ECON402: Practice Final Exam Solutions

Summer 2012

Instructions
There is a total of four problems.
You must answer any three of them.
You get 10% for writing your name and 30% for each of the three best problems that you answer.
You have 100 minutes to complete the exam.
Please don’t forget to write your name on all the pages that you want to be graded.

Bonus points
Please write your name and report the grade that you expect to receive on the attached piece of paper.
I will collect these papers and keep them in my office while the TA grades the exam.
If your reported grade is close enough to the grade assigned by the TA, you will receive an additional 5% bonus.
Formally, if you write the number X and the TA gives you a grade Y and |X − Y | < 2.5,
then your final grade for the exam will be 1.05 ∗ Y

Formulas
Suppose that you want to find the value x ∗ that maximizes a concave and quadratic function f : R → R.
If f is written as f (x) = −a x 2 + bx + c with a > 0, then x ∗ = b/2a.
If f is written as f (x) = −a x − x 1 x − x 2 with a > 0, then x ∗ = (x 1 + x 2 )/2.

The present value of a constant stream of payoffs is ū/(1 − δ).

If v is distributed uniform [0, v̄], then Prob(v ≤ v0 ) = v0 /v̄.

Problem 1.
 
30 pts Suppose that Anna and Bob play the following simultaneous move game twice, and
their total payoffs are the sum of the payoffs they get at each stage. Is there a SPNE on which the players choose
(B,y) on the first stage? If your answer is positive you must provide the SPNE describing the strategies in detail, if
it is negative you must explain why this is the case.

x y z

A −1 , 5 2, 1 4, 3

B −2 , 3 0, 0 1, 2

C −1 , 5 4, 6 3, 5

D −2 , 1 2, 0 9, 2

There seems to be some confusion about this problem. A lot of people got the equivalent problem wrong on
the HW so I will write a detailed description. This problem refers a to a simple extensive form game in which a
strategic form game is played twice. The problem asks you if there is a SPNE in which players choose (B,y) on
the first period. To find SPNE we use backward induction however: there is more than one way to do backward
induction and there are many SPNE. I am only asking you to find one SPNE with the desired property.

1
Its important to start by understanding what is a strategy in this EFG. A strategy has to specify what each player
chooses on each information set. Both players have one information set on the first period and one information
set on the second period corresponding to each different outcome of the first period. So each player has 12 + 1 = 13
information sets. And a strategy must specify what to do on each of these information sets. A simple way of
describing a strategy is to specify what players do on the first period (eg D,z) and to specify what they would do
on the second period conditional on the outcome of the first period by using a table like the following one:

x y z

A A,y D,y D,y

B D,z C,x C,z

C D,x B,z B,x

D C,z A,x A,x

This table specifies, for instance, that if the outcome of the first period is (A,x) then Anna will choose A on the
second period and Bob will choose y on the second period. Notice that there are many different ways of filling
this table. Actually player 1 has 41 3 = 67108864 and player 2 has 31 3 = 1594323 different strategies, so that
trying to write a complete strategic form game is pointless.

SPNE requires that on the second period players choose a NE of the original game. Hence in the second period
players have to choose either (A,x), (C,y) or (D,z) that would result in second period payoffs of (-1,5), (4,6) or
(D,z) respectively. Depending on which NE you pick for each subgame you would different SPNE, I am asking you
to pick them in such a way that you will find a SPNE in which they play (B,y) on the first period. For example
you could specify the following strategy for the second period:

x y z x y z x y z

A A,x D,z D,z A -1,5 9,2 9,2 A -2,10 11,3 13,5

B D,z A,x C,y B 9,2 -1,5 4,6 B 7,5 -1,5 5,8

C C,y A,x C,y C 4,6 -1,5 4,6 C 3,11 3,11 7,11

D D,z C,y A,x D 9,2 4,6 -1,5 D 7,3 6,6 8,7

Cont. strategies Cont. values Total. payoffs

However choosing this strategies for the second period wont help our cause because they wont generate incen-
tives to play (B,y) on the first period. By doing backward induction in this way you will find some SPNE but not
the one that we are looking for. To see this notice that after replacing the subgames with the equilibrium payoffs
we get the previous total payoff table (obtained by adding up the (second stage) continuation payoffs and the
(first stage) payoffs from the original game). Which actually has no NE in pure strategies.

To find the desired SPNE we must choose the continuation values (payoffs corresponding to the second period)
in a smart way that generates the incentives too play (B,y) on the first period. We want to use continuation
strategies with the following property:
◦ if people actually play (B,y) play a continuation equilibrium tomorrow that is good for both (eg (C,y))
◦ if only Anna deviates play a continuation equilibrium that is bad for Anna (eg (A,x))
◦ if only Bob deviates play a continuation equilibrium that is bad for Bob (eg (D,z))

2
Consider the strategies with Anna and Bob choosing (B,y) on the first period and making choices in the second
period that depend on the outcome of the first period according to the following table of continuation strategies:

x y z x y z x y z

A C,y A,x C,y A 4,6 -1,5 4,6 A 3, 11 1, 6 8, 9

B D,z C,y D,z B 9,2 4,6 9,2 B 7, 5 4, 6 10, 4

C C,y A,x C,y C 4,6 -1,5 4,6 C 3, 11 3, 11 7, 11

D C,y A,x C,y D 4,6 -1,5 4,6 D 2, 7 1, 5 13, 8

Cont. strategies Cont. values Total. payoffs

Since (C,y), (D,z) and (A,x) are NE of the stage game, these strategies induce NE in all the proper subgames (in
the second period). Performing one step of backward induction, we obtain the previous table of total payoffs for
the first period. Since (B,y) is a NE of the resulting game, the proposed strategies are indeed a SPNE.

Problem 2.
 
30 pts Consider a Cournot duopoly with firms 1 and 2 producing the same good with constant
marginal cost c = 100 and inverse demand function:

P(q1 , q2 ) = 1000 − q1 − q2

Each firm wishes to maximize its profits:

ui (q1 , q2 ) = (P(q1 , q2 ) − c)qi = (900 − q1 − q2 )qi

Best response functions are given by:

1
BR i (q−i ) = 450 − q−i
2
The symmetric Pareto efficient outcome has both firms choosing q∗ = 225 and the unique Nash equilibrium has
both firms producing q C = 300.

Now suppose that the game is repeated infinitely and firms discount their future profits with a common discount
factor δ ∈ (0, 1). Consider the following grim trigger strategies:

Choose q∗ as long as everyone has chosen q∗ in the

past and choose p C otherwise
Find the minimum value of δ such that the grim trigger strategies are a SPNE of the repeated game? Hint: Start
by looking for the the most profitable deviations along the equilibrium path (ie the best responses to q∗ in the
stage game)

Since (q C , q C ) is a NE of the stage game, it is always IC to play q C forever if you think that your opponent will
play q C forever independently of what you do. Hence we only have to verify that players are willing to choose q∗
along the equilibrium path.
First notice that your most profitable deviation if your opponent is choosing q∗ is q′ :

1
q′ = BR(q∗ ) = 450 − 225 = 337.5
2

3
Now define u∗ , uC and u′ to be:

u∗ = u(q C , q C ) = (900 − 225 − 225) · 225 = 101250

uC = u(q C , q C ) = (900 − 300 − 300) · 300 = 900
u′ = u(q′ , q∗ ) = (900 − 225 − 337.5) · 337.5 = 113906.25

So each player thinks as follows: “If I choose q∗ today I will get u∗ forever whereas if I deviate today I can get at
most u′ today and then I will get uC from tomorrow onwards”. Hence a player wants to deviate if and only if:

1 δ
u∗ < u′ + uC ⇔ δ ≥ 0.53
1−δ 1−δ
For details as to how I got that value see slides 10 on repeated games (we solved this problem in class).

Problem 3.
 
30 pts Consider the following strategic situation with incomplete information involving two
firms: an incumbent and a potential entrant. The incumbent is the only firm currently operating in the industry
and it is sells a product with either good quality (G) or bad quality (B). The quality of the incumbent’s product is
known by only the incumbent, it is not known by the entrant. The product has good quality (G) with probability
1/2 and a bad quality (B) with probability 1/2.

The game begins with the incumbent choosing between a high price (H) and low price (L). After observing this
price, the entrant decides whether to enter (E) or not to enter (N). Payoffs are as follows:

E N E N

H 4 , −1 8, 0 H −1 , 5 3, 0

L 5 , −5 6, 0 L −1 , 1 1, 0

G (1/2) B (1/2)

3.a) Write down an extensive form game with Nature that represents this situation. The game should begin
with Nature choosing the type (cost) of the incumbent.

5 b b
4
−5 E’ E −1
E L I H E
b b b

6 b N’ N b
8
G (1/2)
0 0

bc
0

−1 b b
−1
B (1/2)
1 E’ E 5

b b b

E L’ I H’ E
1 b N’ N b
3
0 0

4
 3.b) Write down a Bayesian strategic form game that represents this situation.

EE’ EN’ NE’ NN’

HH’ 1.5, 2 1.5, 2 5.5, 0 5.5, 0

HL’ 1.5, 0 2.5, −0.5 3.5, 0.5 4.5, 0

LH’ 2, 0 2.5, 2.5 4, −2.5 4.5, 0

LL’ 2, −2 3.5, 0 2, −2 3.5, 0

3.c) Find all the Bayesian Nash equilibria in pure strategies.

The only BNE in pure strategies is (LL’,EN’), ie the incumbent always chooses low prices and the incumbent
chooses to enter if and only if it observes a high price.

Problem 4.
 
30 pts Consider a first price auction with 2 potential buyers. Each buyer i has a private value
vi and values are distributed uniformly on [0, 1]. Buyers simultaneously and independently submit bids bi . The
object is allocated to the buyer with the greatest bid so that payoffs are:

 vi − bi if bi > b−i
ui (v, b) =

0 otherwise

Find the unique Nash equilibrium in pure strategies. Hint: guess that equilibrium bids are linear, ie bi (vi ) = avi

See class slides or chapter 27 in the textbook for the solution.