UNIVERSITY CARLOS III

Master in Economics Master in Industrial Economics and Markets

Game Theory
MIDTERM EXAM–November 6th, 2018

NAME:

X Y Z
A 0, 1 20, 1 15, 2
Problem 1: Consider the following normal form game: B 1, 0 30, 0 10 , 1
C 10, 2 2 , -1 0, 1
D 5, 1 5, 4 -1 , 5
(a) (5 points) What are the strategies that survive the iterated elimination of strictly dominated strategies?
Solution: Strategy Y is strictly dominated by strategy Z for player 2. We obtain

X Z
A 0, 1 15, 2
B 1, 0 10 , 1
C 10, 2 0, 1
D 5, 1 -1 , 5
Now, strategy D is strictly dominated by strategy C for player 1. We obtain

X Z
A 0, 1 15, 2
B 1, 0 10 , 1
C 10, 2 0, 1
The set of rationalizable strategies is {A, B, C} × {X, Z}.
(b) (5 points) Find all pure strategy Nash equilibria and the payoffs of these equilibria.
Solution: The best replies of the players are

X Z
A 0, 1 15, 2
B 1, 0 10 , 1
C 10, 2 0, 1
We obtain the NE (A, Z) with payoffs u1 = 15, u2 = 2 and (C, X) with payoffs u1 = 10, u2 = 2.
(c) (15 points) Compute the mixed strategy Nash equilibria and the expected payoffs of these equilibria.
Solution: Let us look for a NE of the form
σ1 = xA + yB + (1 − x − y)C
σ2 = pX + (1 − p)Z
The expected utilities of player 1 are

u1 (A, σ2 ) = 0 × p + 15(1 − p) = 15 − 15p

u1 (B, σ2 ) = 1 × p + 10(1 − p) = 10 − 9p
u1 (C, σ2 ) = 10p + 0 × (1 − p) = 10p

Graphically,

1
 u1 (σ1 , A) = 15 − 15p

u1 (σ1 , C) = 10p

u1 (σ1 , B) = 10 − 9p

3 p
5 1

Thus, 
3
x = 1, y = 0
 if p< 5
3
BR1 (σ2 ) = x ∈ [0, 1], y = 0 if p= 5
3

x = 0, y = 0 if p>

5

And we see that player 1 will not use strategy B. Hence we may assume y = 0. The expected utilities of player 2
are

u2 (σ1 , X) = 1 × x + 0 × y + 2(1 − x − y) = 2 − x − 2y
u2 (σ1 , Y ) = 2x + 1 × y + 1 × (1 − x − y) = 1 + x

In the NE, we must have that y = 0. Hence, we may assume

u2 (σ1 , X) = 2−x
u2 (σ1 , Y ) = 1+x

Hence, 
1
p = 1
 if x< 2
1
BR2 (σ1 ) = [0, 1] if x= 2
1

p=0 if x>

2

Graphically,

2
 3

BR2 (x)
1

3
5
BR1 (p)

1
1 x
2

And we obtain three NE

(a) x = 0, y = 0, p = 1. That is, (C, X) with payoffs u1 = 10, u2 = 2.
(b) x = 1, y = 0, p = 0. That is, (A, Z) with payoffs u1 = 15, u2 = 2.
(c) x = 21 , y = 0, p = 53 . That is,  
1 1 3 2
A + C, X + Z
2 2 5 5
with payoffs u1 = 6, u2 = 32 .

Problem 2: Two agents, 1 and 2, produce heterogeneous products. If the two agents set, respectively, prices p1
and p2 the quantities demanded of the products of the two agents will be,
n p2 o
x1 (p1 , p2 ) = max 0, 90 − p1 +
2
n p1 o
x2 (p1 , p2 ) = max 0, 90 − p2 +
2

3
Assume that the agents have constant marginal costs MC1 = MC2 = 30. Assume also that the characteristics of the
market are such that the agents have to set simultaneously the prices.

(a) (5 points) Write down the agents’ profits, π1 (p1 , p2 ) and π2 (p1 , p2 ), as functions of the prices they set.
Solution: Assuming that the demand is positive, the profits of the agents are
 p2  p1 p2
π1 (p1 , p2 ) = 90 − p1 + (p1 − 30) = 120p1 − p21 − 15p2 + − 2700
2 2
 p1  p1 p2
π2 (p1 , p2 ) = 90 − p2 + (p2 − 30) = 120p2 − p22 − 15p1 + − 2700
2 2

(b) (10 points) Find the best response of both agents: BR1 (p2 ) and BR2 (p1 ). Draw the best response function and
the Nash equilibrium in the p1 − p2 plane (p1 on the horizontal axis and p2 on the vertical axis).
Solution: The first order condition for agent 1 is
∂π1 1
= 120 − 2p1 + p2 = 0
∂p1 2
The solution is the best reply of player 1
1
BR1 (p2 ) = (p2 + 240)
4
Note that the second order condition is fulfilled.
∂ 2 π1
= −2 < 0
∂p21
Similarly, best reply of player 2 is
1
BR2 (p1 ) = (p1 + 240)
4
Graphically,

p2 BR1 (p2 )

BR2 (p1 )
80

60

60 80 p1

(c) (10 points) Find the Nash equilibrium (p∗1 , p∗2 ) and the equilibrium profits π1 (p1 ,∗ p∗2 ) and π2 (p∗1 , p∗2 ).
Solution: The NE is the solution to the equations

p1 = BR1 (p2 ), p2 = BR2 (p1 ),

That is
1
p1 = (p2 + 240)
4
1
p2 = (p1 + 240)
4

4
 The NE is
p∗1 = p∗2 = 80
The profits are
π1 (p∗1 , p∗2 ) = π2 (p∗1 , p∗2 ) = 2500

Problem 3: Consider the following extensive form game.

1.1

A B

(1, 4) 2.1

X Y

(4, 1) (0, 0)

(a) (5 points) Write the set strategies for each player. Write the normal form of the game.
Solution: The set of strategies for the players are S1 = {A, B}, S2 = {X, Y }. The game may be represented by
the table

Player 2
X Y
Player 1 A 1, 4 1, 4
B 4, 1 0, 0

(b) (10 points) Find all Nash equilibria of this game.

Solution: Let us look for a NE of the form

σ1 = pA + (1 − p)B
σ2 = qX + (1 − q)Y

We compute the expected utilities of the players

u1 (A, σ2 ) = 1
u1 (B, σ2 ) = 4q
u2 (σ1 , X) = 1 + 3q
u2 (σ1 , Y ) = 4q

Thus, we have that best reply of player 1 is


p = 1
 if 0 ≤ q < 41
BR1 (σ2 ) = [0, 1] if q = 14
1

p=0 if 4 <q ≤1


And the best reply of player 2 is (

q=1 if 0≤p<1
BR2 (σ1 ) =
[0, 1] if q=1
Graphically,

5
 q

BR2 (p)

1
BR1 (q)
4

1 p

We see that there are two NE, (A, Y ), with payoffs u1 = 1, u2 = 4 and (B, X), with payoffs u1 = 4, u2 = 1, in
pure strategies and the following NE
1
(A, qX + (1 − q)Y ) 0≤q≤
4
with payoffs u1 = 1, u2 = 4, in mixed strategies.
(c) (5 points) Find the subgame perfect Nash equilibrium of the game.
Solution: There are two subgames. The NE of the subgame that starts in node 1.2 is X. Thus, the SPNE is
(B, X) with payoffs u1 = 4, u2 = 1.

(d) (5 points) Can you identify a non-credible threat?

Solution: The NE (A, Y ) is a non-credible threat.

Problem 4: Suppose that two agents are negotiating an agreement. If the two parties reach an agreement immedi-
ately, each will have a gain of 200. If the two parties don’t achieve an agreement immediately they will have a second
and last chance of achieving an agreement in a month. If the agreement is reached in a month, agent A will have a
gain of 80 and agent B will have a gain of 90. Negotiation works in the following way: In the first period agent A
demands a payment of agent B in order to sign the agreement. If agent B accepts, the agreement is reached, the
payoff to agent A will be 200 plus the payment that agent B has accepted to make. And the payoff to agent B will
be 200 minus the payment it has accepted to make. If agent B rejects the offer, it will make an offer to agent A in
the second period with the offer consisting again of a demand of a payment in order to sign the agreement.

(a) (15 points) Describe the situation as an extensive form game. How many subgames does it have?
Solution: The extensive game form representation is the following.

6
 A.1

d1

B.1

A R

(uA = 200 + d1 , uB = 200 − d1 ) B.2

d2

A.2

A R

(uA = 80 − d2 , uB = 90 + d2 ) (0, 0)

• There is one subgame that starts at A.1.

• There are infinitely many subgames that start at B.1
• There is one subgame that starts at B.2.
• There are infinitely many subgames that start at A.2.

(b) (10 points) Conpute the subgame perfect Nash equilibrium of this game. Write the strategies of the players at
each node. Write the payoffs of the players in the SPNE.
Solution: At node A.2, firm A accepts iff 80 − d2 ≥ 0. That is, firm A accepts iff d2 ≤ 80. Given the best reply
of firm A at node A.2, the best response of firm B at node B.2 is to offer d2 = 80. Thus, we may assume that
if we ever reach node B.2, firm B will offer d2 = 80 and firm A accepts. The payoffs will be uA = 0, uB = 170.
We replace this payoffs at node B.2

7
 A.1

d1

B.1

A D

(uA = 200 + d1 , uB = 200 − d1 ) (uA = 0, uB = 170)

Now, player B at node B.1 accepts iff 200 − d1 ≥ 170. That is, at node B.1 player B accepts iff d1 ≤ 30. The
best response now for player A is to offer d1 = 30 at node A.1 and player B accepts. The SPNE is the following.
• Node A.1: d1 = 30.
• Node B.1: accept iff d1 ≤ 30.
• Node B.2: d2 = 80.
• Node A.2: accept iff d2 ≤ 80.

The payoffs are uA = 230, uB = 170.