UNIVERSITY CARLOS III

Master in Economics Master in Industrial Economics and Markets

Game Theory
MIDTERM EXAM–November 10th, 2020

NAME:

X Y Z
A 10, 2 4, 6 1,3
Problem 1: Consider the following normal form game: B 0, 1 8, 4 2,2
C 0,1 6,1 4,2
D 6,3 5, 7 3,4

(a) (5 points) What are the strategies that survive the iterated elimination of strictly dominated strategies?
Solution: Strategy X is dominated by Z for player 2,

Y Z
A 4,6 1, 3
B 8,4 2,2
C 6,1 4,2
D 5,7 3,4

Now strategy A (resp. D) is dominated by strategy B (resp. C) for player 1

Y Z
B 8,4 2,2
C 6,1 4,2

The set of rationalizable strategies are {B, C} × {Y, Z}.

(b) (5 points) Find all pure strategy Nash equilibria and the payoffs of these equilibria.
Solution: The best replies of the players are

Y Z
B 8, 4 2,2
C 6,1 , 4, 2

The NE in pure strategies are (B, Y ) with payoffs u1 = 8, u2 = 4 and (C, Z) with payoffs u1 = 4, u2 = 2.

(c) (15 points) Draw the best reply functions of the players. Compute the mixed strategy Nash equilibria and the
expected payoffs of these equilibria.

Solution: We look for a NE of the form

σ1 = xB + (1 − x)C
σ2 = yY + (1 − y)Z

The expected utilities of player 1 are

u1 (B, σ2 ) = 8y + 2(1 − y) = 2 + 6y
u1 (C, σ2 ) = 6y + 4(1 − y) = 4 + 2y

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 We see that 
1
C (x = 0)
 if y < 2
1
BR1 (y) = {B, C} (x ∈ [0, 1]) if y = 2
1

B (x = 1) if y >

2

The expected utilities of player 2 are

u2 (Y, σ2 ) = 4x + 1 − x = 1 + 3x
u2 (Z, σ2 ) = 2

We see that 
1
Z (y = 0)
 if x < 3
1
BR2 (x) = {Y, Z} (y ∈ [0, 1]) if x = 3
1

Y (y = 1) if x >

3

Graphically,

1
BR1 (y)

1/2

BR2 (x)

1/3 1 x

And we obtain three NE

(a) (C, Z) with payoffs u1 = 4, u2 = 2 ;

(b) (B, Y ) with payoffs u1 = 8, u2 = 4; and
(c) 13 B + 23 C, 12 Y + 21 Z , with payoffs u1 = 5, u2 = 2.

Problem 2: Two firms operate in a market with a unique homogenous good. The inverse demand function is
P = 17 − 2Q, where Q = q1 + q2 and qi is the amount produced by firm i = 1, 2. The firms have constant marginal
cost c1 = 1, c2 = 3. Both firms decide simultaneously the quantities produced q1 , q2 .

(a) (10 points) Write the benefit of each of the firms, as a function of the output (q1 , q2 ).
Solution: The profits are

Π1 (q1 , q2 ) = (17 − 2q1 − 2q2 )q1 − q1 = (16 − 2q1 − 2q2 )q1

Π2 (q1 , q2 ) = (17 − 2q1 − 2q2 )q1 − 3q1 = (14 − 2q1 − 2q2 )q2

(b) (10 points) Compute the best reply of each of the firms when it considers the production of the other firm as
given.

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 Solution: Player 1 maximizes Π1 (q1 , q2 ) = (16 − 2q1 − 2q2 )q1 = 16q1 − 2q12 − 2q1 q2 The first order condition is

16 − 4q1 − 2q2 = 0

Solving for q1 we obtain

16 − 2q2 8 − q2
q1 = =
4 2
The best reply of player 1 is  
8 − q2
BR1 (q2 ) = max ,0
2
Player 2 maximizes Π2 (q1 , q2 ) = (14 − 2q1 − 2q2 )q2 = 14q2 − 2q22 − 2q1 q2 The first order condition is

14 − 4q2 − 2q1 = 0

Solving for q2 we obtain

14 − 2q1 7 − q1
q2 = =
4 2
The best reply of player 1 is  
7 − q1
BR2 (q1 ) = max ,0
2
Graphically,

q2

BR1 (q2 )

7/2

BR2 (q1 )

4 7 q1

Note that
∂ 2 Π1 ∂ 2 Π2
2 = 2 = −4 < 0
(∂q1 ) (∂q2 )
So, the second order conditions for optimization are fulfilled.
(c) (10 points) Compute the Nash equilibrium and the profits of each firm in the equilibrium.
Solution: The NE is the solution of the system of equations
8 − q2
q1 =
2
7 − q1
q2 =
2
We obtain
q1∗ = 3, q2 = 2

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 The profits are
π1∗ = 18 π2∗ = 8

(d) (10 points) Suppose now that firm 1 can buy firm 2 and adopts the most efficient technology. In this case,
firm 1 behaves a monopolist. What is the maximum amount firm 1 would be willing to pay to acquire firm 2?

Solution: Firm 1 behaves as a monopolist. Thus it maximizes

Π1 (q1 ) = (17 − 2q1 )q1 − q1 = 16q1 − 2q12

The first order condition is

16 − 4q1 = 0
and the monopoly quantity is q̂1 = 4. The monopoly price is p̂ = 9 and the monopoly profit is Π̂1 = 32. Thus,
the maximum amount that firm 1 is willing to pay to acquire firm 2 is 32 − 18 = 14.

Problem 3: Two managers are negotiating how to share a Market, They have two chances to reach an agreement.
And the procedure is the following: In the first period the market generates a profit of 300 million. In this first
period manager A proposes to manager B a way in which they share the 300 million. If manager B accepts, the
agreement is reached and the bill is split as A has proposed.

If manager B rejects the offer, they have to wait until the second period, in which the profit of the market has
reduced to 200 million. In this period it is manager B who proposes to manager A how to share the 200 million. If
manager A accepts, the agreement is reached and the bill is split as B has proposed. Otherwise, they do not reach
an agreement and the market will generate a profit of 50 million each.

Assume that, in case of indifference, the offer is accepted.

(a) (10 points) Describe the situation as an extensive form game. Draw a diagram. How many subgames does it
have?
Solution: The extensive game form representation is the following.

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 A.1

xA

B.1

A R

(uA = xA , uB = 300 − xA ) B.2

xB

A.2

A R

(uA = 200 − xB , uB = xB ) (50, 50)

There are infinitely many subgames.

(b) (10 points) Compute the subgame perfect Nash equilibria of this game. Write the strategies of the players at
each node. Write the payoffs of the players in each of the SPNE.
Solution: At node A.2, agent A accepts iff 200 − xB ≥ 50. That is agent A accepts iff xB ≤ 150. Given the
best reply of agent A at node A.2, the best response of agent B at node B.2 is to propose xB = 150 for himself.
Thus, we may assume that if we ever reach node B.2, agent B will propose to keep xB = 150 for himself and
agent A accepts. The payoffs will be uA = 50, uB = 150. We replace this payoffs at node A.2

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 A.1

xA

B.1

A R

(uA = xA , uB = 300 − xA ) (uA = 50, uB = 150)

Now, player B at node B.1 accepts iff 300 − xA ≥ 150. That, is at node B.1 player B accepts iff xA ≤ 150. The
best response now for player A is to keep xA = 150 for himself at node A.1. The SPNE is the following.
• Node A.1: xA = 150.
• Node B.1: accept iff xA ≤ 150.
• Node B.2: xB = 150.
• Node A.2: accept iff xB ≤ 150.
The payoffs are uA = 150, uB = 150.

(c) (10 points) Imagine now that, if no agreement is reached in any of the two periods, in the second period the
profit generated by the market is X for each firm, with 50 < X ≤ 100. With respect to the previous situation
which player is now better off?

Solution: Since X > 50, player A has more bargaining power in the last period (his outside option in case of
not accepting is higher) and this translates into a higher payoff in the equilibrium.

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Problem 4: Consider the following extensive form game.

1.1
A B
2.1
7
0 X Y

1.3
1.2
C D E F
2.2 2.3

Z T Z T U V U V

10 4 11 5 0 6 12 0
10 11 4 5 0 12 6 0

(a) (10 points) Write the normal form of the game that starts at node 1.2 and find all (that is in pure and mixed
strategies) NE of this game.
Solution: The normal form game is

Z T
C 10, 10 4, 11
D 11, 4 5, 5

Strategy C (resp. Z) is dominated by strategy D (resp. Z). Therefore, the unique NE is (D, T ) with payoffs
u1 = u2 = 5.
(b) (10 points) Write the normal form of the game that starts at node 1.3 and find all (that is in pure and mixed
strategies) NE of this game.
Solution: The normal form game is

U V
E 0, 0 6, 12
F 12, 6 0, 0

There are two NE in pure strategies,

(a) (E, V ) with payoffs u1 = 6, u2 = 12; and
(b) (F, U ) with payoffs u1 = 12, u2 = 6.
Let us look for a NE in mixed strategies of the form

σ1 = pE + (1 − p)F
σ2 = qu + (1 − q)V

We must have

6 − 6q = 12q
6 − 6p = 12p

so,
1
q=p=
3

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 The NE in mixed estrategies is  
1 2 1 2
3 + F, U + V
3 3 3 3
with payoffs u1 = u2 = 4.
(c) (10 points) Find the subgame perfect Nash equilibria of the complete game. Compute the utilities attained by
the players in each SPNE.
Solution: The subgame that starts at node 1.2 has a unique NE. The subgame that starts at node 1.3 has 3 NE.
Correspondingly, we obtain 3 SPNE. We use the notation ((1.1, 1.2, 1.3), (2.1, 2.2, 2.3)).
(a) At node 1.3 the NE (E, V ) with payoffs u1 = 6, u2 = 12 is played.

1.1
A B
2.1
7
0 X Y

5 6
5 12

We obtain the SPN

((A, D, E), (Y, T, V ))
with payoffs u1 = 7, u2 = 0.
(b) At node 1.3 the NE (F, U ) with payoffs u1 = 12, u2 = 6 is played.

1.1
A B
2.1
7
0 X Y

5 12
5 6

8
 We obtain the SPN
((B, D, F ), (Y, T, U ))
with payoffs u1 = 12, u2 = 6.
1
+ 23 F, 13 U + 32 V


(c) At node 1.3 the NE 33 with payoffs u1 = u2 = 4 is played.

1.1
A B
2.1
7
0 X Y

5 4
5 4

We obtain the SPN    

1 2 1 2
A, D, 3 + F , X, T, U + V
3 3 3 3
with payoffs u1 = 7, u2 = 0.