
(8,2)
2
8 (2,8)
Rosa (7,3)
3
3
(3,7)
Ernesto 7
4
(6,4)
4
5
(4,6)
Ernesto 6
(5,5)
5
(5,5)
Ernesto 5’

(b) Answer: In any backward induction equilibrium, Ernesto chooses the pile of $10 −
x for x = 0, 1, 2, 3 or 4 and chooses either one of the two piles if x = 5 (highlighted
in red in the following picture). Rosa chooses x = 5.
Justification: We can find all the backward induction equilibria by the backward
induction procedure, as illustrated in the following two figures.
Step 1: For x = 0, 1, 2, 3, 4, Ernesto’s conditional best-reply is to choose the pile
of 10 − x since 10 − x > x. For x = 5, Ernesto is indifferent between the two piles
since x = 10 − x. Therefore, we consider two scenarios: (i) Ernesto chooses x = 5;
and (ii) Ernesto chooses 10 − x = 5 (indicated by 5′ ) in the figure.
Step 2: In both scenarios, Rosa’s payoff is 5 if she chooses x = 5. Rosa’s payoff is
x is she chooses x = 0, 1, 2, 3, 4. Therefore, the conditional best reply for Rosa is
to choose x = 5.

Page 7
Scenario 1: When Rosa chooses x = 5, Ernest chooses x = 5.

Ernesto 0
(10,0)
10 (0,10)
Ernesto 1
(9,1)
0
9 (1,9)
1
Ernesto 2
(8,2)
2
8 (2,8)
Rosa (7,3)
3
3
(3,7)
Ernesto 7
4
(6,4)
4
5
(4,6)
Ernesto 6
(5,5)
5
(5,5)
Ernesto 5′

Page 8
Scenario 2: When Rosa chooses x = 5, Ernest chooses 10 − x = 5.

Ernesto 0
(10,0)
10 (0,10)
Ernesto 1
(9,1)
0
9 (1,9)
1
Ernesto 2
(8,2)
2
8 (2,8)
Rosa (7,3)
3
3
(3,7)
Ernesto 7
4
(6,4)
4
5
(4,6)
Ernesto 6
(5,5)
5
(5,5)
Ernesto 5′

Page 9
4. Consider an industry with two identical firms, firm 1 and firm 2, each selling a homogenous
good. The demand for the good depends on the quantities the two firms make. If firm 1
produces q1 units of good and firm 2 produces q2 units of good, then the price (in dollars)
for the good is given by p = 10 − q1 − q2 . Firm i has a cost function of Ci (qi ) = qi2 for both
i = 1, 2.

(a) Write down firm 1’s profit as a function of q1 and q2 . [4 points]

Answer:

(b) Find firm 1’s best-reply function. [6 points]

Answer:

Justification:

(c) What is firm 2’s best-reply function? [4 points]

Answer:

Page 10
(d) Find the Nash equilibrium quantity and profit of each firm. [10 points]
Answer:

Justification:

Consider a merger of the two firms, resulting in a monopoly of the market. The merger
might give rise to efficiency gains, in the sense that the firm resulting from the merger has
a cost function of CM (qM ) = eqM 2 with 0 < e ≤ 1.

(e) Write the monopoly firm’s profit as a function of the quantity qM it produces, and solve
for its profit-maximizing quantity. What will its profit be? [10 points]
Answer:

Justification:

Page 11
(f) For what values of e does the merger reduce the price? [7 points]
Answer:

Justification:

(g) For what values of e is the merger beneficial to the merging firm? [7 points]
Answer:

Justification:

Solution:

(a) Answer: The profit function of firm 1 is

π1 (q1 , q2 ) = (10 − q1 − q2 )q1 − q12

Page 12
(b) Answer: Firm 1’s best-reply function is
10 − q2
 
q1 = max ,0 .
4
Justification: The profit function of firm 1 can be rewritten as
π1 (q1 , q2 ) = (10 − q2 )q1 − 2q12
Set the first-order derivative of π1 with respect to q1 to zero and solve for q1 :
10 − q2
10 − q2 − 4q1 = 0 ⇒ q1 = .
4
Alternatively, using the notation in the appendix, B = 10 − q2 and C = 2, the
profit-maximizing quantity is
B 10 − q2
q1 = = .
2C 4
Hence, firm 1’s best-reply function is
10 − q2
 
q1 = max ,0 .
4
(c) Answer: By symmetry, firm 2’s best-reply function is
10 − q1
 
q2 = max ,0 .
4
(d) Answer: The Nash equilibrium quantities are q1 = q2 = 2 and each firm’s profit
is 8.
Justification: Ignoring the non-negativity constraints, the Nash equilibrium can
be found by determining where the two best-reply functions intersect:
10 − q2
q1 =
4
10 − q1
q2 =
4
Solving the system of equations yield q1 = q2 = 2. The profit of each firm is
πi (2, 2) = (10 − 2 − 2) · 2 − 22 = 8.

(e) Answer: The monopoly firm’s profit is 25/(1 + e).

Justification: The monopoly firm’s profit function is
2 2
π (qM ) = (10 − qM )qM − eqM = 10qM − (1 + e)qM .
The profit-maximizing quantity is
5
qM = .
1+e
The monopoly firm’s profit is 25/(1 + e).

Page 13
(f) Answer: The merger reduce the price if e < 0.25.
Justification: The merger reduce the price if

10 − qM < 10 − q1 − q2
⇔ qM > q1 + q2
5
⇔ > 2+2
1+e
⇔ e < 0.25.

9
(g) Answer: The merger is beneficial to the merging firm if e < 16 .
Justification: The merger is beneficial to the merging firm if
25 9
> 8+8 ⇔ e <
1+e 16

Page 14