UNIVERSITY CARLOS III

Master in Economics Master in Industrial Economics and Markets

Game Theory
MIDTERM EXAM–November 6th, 2019

NAME:

X Y Z
A 0, 1 20, 1 15, 2
Problem 1: Consider the following normal form game: B 6, 0 30, 0 -1 , 1
C 10, 2 2 , -1 0, 1
D 8, 1 5, 4 -2 , 5

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

X Z
A 0, 1 15, 2
B 6, 0 -1 , 1
C 10, 2 0, 1
D 8, 1 -2 , 5

Now strategies B and D are dominated by strategy C for player 1

X Z
A 0, 1 15, 2
C 10, 2 0, 1

The set of rationalizable strategies are {A, C} × {X, Y }.

(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
C 10, 2 0, 1

The NE in pure strategies are (A, Z) with payoffs u1 = 15, u2 = 2 and (C, X) with payoffs u1 = 10, 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 = xA + (1 − x)C
σ2 = yX + (1 − y)Z

The expected utilities of player 1 are

u1 (A, σ2 ) = 15(1 − y) = 15 − 15y

u1 (C, σ2 ) = 10y

1
 We see that 
3
A
 if y < 5
3
BR1 (y) = {A, C} if y = 5
3

C if y >

5

The expected utilities of player 2 are

u2 (X, σ2 ) = x + 2(1 − x) = 2 − x
u2 (Z, σ2 ) = 2x + 1 − x = 1 + x

We see that 
1
X
 if x < 2
1
BR2 (x) = {X, Z} if x = 2
1

Z if x >

2

Graphically,

BR2 (x)
1

3/5

BR1 (y)

1/2 1 x

And we obtain three NE

(a) (A, Z) with payoffs u1 = 15, u2 = 2 ;
(b) (C, X) with payoffs u1 = 10, u2 = 2; and
(c) 12 A + 12 C, 35 X + 35 Z , with payoffs u1 = 6, u2 = 3/2.

Problem 2: The planet is divided into two countries: 1 and 2. Politicians from both countries meet at the most
fashionable and expensive resort to negotiate how to deal with climate change. If country 1 invests x1 and country 2
invests x2 monetary units in reducing climate change, their utilities will be the following

u1 (x1 , x2 ) = (3 + x2 )x1 − 2(x1 )2

u2 (x1 , x2 ) = (3 + x1 )x2 − 2(x2 )2

(a) (10 points) What is the most favorable agreement that maximizes the welfare of both countries? What are the
utilities of each country in this agreement?
Solution: The players maximize the sum of the utilities

max u1 + u2
x1 ,x2

2
 The first order conditions are

0 = 3 + x2 − 4x1 + x2
0 = x1 + 3 + x1 − 4x2

That is

3 = 4x1 − 2x2
3 = x2 − 2x1

The solution is
3
x1 = x2 =
2
(b) (10 points) Suppose from now on, that after the meeting both countries decide their investments x1 and x2
simultaneously and without knowing what the other one is doing. Find the best response function of each
country, BR1 (x2 ) and BR2 (x1 ). Draw the best response function in the x1 − x2 plane (x1 on the horizontal axis
and x2 on the vertical axis).
Solution: Player 1 maximizes u1 (x1 , x2 ) = (3 + x2 )x1 − 2(x1 )2 The first order condition is

3 + x2 − 4x1 = 0

The best reply of player 1 is

3 + x2
q1 (q2 ) =
4
Similarly, the reply of player 2 is
3 + x1
q2 (q1 ) =
4
Graphically,

x2

BR2 (x1 )

3/4 BR1 (x2 )

x1
3/4

(c) (10 points) Why the agreement reached in part (a) will not be implemented if each country takes its decision
simultaneous and independently?
Solution: Because   3
3 3+ 2 9
BR1 = =
2 4 8
  3
3 3+ 2 9
BR2 = =
2 4 8

3
(d) (10 points) Find the Nash equilibrium (x∗1 , x∗2 ) if the countries take their decisions simultaneous and indepen-
dently. Compute the utilities of the countries in equilibrium.
Solution: The NE is the solution of
3 + x2 3 + x1
q1 = , q2 =
4 4
That is
q1∗ = q2∗ = 1

Problem 3: Consider the following extensive form game. Consider the following game.
1.1

Z W
1.2
11, 5

E F
1.3
8, 1

A B
2.1

X Y X Y

0, 1 15, 2 10, 2 0, 1

(a) (5 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

X Y
A 0, 1 15, 2
B 10, 2 0, 1
In problem 1 we have computed the NE of this game.
(a) (A, Y ) with payoffs u1 = 15, u2 = 2 ;
(b) (B, X) with payoffs u1 = 10, u2 = 2; and
(c) 12 A + 12 B, 53 X + 35 Y , with payoffs u1 = 6, u2 = 3/2.

(b) (10 points) Find the subgame perfect Nash equilibria of the complete game. Compute the utilities attained by
the players in each SPNE.
Solution:
(a) Let us look for a SPNE in which at node 1.3 the NE (A, Y ) is played.
1.1

Z W
1.2
11, 5

E F

8, 1 15, 2

4
 At node 1.2 player 1 chooses F . Given this, at node 1.2 player 1 chooses W . We have the SPNE
((W, F, A), Y ), with payoffs u1 = 15, u2 = 2.
(b) Let us look for a SPNE in which at node 1.3 the NE (B, X) is played.

1.1

Z W
1.2
11, 5

E F

8, 1 10, 2

At node 1.2 player 1 chooses F . Given this, at node 1.2 player 1 chooses Z. We have the SPNE
((Z, F, B), X), with payoffs u1 = 11, u2 = 5. .
(c) Let us look for a SPNE in which at node 1.3 the NE 21 A + 12 B, 35 X + 53 Y is played.

1.1

Z W
1.2
11, 5

E F

1
8, 1 6, 2

At node 1.2 player
1 chooses
E. Given this, at node 1.2 player 1 chooses Z. We have the SPNE
Z, E, 12 A + 12 B , 35 X + 35 Y , with payoffs u1 = 11, u2 = 5.

Problem 4: Two students, who live in the same apartment, find a 100 euros bill at the entrance of the building. To
decide how to share it, they consult their spiritual leader who tells them to divide the bill according to the procedure
below. They will have two chances to find an agreement. Otherwise, God commands that the spiritual leader keeps
the bill and uses it to finance her TV show.

The procedure is the following: In the first period agent A demands a payment xA ∈ [0, 100] of agent B in order to
reach the agreement. If agent B accepts, the agreement is reached and the bill is split as A has proposed. 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 xB ∈ [0, 100] in order to sign the agreement.

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

5
 A.1

xA

B.1

A R

(uA = xA , uB = 100 − xA ) B.2

xB

A.2

A R

(uA = 100 − xB , uB = xB ) (0, 0)

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 100 − xB ≥ 0. That is agent A accepts iff xB ≤ 100. Given the
best reply of agent A at node A.2, the best response of agent B at node B.2 is to offer xB = 100. Thus, we may
assume that if we ever reach node B.2, agent B will offer xB = 100 and agent A accepts. The payoffs will be
uA = 0, uB = 100. We replace this payoffs at node A.2

A.1

xA

B.1

A R

(uA = xA , uB = 100 − xA ) (uA = 0, uB = 100)

6
Now, player B at node B.1 accepts iff 100 − xA ≥ 100. That, is at node B.1 player B accepts iff xA = 0. The
best response now for player A is to offer any xA at node A.1. The SPNE is the following.
• Node A.1: xA ≥ 0.
• Node B.1: accept iff xA = 0.
• Node B.2: xB = 100.
• Node A.2: accept any xB ≤ 100.
The payoffs are uA = 0, uB = 100.