14.

12 Game Theory, Fall 2001

14.12 Game Theory Fall 2001

Announcement
The final exam is on Friday, Dec. 21, 9:00-12:00 in Walker. The conflict exam will be on Thursday, December 20, 9:00-12:00 in E51-085.

Faculty
Professor: Muhamet Yildiz myildiz@mit.edu (Office hours: M 4:00-5:30, E52-251a, 253-5331) TA: Kenichi Amaya kamaya@mit.edu (Office hours: T 4:00-6:00, E52-303, 253-3591) TA: Astrid Dick astrida@mit.edu

Schedule
Class: Room E51-372 Recitation: F10 or F3, Room E51-085

Handouts
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syllabus Lecture notes 1 Lecture notes 2 Lecture notes 3 Lecture notes 4 Lecture notes 5 Lecture notes 6 Review notes 1 Review notes 2 Review notes 3 (11/30)

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14.12 Game Theory, Fall 2001

Lecture Slides
Some of the slides for lectures 1,2, and 6 are not included, as they are made by another program. q Slides 1
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Slides 2 Slides 3 Slides 4 Slides 5 Slides 6 Slides for lecture 8 Slides for lecture 9 Slides for lecture 10 Slides for lecture 12 Slides for lecture 13 Slides for lecture 15-18 Slides for lecture 19-21

Homeworks
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Homework 1 (due 9/26) Solutions for homework 1 Homework 2 (due 10/3) Solutions for homework 2 Homework 3 (due 10/29) Solutions for homework 3 Revised Homework 4 (due 11/7) Solutions for homework 4 Homework 5 (due 12/7) Solutions for homework 5 Revised

Homework Grading Policies

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You may turn in assignments during the lecture on the day they are due. After the lecture, assignments may be placed in a designated box that will be set out outside E52-303 until 5:30 p.

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14.12 Game Theory, Fall 2001

m. Do not leave assignments in the professor or T. A.'s office or mailbox. You are permitted to discuss course material, including homework, with other students in the class. However, you must turn in your own individual solutions to each homework set. You need to explain how you come up with the answers.Correct answers without proper explanations will receive no credit.

Exams
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Midterm 1 (10/10) Midterm 1 solutions Midterm 1 Grade Distribution Midterm 2 Midterm 2 Solutions New! Midterm 2 Grade Distribution New! Grade distribution of the average of midterm 1 and 2 New! Mock Final New! Mock Final solutions New!

Final exam solutions New! Final exam grade distribution New! Final grade+quiz distribution New! Final grade distribution New!

Past years' exams Midterm 1

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1995 1995 (Solutions) 1997 1999 2000 2000 (Solutions)

Midterm 2
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14.12 Game Theory, Fall 2001

q q q q q q q

1996 1997 1999 Mock Midterm 2000 (11/16) 2000 (11/17) Some previous midterm questions (including some questions from files above) Solutions for Question 7 (or 8)

Final
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2000 2000 solutions 2000 make-up

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zrxog fkrrvh rshud li khu h{shfwhg xwlolw| iurp rshud lv kljkhu/ edoohw li khu h{shfwhg xwlolw| iurp edoohw lv kljkhu/ dqg fdq fkrrvh dq| ri rshud ru edoohw li vkh lv lqglhuhqw ehwzhhq wkhvh wzr1 Vlploduo| zh frpsxwh wkdw ^ ' lv ehvw uhvsrqvh li R : e*D> ^ ' f lv ehvw uhvsrqvh li R e*D> dqg dq| ^ fdq eh ehvw uhvsrqvh li R ' e*D1 Zh sorw wkh ehvw uhvsrqvhv lq wkh
q 1 A
(A, B, C) are all equilibria

iroorzlqj judsk1

1/5

4/5

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4;

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Edfnzdug lqgxfwlrq

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+5/8,

+4/4,

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+6/6,

+4/4,

+3/7,

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4  G

+3/7,

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+5/8,

+4/4,

+3/7,

+6/6,

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(-1, 1)
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O
Head

Tail

(1, -1)

1
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Head

O
Tail (-1, 1)

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(-1,1) Head

Tail

(-1,1)

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4  G

D g

5 

d B

4 

+5/8,

+4/4,

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4  B

+5/8,

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+3/7,

+6/6,

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1 E 1 T B X (2,6)

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1 T B

2 L (0,1) R (3,2) L (-1,3) R (1,5)

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1 E (3,2) X (2,6)

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1 E 1 T B X (2,6)

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1 E 1 T B X (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

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X 1 T B (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

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X 1 T B (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

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14.12 Review Notes 1

Kenichi Amaya September 14, 2001

Why do we learn game theory?

Economic agents (e.g., consumers, rms, government) behavior is described as a maximization problem (utility maximization, prot maximization). For example, consider a rms prot maximization problem. Perfect competition Under perfect competition, a rm takes the price as given, and choose the quantity to sell. max pq c(q)
q

FOC p = c (q) = M C. Monopoly A monopolist choose the price, and the quantity to sell is determined by the demand curve D(p). max pD(p) c(D(p))
p

FOC pD (p) + D(p) = c (D(p))D(p). In the examples above, the rm is the only decision maker and everything other than the choice variables (q in perfect competition and q in monopoly) are exogenously given. Therefore we can solve for the optimal value of the choice variable. Consider the Cournot Duopoly. Firm 1 chooses the quantity to sell q1 , and Firm 2 chooses q2 . Let P (q) be the inverse demand curve, where q = q1 + q2 . Firm 1 maximizes its prot: max P (q1 + q2 )q1 c1 (q1 ).
q1
E52-303,

kamaya@mit.edu

Firm 2 maximizes its prot: max P (q1 + q2 )q2 c2 (q2 ).

q2

To solve for the optimal q1 , we need to know what q2 is. But to know the optimal q2 , we need to know what q1 is. This goes forever and we can never solve it mathematically. We need some theory to solve it: Game theory. Game theory is a tool to analyze peoples behavior under strategic environment: An agents payo depends not only on his decisions but also other agents decisions. Other examples includes: Employer Employee (Wage scheme Eort) Government Firm (Regulation Business strategy) U.S. Government Japanese government (Trade policy)

Decision making under uncertainty

In the environment of games, economic agents often faces uncertainty. They must choose among alternatives which gives dierent probability distribution over outcomes. We often call outcomes of lotteries prizes We call these alternatives lotteries. For example: Lottery 1 gives you beer with probability Lottery 2 gives you beer with probability
1 2 1 3

and chocolate with probability 1 . 2 and coee with probability 2 . 3

We want to have a utility function U () such that U (lottery 1) U (lottery 2) if and only if the agent prefers lottery 1 to lottery 2, i.e., lottery 1 lottery 2. is a

The basic theory of choice implies there exists such a utility function if preference relationship, i.e., it is complete and transitive Completeness For all p, q P , p Transitivity If p q and q q or q r. p.

r, then p

But thinking directly about this function U is too messy! It is more convenient if we have a function u such that U (lottery 1) = 1 1 u(beer) + u(chocolate), 2 2 2 1 U (lottery 2) = u(beer) + u(cof f ee). 3 3

But can we really nd such an convenient function u? Actually, it is known that we can nd u if the agents preference over lotteries satises the following condition, in addition to completeness and transitivity. Independence For any p, q, r P , and any a (0, 1], ap + (1 a)r Continuity For any p, q, r P , if p ap + (1 p)r aq + (1 a)r p q.

r, then there exist a, b (0, 1) such that q bp + (1 b)r. ,

Furthermore, if a von-Neuman Morgenstern utility function u represents then its ane transformation u = au + b where a > 0 also represents .

Attitudes toward risk

Suppose now the prizes of lotteries are money. Lottery A gives you 50 dollars for sure (a degenerated lottery). Lottery B gives you 100 dollars with probability 1 1 2 and 0 with probability 2 . Which do you prefer? The two lotteries give you the same expected amount of money, 50 dollars, so your choice reects whether you like risk or not. If you prefer Lottery A, then we can say you are risk averse. Your vNM utility function satises u(50) > 1 1 u(0) + u(100). 2 2

This is true if your vNM utility function is concave (u < 0 if u is twice dierentiable). In general, if your vNM utility function is concave, you always prefer getting the avarage for sure to getting some risky lottery. In contrast, if your vNM utility function is concave, you always prefer getting some risky lottery to getting the avarage for sure. In this case, you are called risk loving. If your vNM utility function is linear, you are indierent between getting some risky lottery and getting the avarage for sure. In this case, you are called risk neutral. 3

Modelling games

When we write down a game which represents some economic environment, the payos of the game are vNM utilities of the players, not the actual money amount received. In this way, we can assume the players maximize their expected payos. The only case where the payos of a player is equal to the actual money amount received is the case where the player is risk neutral. Actually, in many textbook modelling we nd the players are assumed to be risk neutral and therefore maximize expected revenue.

14.12 Review Notes Dynamic games with incomplete information

Kenichi Amaya November 30, 2001

Perfect Bayesian equilibrium

s = (s1 , , sn ): strategy prole. A belief at an information set is a probability distribution over decision nodes in the information set. A belief system is the collection of beliefs at all information sets.

Denition A pair of strategy prole and a belief system (s, ) is a Perfect Bayesian (Nash) equilibrium (PBE) if 1. Given their beliefs, the players strategies must be sequentially rational. That is, at each information set the action taken by the player with the move (and the players subsequent strategy) must be optimal given the players belief at that information set and the other players subsequent strategies. 2. Beliefs are determined by Bayes rule and the players equilibrium strategies wherever possible. Note 1: When you are asked to describe a PBE, you need to show not only the strategy prole but also the belief system. (However, you usually dont need to describe the belief at a singleton information set because it is obvious). Note 2: PBE is a stronger concept than subgame perfect Nash equilibrium. Therefore, the strayegy prole of a PBE is a subgame perfect Nash equilibrium.
E52-303,

kamaya@mit.edu

How do we nd PBE?
1. Using sequential rationality and Bayes rule, determine strategies and beliefs wherever possible. If you can determine strategies and beliefs everywhere, thats it. 2. When you cant do more, make an assumption about a strategy at any information set. Then, using sequential rationality and Bayes rule, determine strategies and beliefs wherever possible. 3. You may be able to determine strategies and beliefs everywhere, i.e., to nd an equilibrium. Then, change your assumption and look for another equilibrium. 4. You may reach a contradiction. In this case, the assumption was wrong. Change your assumption. 5. When you cant do more only with the assumption you made, make a further assumption.

Here is an abstract procedure of looking for PBE.

The idea we use in nding a mixed strategy Nash equilibrium applies here too: The mixing probability must be such that the other player is indierent between the strategies he is mixing.

14.12 Economic Applications of Game Theory

Professor: Muhamet Yildiz Lecture: MW 2:30-4:00 @4-153? Office Hours: M 4-5:30 @E52-251a TA: Kenichi Amaya F 10,3 @E51-85 Office Hours:TBA Web: http://web.mit.edu/14.12/www/

Name of the game

Game Theory = Multi-person decision theory The outcome is determined by the actions independently taken by multiple decision makers. Strategic interaction.
Need to understand what the others will do what the others think that you will do

Hawk-Dove game

V c V c , 2 2

(V,0) (V/2,V/2)

(0,V)

Chicken

(-1,-1) (0,1)

(1,0) (1/2,1/2)

Stag Hunt

(2,2) (0,4)

(4,0) (6,6)

Quiz Problem
Without discussing with anyone, each student is to write down a real number xi between 0 and 100 on a paper and submit it to the TA. The TA will then compute the average
x= x1 + x2 +  + xn . n

The students who submit the number that is closest to x / 3 will share 100 points equally;
the others will get 0.

14.12 Game Theory

Lecture 2: Decision Theory Muhamet Yildiz

Road Map
1. Basic Concepts (Alternatives, preferences,) 2. Ordinal representation of preferences 3. Cardinal representation Expected utility theory 4. Applications: Risk sharing and Insurance

5. Quiz

Basic Concepts: Alternatives

Agent chooses between the alternatives X = The set of all alternatives Alternatives are Mutually exclusive, and Exhaustive Example: Options = {Tea, Coffee} X = {T, C, TC, NT} where T= Tea, C = Coffee, TC = Tea and Coffee, NT = Neither Tea nor Coffee

Basic Concepts: Preferences

TeX TeX ordinal representation

Examples
Define a relation among the students in this class by
x T y iff x is at least as tall as y; x M y iff xs final grade in 14.04 is at least as high as ys final grade; x H y iff x and y went to the same high school; X Y y iff x is strictly younger than y; x S y iff x is as old as y;

Exercises
Imagine a group of students sitting around a round table. Define a relation R, by writing x R y iff x sits to the right of y. Can you represent R by a utility function? Consider a relation } among positive real 2 numbers represented by u with u ( x ) = x . Can this relation be represented byu * ( x ) = x ? What about u **( x) = 1/ x ?

TeX OR Theorem TeX Cardinal representation VNM Axioms Theorem

A Lottery

Two Lotteries
$1000 .3
.3

$1M .00001

$10 .99999 $0 $0

.4

Exercise
Consider an agent with VNM utility 2 function u with u ( x ) = x . Can his preferences be represented by VNM utility function u * ( x ) = x ? What about u **( x) = 1/ x ?

Attitudes towards Risk

p

A fair gamble:
1-p

x y

px+(1-p)y = 0.

An agent is said to be risk neutral iff he is indifferent towards all fair gambles. He is said to be (strictly) risk averse iff he never wants to take any fair gamble, and (strictly) risk seeking iff he always wants to take fair gambles.

A utility function
EU u A u(pW1+(1- p)W2) C EU(Gamble) B

W1

pW1+(1-p)W2

W2

 An agent is risk-neutral iff he has a linear utility function, i.e., u(x) = ax + b. An agent is risk-averse iff his utility function is concave. An agent is risk-seeking iff his utility function is convex.

Risk Sharing
Two agents, each having a utility function u with u ( x ) = x and an asset: .5
$100 $0

For each agent, the value of the asset is Assume that the value of assets are independently distributed.

.5

 If they form a mutual fund so that each agent owns half of each asset, each gets
$100 1/4 1/2 1/4 $0 $50

Insurance
We have an agent with u(x ) = x and
.5 .5 $1M $0

And a risk-neutral insurance company with lots of money, selling full insurance for premium P.

Lecture 3 Decision Theory/Game Theory

14.12 Game Theory Muhamet Yildiz

Road Map
1. 2. Basic Concepts (Alternatives, preferences,) Ordinal representation of preferences

3. Cardinal representation Expected utility theory

4. Applications: Risk sharing and Insurance

5. Quiz 6. Representation of games in strategic and extensive forms 7. Quiz?

A Lottery

Two Lotteries
$1000 .3
.3

$1M .00001

$10 .99999 $0 $0

.4

Exercise
Consider an agent with VNM utility 2 function u with u ( x ) = x . Can his preferences be represented by VNM utility function u * ( x ) = x ? What about u **( x) = 1/ x ?

Attitudes towards Risk

A fair gamble:
p 1-p x y

px+(1-p)y = 0.

An agent is said to be risk neutral iff he is indifferent towards all fair gambles. He is said to be (strictly) risk averse iff he never wants to take any fair gamble, and (strictly) risk seeking iff he always wants to take fair gambles.

A utility function
EU u A u(pW1+(1- p)W2) C EU(Gamble) B

W1

pW1+(1-p)W2

W2

An agent is risk-neutral iff he has a linear utility function, i.e., u(x) = ax + b. An agent is risk-averse iff his utility function is concave. An agent is risk-seeking iff his utility function is convex.

Risk Sharing
Two agents, each having a utility function u with u ( x ) = x and an asset: .5
$100 $0

For each agent, the value of the asset is Assume that the value of assets are independently distributed.

.5

If they form a mutual fund so that each agent owns half of each asset, each gets
$100 1/4 1/2 1/4 $0 $50

Insurance
We have an agent with u(x ) = x and
.5 .5 $1M $0

And a risk-neutral insurance company with lots of money, selling full insurance for premium P.

Quiz Problem
Without discussing with anyone, each student is to write down a real number xi between 0 and 100 on a paper and submit it to the TA. The TA will then compute the average
x= x1 + x2 +  + xn . n

The students who submit the number that is closest to x / 3 will share 100 points equally;
the others will get 0.

Multi-person Decision Theory

Who are the players? Who has which options? Who knows what? Who gets how much?

Knowledge
1. 2. 3. 4. If I know something, it must be true. If I know x, then I know that I know x. If I dont know x, then I know that I dont know x. If I know something, I know all its logical implications. Common Knowledge: x is common knowledge iff Each player knows x Each player knows that each player knows x Each player knows that each player knows that each player knows x Each player knows that each player knows that each player knows that each player knows x ad infinitum

Representations of games

Normal-form representation
Definition (Normal form): A game is any list
G = (S1 , l , S n ; u1 , l , u n )

where, for each i N = {1,2,l, n}, Si is the set of all strategies available to i, ui : S1 m Sn is the VNM utility function of player i.

Assumption: G is common knowledge.

Definition: A player i is rational iff he tries to maximize the expected value of ui given his beliefs.

Chicken

(-1,-1) (0,1)

(1,0) (1/2,1/2)

Extensive-form representation
Definition: A tree is a set of nodes connected with directed arcs such that 1. For each node, there is at most one incoming arc; 2. each node can be reached through a unique path;

A tree?

A tree??
B
A B

A C
D C

10

A tree
Non-terminal nodes Terminal Nodes

Extensive form definition

Definition: A game consists of
a set of players a tree an allocation of each non-terminal node to a player an informational partition (to be made precise) a payoff for each player at each terminal node.

11

Information set
An information set is a collection of nodes such that 1. The same player is to move at each of these nodes; 2. The same moves are available at each of these nodes. An informational partition is an allocation of each non-terminal node of the tree to an information set.

A game
1 L (2,2) l 1 (1,3) (3,1) (3,3) R 2 r 1 u (1,1) (0,0)

12

Another Game
1 T 2 L R L R x

The same game

1 T 2 L R L R B x

13

Strategy
A strategy of a player is a complete contingent-plan, determining which action he will take at each information set he is to move (including the information sets that will not be reached according to this strategy).

Matching pennies with perfect information

1 Head 2 head (-1,1) tail (1,-1) 2 head (1,-1) tail (-1,1) Tail 2s Strategies: HH = Head if 1 plays Head, Head if 1 plays Tail; HT = Head if 1 plays Head, Tail if 1 plays Tail; TH = Tail if 1 plays Head, Head if 1 plays Tail; TT = Tail if 1 plays Head, Tail if 1 plays Tail.

14

Matching pennies with perfect information

2

HH

HT

TH

TT

Head

Tail

Matching pennies with Imperfect information

1 Head 2 head (-1,1) tail (1,-1) head (1,-1) tail (-1,1) Tail 1 2

Head (-1,1) (1,-1)

Tail (1,-1) (-1,1)

Head Tail

15

A game with nature

Left 1 Head 1/2 Nature 1/2 Tail 2 Left Right (2, 2) (3, 3) (5, 0)

Right (0, -5)

A centipede game
1 D (4,4) A 2 (5,2) d (3,3) 1 a (1,-5)

16

Lecture 4 Representation of Games & Rationalizability

14.12 Game Theory Muhamet Yildiz

Road Map
1. Representation of games in strategic and extensive forms 2. Dominance 3. Dominant-strategy equilibrium 4. Rationalizability

Normal-form representation
Definition (Normal form): A game is any list
G = (S1 , l , S n ; u1 , l , u n )

where, for each i N = {1,2,l, n}, Si is the set of all strategies available to i, ui : S1 m Sn is the VNM utility function of player i.

Assumption: G is common knowledge.

Definition: A player i is rational iff he tries to maximize the expected value of ui given his beliefs.

Chicken

(-1,-1) (0,1)

(1,0) (1/2,1/2)

Extensive-form representation
Definition: A tree is a set of nodes connected with directed arcs such that 1. For each node, there is at most one incoming arc; 2. each node can be reached through a unique path;

A tree
Non-terminal nodes Terminal Nodes

Extensive form definition

Definition: A game consists of
a set of players a tree an allocation of each non-terminal node to a player an informational partition (to be made precise) a payoff for each player at each terminal node.

Information set
An information set is a collection of nodes such that 1. The same player is to move at each of these nodes; 2. The same moves are available at each of these nodes. An informational partition is an allocation of each non-terminal node of the tree to an information set.

A game
1 L (2,2) l 1 (1,3) (3,1) (3,3) R 2 r 1 u (1,1) (0,0)

Another Game
1 x

T 2 L R L

The same game

1 x

T 2 L R L

Strategy
A strategy of a player is a complete contingent-plan, determining which action he will take at each information set he is to move (including the information sets that will not be reached according to this strategy).

Matching pennies with perfect information

1 Head 2 head (-1,1) tail (1,-1) 2 head (1,-1) tail (-1,1) Tail 2s Strategies: HH = Head if 1 plays Head, Head if 1 plays Tail; HT = Head if 1 plays Head, Tail if 1 plays Tail; TH = Tail if 1 plays Head, Head if 1 plays Tail; TT = Tail if 1 plays Head, Tail if 1 plays Tail.

Matching pennies with perfect information

2 1

HH

HT

TH

TT

Head

Tail

Matching pennies with Imperfect information

1 1 Head 2 head (-1,1) tail (1,-1) head (1,-1) tail Tail 2

Head (-1,1)

Tail (1,-1)

Head

Tail
(-1,1)

(1,-1)

(-1,1)

A game with nature

Left 1 Head 1/2 Nature 1/2 Tail 2 Right (0, -5) Left (3, 3) Right (2, 2) (5, 0)

Mixed Strategy
Definition: A mixed strategy of a player is a probability distribution over the set of his strategies. Pure strategies: Si = {si1,si2,,sik} A mixed strategy: i: S [0,1] s.t. i(si1) + i(si2) + + i(sik) = 1. If the other players play s-i =(s1,, si-1,si+1,,sn), then the expected utility of playing i is i(si1)ui(si1,s-i) + i(si2) ui(si2,s-i) + + i(sik) ui(sik,s-i).

How to play

Dominance
s-i =(s1,, si-1,si+1,,sn) Definition: A pure strategy si* strictly dominates si if and only if

u i ( si* , s i ) > u i ( si , s i )

si .

A mixed strategy i* strictly dominates si iff

i ( si1 )ui ( si1 , si ) + m + i ( sik )ui ( sik , si ) > ui ( si , si ) si

A rational player never plays a strictly dominated strategy.

Prisoners Dilemma
2 1

Cooperate (5,5) (6,0)

Defect (0,6) (1,1)

Cooperate Defect

10

A game
1 2

L (3,0) (1,0) (0,3)

m (1,1) (0,10) (1,1)

R (0,3) (1,0) (3,0)

T M B

Weak Dominance
Definition: A pure strategy si* weakly dominates si if and only if

u i ( si* , s i ) u i ( si , s i )

si .

and at least one of the inequalities is strict. A mixed strategy i* weakly dominates si iff

i ( si1 )ui ( si1 , si ) +  + i ( sik )ui ( sik , si ) > ui ( si , si ) si

and at least one of the inequalities is strict. If a player is rational and cautious (i.e., he assigns positive probability to each of his opponents strategies), then he will not play a weakly dominated strategy.

11

Dominant-strategy equilibrium
Definition: A strategy si* is a dominant strategy iff si* weakly dominates every other strategy si. Definition: A strategy profile s* is a dominant-strategy equilibrium iff si* is a dominant strategy for each player i. If there is a dominant strategy, then it will be played, so long as the players are

Prisoners Dilemma
2 1

Cooperate (5,5) (6,0)

Defect (0,6) (1,1)

Cooperate Defect

12

Second-price auction
N = {1,2} buyers; The value of the house for buyer i is vi; Each buyer i simultaneously bids bi; i* with bi* = max bi gets the house and pays the second highest bid p = maxjibj.

Question
What is the probability that an nxn game has a dominant strategy equilibrium given that the payoffs are independently drawn from the same (continuous) distribution on [0,1]?

13

(1/n) 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

(2n-2)

10

A game
2 1

Assume: Players are rational and player 2 knows that 1 is rational. 1 is rational and 2 knows this:

L (3,0) (1,0) (0,3)

m (1,1) (0,10) (1,1)

R T (0,3) (1,0) (3,0) T B B

(3,0) (1,1) (0,3) (0,3) (1,1) (3,0)

T M B

And 2 is rational:

(3,0) (0,3) (0,3) (3,0)

14

Rationalizability
Eliminate all the strictly dominated strategies.

Yes

Any dominated strategy In the new game? No Rationalizable strategies

The play is rationalizable, provided that

Simplified price-competition
Firm 2 Firm 1

High 6,6 10,0 8,0

Medium 0,10 5,5 8,0

Low 0,8 0,8 4,4

High Medium Low

Dutta

15

A strategy profile is rationalizable when

Each players strategy is consistent with his rationality, i.e., maximizes his payoff with respect to a conjecture about other players strategies; These conjectures are consistent with the other players rationality, i.e., if i conjectures that j will play sj with positive probability, then sj maximizes js payoff with respect to a conjecture of j about other players strategies; These conjectures are also consistent with the other players rationality, i.e., Ad infinitum

16

Lecture 5 Nash equilibrium & Applications

14.12 Game Theory Muhamet Yildiz

Road Map
1. Rationalizability summary 2. Nash Equilibrium 3. Cournot Competition
1. Rationalizability in Cournot Duopoly

4. 5. 6. 7.

Bertrand Competition Commons Problem Quiz Mixed-strategy Nash equilibrium

Dominant-strategy equilibrium
s-i =(s1,, si-1,si+1,,sn) Definition: si* strictly dominates si iff si* weakly dominates si iff u i ( s , s i ) u i ( si , s i ) si and at least one of the inequalities is strict. Definition: A strategy si* is a dominant strategy iff si* weakly dominates every other strategy si. Definition: A strategy profile s* is a dominantstrategy equilibrium iff si* is a dominant strategy for each player i. Examples: Prisoners Dilemma; Second-Price auction.
* i

u i ( si* , s i ) > u i ( si , s i )

si ;

Question
What is the probability that an nxn game has a dominant strategy equilibrium given that the payoffs are independently drawn from the same (continuous) distribution on [0,1]?

(1/n) 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

(2n-2)

10

Rationalizability
Eliminate all the strictly dominated strategies.

Yes

Any dominated strategy In the new game? No Rationalizable strategies

The play is rationalizable, provided that

Simplified price-competition
Firm 2 Firm 1

High 6,6 10,0 8,0

Medium 0,10 5,5 8,0

Low 0,8 0,8 4,4

High Medium Low

Dutta

A strategy profile is rationalizable when

Each players strategy is consistent with his rationality, i.e., maximizes his payoff with respect to a conjecture about other players strategies; These conjectures are consistent with the other players rationality, i.e., if i conjectures that j will play sj with positive probability, then sj maximizes js payoff with respect to a conjecture of j about other players strategies; These conjectures are also consistent with the other players rationality, i.e., Ad infinitum

Stag Hunt

(2,2) (0,4)

(4,0) (6,6)

A summary
If players are rational (and cautious), then they play the dominant-strategy equilibrium whenever it exists
But, typically, it does not exist

If it is common knowledge that players are rational, then they will play a rationalizable strategy-profile
Typically, there are too many rationalizable strategies

Now, a stronger assumption: The players are rational and their conjectures are mutually known.

Nash Equilibrium
Definition: A strategy-profile s* =(s1*,,sn*) is a Nash Equilibrium iff, for each player i, and for each strategy si, we have
* u i ( s1* , l , si*1 , si* , si*+1 , l , s n ) * * u i ( s1 , l , si*1 , si , si*+1 , l , s n ),

i.e., no player has any incentive to deviate if he knows what the others play. ??If players are rational, and their conjectures about what the others play are mutually known, then they must be playing a Nash equilibrium.

Stag Hunt

(2,2) (0,4)

(4,0) (6,6)

Economic Applications
1. Cournot (quantity) Competition
1. Nash Equilibrium in Cournot duopoly 2. Nash Equilibrium in Cournot oligopoly 3. Rationalizability in Cournot duopoly

2. Bertrand (price) Competition 3. Commons Problem

Cournot Oligopoly
N = {1,2,,n} firms; Simultaneously, each firm i produces qi units of a good at marginal cost c, and sells the good at price P = max{0,1-Q} where Q = q1++qn. Game = (S1,,Sn; 1,,n) where Si = [0,),
P 1

Q 1

i(q1,,qn) = qi[1-(q1++qn)-c] if q1++qn < 1, -qic otherwise.

Cournot Duopoly -- profit

qj=0.2 Profit 0 qi(1-qj-c) -cqi c=0.2

-0.2

(1-qj-c)/2

1-qj-c

C-D best responses

qiB(qj) = max{(1-qj-c)/2,0};
q2 q1=q1B(q2)

Nash Equilibrium q*: q1* = (1-q2*-c)/2; q2* = (1-q1*-c)/2; q1* = q2* = (1-c)/3

q*
1 c 2

q2=q2B(q1) q1

1-c

Cournot Oligopoly --Equilibrium

q>1-c is strictly dominated, so q 1-c.
i(q1,,qn) = qi[1-(q1++qn)-c] for each i. FOC: ( q , , q ) [ qi (1 q1  qn c )] 1 i n

qi

q=q

qi

q = q*

* * = (1 q1  qn c ) qi* = 0.

That is,

* * * 2q1 + q2 +  + qn = 1 c * * * q1 + 2q2 +  + qn = 1 c


* * * q1 + q2 +  + nqn = 1 c

Therefore, q1*==qn*=(1-c)/(n+1).

Cournot oligopoly comparative statics

P

n=1 n=2 n=3 n=4 Q c 1

Rationalizability in Cournot Duopoly

q2 1-c Assume that players are rational.

1 c 2

q1
1 c 2

1-c

Players are rational:

q2 1-c Assume that players know this.

1 c 2

q1
1 c 2

1-c

10

Players are rational and know that players are rational

q2 1-c Assume that players know this.

1 c 2

q1
1 c 2

1-c

Players are rational; players know that players are rational; players know that players know that players are rational q
2

1-c Assume that players know this.

1 c 2

q1
1 c 2

1-c

11

Rationalizability in Cournot duopoly

If i knows that qj q, then qi (1-c-q)/2. If i knows that qj q, then qi (1-c-q)/2. We know that qj q0 = 0. Then, qi q1 = (1-c-q0)/2 = (1-c)/2 for each i; Then, qi q2 = (1-c-q1)/2 = (1-c)(1-1/2)/2 for each i; Then, qn qi qn+1 or qn+1 qi qn where qn+1 = (1-c-qn)/2 = (1-c)(1-1/2+1/4-+(-1/2)n)/2. As n, qn (1-c)/3.

Bertrand (price) competition

N = {1,2} firms. Simultaneously, each firm i sets a price pi; If pi < pj, firm i sells Q = max{1 pi,0} unit at price pi; the other firm gets 0. If p1 = p2, each firm sells Q/2 units at price p1, where Q = max{1 p1,0}. The marginal cost is 0. if p1 < p2 p1 (1 p1 ) 1 ( p1 , p2 ) = p1 (1 p1 ) / 2 if p1 = p2 0 otherwise.

12

Bertrand duopoly -- Equilibrium

Theorem: The only Nash equilibrium in the Bertrand game is p* = (0,0). Proof: 1. p*=(0,0) is an equilibrium. 2. If p = (p1,p2) is an equilibrium, then p = p*.
1. If p = (p1,p2) is an equilibrium, then p1 = p2...
If pi > pj= 0, for sufficiently small >0, pj = is a better response to pi for j. If pi > pj> 0, pi = pj is a better response for i. If p1 = p2>0, for sufficiently small >0, pj = pj - is a better response to pj for i.

2. Given any equilibrium p = (p1,p2) with p1 = p2, p = p*.

Commons Problem
N = {1,2,,n} players, each with unlimited money; Simultaneously, each player i contributes xi 0 to produce y = x1+xn unit of some public good, yielding payoff Ui(xi,y) = y1/2 xi.

13

Quiz
Each student i is to submit a real number xi. We will pair the students randomly. For each pair (i,j), if xi xj, the student who submits the number that is closer to (xi+xj)/4 gets 100; the other student gets 20. If xi = xj, then each of i and j gets 50.

14

Lectures 6-7
Nash Equilibrium & Backward Induction
14.12 Game Theory Muhamet Yildiz

Road Map
1. 2. 3. 4. 5. 6. 7. Bertrand Competition Commons Problem Mixed-strategy Nash equilibrium Bertrand competition with costly search Backward Induction Stackelberg Competition Sequential Bargaining

Bertrand (price) competition

N = {1,2} firms. Simultaneously, each firm i sets a price pi; If pi < pj, firm i sells Q = max{1 pi,0} unit at price pi; the other firm gets 0. If p1 = p2, each firm sells Q/2 units at price p1, where Q = max{1 p1,0}. The marginal cost is 0. if p1 < p2 p1 (1 p1 ) 1 ( p1 , p2 ) = p1 (1 p1 ) / 2 if p1 = p2 0 otherwise.

Bertrand duopoly -- Equilibrium

Theorem: The only Nash equilibrium in the Bertrand game is p* = (0,0). Proof: 1. p*=(0,0) is an equilibrium. 2. If p = (p1,p2) is an equilibrium, then p = p*.
1. If p = (p1,p2) is an equilibrium, then p1 = p2...
If pi > pj= 0, for sufficiently small >0, pj = is a better response to pi for j. If pi > pj> 0, pi = pj is a better response for i. If p1 = p2>0, for sufficiently small >0, pj = pj - is a better response to pj for i.

2. Given any equilibrium p = (p1,p2) with p1 = p2, p = p*.

Commons Problem
N = {1,2,,n} players, each with unlimited money; Simultaneously, each player i contributes xi 0 to produce y = x1+xn unit of some public good, yielding payoff Ui(xi,y) = y1/2 xi.

Stag Hunt

(2,2) (0,4)

(4,0) (5,5)

Equilibrium in Mixed Strategies

What is a strategy?
A complete contingent-plan of a player. What the others think the player might do under various contingency.

What do we mean by a mixed strategy?

The player is randomly choosing his pure strategies. The other players are not certain about what he will do.

Stag Hunt

(2,2) (0,4)

(4,0) (5,5)

Mixed-strategy equilibrium in Stag-Hunt game

Assume: Player 2 thinks that, with probability p, Player 1 targets for Rabbit. What is the best probability q she wants to play Rabbit? His payoff from targeting Rabbit: U2(R;p) = 2p + 4(1-p) = 4-2p. From Stag: U2(R;p) = 5(1-p) She is indifferent iff 4-2p = 5(1-p) iff p = 1/3.
5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 5(1-p) 4 - 2p

0.2

0.4

0.6

0.8

if p < 1/3 0 q ( p ) = q [0,1] if p = 1/3 1 if p > 1/3

BR

Best responses in Stag-Hunt game

q

1/3 p 1/3

Bertrand Competition with costly search

N = {F1,F2,B}; F1, F2 are firms; B is buyer B needs 1 unit of good, worth 6; Firms sell the good; Marginal cost = 0. Possible prices P = {1,5}. Buyer can check the prices with a small cost c > 0. Game: 1. Each firm i chooses price p i; 2. B decides whether to check the prices; 3. (Given) If he checks the prices, and p1p2, he buys the cheaper one; otherwise, he buys from any of the firm with probability .

Bertrand Competition with costly search

F2 F1 High F2 High Low F1 High High Low

Low

Low

Check

Dont Check

Mixed-strategy equilibrium
Symmetric equilibrium: Each firm charges High with probability q; Buyer Checks with probability r. U(check;q) = q21 + (1-q2)5 c = 5 - 4 q2 c; U(Dont;q) = q1 + (1-q)5 = 5 - 4 q; Indifference: 4q(1-q) = c; i.e., U(high;q,r) = 0.5(1-r(1-q))5; U(low;q,r) = qr1 + 0.5(1-qr) Indifference = r = 4/(5-4q).

Dynamic Games of Perfect Information & Backward Induction

Definitions
Perfect-Information game is a game in which all the information sets are singleton. Sequential Rationality: A player is sequentially rational iff, at each node he is to move, he maximizes his expected utility conditional on that he is at the node even if this node is precluded by his own strategy. In a finite game of perfect information, the common knowledge of sequential rationality gives Backward Induction outcome.

A centipede game
1 D (4,4) A 2 (5,2) d (3,3) 1 a (1,-5)

Backward Induction
Take any pen-terminal node Pick one of the payoff vectors (moves) that gives the mover at the node the highest payoff Assign this payoff to the node at the hand; Eliminate all the moves and the terminal nodes following the node Yes Any non-terminal node No The picked moves

Battle of The Sexes with perfect information

1

2 L R L

2 R

(2,1)

(0,0)

(0,0)

(1,2)

Note
There are Nash equilibria that are different from the Backward Induction outcome. Backward Induction always yields a Nash Equilibrium. That is, Sequential rationality is stronger than rationality.

Matching Pennies (wpi)

1 Head 2 head tail 2 head (1,-1) tail (-1,1)

Tail

(-1,1)

(1,-1)

10

Stackelberg Duopoly
Game: P N = {1,2} firms w MC = 0; 1. Firm 1 produces q1 units 1 2. Observing q1, Firm 2 produces q2 units 3. Each sells the good at price P = max{0,1-(q1+q2)}. i(q1, q2) = qi[1-(q1+q2)] if q1+ q2 < 1, 0 otherwise.
1

Stackelberg equilibrium
If q1 > 1, q2*(q1) = 0. If q1 1, q2*(q1) = (1-q1)/2. Given the function q2*, if q1 1 = q1 (1-q1)/2; 0 otherwise. q1* = . q2*(q1*) = .
1 P 1

1(q1;q2*(q1)) = q1[1-(q1+ (1-q1)/2)]

11

Sequential Bargaining
1 D

N = {1,2} X = feasible expected-utility pairs (x,y X ) Ui(x,t) = itxi d = (0,0) D disagreement payoffs
1

Timeline 2 period
At t = 1,
Player 1 offers some (x1,y1), Player 2 Accept or Rejects the offer If the offer is Accepted, the game ends yielding (x1,y1), Otherwise, we proceed to date 2.

At t = 2,
Player 2 offers some (x2,y2), Player 1 Accept or Rejects the offer If the offer is Accepted, the game ends yielding payoff (x2,y2). Otherwise, the game end yielding d = (0,0).

(x1,y1)

2 Reject

(x2,y2)

(0,0) Reject (x2,y2)

Accept

Accept

(x1,y1)

12

(x1,y1)

2 Reject

(x2,y2)

(0,0) Reject (x2,y2)

Accept

Accept

(x1,y1)

At t = 2, Accept iff y2 0. Offer (0,1). At t = 1, Accept iff x2 . Offer (1,).

Timeline 2n period
T = {1,2,,2n-1,2n} If t is odd,
Player 1 offers some (xt,yt), Player 2 Accept or Rejects the offer If the offer is Accepted, the game ends yielding t(xt,yt), Otherwise, we proceed to date t+1.

If t is even
Player 2 offers some (xt,yt), Player 1 Accept or Rejects the offer If the offer is Accepted, the game ends yielding payoff (xt,yt), Otherwise, we proceed to date t+1, except at t = 2n, when the game end yielding d = (0,0).

13

Equilibrium
Scientific Word

14

Lectures 8
Subgame-perfect Equilibrium & Applications
14.12 Game Theory Muhamet Yildiz

Road Map
1. Subgame-perfect Equilibrium
1. 2. 3. 4. Motivation What is a subgame? Definition Example

2. Applications
1. Bank Runs 2. Tariffs & Intra-industry trade

3. Quiz

A game
1 E 1 T B X (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

Sequential Bargaining
1 D

N = {1,2} X = feasible expected-utility pairs (x,y X ) Ui(x,t) = itxi d = (0,0) D disagreement payoffs
1

Timeline period
T = {1,2,, n-1,n,} If t is odd,
Player 1 offers some (xt,yt), Player 2 Accept or Rejects the offer If the offer is Accepted, the game ends yielding t(xt,yt), Otherwise, we proceed to date t+1.

If t is even
Player 2 offers some (xt,yt), Player 1 Accept or Rejects the offer If the offer is Accepted, the game ends yielding payoff (xt,yt), Otherwise, we proceed to date t+1.

Backward induction
Can be applied only in perfect information games of finite horizon. How can we extend this notion to infinite horizon games, or to games with imperfect information?

A subgame
A subgame is part of a game that can be considered as a game itself. It must have a unique starting point; It must contain all the nodes that follow the starting node; If a node is in a subgame, the entire information set that contains the node must be in the subgame.

A game
1 D (4,4) A 2 (5,2) d (3,3) 1 a (1,-5)

And its subgames

1 a d (3,3) (1,-5) 2 (5,2) 1 a d (1,-5)

(3,3)

A game
1 E 1 T B X (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

Definitions
A substrategy is the restriction of a strategy to a subgame. A subgame-perfect Nash equilibrium is a Nash equilibrium whose substrategy profile is a Nash equilibrium at each subgame.

Example
1 E 1 T B X (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

A Backward-Induction-like method
Take any subgame with no proper subgame Compute a Nash equilibrium for this subgame Assign the payoff of the Nash equilibrium to the starting node of the subgame Eliminate the subgame Yes Any non-terminal node No The moves computed as a part of any (subgame) Nash equilibrium

Theorem
In a finite, perfect-information game, the set of subgame-perfect equilibria is the set of strategy profiles that are computed via backward induction.

A subgame-perfect equilibrium?
X 1 T B (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

Bank Run
1 W 2 W (r,r) DW W W DW 1 DW DW (R,R) DW R > D > r > D/2

(D,2r-D) (2r-D,D)

2 W (R,R) DW W

(2R-D,D) (D,2R-D)

Lectures 9 Applications of Subgame-perfect

Equilibrium & Forward Induction
14.12 Game Theory Muhamet Yildiz

Road Map
1. Applications
1. Tariffs & Intra-industry trade 2. Infinite horizon bargaining Singledeviation principle

2. Forward Induction Examples 3. Finitely Repeated Games 4. Quiz

Single-Deviation principle
Definition: An extensive-form game is continuous at infinity iff, given any > 0, there exists some t such that, for any two path whose first t arcs are the same, the payoff difference of each player is less than . Theorem: Let G be a game that is continuous at infinity. A strategy profile s = (s1,s2,,sn) is a subgame-perfect equilibrium of G iff, at any information set, where a player i moves, given the other players strategies and given is moves at the other information sets, player i cannot increase his conditional payoff at the information set by deviating from his strategy at the information set.

Sequential Bargaining
1 D

N = {1,2} D = feasible expected-utility pairs (x,y D ) Ui(x,t) = itxi d = (0,0) D disagreement payoffs
1

Timeline period
T = {1,2,, n-1,n,} If t is odd,
Player 1 offers some (xt,yt), Player 2 Accept or Rejects the offer If the offer is Accepted, the game ends yielding t(xt,yt), Otherwise, we proceed to date t+1.

If t is even
Player 2 offers some (xt,yt), Player 1 Accept or Rejects the offer If the offer is Accepted, the game ends yielding payoff t(xt,yt), Otherwise, we proceed to date t+1.

SPE of -period bargaining

Theorem: At any t, proposer offers the other player /(1+), keeping himself 1/(1+), while the other player accept an offer iff he gets /(1+). Proof: Single-deviation principle: Take any date t, at which i offers, j accepts/rejects. According to the strategies in the continuation game, at t+1, j will get 1/(1+). Hence, j accepts an offer iff she gets at least /(1+). i must offer /(1+).

Forward Induction
Strong belief in rationality: At any history of the game, each agent is assumed to be rational if possible. (That is, if there are two strategies s and s of a player i that are consistent with a history of play, and if s is strictly dominated but s is not, at this history no player j believes that i plays s.)

Table for the bidding game

Ui = 20(2+2minjbidj bidi)

min bid 1 2 3

1 60 40 20

2 80 60

3 100

Nash equilibria of bidding game

3 equilibria: s1 = everybody plays 1; s2 = everybody plays 2; s3 = everybody plays 3. Assume each player trembles with probability < 1/2, and plays each unintended strategy w.p. /2, e.g., w.p. /2, he thinks that such other equilibrium is to be played. s3 is an equilibrium iff s2 is an equilibrium iff s1 is an equilibrium iff

1 0.8 0.6 0.4 0.2 0 -0.2 (1-/2) -1/2 -0.4 -0.6 -0.8 -1 0.032 0.05 (1-) +(1-/2) -1 0 0.1 0.15 0.2
n n n

0.047

Bidding game with entry fee

Each player is first to decide whether to play the bidding game (E or X); if he plays, he is to pay a fee p > 60.
min
Bid

1 60 40 20

2 80 60

3 100

1 2 3

For each m =1,2,3, SPE: (m,m,m) is played in the bidding game, and players play the game iff 20(2+m) p.
Forward induction: when 20(2+m) < p, (Em) is strictly dominated by (Xk). After E, no player will assign positive probability to min bid m. FI-Equilibria: (Em,Em,Em) where 20(2+m) p.
What if an auction before the bidding game?

Burning Money
0 1 D
BB BS SB SS

B S

B 3,1 0,0

S 0,0 1,3

B S

B 2,1 -1,0

S -1,0 0,3

0B 0S
DB DS

O T

H E

Repeated Games

Entry deterrence
1 X (0,2) Enter 2 Acc. Fight (-1,-1) (1,1)

Entry deterrence, repeated twice

1 X 2 Enter 1 X (0,4) 1 X (-1,1) Enter 2 Acc. Fight 1 X Enter 2 Acc. Fight (2,2)

(1,3)

Acc. Fight

(1,3) (0,0) Enter 2 Acc. Fight (-2,-2)

(0,0)

(-1,1)

Lectures 10 -11
Repeated Games

14.12 Game Theory Muhamet Yildiz

Road Map
1. Forward Induction Examples

2. Finitely Repeated Games with observable actions

1. Entry-Deterrence/Chain-store paradox 2. Repeated Prisoners Dilemma 3. A general result 4. When there are multiple equilibria

3. Infinitely repeated games with observable actions

1. 2. 3. 4. 5. Discounting / Present value Examples The Folk Theorem Repeated Prisoners Dilemma, revisited tit for tat Repeated Cournot oligopoly

4. Infinitely repeated games with unobservable actions

Forward Induction
Strong belief in rationality: At any history of the game, each agent is assumed to be rational if possible. (That is, if there are two strategies s and s of a player i that are consistent with a history of play, and if s is strictly dominated but s is not, at this history no player j believes that i plays s.)

Bidding game with entry fee

Each player is first to decide whether to play the bidding game (E or X); if he plays, he is to pay a fee p > 60.
min
Bid

1 60 40 20

2 80 60

3 100

1 2 3

For each m =1,2,3, SPE: (m,m,m) is played in the bidding game, and players play the game iff 20(2+m) p.
Forward induction: when 20(2+m) < p, (Em) is strictly dominated by (Xk). After E, no player will assign positive probability to min bid m. FI-Equilibria: (Em,Em,Em) where 20(2+m) p.
What if an auction before the bidding game?

Burning Money
0 1 D
BB BS SB SS

B S

B 3,1 0,0

S 0,0 1,3

B S

B 2,1 -1,0

S -1,0 0,3

0B 0S
DB DS

O T

H E

Repeated Games

Entry deterrence
1 X (0,2) Enter 2 Acc. Fight (-1,-1) (1,1)

Entry deterrence, repeated twice, many times

1 X 2 Enter 1 Enter 2 Acc. Fight

1 X

Enter

2 Acc. Fight

(2,2)

(1,3)

Acc. Fight

X (0,4)

1 X (-1,1)

(1,3) (0,0) Enter 2 Acc.

(0,0)

(-1,1)

Fight (-2,-2)

What would happen if repeated n times?

Prisoners Dilemma, repeated twice, many times

Two dates T = {0,1}; At each date the prisoners dilemma is played:

C C 5,5 D 6,0

D 0,6 1,1

At the beginning of 1 players observe the strategies at 0. Payoffs= sum of stage payoffs.

Twice-repeated PD
1 C D 1 D 2 D C
5 11 11 5

D 2 D 1 D 2 D
1 7

C 1 C C
10 10

C 1 D 2 C

C D
7 1

D 2 D C D
2 2

D C
6 6 5 11

D C
0 12 6 6

C
11 5

D
6 6

C
12 0

C
6 6

1 7

7 1

What would happen if T = {0,1,2,,n}?

A general result
G = stage game = a finite game T = {0,1,,n} At each t in T, G is played, and players remember which actions taken before t; Payoffs = Sum of payoffs in the stage game. Call this game G(T). Theorem: If G has a unique subgame-perfect equilibrium s*, G(T) has a unique subgameperfect equilibrium, in which s* is played at each stage.

With multiple equilibria

T = {0,1}
1 2

L 1,1 0,5 0,0

M2 5,0 4,4 0,0

R 0,0 0,0 3,3

T M1 B

s* = At t = 0, each i play Mi; At t = 1, play (B,R) if (M1,M2) at t = 0, play (T,L) otherwise.

L T M1 B 2,2 1,6 1,1

M2 6,1 7,7 1,1

R 1,1 1,1 4,4

Infinitely repeated Games with observable actions

T = {0,1,2,,t,} G = stage game = a finite game At each t in T, G is played, and players remember which actions taken before t; Payoffs = Discounted sum of payoffs in the stage game. Call this game G(T).

Definitions
The Present Value of a given payoff stream = (0,1,,t,) is PV(;) = t=1 tt = 0 + 1 + + tt + The Average Value of a given payoff stream is (1)PV(;) = (1)t=1 tt The Present Value of a given payoff stream at t is PVt(;) = s=t s-t s = t + t+1 + + st+s +

Infinite-period entry deterrence

1 X (0,2) Enter 2 Acc. Fight (-1,-1) (1,1)

Strategy of Entrant: Enter iff Accomodated before. Strategy of Incumbent: Accommodate iff accomodated before.

Incumbent: V(Acc.) = VA = 1/(1); V(Fight) = VF = 2/(1); Case 1: Accommodated before.

Fight => -1 + VA Acc. => 1 + VA.

Entrant: Accommodated
Enter => 1+VAE X => 0 +VAE

Not Acc.
Enter =>-1+VFE X => 0 +VFE

Case 2: Not Accommodated

Fight => -1 + VF Acc. => 1 + VA Fight -1 + VF 1 + VA VF VA = 1/(1) 2/ 2/3.

Infinitely-repeated PD
C C 5,5 D 6,0 D 0,6 1,1

VD = 1/(1); VC = 5/(1) = 5VD; Defected before (easy) Not defected

D => C => C

A Grimm Strategy: Defect iff someone defected before.

Tit for Tat

Start with C; thereafter, play what the other player played in the previous round. Is (Tit-for-tat,Tit-for-tat) a SPE? Modified: Start with C; if any player plays D when the previous play is (C,C), play D in the next period, then switch back to C.

Folk Theorem
Definition: A payoff vector v = (v1,v2,,vn) is feasible iff v is a convex combination of some pure-strategy payoff-vectors, i.e., v = p1u(a1) + p2u(a2) ++ pku(ak), where p1 + p2 ++ pk = 1, and u(aj) is the payoff vector at strategy profile aj of the stage game. Theorem: Let x = (x1,x2,,xn) be s feasible payoff vector, and e = (e1,e2,,en) be a payoff vector at some equilibrium of the stage game such that xi > ei for each i. Then, there exist < 1 and a strategy profile s such that s yields x as the expected average-payoff vector and is a SPE whenever > .

Folk Theorem in PD
C C 5,5 D 6,0 D 0,6 1,1

A SPE with PV (1.1,1.1)?

With PV (1.1,5)? With PV (6,0)? With PV (5.9,0.1)?

Infinitely-repeated Cournot oligopoly

N firms, MC = 0; P = max{1-Q,0}; Strategy: Each is to produce q = 1/(2n); if any firm defects produce q = 1/(1+n) forever. VC = VD = V(D|C) = Equilibrium

1 0.95 0.9 0.85 0.8 0.75 0.7 0.65 0.6 0.55 0.5 0 20 40 60 80 100

1 0.95 0.9 0.85 0.8 0.75 0.7 0.65 0.6 0.55 0.5 0 200 400 600 800 1000

IRCD (n=2)
Strategy: Each firm is to produce q*; if any one deviates, each produce 1/(n+1) thereafter. VC = q*(1-2q*)/(1-); VD = 1/(9(1-)); 2 VD|C = max q(1-q*-q) +VD = (1 q *) / 4 + 9(1 ) Equilibrium iff 2 q * (1 2q *) (1 )(1 q *) / 4 + / 9
9 5 q* 3(9 )

0.4 0.3 0.2 0.1 0 0

x = , y = (3-5/3 )/(9- )

0.2

0.4 x

0.6

0.8

Carrot and Stick

Produce at the beginning; at ant t > 0, produce if both produced or both produced x at t-1; otherwise, produce x.
Two Phase: Cartel & Punishment VC = 1/8(1-). Vx = x(1-2x) + VC. VD|C = max q(1-1/4-q) + VX = (3/8)2 + VX VD|x = max q(1-x-q) + VX = (1-x)2/4 + VX VC VD|C VC (3/8)2 + 2VC + x(1-2x) (1-2) VC - (3/8)2 x(1-2x) (1+)/8 - (3/8)2 x(1-2x) (1-)Vx (1-x)2/4 (1-)(x(1-2x) + /8(1-)) (1-x)2/4 VX VD|C (1-)x(1-2x) + /8 (1-x)2/4 2x2 x + 1/8 9/64 0 (9/4-2)x2 (3-2)x +/8(1-) 0

Lectures 12-13
Incomplete Information Static Case
14.12 Game Theory Muhamet Yildiz

Road Map
1. Examples 2. Bayes rule 3. Definitions
1. Bayesian Game 2. Bayesian Nash Equilibrium

4. Mixed strategies, revisited 5. Economic Applications

1. Cournot Duopoly 2. Auctions 3. Double Auction

Incomplete information
We have incomplete (or asymmetric) information if one player knows something (relevant) that some other player does not know.

An Example
W ork W Firm H igh p N ature D o not hire Low 1-p H ire (0, 0) W W ork Shirk D o not hire (1, 1) H ire Shirk (0, 1) (1, 2)

(-1, 2)

(0, 0)

The same example

Work W Nature Hire Firm Low 1-p Do not (0, 0) Work W Shirk (-1, 2) High p Shirk (0, 1) hire (1, 1) (1, 2)

Another Example Buy

B Seller High 0.5 Nature B p Dont p Buy p Dont

(p, 2-p)

(0, 0)
(p,2-p)

p B

Buy Dont

Buy

(0, 0) (p, 1-p)

Low .5

What would you ask if you were to choose p from [0,4]?

(0,0)

(p, 1-p) (0, 0)

Dont

Same Another Example

Buy B High 0.5 (p, 2-p)

Nature
p Seller p Nature High 0.5 B Low .5

Dont Buy

(0, 0)
(p,2-p)

B
Buy Dont

Dont

(0, 0) (p, 1-p)

What would you ask if you were to choose p from [0,4]?

(0,0)

Low .5

Buy

(p, 1-p) (0, 0)

Dont

Bayes Rule
Prob(A and B) Prob(A|B) = Prob(B)
Prob(A and B) = Prob(A|B)Prob(B) = Prob(B|A)Prob(A)

Prob(B|A)Prob(A) Prob(A|B) = Prob(B)

Example
p Work 1-p 1-p Shirk 1 Failure p Success

Prob(Work|Success) = p/[p + (1)(1-p)] Prob(Work|Failure) =

(1-)p/[(1p) + (1)p]

1 0.9 0.8 0.7 P (w|S ),P (W|F) 0.6 0.5 0.4 0.3 0.2 0.1 0

P(W|S)

P(W|F)

0.2

0.4

0.6

0.8

Bayesian Game (Normal Form)

A Bayesian game is a list G = {A1,,An;T1,,Tn;p1,,pn;u1,,un} where Ai is the action space of i (ai in Ai) Ti is the type space of i (ti) pi(t-i|ti) is is belief about the other players ui(a1,,an;t1,,tn) is is payoff.

An Example
Work W Firm High p Nature Do not (0, 0) hire Low 1-p Hire W Work Shirk Do not hire (1, 1) Hire Shirk (0, 1) (1, 2)

TFirm={tf}; TW = {High,Low} AFirm = {Hire, Dont} AW = {Work,Shirk} pF(High) = p pF(Low) = 1-p

(-1, 2)

(0, 0)

Bayesian Nash equilibrium

A Bayesian Nash equilibrium is a Nash equilibrium of a Bayesian game. Given any Bayesian game G = {A1,,An;T1,,Tn;p1,,pn;u1,,un} a strategy of a player i in a is any function si:Ti Ai; A strategy profile s* = (s1*,, s1*) is a Bayesian Nash equilibrium iff si*(ti) solves

max u (s (t ),..., s (t ), a , s (t ),..., s (t ); t )p (t

ai Ai t i T i i * 1 1 * i 1 i 1 i * i +1 i +1 * n n i

| ti )

i.e., si* is a best response to s-i*.

An Example
Work W Firm High p Nature Do not (0, 0) hire Low 1-p Hire W Work Shirk Do not hire (1, 1) Hire Shirk (0, 1) (1, 2)

TFirm={tf}; TW = {High,Low} AFirm = {Hire, Dont} AW = {Work,Shirk} pF(High) = p >1/2 pF(Low) = 1-p sF* = Hire, sF* (High) = Work sF* (Low) = Shirk Another equilibrium?

(-1, 2)

(0, 0)

Stag Hunt, Mixed Strategy

(2,2) (0,4)

(4,0) (6,6)

Mixed Strategies
t and v are iid with uniform distribution on [,]. t and v are privately known by 1 and 2, respectively, i.e., are types of 1 and 2, respectively. Pure strategy: 2+t,2+v 4+t,0 s1(t) = Rabbit iff t > 0; s2(v) = Rabbit iff t > 0. 0,4+v 6,6 p = Prob(s1(t)=Rabbit|v) = Prob(t > 0) = 1/2. U1(R|t) = t +2q+4(1-q) = t + 4 2q q = Prob(s2(v)=Rabbit|t) = U1(S|t) = 6(1-q); 1/2. U1(R|t) > U1(S|t) t+42q > 6(1-q) t > 6-6q+2q-4 = 2 4q = 0.

Economic Applications with Incomplete Information

14.12 Game Theory Muhamet Yildiz

Road Map
1. Cournot duopoly with Incomplete Information 2. A rst price auction 3. A double auction 4. Quiz

1 Cournot duopoly with Incomplete Information

 Demand:  E' ' @ ' where ' ' ^ n ^2.  The marginal cost of Firm 1 = S common knowledge.  Firm 2s marginal cost: SM with probaility w, Su with probaility w its private information.  Each rm maximizes its expected prot.

1.1 Bayesian Nash Equilibrium

Firm 2 of high type: 4@ E SM ^2 ' 4@ d@
^5 ^5

^ SM

^2

SM o ^2

^2 ESM  ' Firm 2 of low type: 4@ d@

^5

^ 2 ^2 ^ 2

(*)

^ @

Suo ^2, Su 
(**)

^2 ESu '
Firm 1:

4@ w d@
^4

^ n E

^2 ESM  w d@ ^

So ^ ^2 ESu w d@ So ^ ^2 ESu
(***)

^ '

w d@

^2 ESM 

So n E 2

So

Solve *, **, and *** for ^ c ^2 ESuc ^2 ESM .

2 w w ^ C ^2 ESM  D ' 7 2 f 8 f 2 ^2 ESu ^2 ESM  ' ^2 ESu ' ^ ' @ @ @

@ S C @ SM D ( @ Su Su

2SM n S E wESM n  S 2Su n S wESM Su  S 2S n wSM n E wSu 

2 A First-price Auction
 One object, two bidders   ' Valuation of bidder i iid with uniform distribution over dfc o.  Simultaneously, each bidder  submits a bid K, then the highest bidder wins the object and pays her bid.  The payoffs: ; ?  K if K : K c l Kl if K ' K c  EKc K2 c  c 2  ' = 2 f if K K   Objective of : 4@ . d EKc K2c c 2o
Kl

where . d o ' E

K hiK : K E j n E K hiK ' K E j 2

2.1 Symmetric, linear equilibrium

K ' @ n S 
Then,

hiK ' K E j ' f Equilibrium condition: @  K  . Hence, . d o ' E ' E ' E
FOC:

K hiK  @ n S j K @ j K hi  S K @  K  S

2

K '
Therefore,

 ln@ @

if   @ if  @

(1)

K '  2
6

2.2 Any symmetric equilibrium

K ' K E
Hence,

. d o ' E K hiK  KE j ' E K hi  K EKj ' E KK EK  FOC (Y*YK ' f): _K EK K EK n E K ' f _K ' f  n E K E 3 K E K3 E  n K E '  _ dK E o '  _ K E  ' 2*2 n SJ?r| K E ' *2 n SJ?r|* K Ef ' f, =: cons = 0. K E ' *2
7

3 Double Auction
1. Simultaneously, Seller names Rr and Buyer names RK.

Rr, then no trade b. if RK  Rr, trade at price R ' RenRv . 2 2. Valuations are private information: K, r iid w/ uniform on dfc o. 3. Payoffs:  K RenRv if RK  Rr 2 K ' f otherwise  RenRv r if RK  Rr 2 r ' f otherwise 4. The buyers problem:   RK n RrEr G RK  RrEr  4@ . K Re 2
5. The sellers problem:   Rr n RKEK r G RKEK  Rr  4@ . Rv 2

a. If RK

An Equilibrium:  f RK ' f  f Rr '

vb

if K  f c otherwise if r  f  otherwise
v b /v s

Trade X Efficient not to trade

0 Inefficient lack of trade

vS

Equilibrium with linear strategies: RK ' @K n SKK Rr ' @r n Srr

RK  Rr Er ' @r n Srr +, r  Rr  RK EK ' @K n SKK +, K 

RK Sr Rr SK

@r @K

10

 RK n RrEr G RK  RrEr . d Ko ' . K 2 se dv   ] fv RK n RrEr K _r ' 2 f se dv ] k fv RK n @r n Srr l K _r ' 2 f   S ] sefvdv RK @r RK n @r r K ' r_r Sr 2 2 f 2  RK @r  RK n @r  Sr RK @r K ' Sr  2 e S r RK @r RK n @r RK @r K ' Sr  2  e RK @r RK n @r ' K  Sr e F.O.C. (4@ Re . d Ko):   ERK @r RK n @r K 'f Sr e eSr i.e., 2 RK ' K n @r (2)  
11

Similarly,   Rr n RKEK r G RKEK  Rr . d ro ' . 2 ] k l Rr n @K n SKK ' r _K sv de 2 k  fe l S ] Rr n @K Rr @K K r n ' K_K sv de SK 2 2 f e k  l Rr n @K Rr @K r ' 2 $ # SK 2 Rr @K SK n e SK    Rr n @K Rr @K SK Rr @K r n n ' SK   2 e  e  Rr n @K SK Rr @K r n ' SK e e

12

F.O.C. (4@ Rv . d r o):    Rr n @K r n n SK e e e

Rr SK ERr

@K

 'f

Rr n @K e

 SK r n n ESK e e

@K ' fc

Rr ' 2
i.e.,

@K n r e

SK  @K n SK n ESK n @K ' r n e e 2

   

@K ' @r* @r ' @K* n 2*b Hence, b@r ' @r n 2, @r ' *e @K ' *2. 2 RK ' K n  2 2 Rr ' r n   e
13

2 @K n SK  Rr ' r n  

(3)

(4) (5)

We have trade iff RK  Rr iff iff

K

2 2 K n  r n  2  e     ' '  r  2 e 2 2S e

3/4

ps

1/4 1/12 pb

14

Lectures 15-18 Dynamic Games with Incomplete Information

14.12 Game Theory Muhamet Yildiz

Road Map
1. 2. 3. 4. Examples Sequential Rationality Perfect Bayesian Nash Equilibrium Economic Applications
1. Sequential Bargaining with incomplete information 2. Reputation

An Example
Firm High 0.7 Nature Do not hire Low 0.3 Hire (0, 0) W Work Shirk Do not hire (1, 1) W Hire Shirk (0, 1) Work (1, 2)

(-1, 2)

(0, 0)

What is wrong with this equilibrium?

Firm High .7 Nature Do not hire Low .3 Hire (0, 0) W Work Shirk Do not hire (1, 1) W Hire Shirk (0, 1) Work (1, 2)

(-1, 2)

(0, 0)

What is wrong with this equilibrium?

X 1 T B (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

Beliefs
X Beliefs of an agent at a given 1 (2,6) information set is a probability distribution on T B the information set. For each information set, we 1 must specify the beliefs of 2 the agent who moves at that L R L R information set. (0,1) (3,2) (-1,3) (1,5)

Sequential Rationality
A player is said to be sequentially rational iff, at each information set he is to move, he maximizes his expected utility given his beliefs at the information set (and given that he is at the information set) even if this information set is precluded by his own strategy.

An Example
Firm High 0.7 Nature Do not hire Low 0.3 Hire (0, 0) W Work Shirk Do not hire (1, 1) W Hire Shirk (0, 1) Work (1, 2)

(-1, 2)

(0, 0)

Another example
X 1 T B (2,6)

2 L (0,1) R (3,2) L (-1,3) R (1,5)

Example
1 T
.1

B
.9

2 L (0,10)

R (3,2)

L (-1,3)

R (1,5)

Consistency
Definition: Given any (possibly mixed) strategy profile s, an information set is said to be on the path of play iff the information set is reached with positive probability if players stick to s. Definition: Given any strategy profile s and any information set I on the path of play of s, a players beliefs at I is said to be consistent with s iff the beliefs are derived using the Bayes rule and s.

Example
1 T B

2 L (0,10) R (3,2) L (-1,3) R (1,5)

Example
1 E 2 T B X
2 0 0

3 L 1 2 1
3 3 3

L
0 1 2 0 1 1

Consistency
Given s and an information set I, even if I is off the path of play, the beliefs must be derived using the Bayes rule and s whenever possible, e.g., if players tremble with very small probability so that I is on the path, the beliefs must be very close to the ones derived using the Bayes rule and s.

Example
1 E 2 T B X
2 0 0

3 L 1 2 1
3 3 3

L
0 1 2 0 1 1

Perfect Bayesian Nash Equilibrium

A Perfect Bayesian Nash Equilibrium is a pair (s,b) of strategy profile and a set of beliefs such that 1. Strategy profile s is sequentially rational given beliefs b, and 2. Beliefs b are consistent with s. Nash Bayesian Nash Subgame-perfect Perfect Bayesian

Example
1 E 2 T B X
2 0 0

3 L 1 2 1
3 3 3

L
0 1 2 0 1 1

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Example
1 .9 2 1 (1,-5)

.1

(4,4) 1

(5,2) 2

(3,3) 1 (0,-5)

(-1,4)

(0,2)

(-1,3)

Sequential Bargaining
1. 2. 3. 4. 1-period bargaining 2 types 2-period bargaining 2 types 1-period bargaining continuum 2-period bargaining continuum

Sequential bargaining 1-p

A seller S with valuation 0 A buyer B with valuation v;
B knows v, S does not v = 2 with probability = 1 with probability 1-
H S L

p Y p 2-p N 0 0 Y p 1-p

p N 0 0

S sets a price p 0; B either

buys, yielding (p,v-p) or does not, yielding (0,0).

Solution
1. B buys iff v p;
1. If p 1, both types buy: 1 S gets p. 2. If 1 < p 2, only H-type buys: S gets p. 3. If p > 2, no one buys.

2. S offers 1 if < , 2 if > .

Sequential bargaining 2-period

A seller S with valuation 0 A buyer B with valuation v;
B knows v, S does not v = 2 with probability = 1 with probability 1-

1. At t = 0, S sets a price p0 0; 2. B either

buys, yielding (p0,v-p0) or does not, then

3. At t = 1, S sets a price p0 0; 4. B either

buys, yielding (p0,(v-p0)) or does not, yielding (0,0)

Solution, 2-period
1. 2. 3. 4. 5. 6. 7. Let = Pr(v = 2|history at t=1). At t = 1, buy iff v p; If > , p1 = 2 If < , p1 = 1. If = , mix between 1 and 2. B with v=1 buys at t=0 if p0 1. If p0 > 1, = Pr(v = 2|p0,t=1) .

Solution, cont. <1/2

1. 2. 3. 4. = Pr(v = 2|p0,t=1) <1/2. At t = 1, buy iff v p; p1 = 1. B with v=2 buys at t=0 if p0 2. (2-p0) (21) = 5. p0 = 1: (2) + (1) = 2(1) + < 1+ = 1.

Solution, cont. >1/2

If v=2 is buying at p0 > 2, then
= Pr(v = 2|p0 > 2,t=1) = 0; p1 = 1; v = 2 should not buy at p0 > 2.

If v=2 is not buying at 2> p0 > 2, then

= Pr(v = 2|p0 > 2,t=1) = > 1/2; p1 = 2; v = 2 should buy at 2 > p0 > 2.

No pure-strategy equilibrium.

Mixed-strategy equilibrium, >1/2

1. For p0 > 2, (p0) = ; 2. (p0) = 1- Pr(v=2 buys at p0)
= ( p0 ) 1 1 = ( p0 ) = 1 ( p0 ) = . ( p0 ) + (1 ) 2

3. v = 2 is indifferent towards buying at p0: (p0) = (2- p0)/ 2- p0 = (p0) where (p0) = Pr(p1=1|p0).

Sequential bargaining, v in [0,1]

1 period:
B buys at p iff v p; S gets U(p) = p Pr(v p); v in [0,a] => U(p) = p(a-p)/a; p = a/2.

Sequential bargaining, v in [0,1]

2 periods: (p0,p1)
At t = 0, B buys at p0 iff v a(p0); p1 = a(p0)/2; Type a(p0) is indifferent: a(p0) p0 = (a(p0) p1 ) = a(p0)/2 a(p0) = p0/(1-/2) 2 S gets p p
0 p0 + 0 1 1 / 2 2

FOC:

(1 / 2 ) 2 p0 2 p0 + = 0 p0 = 1 / 2 2 2(1 3 / 4 )
2

Reputation

Centipede Game
1 2 1 1 1 0 3 2 2 98 98 97 100 99 99 98 101 1 2 1 2 100 100

{.999} 1

197 2

Centipede Game with doubt

5 2 4 1 3 2 2 3 1 1 2 5 1

=n 100 100

1 1 {.001} 1

0 3 2

96 99 2

98 98 1

97 100

99 99 2 1

98 101 2 0 100

-1 1

0 3

0 99

-1 98

0 100

-1 99

0 101

Facts about the Centipede

Every information set of 2 is reached with positive probability. 2 always goes across with positive probability. If 2 strictly prefers to go across at n, then
she must strictly prefer to go across at n+1, her posterior at n is her prior.

For any n > 2, 1 goes across with positive probability. If 1 goes across w/p 1 at n, then 2s posterior at n-1 is her prior.

If 2s payoff at any n is x and 2 is mixing, then x = n(x+1) + (1- n)[(x-1)pn +(1-pn)(x+1)] = n(x+1) + (1- n)[ (x+1) -2pn] = x+1 - 2pn(1- n) (1- n) pn= 1/2
n 1 =

n n = = 2 n n + (1 n )(1 pn ) n + (1 n ) pn (1 n )
n = n 1
2

0.5 0.45 0.4 0.35 0.3 0.25 0.2 0.15 0.1 0.05 0

Go Across

Mix
0 20 40 60 80 100

Lecture 19-21
14.12 Game Theory Muhamet Yildiz

Road Map
Market for Lemons (Adverse Selection) Insurance Market (Screening) Signaling theory Job Market Signaling

Example for Adverse selection

A buyer and a seller, who owns an object. The value of the object is
v for the seller, v+b for the buyer.

v is uniformly distributed on [0,1]. Seller knows v. b > 0 is a known constant. Buyers offers a price p; seller decides on whether to sell.

Solution
Seller sells at p iff p v; Buyers payoff: p 1 p U ( p ) = (v + b p )dv = p 2 + p (b p ) = p b 2 2 0 Buyer offers p = 2b.

Example for Adverse selection

A buyer and a seller, who owns an object. The value of the object is
v for the seller, 3v/2 for the buyer.

v is uniformly distributed on [0,1]. Seller knows v. Buyers offers a price p; seller decides on whether to sell.

Solution
Seller sells at p iff p v; Buyers payoff: p 3 3 p U ( p ) = v p dv = p p = p2 / 4 2 2 2 0 Buyer offers p = 0.

Market for Lemons

Two types of cars: Lemons and Peaches.
A Peach is worth $2500 to seller, $3000 to buyer; A lemon is worth $1000 to seller, $2000 to buyer;

Each seller knows whether his car is a Peach or Lemon; buyers cannot tell. There are 200 Lemons and 100 Peaches. Equilibrium: a market clearing price p.

Demand/Supply Market for Lemons

P Supply

2000

1000

200

300

Quiz
The students are grouped in pairs; In each pair, one is assigned to be seller, the other one is buyer. The buyer is given a valuation v, an integer between 20 and 40 with uniform distribution. Buyer offers a price p; seller accepts or rejects; If seller accepts, seller gets p, buyer gets 20+v-p. If seller rejects, w/probability 0.1 each gets 20; w/p 0.95 we proceed to next date, and Seller offers a price p; If buyer accepts, seller gets p, buyer gets 20+v-p; otherwise each gets 20.

Insurance with adverse selection

Two states: s1, s2. A risk averse agent with
risky endowment (Y1,Y2) where Y1 > Y2, and Utility function u.

Two types:
High risk: U(y1,y2) = (1H)u(y1) + Hu(y2) Low risk: U(y1,y2) = (1L)u(y1) + Lu(y2), where H > L.

A risk neutral insurance company offers a menu ((y1H,y2H), (y1L,y2L)) of insurance policies, and the risk averse agent either chooses one of the policies in the menu or rejects the offer. Agent knows his type, the company does not.

High-risk Agent

Y2

Y1

Low-risk Agent

Y2

Y1

High- and Low-risk Agent

Y2

Y1

Optimal menu

Y2

Y1

Signaling Games

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Signaling Game -- Definition

Two Players: (S)ender, (R)eceiver 1. Nature selects a type ti from T = {t1,,tI} with probability p(ti); 2. Sender observes ti, and then chooses a message mj from M = {m1,,mI}; 3. Receiver observes mj (but not ti), and then chooses an action ak from A = {a1,,aK}; 4. Payoffs are US(ti,mj,ak) and US(ti,mj,ak).

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Types of Equilibria
A pooling equilibrium is an equilibrium in which all types of sender send the same message. A separating equilibrium is an equilibrium in which all types of sender send different messages. A partially separating/pooling equilibrium is an equilibrium in which some types of sender send the same message, while some others sends some other messages.

A Pooling equilibrium
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A Separating equilibrium
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A Mixed equilibrium
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Job Market Signaling

Model
A worker
with ability t = H or t = L (his private information) Pr(t = H) = q, obtains an observable education level e, incurring cost c(t,e) where c(H,e) < c(L,e), and finds a job with wage w(e), where he produces y(t,e).

Firms compete for the worker: in equilibrium, w(e) = (H|e)y(H,e) + (1 (H|e))y(L,e).

Equilibrium
(eH, eL, w(e), (H|e)) where et = argmaxe w(e) c(t,e) for each t; w(e) = (H|e)y(H,e) + (1 (H|e))y(L,e); (H|e) = qPr(eH = e)

qPr(eH = e) + (1-q)Pr(eL = e) whenever well-defined.

If t were common knowledge

w
e) y(t, =

w (e

e*(t)

No need to imitate
w
, e) y (H

e) (L, y

e*(L)

e*(H)

No need to imitate
w
, e) (H y

w(.)

e) (L, y

e*(L)

e*(H)

want to imitate
w
, e) y (H

e) (L, y

e*(L) e*(H)

A pooling equilibrium
w
qy

e) H, y(
e)+ (H , (1(L q) y

,e)

e) (L, y

e*(L) e*(H)

A separating equilibrium
w
, e) y (H

e) (L, y

eL=e*(L)

e*(H)

eH

An intuitive separating equilibrium

w
, e) (H y

e) (L, y

eL=e*(L)

eH

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14.12 Solutions for Homework 1 Kenichi Amaya1 September 28, 2001 Question 1 (a) Remember that a binary relation and transitive Completeness For all x, y X, x Transitivity If x y and y is a preference relation if it is complete y or y z. x.

z, then x

The relation dened here is complete, but it is not transitive. We can show this by a counterexample. Suppose x = 0, y = .5, and z = 1. Then, x y because x = 0 = y 1 , and y z because y = 1 = z 1 , but we dont have x z 2 2 2 1 1 because x = 0 < 2 = z 2 . Therefore, is not a preference relation. (b)

x y x y 1/2 and y < x 1/2 x > y + 1/2 Suppose x that y and y z. Then, x > y + 1/2 and y > z + 1/2. This implies

x > y + 1/2 > (z + 1/2) + 1/2 > z + 1/2. Therefore is transitive. We can show that is not transitive by using the same counterexample used y and in (a). Suppose x = 0, y = .5, and z = 1. Since x = 0 = y 1 , x 2 y x, therefore x y. Since y = 1 = z 1 , y z and z y, therefore y z. 2 2 However, we dont have x z because x = 0 < 1 = z 1 . Therefore x z is 2 2 not satised. (c) If we had x, y X = {0, 1, 2, }, x y x y 1/2 x y. is a preference rela-

Then both completeness and transitivity are satised, so tion.

1 E52-303,

kamaya@mit.edu, 253-3591

Question 2 Since the agent is risk neutral, his von-Neuman Morgenstern utility function is represented by the amount of money he receives (or any ane transformation of it). (a) If he doesnt buy the security, the amount of money he has at date 1 is 0 for sure, so the expected utility is 0. If he buys the security at price p, the amount of money he has at date 1 is 100 p, 50 p, or p, each with probability 1/3, and thus the expected utility is 1 1 1 (100 p) + (50 p) + (p). 3 3 3 He wants to buy this security if and only if this expected utility is higher than or equal to 0, the expected utility from not buying. 1 1 1 (100 p) + (50 p) + (p) 0 p 50. 3 3 3 Therefore S = 50. (b) If the agent exercises the option, he will pay K and receive the dividend d, so he will receive net payment of d K. If he doesnt exercise the option, he receives 0. Therefore he will excercise if and only if d K 0. His utility is represented by u(d) = max{0, d K} p, where p is the price of the option. (c) Case 1 K > 100 In this case, the agent will never exercise the option, so he ends up with receiving 0 no matter what the dividend is. Therefore he wants to pay for this option no more than 0. Case 2 50 < K 100 If d = 100, the agent will exercise the option and receive net payment of 100 K. However, if d = 0 or 50, he wont exercise the option and receive 0. Therefore, he wants to buy this option if 1 2 (100 K p) + (p) 0 3 3 1 p (100 K). 3 2

Case 3 0 K 50 If d = 50 or 100, the agent will exercise the option and receive net payment of d K. However, if d = 0, he wont exercise the option and receive 0. Therefore, he wants to buy this option if 1 1 1 (100 K p) + (50 K p) + (p) 0 3 3 3 2 p 50 K. 3 To summarise, O = Question 3 Here is an example. s s s L 4,0 0,0 1,1 R 0,0 6,0 1,1 0
1 3 (100 K) 50 2 K 3

if if if

K > 100 50 < K 100 0 K 50

The mixed strategy 1 s + 1 s gives player 1 expected utility of 2 if player 2 2 2 plays l and expected utility of 3 if player 2 plays r. Question 4 The intuition tells us only 0 would be selected, but actually, all strategies except 100 are rationalizable! The reason is that a players objective is just to win the game, i.e., to name closer number to one third of the average than everyone else, and not to name exactly one third of the average. For example, if everybody else is naming 100, you can win by naming any number below 100, even 99 wins. The proof is given in the answer 1. But if, not like this game, a players objective is to name exactly one third of the average, our rst intuition works. The proof for this case is given in the answer 2. Answer 1 If 0 x < 100, x is the best response to all other players playing x , where x < x < 100 and x is close enough to x. To see this, if a player plays x and all others plays x , x/3 < x (because x is close enough to x), therefore she is the

only winner. Since she can do no better than being the only winner, x is the best response. For any 0 x < 100, we can nd a sequence x < x1 < x2 < < 100 such that x is a best response to everyone elses playing x1 , x1 is a best response to everyone elses playing x2 , and so on. Naming 100 is not a best response to anything. The only case a player wins is when everyone is naming 100, but even in this case, she can be the only winner by naming a smaller number. To conclude, x is rationalizable if and only if 0 x < 100. Answer 2
Suppose the award is 100 |x x |, so that a player always want to name 3 x exactly 3 . Given that 0 xi 100 for all i, x always lies between 0 and 33.33 . So 3 x > 33.33 is never best response, i.e., it is not rationalizable. As long as everyone is naming 0 xi 33.33 , x always lies between 0 3 and 11.11 . So x > 11.11 is never best response, i.e., it is not rationalizable. Repeating this procedure forever, any number greater than 0 is not rationalizable. If everyone else is naming 0, the best response is to name 0 as well. Therefore 0 is rationalizable. To conclude, x = 0 is the only rationalizable strategy. Bonus: In the discussion above, the number of players played no role at all.

Question 5 (a) l 2,2 2,2 2,2 2,2 2,2 2,2 1,3 1,3 1,3 3,1 3,1 3,1 r 2,2 2,2 2,2 2,2 2,2 2,2 3,3 1,1 0,0 3,3 1,1 0,0

L LP Lu L LP Lu R RP Ru R RP Ru (b)

First, R weakly dominates all other strategies of player 1. We eliminate them and then we have the following game. R l 3,1 r 3,3

Now, l is weakly dominated by r, so we eliminate l and we have R r 3,3

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14.12 Solutions for Homework 2 Kenichi Amaya1 October 5, 2001 Question 1 (a) L 1,1 0,1 R 1,0 0,10000

T B

Fact: The set of rationalizable strategies is same as the set of strategies which survives iterated elimination of strictly dominated strategies. Step 1: For player 1, B is strictly dominated by T. Now we have T L 1,1 R 1,0

Step 2: For player 2, R is strictly dominated by L. Now we have T L 1,1

Therefore, the rationalizable strategies are T for player 1 and L for player 2. (b) There was a typo in the problem. If player 2 intends to play L, L is played with probability 1 , and R is played with probability . Of course, if you interpreted the problem dierently, you will get credit as long as you are solving the problem consistently with your interpretation. We can write a new game which represents this situation as following: We look for the players expected payos as functions of the intended play. If player 1 intends to play T and player intends to play L, what are the expected payos? (T,L) is realized with probability (1 )2 , (T,R) and (B,L) are realized each with probability (1 ), and (B,R) is realized with probability 2 . Therefore, the expected payo of player 1 is (1 )2 1 + (1 ) 1 + (1 ) 0 + In the same way, player 2s expected payo is (1 )2 1 + (1 ) 0 + (1 ) 1 + Therefore we must have
1 E52-303,

0 = 1 = .999.

10000 = (1 ) +

10000 = 1.009

kamaya@mit.edu, 253-3591

T B

L .999, 1.009

In the same way, we can calculate expected payos for the remaining of the payo matrix and we have T B L .999, 1.009 .001, 10.999 R .999, 9.991 .001, 9980.01

For player 1, B is strictly dominated by T, and for player 2, L is strictly dominated by R. Now we have T 2. (c) For player 1, the possibility that opponent trembles doesnt aect her optimal choice because T gives higher payo than B no matter what the opponent is doing. For player 2, in the case of (a), the large payo diernce between (B,L) and (B,R) didnt matter because he was sure B is never played. However, when we introduce trembles, this large payo dierence matters with positive probability even though player 2 knows that player 1 never intends to play B. In this situation, the payo dierence between (T,L) and (T,R) is so small that it is outweighed by the payo diernce between (B,L) and (B,R). Question 2 Fact All the Nash equilibrium strategies are rationalizable, and therefore survives iterated elimination of strictly dominated strategies. When we look for Nash equilibria, we can rst eliminate strictly dominated strategies and then nd Nash equilibria of the game left. A B C L 3,1 0,0 1,1 M 0,0 1,3 0,1 R 1,0 1,1 0,10 R .999, 9.991

Therefore, the rationalizable strategies are T for player 1 and R for player

Step 1 For player 1, C is strictly dominated by 1 A + 1 B. Now we have 2 2 A B L 3,1 0,0 2 M 0,0 1,3 R 1,0 1,1

Step 2 For player 2, R is stricly dominated by 1 L + 1 M . Now we have 2 2 A B L 3,1 0,0 M 0,0 1,3

Step 3 In the game left, (A,L) and (B,M) are pure strategy Nash equilibria, because players are taking best response to each other. Step 4 We want to nd the mixed strategy equilibrium. Let (pA + (1 p)B, qL + (1 q)M ) be the equilibrium. First, player 1 must be indierent between playing A and B, which implies 3q = 1(1 q), where the LHS is the expected payo of playing A and the RHS is that of B, when player 2 is playing the equilibrium strategy. This implies q= 1 . 4

Next, player 2 must be indierent between playing L and M, implying 1p = (1 p)3 3 p= . 4 To conclude, the Nash equilibria are; (A,L), (B,M), and ( 3 A+ 1 B, 1 L+ 3 M ). 4 4 4 4 Question 3 This question is hard! Notice that in the Cournot model with xed cost, there can be equilibria where not every rm is producing. For example, if there are two rms, there can be an equilibrium where one rm is producing the monopoly quiantity and the other rm is producing nothing. (Of course, whether this is actually a Nash equilibrium or not depends on the cost and demand structure.) To see why this can be an equilibium, consider each rms best response. If the opponent rm is producing the monopoly quantity, the revenue from selling some amount can not cover the xed cost, if the xed cost is large enough, and thus producing nothing is the best response. On the other hand, if the opponent is producing nothing, you can get a revenue equal to the monopoly prot, which is higher than the xed cost. It is hard to characterize all the equilibria, so we limit attention to pure strategy equilibria which are symmetric in the sense that all the producing rms are choosing the same quantity. (Keep in mind that there might be other equilibria! Actually, it is not very hard to show that all pure strategy equilibria are symmetric. This would be a good exercise.) 3

First, consider the equilibrium where all rms are producing q . What we need is that q is a best response to all other rms choosing q . The prot of rm i when it is producing qi and all other rms are producing q is i (qi , q ) = (max{1 (qi + (1 n)q ), 0} c)qi F. (1)

In the equilibrium all rms must be getting positive revenue (because there is xed cost), so it must be 1 (qi + (n 1)q ) > 0. Therefore i (qi , q ) = (1 (qi + (n 1)q ) c)qi F. Taking rst order condition, qi = 1 (n 1)q c . 2 (3) (2)

In the symmetric equilibium, we must have qi = q , thus q = 1c . n+1 (4)

For this quantity to be actually construct equilibrium, each rm must be getting nonnegative prot. Plugging this into (2), i = 1c n+1
2

F.

(5)

1c Therefore there exists an equilibrium where all rms are producing q = n+1 if 1c and only if ( n+1 )2 F and c 1. Next consider an equilibrium where only k < n rms are producing q . We need to check incentives of rms which are producing and incentives of rms which are not producing. For a rm which is producing, qi = q must be a best response to k 1 of other rms producing q and the rest producing zero. The rms prot when producing qi is

i (qi , q ) = (max{1 (qi + (1 k)q ), 0} c)qi F.

(6)

Notice this is same as equation (1), n being replaced by k. Therefore the same argument as above holds. 1c q = , (7) k+1
1c For this to be an equilibrium, we need ( k+1 )2 F and c 1. However, this is not a sucient condition. It must also be true that for nonproducing rms, not producing is actually the best response. From the point

of view of a non-producing rm i, k other rms are producing q . By the same argument above, if this rm does choose to produce, the optimal amount is
qi =

1 kq c , 2

(8)

and the payo is

1 kq c 2 F. (9) 2 If this prot is positive, the rm wants to produce qi rather than producing i = nothing. Therefore, we need
1kq c 2 2

F , i.e.,
2

1c 2(k + 1)

F.

(10)

Finally, consider an equilibrium where no rm produces. This is the case where c 1 or where even the monopoly prot is less than the xed cost. That is, 1c 2 F. (11) 2 Question 4 Each player i = 1, , n chooses his price of meal pi . The payo of player i is ui = = pi
n j=1

pj

n
j=i

pi pi n 1 1 = 2 pi n pi = n2 . 4

pj

Taking rst order condition,

This gives the best response, but actually this optimum does not depend on what other players are doing, which means that it is the dominant strategy. To conclude, the Nash equilibrium is pi = n2 i. 4

Notice if n = 1 then p = 1 . This is the ecient choice, because there is no 2 externality. If n , then pi . This is because every marginal increase in the price of the meal will splitted by all the people and the marginal increase of the payment of the player herself converges to 0. 5

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1 2 2 2 2 2 1

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14.12 Solutions for Homework 3 Kenichi Amaya1 November 2, 2001 Question 1 We solve this problem by backward induction. First, we solve for the quantity choice (stage 2) given the entrance decision, and then we solve for the entrance decision (stage 1). Stage 2 Suppose m rms has entered in stage 1. Assuming 1 Q 0 in equilibrium (we check this is actually true later), each rm i maximizes i = qi (1 Q) = qi (1
j=i

qj qi ).

Notice, since the xed cost F was payed in stage 1 already, i.e., it is already sunk, the rm doesnt care about it any more. Taking rst order condition, 1 j=i qj . qi = 2 Assuming the equilibrium is symmetric (qi is same for all i), qi = implying 1 . m+1 (It is not hard to prove the equilibrium is actually symmetric.) Now we can conrm that our assumption 1 Q 0 is actually satised because m < 1. Q = mqi = m+1 qi = The equilibrium payo of each rm is = 1 . (m + 1)2 1 (m 1)qi , 2

Stage 1 Let (m) be the prot (gained in stage 2) of each rm when m rms are entering. As we solved above, (m) = 1 . (m + 1)2

There are three possible classes of equilibria:

1 E52-303,

kamaya@mit.edu, 253-3591

1. All n rms enter. 2. No rm enters 3. k rms enter, where 0 < k < n. The rst class of equilibrium exists if it is better to enter and gain (n)F than to exit and gain 0. That is, (n) F 0, 1 F. (n + 1)2 The second class of equilibrium exists if it is better to exit and get 0 than to enter to be the only entering rm and gain (1) F . That is, (1) F < 0, 1 F. 4 To see when the third class of equilibrium exists, we need to check the incentives of the rms which are entering and the rms which are not entering. Lets consider the incentive of an entering rm rst. It gets (k) F if it enters, and gets 0 if it exits. Therefore, there is no incentive to deviate if (k) F 0, 1 F. (k + 1)2 Next consider the incentive of an exiting rm. It gets 0 if it exits. If it enters, it gets (k + 1) F because k other rms are also entering. Therefore, there is no incentive to deviate if (k + 1) F 0, 1 F. (k + 2)2 Notice, the argument above says nothing about which k rms enter. If the condition above is satised, any selection of k rms constitutes an equilibrium. To summarize, lets formally describe the equilibrium strategies. Remember, we need to describe all the contingent plans for stage 2, even for the information sets which are not achieved on the equilibrium path. The equilibrium strategies are as the following. 2

1.

All rms enter in stage 1. If m rms enter in stage 1, each entering rm produces 2.
1 m+1

in stage

1 The equilibrium payo is (n+1)2 F for every rm. This equilibrium exists 1 if and only if (n+1)2 F .

2.

No rm enter in stage 1. If m rms enter in stage 1, each entering rm produces 2.

1 m+1

in stage

The equilibrium payo is 0 for every rm. This equilibrium exists if and only if 1 F . 4 3. k rms enter in stage 1, where 0 < k < n. If m rms enter in stage 1, each entering rm produces 2.
1 m+1

in stage

1 The equilibrium payo is (k+1)2 F for every entering rm, and 0 for 1 every exiting rm. This equilibrium exists if and only if (k+1)2 F and 1 (k+2)2 F .

Question 2 (a) 1 e X eN e  e2 (2,2) d x d n d  d1 (2,2) d L d R d d2 e e l e r l e r e e  e  e (3,3) (0,0) (0,0) (1,1)

We can solve for subgame perfect equilibria by backward induction. This game has three subgames: the whole game itself, a subgame starting from player 3

2s rst decision node, and a subgame starting from player 1s second decision node. First we look at the subgame starting from player 1s second decision node. This subgame is equivalent to the following nomal form game: L R l 3,3 0,0 r 0,0 1,1

Obviously, pure strategy equilibria are (L,l) and (R,r). If (L,l) is played in this subgame, player 2 chooses n at his rst decision node, because he gets payo of 2 by playing x and 3 by playing n. Given this, player 1 chooses N at her rst decision node because she gets payo of 2 by playing X and 3 by playing N. Therefore, player 1s strategy (N,L) and player 2s strategy (n,l) constitute a subgame perfect Nash equilibrium. If (R,r) is played in the subgame starting from player 1s second decision node, player 2 chooses x at his rst decision node, because he gets payo of 2 by playing x and 1 by playing n. Given this, player 1 is indierent between X and N at her rst decision node because she gets payo of 2. Therefore, player 1s strategy (X,R) and player 2s strategy (x,r) constitute a subgame perfect Nash equilibrium, and player 1s strategy (N,r) and player 2s strategy (x,r) constitute another subgame perfect Nash equilibrium. To conclude, there are three subgame perfect Nash equilibria: 1. Player 1: (N,L), Player 2: (n,l) 2. Player 1: (X,R), Player 2: (x,r) 3. Player 1: (N,R), Player 2: (x,r) (b) Lets apply the forward induction argument here. Suppose player 1s second decision node is reached. This means that player 2 has chosen N at his rst decision node, i.e., his strategy is either (n,l) or (n,r) (or any mixture of them). Should player 1 think that player 2 is choosing (n,r)? Player 2 can get payo of 0 or 1 by playing (n,r), whereas he can get 2 for sure by playing (x,l) or (x,r). In other words, (n,r) is a strictly dominated strategy. If player 1 knows player 2 is rational, she must know that there is no reason player 2 play (n,r). Therefore, given player 2 has played N at his rst decision node, player 1 must conclude player 2 is choosing (X,l), and choose the best response to it, namely L. To conclude, in any subgame perfect equilibrium which is consistent with common knowlegde of rationality, player 1s choice at his second decision node must be L. Therefore, only the rst equilibrium (N,L), (n,l) is consistent.

Question 3 (a)
1 The monopoly price is pm = 2 . Construct the following trigger strategy.

Start with playing pm , and play pm if everybody has played pm all the time. Play 0 if anybody has played something dierent from pm at least once. By the single deviation principle, it is sucient to check incentives to deviate only once, in order to check when this is actually a subgabe perfect Nash equilibrium. Firstly, check the incentive when nobody has deviated from pm before. If a rm plays pm , as suggested by the strategy, then everyone will be playing pm all the time in future, and a rms prot per period is pm (1 pm ) 1 = , 2 8 and the present discounted sum of the prot sequence from today is 1 1 1 1 1 + + 2 + = . 8 8 8 18 If the rm is to deviate, the best it can do today is to set a price slightly less than pm and get the whole monopoly prot pm (1 pm ) = 1 . 4

If the rm does deviate, everyone will be playing 0 from the next period, yielding per period payo of zero. Therefore, the present discounted sum of the prot sequence from today is 1 1 + 0 + 2 0 + = . 4 4 The rm has no incentive to deviate if and only if 1 1 1 18 4 1 . 2 Secondly, check the incentive when somebody has ever deviated from pm before. In this case, a rms action today doesnt aect its future payo because everyone will be playing 0 in future no matter what happens today. Therefore it is sucient to check if the rm can increase the present period prot by deviating. If it plays p = 0, as suggested by the strategy, it gets a payo of 0. 5

If it deviates and plays p > 0, it gets a payo of 0 again because all consumers buy from the other rm which is choosing p = 0. Therefore it cant benet from deviating. To conclude, the trigger strategy constitutes a subgame perfect Nash equi1 librium if 2 . (b) When there are n rms, we can use the trigger strategy constructed in part (a) again. As we did in part (a), we check incentives to deviate before and after any deviation. Firstly, check the incentive when nobody has deviated from pm before. If a rm plays pm , as suggested by the strategy, then everyone will be playing pm all the time in future, and a rms prot per period is 1 pm (1 pm ) = , n 4n and the present discounted sum of the prot sequence from today is 1 1 1 1 1 + + 2 + = . 4n 4n 4n 1 4n If the rm is to deviate, the best it can do today is to set a price slightly less than pm and get the whole monopoly prot pm (1 pm ) = 1 . 4

If the rm does deviate, everyone will be playing 0 from the next period, yielding per period payo of zero. Therefore, the present discounted sum of the prot sequence from today is 1 1 + 0 + 2 0 + = . 4 4 The rm has no incentive to deviate if and only if 1 1 1 1 4n 4 n1 . n To check the incentive when somebody has ever deviated from pm before, the same argument as in part (a) holds. To conclude, the trigger strategy constitutes a subgame perfect Nash equilibrium if n1 . n Question 4 (a) 6

To begin with, lets nd the subgame perfect Nash equilibrium of the stage game. We do this by backward induction. The long run rm, observing the short run rms quantity xt , chooses its quantity yt to maximize its prot
L t = yt (1 (xt + yt )).

Solving rst order condition, the optimum is

yt (xt ) =

1 xt . 2

The short run rm chooses its quantity xt to maximize its prot

S t = xt (1 (xt + yt )),

knowing that if it choose xt , the long run rm reacts with

yt (xt ) =

1 xt . 2

Therefore, the short run rms objective function can be rewritten as a function of xt ; 1 xt S t = xt (1 (xt + )). 2 Solving rst order condition, the optimum is x = t 1 . 2

Therefore, the subgame perfect Nash equilibrium of the stage game is x = t 1 1 xt , yt (xt ) = . 2 2

Now lets solve for the subgame perfect Nash equilibrium of the nitely repeated game. Since it is nite, we can use backward induction. At the last period, t = T , the players dont care about future and they concern only about the payo of that period. Therefore they must play the subgame perfect Nash equilibrium of the stage game, regardless of what happened in the past. At time t = T 1, the players know that the actions today doesnt aect tomorrows outcome, so they concern only about the payo of that period. Therefore they must play the subgame perfect Nash equilibrium of the stage game, regardless of what happened in the past. We can repeat the same argument until we reach the very rst period. Therefore, the subgame perfect Nash equilibrium of the repeated game is x = t regardless of the history. 7 1 1 xt , yt (xt ) = for all t, 2 2

(b) Construct the following trigger strategy. Long rum rm Start with playing the following strategy: () yt (xt ) = 1/2 1 xt if if xt 1/2 xt 1/2

Keep playing this strategy as long it has not deviated from it.
Play yt (xt ) = 1xt 2

if it has deviated from (*) at least once.

Short run rms Play xt = 1/4 if the long run rm has not deviated from (*) before. Play xt =
1 2

if the long run rm has deviated from (*) at least once.

To see this is actually a subgame perfect Nash equilibrium, lets check incentives to deviate. Firstly, consider the long run rms incentive when it has never deviated from (*) before. Case 1: xt 1/2 If it follows the strategy and choose yt = 1/2, the present period prot of the long run rm is 1 1 (1 ( + xt )). 2 2 Starting from the next period, the outcome will be xt = 1/4 and yt = 1/2 every period, and the long run rms per period prot is 1/8 and therefore the present discounted value of the prot sequence is 1 1 (1 ( + xt )) + . 2 2 8(1 ) If it is to deviate, the best it can do today is to play yt = and get payo of (1 xt )2 . 4 However, starting from next period, the outcome will be xt = 1/2 and yt = 1/4 and the long run rms per period prot is 1/16. Therefore the present discounted value of the prot sequence is (1 xt )2 + . 4 16(1 ) 8 1 xt 2

If = 0.99, 1 1 (1 xt )2 (1 ( + xt )) + > + , 2 2 8(1 ) 4 16(1 ) (check it!), and therefore it is better to follow the equilibrium strategy than to deviate. Case 2: xt 1/2 If it follows the strategy, pt = 0 and todays payo is 0, and the outcome will be xt = 1/4 and yt = 1/2 every period, starting the next period. The long run rms per period prot is 1/8 and therefore the present discounted value of the prot sequence is . 8(1 ) If it is to deviate, the best it can do today is to play yt =
1xt and get 2 (1xt )2 . However, starting from next period, the outcome will be 4 and yt = 1/4 and the long run rms per period prot is 1/16.

payo of xt = 1/2 Therefore the present discounted value of the prot sequence is (1 xt )2 + . 4 16(1 ) This value is the largest when xt = 1/2 and is equal to 1 + . 16 16(1 )

If = 0.99, it is better to follow the equilibrium strategy than to deviate (check it!). Secondly, consider the long run rms incentive when it has deviated from (*) before. According to the strategy strategy prole, future outcomes dont depend on todays behavior. Therefore the long run rm cares only about its payo today. Actually, by following the strategy, it is taking best response to the short run rm. Finally, consider the short run rms incentives. Since they never care about future payo, it must be playing a best response to the long run rms strategy, which is actually true. (Check it!) (c) In the equilibrium we saw in part (b), the per period prot on the equilibrium path were 1/8 for the long run rm and 1/16 for the short run rms.

If there is a subgame perfect Nash equilibrium where xt = yt 1/4 on th eequilibrium path, then the per period prot on the equilibrium path are 1/8 for the long run rm and 1/8 for the short run rms. Construct the following trigger strategy, which is dierent from (b) only in (*) where xt = 1/4: Long rum rm Start with playing the if 1/4 1/2 if () yt (xt ) = 1 xt if
1xt 2

following strategy: xt = 1/4 xt 1/2 and xt = 1/4 xt 1/2

Keep playing this strategy as long it has not deviated from it.
Play yt (xt ) =

if it has deviated from (*) at least once.

Short run rms Play xt = 1/4 if the long run rm has not deviated from (*) before. Play xt =
1 2

if the long run rm has deviated from (*) at least once.

The incentive of the long run rm when it is supposed to play (*) and xt = 1/4 is satised because it gets current payo of 1/8, which is same as part (b), and what it can get by deviating is same as in part (b). The incentive problem of the long run rm is same as in (b). The incentives of the short run rms are also satised because the payo from following the strategy is larger than part (b) and payo when deviating is same as in (b).

10

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14.12 Solutions for Homework 4 Kenichi Amaya1 November 9, 2001 Question 1 (a) Action spaces A1 = A2 = {B, S}. Type spaces T1 = {}, T2 = {1 , 2 }. Since player 1 has no private information, we can model it so that her type can take only one value. Player 2 knows that the game above is played when his type is 1 and he knows that the game below is played when his type is 2 . Belief Player is belief i (tj |ti ) is the probability that player js type is tj conditional on that player is type is ti . In this model, since it is assumed that the types are independent, 1 (1 |) = 1 (2 |) = 1 , 2 2 (|1 ) = 2 (|2 ) = 1.

vNM utility function ui (a1 , a2 , t1 , t2 ) is the vNM utility when player 1s action is a1 , player 2s action is a2 , player 1s type is t1 and player 2s type is t2 . u1 (B, B, , 1 ) = 2, u2 (B, B, , 1 ) = 1, u1 (B, S, , 1 ) = 0, u2 (B, S, , 1 ) = 0, u1 (S, B, , 1 ) = 0, u2 (S, B, , 1 ) = 0, u1 (S, S, , 1 ) = 1, u2 (S, S, , 1 ) = 2, u1 (B, B, , 2 ) = 2, u2 (B, B, , 2 ) = 0, u1 (B, S, , 2 ) = 0, u2 (B, S, , 2 ) = 2, u1 (S, B, , 2 ) = 0, u2 (S, B, , 2 ) = 1, u1 (S, S, , 2 ) = 1, u2 (S, S, , 2 ) = 0. (b) First consider player 1s incentive. Since she doesnt know the game which is being played, she maximizes her expected payo. If she plays B, with probability 1/2 the top game is being played and player 2 chooses B and thus she gets a payo of 2, and with probability 1/2 the bottom game is being played and player 2 chooses S and thus she gets a payo of 0.
1 E52-303,

kamaya@mit.edu, 253-3591

Therefore her expected payo is 1. If she plays S, with probability 1/2 the top game is being played and player 2 chooses B and thus she gets a payo of 0, and with probability 1/2 the bottom game is being played and player 2 chooses S and thus she gets a payo of 1. Therefore her expected payo is 1/2. Therefore B is actually player 1s best response against player 2s strategy. Next consider player 2s incentive. When he knows that the top game is being played, B is the best response given player 1 is choosing B. When he knows that the bottom game is being played, S is the best response given player 1 is choosing B. Therefore choosing B when the top game is being played and choosing S when the bottom game is being played is actually player 2s best response against player 1s strategy. Since both players are taking a best response to each other, the strategy prole constitutes a Bayesian Nash equilibrium. Question 2 Each players action is the choice of price. A price can take any nonnegative real number. Therefore the action space is R+ for both players. Player is type is her private information. In this model, bi is player is type. bi is either bH or bL . Therefore, the type space of each player is {bH , bL }. Player is belief i (bj |bi ) is the probability that player js type is bj conditional on that player is type is bi . In this model, since it is assumed that the types are independent, i (bj |bi ) = 1 if if b j = bH . b j = bL

(von Neuman Morgenstern) utility in this model is the prot of each player (assuming the rms are risk neutral) as a function of the actions and types of both players: ui (pi , pj , bi , bj ) = pi (a pi bi pj ). Player is strategy species what action to take for any realization of her type. In this model, it is a two dimensional vector (pi (bH ), pi (bL )), where pi (bH ) is the price when its type is bH and pi (bL ) is the price when its type is bL . The 2 strategy space is R+ for each i. A strategy prole {(p (bH ), p (bL )), (p (bH ), p (bL ))} constitutes a Bayesian 1 1 2 2 Nash equilibrium if each p (bi ) is a best response, i.e., a maximizer of player is i expected payo, conditional on that her type is bi and the opponent is choosing strategy (p (bH ), p (bL )). That is: j j p (bH ) = argmaxp1 p1 (a p1 bH p (bH )) + (1 )p1 (a p1 bH p (bL )), 1 2 2 p (bL ) = argmaxp1 p1 (a p1 bL p (bH )) + (1 )p1 (a p1 bL p (bL )), 1 2 2 p (bH ) = argmaxp2 p2 (a p2 bH p (bH )) + (1 )p2 (a p2 bH p (bL )), 2 1 1 p (bL ) = argmaxp2 p2 (a p2 bL p (bH )) + (1 )p2 (a p2 bL p (bL )). 2 1 1 2

Taking rst order conditions, a bH (p (bH ) + (1 )p (bL )) 2 2 , 2 a bL (p (bH ) + (1 )p (bL )) 2 2 p (bL ) = , 1 2 a bH (p (bH ) + (1 )p (bL )) 1 1 p (bH ) = , 2 2 a bL (p1 (bH ) + (1 )p1 (bL )) p (bL ) = . 2 2 p (bH ) = 1 Since the game is symmetric, lets look for a symmetric equilibrium where p (bH ) = p (bH ) = p and p (bL ) = p (bL ) = p . Then the conditions are 1 2 1 2 H L reduced to p = H a bH (p + (1 )p ) H L , 2 a bL (p + (1 )p ) H L . p = L 2

Solving these, we get p = H a bH (1 ), 2 2 + bH + (1 )bL a bL ). p = (1 L 2 2 + bH + (1 )bL

Question 3 Consider the following incomplete information game. H T H 1 + , 1 + 1, 1 + T 1 + , 1 1, 1

Here, is player 1s type, is player 2s type, and are independent draw from uniform distribution in the interval [0, 1], and > 0 is a constant. The interpretation is like this: Player 1 (2) can get an extra payo of ( ) by playing head, in addition to the payo generated from the original game. This extra payo is her private information. Notice, as we converge to 0, the game converges to the original game. From the construction, player 1 (2) is more tempted to play H if she has a higher value of (). Observing this, try to nd the pure strategy Bayesian Nash equilibrium of the following form. Player 1 chooses H if and chooses L if , where [0, 1] is a constant. 3

 Player 2 chooses H if and chooses L if , where [0, 1] is a constant. This strategy prole is actually a Bayesian Nash equilibrium if player 1 with cuto type and player 2 with cuto type are indierent between choosing H and T. According to the strategy, the probability that player 2 plays H is 1 , and Therefore, if player 1 of type plays the probability that player 2 plays L is . H, her expected payo is 1(1 ) + (1) + , and if she plays T, she gets (1)(1 ) + 1. Therefore, we need 1(1 ) + (1) + = (1)(1 ) + 1. (1)

We do the same thing for player 2 with type . According to the strategy, the probability that player 1 plays H is 1 , and the probability that player 1 plays L is . Therefore, if player 2 of type plays H, his expected payo is (1)(1 ) + 1 + , and if she plays T, she gets 1(1 ) + (1) . Therefore, we need (1)(1 ) + 1 + = 1(1 ) + (1) . Solving (1) and (2), we get = 82 , 16 + 2 8+2 = . 16 + 2 (3) (4) (2)

Now, as we converge to 0, i.e., as we converge the game to the complete information game, both and converge to 1/2. Therefore, in the limit, both players are choosing H and T with probability 1/2, which is equivalent to the mixed strategy equilibrium of the complete information game. Question 4 4

Let i = 1, , n be the index of bidders, vi be bidder is valuation of the good, and bi be player is bid. We denote player is strategy by a function xi (vi ), meaning that player i bids bi = xi (vi ) when her valuation is vi . We want to show that the strategy prole xi (vi ) = (n 1)vi for all i n

constitutes a Bayesian Nash equilibrium. Since the game is symmetric and strategy prole is symmetric, it is sucient to check one players incentive because every player is facing the same incentive problem. We are going to show that if player is valuation is vi and all other players are taking the strategy (n 1)vj xj (vj ) = , n then the bid which maximizes her expected payo is bi = xi (vi ) = (n 1)vi . n

First consider the probability of winning the auction by bidding bi . She wins if and only if all other players bids are less than bi , i.e., xj (vj ) = This is equivalent to vj Since P rob(vj nbi for all j = i. n1 nbi nbi )= n1 n1 (n 1)vj bi for all j = i. n

for all j because vj is uniformly distributed in [0.1], P rob(win) = P rob(vj nbi for all j = i) n1 nbi n1 = P rob(vj ) n1 nbi n1 = . n1

Therefore, the expected payo from bidding bi is Ui = (vi bi )P rob(win) = (vi bi ) nbi n1
n1

Taking rst order condition, nbi Ui = (vi bi )(n 1) bi n1

n2

nbi n n1 n1

n1

= 0,

(vi bi )n =

nbi , n1 (n 1)vi bi = . n

Therefore, the strategy of player i bi = xi (vi ) = (n 1)vi n

is actually the best response to other players playing xj (vj ) = Q.E.D. (n 1)vj . n

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14.12 Game Theory Fall 2001 Problem Set 5 Solutions

December 14, 2001

1. The possibilities are: Pooling on A, pooling on D, and hybrid equilibria (since there are only two possible actions for player 1, but three possible types of player 1). Let us write the strategies in the form (t11 , t21 , t31 ; t12 , t22 , t32 ) for player 1, where ti j indicates the action taken by type i at the jth move, and (a) for the strategy of player 2, which gets to move only once and has only one information set. The only equilibrium here is (A, A, D; d, a, d) and (). Player 2 moves since u2 () = 5/6(3) + 1/6(5) = 5/3 < 2 = u2 () note how beliefs are updated. Finally, each type of player 1 does not have an incentive to deviate: top type is getting 5 as opposed to 4 (if deviates and plays D); middle type is getting 0 as opposed to -1 (if deviates and plays D); bottom type is getting 0 as opposed to -1 (if deviates and plays A). 2. In the second stage of the game, it is clear that each type will always play the static best response: a = 2 type will ght and a = 1 type will accomodate. The possibilities for the rst stage are: (a) Pooling on Fight: If = 0.4, then at t = 2, given no updating of beliefs (so that (a = 2|F ) = ), the entrant stays out since EU (Enter) = 2 1 = 0.2 < 0 = EU (Out). Then, in t = 1, incumbents pool on ght. The PBE equilibrium is [(F, F ; F, A), (O, O, E)], where we write the strategy for player 1 as (t11 , t21 ; t12 , t22 ) where ti j is the action taken by type i in stage j and for player 2 as (a1 , a21 , a22 where a1 refers to the rst information set in t = 1, and the other two refer to the information sets in t = 2: a21 being the information set after the incumbent ghts in the rst period, and a22 being the information set after the incumbent ghts in the rst period. Beliefs are not updated on a21 and o the equilibrium belief on a22 is (a = 1|accomodate) = 1. (b) Separating equilibrium: If = 0.9, then entrant always enters since EU (Enter) = 2 1 = 0.8 > 0 = EU (Out), a=2 type ghts and a=1 type accomodates. The PBE is [(F, A; F, A), (E, O, E)]. Beliefs are updated such that at a22 we have (a = 1|accomodate) = 1 and at a21 we have (a = 2|f ight) = 1. 1

If the game is repeated 100 times a similar structure applies. 3. In t = 1, buyer of type 1 will accept if and only if: 0.9(1 p1 ) 0, that is p1 1 0.9(2 p1 ) 0, that is p1 2 and seller will oer p1 0. If seller oers 1 p1 2, then type 1 rejects the oer and type 2 accepts it: EU (seller) = (1 )(0) + p1 = p1 or simply 2, which is the value that maximizes the sellers utility. If seller oers 0 p1 1 then both types accept the oer: EU (seller) = p1 (1 ) + p1 = p1 or simply 1, which is the value that maximizes the sellers utility. If > 1/2, then seller oers p1 = 2 in t = 1 and she accepts oers in t = 0 p0 0.9 since if she waits until t = 1 she can get 0.9(1)=0.9 . If < 1/2, then seller oers p1 = 1 and she accepts oers in t = 0 p0 1.8 since in t = 1 she can get 0.9(2)=1.8. 4. Proposed pooling strategy of Sender: Suppose there is an equilibrium in which the Senders strategy is (R, R), where (m , m ) means that type t1 chooses m and type t2 chooses m . Receivers belief at R: Then the Receivers information set corresponding corresponding to R is on the equilibrium path, so the Receivers belief (p, 1 p) at this information set is determined by Bayesrule and the Senders strategy: p = .5, the prior distribution (since there is no updating of belief in pooling). Receivers best response at R: Given this belief, the Receivers best response following R is to play d since u2 (u|R) = 1(.5) + 0(.5) = .5 < u2 (d|R) = 0(.5) + 2(.5) = 1 Receivers belief and best response at information set for L: To determine whether both Sender types are willing to choose R, we need to specify how the Receiver would react to L. In particular, we need to pin down the beliefs such that u2 (u|L) > u2 (d|L) in order for the Senders willingness to choose R. The Receivers belief at the information set corresponding to L needs to be, in order for u to be the best response, q 1/3. Thus, if there is an equilibrium in which the Senders strategy is (R, R) then the Receivers strategy must be (d, u) where (a , a ) means that the Receiver plays a following R and a following L. Pooling perfect Bayesian equilibrium: [(R, R), (d, u), p = .5, q] for q 1/3. 5. Part a.

 Pooling on R: Beliefs on the equilibrium path: (t1 |R) = .5 Receivers best response: u2 (u|R) = .5(2) = 1 > u2 (d|R) = .5(1) = .5 Senders payo: ut1 (R) = 2,ut2 (R) = 1. Any play by Receiver after observing L sustains (R, R). PBE: [(R, R), (u, u), q > 1/2], [(R, R), (u, d), q < 1/2], [(R, R), (u, u + (1 )d), q = 1/2] Pooling on L: Not an equilibrium, since t2 will always want to play R. t1 plays R, t2 plays L: Then both of the Receivers information sets are on the equilibrium path, so both beliefs are determined by Bayes rule and the Senders strategy: (t1 |R) = 1, (t2 |L) = 1. Receivers best response: (u, d) t2 , however, will always play R. t1 plays L, t2 plays R: (t1 |L) = 1, (t2 |R) = 1. Receivers best response: (u, d) Senders payo: ut1 (L) = 1,ut2 (R) = 1. PBE: [(L, R), (u, d)] Part b. Pooling on R: Beliefs on the equilibrium path: (t1 |R) = .5 Receivers best response: u2 (u|R) = .5(2) = 1 > u2 (d|R) = .5(1) = .5 Senders payo: ut1 (R) = 0,ut2 (R) = 1. However, this is not an equilibrium since t1 would always play L. Pooling on L: Beliefs on the equilibrium path: (t1 |R) = .5 Receivers best response: u2 (u|L) = .5(3) = 1.5 > u2 (d|L) = .5(1) + .5(1) = 1 Senders payo: ut1 (L) = 3,ut2 (L) = 3. Receivers belief and best response at information set for R: u2 (u|R) = 2(1 p) > u2 (d|R) = p when p < 2/3. PBE: [(L, L), (u, u), p < 2/3] t1 plays R, t2 plays L: Then both of the Receivers information sets are on the equilibrium path, so both beliefs are determined by Bayes rule and the Senders strategy: (t1 |R) = 1, (t2 |L) = 1. Receivers best response: (d, u) No deviations are protable. PBE: [(R, L), (d, u)] t1 plays L, t2 plays R: (t1 |L) = 1, (t2 |R) = 1. Receivers best response: (d, u) No deviations are protable. PBE: [(L, R), (d, u)]

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2 2

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4?

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Grade Distribution For Midterm 1

Average = 67.96 Std.Dev.= 18.05 100 Assuming that you will exhibit similar performance in the future, if you got above 70, you will probably get A(+/-); if you got above 50, you will probably get B(+/-) or above; if you got below 40, you should reconsider ...

90

80

70

60 grade

50

40

30

20

10

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 rank

14.12 Game Theory Midterm II 10/10/2001 Prof. Muhamet Yildiz Instructions. This is an open book exam; you can use any written material. You have one hour and 20 minutes. Each question is 25 points. Good luck! 1. Consider the following game:
2 X 5/2 5/2 l 3 3 L E 1 R 2 r 0 2 l 2 0 r 2 2

Compute all the pure-strategy subgame-perfect equilibria. Use a forward induction argument to eliminate one of these equilibria. 2. Below, there are pairs of stage games and strategy proles. For each pair, check whether the strategy prole is a subgame-perfect equilibrium of the game in which the stage game is repeated innitely many times. Each agent tries to maximize the discounted sum of his expected payos in the stage game, and the discount rate is = 0.99. (a) Stage Game: 1\2 L M R T 2,-1 0,0 -1,2 M 0,0 0,0 0,0 B -1,2 0,0 2,-1 Strategy prole: Until some player deviates, player 1 plays T and player 2 alternates between L and R. If anyone devites, then each play M thereafter. (b) Stage Game: 1\2 A B A 2,2 1,3 B 3,1 0,0 Strategy prole: The play depends on three states. In state S0 , each player plays A; in states S1 and S2 , each player plays B. The game start at state S0 . In state S0 , if each player plays A or if each player plays B, we stay at S0 , but if a player i plays B while the other is playing A, then we switch to state Si . At any Si , if player i plays B, we switch to state S0 ; otherwise we state at state Si .

3. Consider the following rst-price, sealed-bid auction where an indivisible good is sold.There are n 2 buyers indexed by i = 1, 2, . . . , n. Simultaneously, each buyer i submits a bid bi 0. The agent who submits the highest bid wins. If there are k > 1 players submitting the highest bid, then the winner is determined randomly among these players each has probability 1/k of winning. The winner i gets the object and pays his bid bi , obtaining payo vi bi , while the other buyers get 0, where v1 , . . . , vn are independently and identically distributed with probability density function f where 2 3x x [0, 1] f (x) = 0 otherwise. (a) Compute the symmetric, linear Bayesian Nash equilibrium. (b) What happens as n ? [Hint: Since v1 , v2 , . . . , vn is independently distributed, for any w1 , w2 , . . . , wk , we have Pr(v1 w1 , v2 w2 , . . . , vk wk ) = Pr(v1 w1 ) Pr(v2 w2 ) . . . Pr(vk wk ).] 4. This question is about a thief and a policeman. The thief has stolen an object. He can either hide the object INSIDE his car on in the TRUNK. The policeman stops the thief. He can either check INSIDE the car or the TRUNK, but not both. (He cannot let the thief go without checking, either.) If the policeman checks the place where the thief hides the object, he catches the thief, in which case the thief gets -1 and the police gets 1; otherwise, he cannot catch the thief, and the thief gets 1, the police gets -1. (a) Compute all the Nash equilibria. (b) Now imagine that we have 100 thieves and 100 policemen, indexed by i = 1, . . . , 100, and j = 1, . . . , 100. In addition to their payos above, each thief i gets extra payo bi form hiding the object in the TRUNK, and each policeman j gets extra payo di from checking the TRUNK. We have b1 < b2 < < b50 < 0 < b51 < < b100 , d1 < d2 < < d50 < 0 < d51 < < d100 . Policemen cannot distinguish the thieves from each other, nor can the thieves distinguish the policemen from each other. Each thief has stolen an object, hiding it either in the TRUNK or INSIDE the car. Then, each of them is randomly matched to a policeman. Each matching is equally likely. Again, a policeman can either check INSIDE the car or the TRUNK, but not both. Compute a pure-strategy Bayesian Nash equilibrium of this game.

The game for problem 1.

2 X 5/2 5/2 l 3 3 2 X 5/2 5/2 l 3 3 L E 1 R 2 r 0 2 l 2 0 r 2 2 L E 1 R 2 r 0 2 l 2 0 r 2 2

14.12 Game Theory Midterm II 10/10/2001 Prof. Muhamet Yildiz Instructions. This is an open book exam; you can use any written material. You have one hour and 20 minutes. Each question is 25 points. Good luck! 1. Consider the following game:
2 X 5/2 5/2 l 3 3 L E 1 R 2 r 0 2 l 2 0 r 2 2

Compute all the pure-strategy subgame-perfect equilibria. Use a forward induction argument to eliminate one of these equilibria. Answer: There are two pure strategy Nash equilibria in the proper subgame, yielding subgame-perfect equilibria:

2 X 5/2 5/2 l 3 3 L E 1 R 2 r 0 2 l 2 0 r 2 2

2 X 5/2 5/2 l 3 3 L E 1 R 2 r 0 2 l 2 0 r 2 2

For player 2, Er is strictly dominated by Xr, while El is not dominated. Hence, if player 1 keeps believing that 2 is rational whenever it is possible, then when he sees that 2 played E, he ought to believe that 2 plays strategy El not the dominated strategy Ex. In that case, 1 would play L, and 2 would play E. Therefore, the equilibrium on the left is eliminated. 1

2. Below, there are pairs of stage games and strategy proles. For each pair, check whether the strategy prole is a subgame-perfect equilibrium of the game in which the stage game is repeated innitely many times. Each agent tries to maximize the discounted sum of his expected payos in the stage game, and the discount rate is = 0.99. (a) Stage Game: 1\2 L M R T 2,-1 0,0 -1,2 M 0,0 0,0 0,0 B -1,2 0,0 2,-1 Strategy prole: Until some player deviates, player 1 plays T and player 2 alternates between L and R. If anyone deviates, then each play M thereafter. Answer: It is subgame perfect. Since (M,M) is a Nash equilibrium of the stage game, we only need to check if any player wants to deviate when player 1 plays T and player 2 alternates between L and R. In this regime, the present value of player 1s payos is V1L = when 2 is to play L and V1R = 2 1 2 1 = = 98 1 1 1 2 2 = >0 1 1 1

when 2 is to play R. When 2 plays L, 1 cannot gain by deviating. When 2 plays R, the best 1 gets by deviating is 2 + 0 < 98 (when he plays B). The only possible protable deviation for player 2 is to play R when he is supposed to play left. In that contingency, if he follows the strategy he gets V1R = 98; if he deviates, he gets 2 + 0 < V1R . (b) Stage Game: 1\2 A B A 2,2 1,3 B 3,1 0,0 Strategy prole: The play depends on three states. In state S0 , each player plays A; in states S1 and S2 , each player plays B. The game start at state S0 . In state S0 , if each player plays A or if each player plays B, we stay at S0 , but if a player i plays B while the other is playing A, then we switch to state Si . At any Si , if player i plays B, we switch to state S0 ; otherwise we state at state Si . Answer: It is not subgame-perfect. At state S2 , player 2 is to play B, and we will switch to state S0 no matter what 1 plays. In that case, 1 would gain by deviating and playing A (in state S2 ).

3. Consider the following rst-price, sealed-bid auction where an indivisible good is sold. There are n 2 buyers indexed by i = 1, 2, . . . , n. Simultaneously, each buyer i submits a bid bi 0. The agent who submits the highest bid wins. If there are k > 1 players submitting the highest bid, then the winner is determined randomly among these players each has probability 1/k of winning. The winner i gets the object and pays his bid bi , obtaining payo vi bi , while the other buyers get 0, where v1 , . . . , vn are independently and identically distributed with probability density function f where 2 3x x [0, 1] f (x) = 0 otherwise. (a) Compute the symmetric, linear Bayesian Nash equilibrium. Answer: We look for an equilibrium of the form bi = a + cvi where c > 0. Then, the expected payo from bidding bi with type vi is U (bi ; vi ) = (vi bi ) Pr (bi > a + cvj j 6= i) Y Pr (bi > a + cvj ) = (vi bi ) bi a Pr vj < = (vi bi ) c j6=i Y bi a 3 = (vi bi ) c j6=i 3(n1) bi a = (vi bi ) c Y
j6=i

for bi [a, a + c]. The rst order condition is 3(n1) 3(n1)1 bi a 1 bi a U (bi ; vi ) = + 3 (n 1) (vi bi ) = 0; bi c c c i.e., bi a c i.e., + 3 (n 1) 1 (vi bi ) = 0; c

a + 3 (n 1) vi . 3 (n 1) + 1 Since this is an identity, we must have bi = a= and c= 3 a = a = 0, 3 (n 1) + 1 3 (n 1) . 3 (n 1) + 1

(b) What happens as n ? Answer: As n ,

In the limit, each bidder bids his valuation, and the seller extracts all the gains from trade. [Hint: Since v1 , v2 , . . . , vn is independently distributed, for any w1 , w2 , . . . , wk , we have Pr(v1 w1 , v2 w2 , . . . , vk wk ) = Pr(v1 w1 ) Pr(v2 w2 ) . . . Pr(vk wk ).] 4. This question is about a thief and a policeman. The thief has stolen an object. He can either hide the object INSIDE his car on in the TRUNK. The policeman stops the thief. He can either check INSIDE the car or the TRUNK, but not both. (He cannot let the thief go without checking, either.) If the policeman checks the place where the thief hides the object, he catches the thief, in which case the thief gets -1 and the police gets 1; otherwise, he cannot catch the thief, and the thief gets 1, the police gets -1. (a) Compute all the Nash equilibria. Answer: This is a matching-pennies game. There is a unique Nash equilibrium, in which Thief hides the object INSIDE or the TRUNK with equal probabilities, and the Policeman checks INSIDE or the TRUNK with equal probabilities. (b) Now imagine that we have 100 thieves and 100 policemen, indexed by i = 1, . . . , 100, and j = 1, . . . , 100. In addition to their payos above, each thief i gets extra payo bi form hiding the object in the TRUNK, and each policeman j gets extra payo dj from checking the TRUNK. We have b1 < b2 < < b50 < 0 < b51 < < b100 , d1 < d2 < < d50 < 0 < d51 < < d100 . Policemen cannot distinguish the thieves from each other, nor can the thieves distinguish the policemen from each other. Each thief has stolen an object, hiding it either in the TRUNK or INSIDE the car. Then, each of them is randomly matched to a policeman. Each matching is equally likely. Again, a policeman can either check INSIDE the car or the TRUNK, but not both. Compute a pure-strategy Bayesian Nash equilibrium of this game. Answer: A Bayesian Nash equilibrium: A thief i hides the object in INSIDE if bi < 0 TRUNK if bi > 0; a policeman j checks INSIDE if dj < 0 TRUNK if dj > 0. This is a Bayesian Nash equilibrium, because, from the thiefs point of view the policeman is equally likely to to check TRUNK or INSIDE the car, hence it is the best response for him to hide in the trunk i the extra benet from hiding in the trunk is positive. Similar for the policemen.

bi vi .

14.12 Midterm 2 Grade Distribution

100 90 80 70 60 grade 50 40 30 20 10 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 Rank 45

14.12 Grade Distribution (Midterm 1 + Midterm 2)/2

100

90

80

70

grade

60

50

40

30

20 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 rank 45

14.12 Game Theory Final 12/10/2001 Prof. Muhamet Yildiz Instructions. This is an open book exam; you can use any written material. You have 2 hours 50 minutes. Each question is 20 points. Good luck! 1. Consider the following extensive form game.
1 O I

2 2

2 L R 1 L R L R

3 1

0 0

0 0

1 3

(a) Find the normal form representation of this game. (b) Find all rationalizable pure strategies. (c) Find all pure strategy Nash equilibria. (d) Which strategies are consistent with all of the following assumptions? (i) (ii) (iii) (iv) 1 is rational. 2 is sequentially rational. at the node she moves, 2 knows (i). 1 knows (ii) and (iii).

2. This question is about a milkman and a customer. At any day, with the given order, Milkman puts m [0, 1] liter of milk and 1 m liter of water in a container and closes the container, incurring cost cm for some c > 0; Customer, without knowing m, decides on whether or not to buy the liquid at some price p. If she buys, her payo is vm p and the milkmans payo is p cm. If she does not buy, she gets 0, and the milkman gets cm. If she buys, then she learns m.

(a) Assume that this is repeated for 100 days, and each player tries to maximize the sum of his or her stage payos. Find all subgame-perfect equilibria of this game. (b) Now assume that this is repeated innitely many times and each player tries to maximize the discounted sum of his or her stage payos, where discount rate is (0, 1). What is the range of prices p for which there exists a subgame perfect equilibrium such that, everyday, the milkman chooses m = 1, and the customer buys on the path of equilibrium play? 3. For the game in question 3.a, assume that with probability 0.001, milkman strongly believes that there is some entity who knows what the milkman does and will punish him severely on the day 101 for each day the milkman dilutes the milk (by choosing m < 1). Call this type irrational. Assume that this is common knowledge. For v > p > c, nd a perfect Bayesian equilibrium of this game. Bonus: [10 points] Discuss what would happen if the irrational type were known to dilute the milk by accident with some small but positive probability. 4. Find a perfect Bayesian equilibrium of the following game.

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el el d du

 Then, entrepreneur decides whether to borrow ($100,000) and invest. Then, uncertainty is resolved. (a) Compute the subgame perfect equilibrium for the case when the wealth is common knowledge. (b) Now assume that the bank does not know the wealth of the entrepreneur. The probability that the entrepreneur is rich is 1/4. Compute the perfect Bayesian equilibrium.

14.12 Game Theory Final 12/10/2001 Prof. Muhamet Yildiz Instructions. This is an open book exam; you can use any written material. You have 2 hours 50 minutes. Each question is 20 points. Good luck! 1. Consider the following extensive form game.
1 O I

2 2

2 L R 1 L R L R

3 1

0 0

0 0

1 3

(a) Find the normal form representation of this game. A: L R OL 2,2 2,2 OR 2,2 2,2 IL 3,1 0,0 IR 0,0 1,3 (b) Find all rationalizable pure strategies. L R OL 2,2 2,2 OR 2,2 2,2 IL 3,1 0,0 (c) Find all pure strategy Nash equilibria. L R OL 2,2 2,2 OR 2,2 2,2 IL 3,1 0,0 1

(d) Which strategies are consistent with all of the following assumptions? (i) (ii) (iii) (iv) 1 is rational. 2 is sequentially rational. at the node she moves, 2 knows (i). 1 knows (ii) and (iii).

ANSWER: By (i) 1 does not play IR. Hence, by (iii), at the node she moves, 2 knows that 1 does not play IR, hence he knows IL. Then, by (ii), 2 must play L. Therefore, by (i) and (iv), 1 must play IL. The answer is (IL,L). 2. This question is about a milkman and a customer. At any day, with the given order, Milkman puts m [0, 1] liter of milk and 1 m liter of water in a container and closes the container, incurring cost cm for some c > 0; Customer, without knowing m, decides on whether or not to buy the liquid at some price p. If she buys, her payo is vm p and the milkmans payo is p cm. If she does not buy, she gets 0, and the milkman gets cm. If she buys, then she learns m. (a) Assume that this is repeated for 100 days, and each player tries to maximize the sum of his or her stage payos. Find all subgame-perfect equilibria of this game. ANSWER: The stage game has a unique Nash equilibrium, in which m = 0 and the customer does not buy. Therefore, this nitely repeated game has a unique subgame-perfect equilibrium, in which the stage equilibrium is repeated. (b) Now assume that this is repeated innitely many times and each player tries to maximize the discounted sum of his or her stage payos, where discount rate is (0, 1). What is the range of prices p for which there exists a subgame perfect equilibrium such that, everyday, the milkman chooses m = 1, and the customer buys on the path of equilibrium play? ANSWER: The milkman can guarantee himself 0 by always choosing m = 0. Hence, his continuation value at any history must be at least 0. Hence, in the worst equilibrium, if he deviates customer should not buy milk forever, giving the milkman exactly 0 as the continuation value. Hence, the SPE we are looking for is the milkman always chooses m=1 and the customer buys until anyone deviates, and the milkman chooses m=0 and the customer does not buy thereafter. If the milkman does not deviate, his continuation value will be V = pc . 1

The best deviation for him (at any history on the path of equilibrium play) is to choose m = 0 (and not being able to sell thereafter). In that case, he will get Vd = p + 0 = p. In order this to be an equilibrium, we must have V Vd ; i.e., pc p, 1

i.e.,

c p . In order that the customer buy on the equilibrium path, we must also have p v. Therefore, c vp .

3. For the game in question 2.a, assume that with probability 0.001, milkman strongly believes that there is some entity who knows what the milkman does and will punish him severely on the day 101 for each day the milkman dilutes the milk (by choosing m < 1). Call this type irrational. Assume that this is common knowledge. For some v > p > c, nd a perfect Bayesian equilibrium of this game. [If you nd it easier, take the customers at dierent dates dierent, but assume that each customer knows whatever the previous customers knew.] ANSWER: [It is very dicult to give a rigorous answer to this question, so you would get a big partial grade for an informal answer that shows that you understand the reputation from an incomplete-information point of view.] Irrational type always sets m = 1. Since he will be detected whenever he sets m < 1 and the customer buys, the rational type will set either m = 1 or m = 0. We are looking for an equilibrium in which early in the relation the rational milkman will always set m = 1 and the customer will always buy, but near the end of the relation the rational milkman will mix between m = 1 and m = 0, and the customer will mix between buy and not buy. In this equilibrium, if the milkman sets m < 1 or the customer does not buy at any t, then the rational milkman sets m = 0 at each s > t. In that case, if in addition the costumer buys at some dates in the period {t + 1, t + 2, . . . , s 1} and if the milkman chooses m = 1 at each of those days, then the costumer will assign probability 1 to that the milkman is irrational and buy the milk at s; otherwise, he will not buy the milk. On the path of such play, if the milkman sets m < 1 or the customer does not buy at any t, then the rational milkman sets m = 0 and the costumer does not buy at each s > t. In order this to be an equilibrium, the probability t that the milkman is irrational at such history must satisfy t (100 t) (v p) (1 t ) p 0, where the rst term is the expected benet from experimenting (if the milkman happens to be irrational) and the second term is the cost (if he is rational). That is, t p . p + (100 t) (v p)

Now we determine what happens if the milkman has always been setting m = 1, and the customer has been buying. In the last date, the rational type will set m = 0, and the rational type will set m = 1; hence, the buyer will buy i 100 (v p) (1 100 ) p 0, 3

i.e., Since we want him to mix, we set

p 100 . v

p 100 = . v We derive t for previous dates using the Bayes rule and the indierence condition necessary for the customers mixing. Lets write t for the probability that the rational milkman sets m = 1 at t, and at = t + (1 t ) t for the total probability that m = 1 at date t. Since the customer will be indierent between buying and not buying at t + 1, his expected payo at t + 1 will be 0. Hence, his expected payo from buying at t is at (v p) + (1 at ) (p) . For indierence, this must be equal to zero, thus p at = . v On the other hand, by Bayes rule, t+1 = Therefore, That is, 100 = 99 = 98 = p v p 2 . . . Note that v p 3 v t . at

p t = at t+1 = t+1 . v

Assume that (p/v)100 < 0.001. Then, we will have a date t such that p 101t v < 0.001 < p 100t v .

p t p v . at = = t + (1 t ) t t = v 1 t

At each date t > t , we will have t = (p/v)101t and the players will mix so that p at = v . At each date t < t , the milkman will set m = 1 and the customer will buy. At date t , the rational milkman will mix so that p 100t 0.001 = t +1 = t = , v at at 4

hence

Note that at > p/v, hence the customer will certainly buy at t . Lets write t for the probability that the customer will buy at day t. In the day 99, if the rational milkman sets m = 1, he will get U = 99 (p c) + 99 100 p + (1 99 ) (c) , where the rst term is the prot from selling at day 99, the second term is the prot from day 100 (when he will set m = 0), and the last term is the loss if the customer does not buy at day 99. If he sets m = 0, he will get 99 p (from the sale at 99, and will get zero thereafter). Hence, he will set m = 1 i 99 (p c) + 99 100 p + (1 99 ) (c) 99 p i.e., c 99 100 . p We are looking for an indierence, hence we set c 99 100 = . p Similarly, at day 98 the rational milkman will set m = 1 i 98 (p c) + 98 99 p + (1 98 ) (c) 98 p, where the second term is due to the fact that at date 99 he will be indierent between choosing m = 0 and m = 1. For indierence, we set c 98 99 = . p We will continue on like this as long as we need the milkman to mix. That is, we will have t t +1 = t +1 t +2 c , p c , = p . . . c = , p c = . p

0.001 at = p 100t .
v

98 99 99 100

c As we noted before, t = 1. Hence, t +1 = p . Hence, t +2 = 1, ... That is,

t = 1, c t +1 = , p t +2 = 1, c t +3 = , p . . . Bonus: [10 points] Discuss what would happen if the irrational type were known to dilute the milk by accident with some small but positive probability. 4. Find a perfect Bayesian equilibrium of the following game.

-1 1 0 0 1 0 3 1

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5. A risk-neutral entrepreneur has a project that requires $100,000 as an investment, and will yield $300,000 with probability 1/2, $0 with probability 1/2. There are two types of entrepreneurs: rich who has a wealth of $1,000,000, and poor who has $0. For some reason, the wealthy entrepreneur cannot use his wealth as an investment towards this project. There is also a bank that can lend money with interest rate . That is, if the entrepreneur borrows $100,000 to invest, after the project is completed he will pay back $100, 000 (1 + ) if he has that much money. If his wealth is less than this amount at the end of the project, he will pay all he has. The order of the events is as follows: First, bank posts .

Then, entrepreneur decides whether to borrow ($100,000) and invest. Then, uncertainty is resolved.

(a) Compute the subgame perfect equilibrium for the case when the wealth is common knowledge. ANSWER: The rich entrepreneur is always going to pay back the loan in full amount, hence his expected payo from investing (as a change from not investing) is (0.5)(300, 000) 100, 000 (1 + ) . Hence, he will invest i this amount is non-negative, i.e., 1/2. Thus, the bank will set the interest rate at R = 1/2. 7

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don

The poor entrepreneur is going to pay back the loan only when the project succeeds. Hence, his expected payo from investing is (0.5)(300, 000 100, 000 (1 + )). He will invest i this amount is non-negative, i.e., 2. Thus, the bank will set the interest rate at P = 2. (b) Now assume that the bank does not know the wealth of the entrepreneur. The probability that the entrepreneur is rich is 1/4. Compute the perfect Bayesian equilibrium. ANSWER: As in part (a), the rich type will invest i R = .5, and the poor type will invest i P = 2. Now, if R , the banks payo is 3 1 1 1 100, 000 (1 + ) + 100, 000 (1 + ) + 0 100, 000 U () = 4 4 2 2 5 100, 000 (1 + ) 100, 000 = 8 5 100, 000 (1 + R ) 100, 000 8 5 1 = 100, 000 (1 + 1/2) 100, 000 = 100, 000 < 0. 8 16 If R < P , the banks payo is 1 3 1 100, 000 (1 + ) + 0 100, 000 U () = 4 2 2 3 = 100, 000 ( 1) , 8 which is maximized at P , yielding 3 100, 000. If > P , U () = 0. Hence, the 8 bank will choose = P .

14.12 Game Theory Final 12/21/2001 Prof. Muhamet Yildiz Instructions. This is an open book exam; you can use any written material. You have 2 hours 50 minutes. Each question is 20 points. Good luck! 1. Consider the following extensive form game.

1 D (1,1)

2 (0,3)

(1,4)

(2,2)

(a) Find the normal form representation of this game. 1\2 Aa Ad Da Dd (b) Find all rationalizable pure strategies. 1\2 Ad 2,2 0,3 Da 1,1 1,1 Dd 1,1 1,1 (c) Find all pure strategy Nash equilibria. 1\2 Ad 2,2 0,3 Da 1,1 1,1 Dd 1,1 1,1 (d) Which strategies are consistent with all of the following assumptions? (i) (ii) (iii) (iv) 1 is rational. 2 is sequentially rational. at the node she moves, 2 knows (i). 1 knows (ii) and (iii). 1,4 2,2 1,1 1,1 0,3 0,3 1,1 1,1

ANSWER: By (i) 1 does not play Aa. Hence, by (iii), at the node she moves, 2 knows that 1 does not play Aa, hence he knows that 1 plays Ad. Then, by (ii), 2 must play . Therefore, by (i) and (iv), 1 must play Ad or Aa. The answer is 1 plays A, given chance 2 would play . 2. This question is about a game between a possible applicant (henceforth student) to a Ph.D. program in Economics and the Admission Committee. Ex-ante, Admission Committee believes that with probability .9 the student hates economics and with probability .1 he loves economics. After Nature decides whether student loves or hates economics with the above probabilities and reveals it to the student, the student decides whether or not to apply to the Ph.D. program. If the student does not apply, both the student and the committee get 0. If student applies, then the committee is to decide whether to accept or reject the student. If the committee rejects, then committee gets 0, and student gets -1. If the committee accepts the student, the payos depend on whether the student loves or hates economics. If the student loves economics, he will be successful and the payos will be 20 for each player. If he hates economics, the payos for both the committee and the student will be -10. Find a separating equilibrium and a pooling equilibrium of this game. ANSWER: A separating equilibrium:

(-10,-10) Apply {0} .9 Dont Hate (0,0) .1 Love Apply Dont (0,0) {1} Accept Reject (-1,0) (20,20) Accept Reject (-1,0)

A pooling equilibrium:

(-10,-10) Apply {.9} .9 Dont Hate (0,0) .1 Love Apply Dont (0,0) {.1} Accept (20,20) Accept Reject (-1,0)

Reject (-1,0)

3. Consider a bargaining problem where two risk-neutral players are trying to divide a dollar they own, which they cannot use until they reach an agreement. The players do not discount the future, but at the end of each rejection of an oer the bargaining breaks down with probability 1 (0, 1) and each player gets 0. (a) Consider the following bargaining procedure. Player 1 makes an oer (x, 1 x), where x is player 1s share. Then, player 2 decides whether or not to accept the oer. If she accepts, they implement the oer, yielding division (x, 1 x). If she rejects the oer, then with probability 1 , the bargaining breaks down an each gets 0; with probability , player 1 makes another oer, which will be accepted or rejected by player 2 as above. (If player 2 rejects the oer, bargaining will break down with probability 1 again.) If the oer is rejected and the bargaining did not break down, now player 2 makes a counter oer, and player 1 accepts or rejects this counter oer as above. If the oer is rejected, this time the game will end, and each will get 0. Find the subgame-perfect Nash equilibrium of this game. Compute the expected payo of each player at the beginning of the game in this equilibrium. ANSWER: On the last day, 1 accepts any oer, so 2 oers (0,1). Hence, on the previous day, 2 accepts an oer i she gets at least . Hence, 1 oers (1 , ) accepted. Thus, in the rst day, 2 accepts an oer i she gets at least 2 . Hence, 1 oers 1 2 , 2 accepted. The expected payos are 1 2 , 2 .

(b) Compute the subgame-perfect equilibrium of the game in which the procedure in part (a) is repeated 2 times. (The probability of bargaining breakdown after each rejection is 1 , except for the end of the game.) ANSWER: The last period as above. Lets look at the rst period. On the last day of the rst period, 1 accepts an oer i he gets at least 1 2 , so 2 oers 3

 1 2 , 1 1 2 . Hence, on the previous day, 2 accepts an oer i she 2 gets at least 1 1 . Hence, 1 oers = 1 + 2 1 2 , 1 1 2 1 1 1 2 , 1 1 2

accepted. Thus, in the rst day, 2 accepts an oer i she gets at least 2 1 1 2 . Hence, 1 oers = 1 2 + 3 1 2 , 2 1 1 2 1 2 1 1 2 , 1 1 2 accepted.

(c) Find the subgame-perfect equilibrium of the game in which this procedure is repeated until they reach an agreement. Note that player 1 makes two oers, then 2 makes one oer, then 1 makes two oers, and so on. You need to show that the proposed strategy prole is in fact a subgame-perfect equilibrium. (The probability of bargaining breakdown after each rejection is 1 .) [Hint: One way is to compute the SPE for the game in which the procedure is repeated n times and let n . A somewhat easier way is to consider an alternating oer bargaining procedure with some eective discount rates dierent for a dierent player.] ANSWER: If you compare the calculations above with the calculations with the alternating oer case with asymmetric discount rates, you should realize that the rst oer player 1 makes and the oer player 2 makes are identical to the oers players 1 and 2 make, respectively, if the discount rates were 1 = and 2 = 2 . Intuitively, in his second oer player 1 makes player 2 indierent between accepting 1s second oer and making an oer next day, and in his rst oer he makes her indierent between accepting the oer and waiting for the second oer. Therefore, 2 is indierent between accepting 1s rst oer and waiting two days two make an oer, as in the the alternating oer case when her discount rate is 2 . Now conjecture that the subgame-perfect equilibrium would be as in the alternating oer game with above discount rates. That is, in his rst oer, player 1 oers 1 2 2 (1 1 ) 1 2 2 (1 ) 1 2 1 2 ,1 , , 1 12 1 12 1 1 2 1 1 2 1 3 1 3 1+ 2 ; , 1 + + 2 1 + + 2 in his secon oer, he will oer (1 1 ) (1 1 ) 1 + 2 1 ; , , 1 12 1 12 1 + + 2 1 + + 2 player 2 will oer 1 1 1 (1 2 ) 1 1 + 2 1 1 1 1 . , , , 1 1 2 1 1 2 1 12 1 12 1 + + 2 1 + + 2 4

Player 1s rst oer and player 2s oer are by formula for alternating oer, player 1s second oer is calculated by backward induction using the player 2s oer in the next period. Using single deviation property, you need to check that this is an equilibrium. 4. We have an employer and a worker, who will work as a salesman. The worker may be a good salesman or a bad one. In expectation, if he is a good salesman, he will make $200,000 worth of sales, and if he is bad, he will make only $100,000. The employer gets 10% of the sales as prot. The employer oers a wage w. Then, the worker accepts or rejects the oer. If he accepts, he will be hired at wage w. If he rejects the oer, he will not be hired. In that case, the employer will get 0, the worker will get his outside option, which will pay $15,000 if he is good, $8,000 if he is bad. Assume that all players are risk-neutral. (a) Assume that the workers type is common knowledge, and compute the subgameperfect equilibrium. ANSWER: A worker will accept a wage i it is at least as high as his outside option, and the employer will oer the outside option as he still makes prot. That is, 15,000 for the good worker 8,000 for the bad. (b) Assume that the worker knows his type, but the employer does not. Employer believes that the worker is good with probability 1/4. Find the perfect Bayesian Nash equilibrium. ANSWER: Again a worker will accepts an oer i his wage at least as high as his outside option. Hence if w 15, 000 the oer will be accepted by both types, yielding U (w) = (1/4) (.1) 200, 000 + (3/4) (.1) 100, 000 w = 12, 500 w < 0 as the prot for the employer. If 8, 000 w < 15, 000, then only the bad worker will accept the oer, yielding U (w) = (3/4) [(.1) 100, 000 w] = (3/4) [10, 000 w] as prot. If w < 0, no worker will accept the oer, and the employer will get 0. In that case, the employer will oer w = 8, 000, hiring the bad worker at his outside option. (c) Under the information structure in part (b), now consider the case that the employer oers a share s in the sales rather than the xed wage w. Compute the perfect Bayesian Nash equilibrium. ANSWER: Again a worker will accept the share s i his income is at least as high as his outside option. That is, a bad worker will accept s i 100, 000s 8, 000 5

i.e., s sB = A good worker will accept s i s sG =

8, 000 = 8%. 100, 000

15, 000 = 7.5%. 200, 000

In that case, if s < sG no one will accept the oer, and the employer will get 0; if sG s < sB , the good worker will accept the oer and the employer will get (1/4) (10% s) 200, 000 = 50, 000 (10% s) , and if s sB , each type will accept the oer and the employer will get (10% s) [(1/4) 200, 000 + (3/4) 100, 000] = 125, 000 (10% s) . Since 125, 000 (10% sB ) = 2%125, 000 = 2, 500 is larger than 50, 000 (10% sG ) = 2.5%50, 000 = 1, 250, he will oer s = sB , hiring both types. 5. As in question 4, We have an employer and a worker, who will work as a salesman. Now the market might be good or bad. In expectation, if the market is good, the worker will make $200,000 worth of sales, and if the market is bad, he will make only $100,000 worth of sales. The employer gets 10% of the sales as prot. The employer oers a wage w. Then, the worker accepts or rejects the oer. If he accepts, he will be hired at wage w. If he rejects the oer, he will not be hired. In that case, the employer will get 0, the worker will get his outside option, which will pay $12,000. Assume that all players are risk-neutral. (a) Assume that whether the market is good or bad is common knowledge, and compute the subgame-perfect equilibrium. ANSWER: A worker will accept a wage i it is at least as high as his outside option 12,000. If the market is good, the employer will oer the outside option w = 12, 000, and make 20, 000 12, 000 = 8, 000 prot. If the market is bad, the return 10,000 is lower than the workers outside option, and the worker will not be hired. (b) Assume that the employer knows whether the market is good or bad, but the worker does not. The worker believes that the market is good with probability 1/4. Find the perfect Bayesian Nash equilibrium. ANSWER: As in part (a). [We will have a separating equilibrium.] (c) Under the information structure in part (b), now consider the case that the employer oers a share s in the sales rather than the xed wage w. Compute a perfect Bayesian Nash equilibrium. ANSWER: Note that, since the return is 10% independent of whether the market is good or bad, the employer will make positive prot i s < 10%. Hence, except 6

for s = 10%, we must have a pooling equilibrium. Hence, at any s, the workers income is [(1/4) 200, 000 + (3/4) 100, 000] s = 125, 000s. This will be at least as high as his outside option i s s = 12, 000 = 9.6% < 10%. 125, 000

Hence an equilibrium: the worker will accept an oer s i s s , and the employer will oer s . The workers beliefs at any oer s is that the market is good with probability 1/4. [Note that this is an inecient equilibrium. When the market is bad, the gains from trade is less than the outside option.] There are other inecient equilibria where there is no trade (i.e., worker is never hired). In any such equilibrium, worker take any high oer as a sign that the market is bad, and does not accept an oer s unless s 12, 000/100, 000 = 12%, and the employer oers less than 12%. When the market is good, in any such pure strategy equilibrium, he must in fact be oering less than s . (why?) For instance, employer oers s = 0 independent of the market, and the worker accept s i s > 12%.

14.12 Final Exam Grade Distribution

Average = 73.82 120 Std. Dev = 20.74

100

80

grade

60

40

20

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100

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90 88

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14.12 Game Theory Midterm I 10/19/2000 Prof. Muhamet Yildiz Instructions. This is an open book exam; you can use any written material. You have one hour and 20 minutes. Each question is 33 points. Good luck! 1. Consider the following game. 1\2 T B L M R 3,2 4,0 1,1 1,1 0,2 2,3

M 2,0 3,3 0,0

a. Iteratively eliminate all the strictly dominated strategies. b. State the rationality/knowledge assumptions corresponding to each elimination. c. What are the rationalizable strategies? d. Find all the Nash equilibria. (Dont forget the mixed-strategy equilibrium!) 2. Consider the following extensive form game.

X 1 T B 2 R (0,0) L (5,0) R (0,1) (2,2)

2 L (3,1)

a. Find the normal form representation of this game. b. Find all pure strategy Nash equilibria. c. Which of these equilibria are subgame perfect? 3. Consider two agents 1, 2 owning one dollar which they can use only after they divide it. Each players utility of getting x dollar at t is - t x for -  0, 1. Given any n  0, consider the following n-period symmetric, random bargaining model. Given any date t  0, 1, T , n " 1, we toss a fair coin; if it comes Head (which comes with probability 1/2), we select player 1; if it comes Tail, we select player 2. The selected player makes an offer x, y  0, 1 2 such that x  y t 1. Knowing what has been offered, the other player accepts or rejects the offer. If the offer x, y is accepted, the game ends, yielding payoff vector - t x, - t y. If the offer is rejected, we proceed to the next date, when the same procedure is repeated, except for t  n " 1, after which the game ends, yielding (0,0). The coin tosses at different dates are stochastically independent. And everything described up to here is common knowledge. a. Compute the subgame perfect equilibrium for n  1. What is the value of playing this game for a player? (That is, compute the expected utility of each player before the coin-toss, given that they will play the subgame-perfect equilibrium.) b. Compute the subgame perfect equilibrium for n  2. Compute the expected utility of each

player before the first coin-toss, given that they will play the subgame-perfect equilibrium. c. What is the subgame perfect equilibrium for n u 3.

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14.12 Solutions for Question 7 (or 8) Kenichi Amaya1 November 9, 2001 (a) Lets denote rm 2s by c2 , i.e., c2 {cL , cH }. Let p1 and p2 be each rms price (action). Then, each rms payo functions can be written as p1 c if p1 < p2 p1 c 1 (p1 , p2 ) = if p1 = p2 , 2 0 if p1 > p2 p2 c2 if p2 < p1 p2 c2 2 (p1 , p2 ; c2 ) = if p2 = p1 2 0 if p2 > p1 (b) A pure strategy prole {p , (p , p )} is a Bayesian Nash equilibrium if 1 2L 2H p = argmaxp1 1 (p1 , p ) + (1 )1 (p1 , p ), 1 2L 2H p = argmaxp2 2 (p , p2 ; cL ), 2L 1 p = argmaxp2 2 (p , p2 ; cH ), 2H 1 (c) If there exists a pure strategy Bayesia Nash equilibrium, it must be true that p = min{p , p }. 1 2L 2H To see this, if p < min{p , p }, rm 1 is always selling to the whole market. 1 2L 2H If it increases the price slightly, it still sells the whole market. So it can increase the payo. If p < p , where k is either L or H, rm 2 is selling to the whole 1 2k market when its type is k. If it increases the price slightly, it still sells the whole market. So it can increase the payo. Next, if there exists a pure strategy Bayesia Nash equilibrium, it must be true that p = min{p , p } = c. 1 2L 2H To see this, if p < c, rm 1 is selling positive amount and losing money. 1 Therefore its better to charge a price higher than R and not to sell to get zero prot. On the other hand, if p < c, rm 1 can increase its prot by slightly 1 reducing its price. Finally, p = min{p , p } = c can not be an equilibrium because rm 2 1 2L 2H of type L can increase its prot by choosing a price slightly smaller than c.
1 E52-303,

kamaya@mit.edu, 253-3591

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14.12 Game Theory Fall 2000 Final Exam Solutions

December 14, 2001

1. (a) Given perfect competition among rms, wages will be w1 = 1,w2 = 2 and w3 = 3 for types t = 1, 2, 3 respectively. The incentive compatibility constraints give us the conditions that the education levels must fulll in equilibrium: e 1 + e and e 2 + e for t = 1, e 2 + e and 2 1 3 1 2 1 e 2 + e for t = 2, and e 3 + e and e 6 + e for t = 3. 3 2 3 2 3 1 If we let, for example, e = 0, then e = 1 and e = 3. Beliefs are 1 2 3 (t = 1|e ) = 1, where e is in [0, inf), (t = 2|e = 1) = 1 and (t = 3|e = 3) = 1. (b) Let w1 = 1 as before, since type 1 is separating. Given that types 2 and 3 are pooling, their wage is the expected marginal productivity or 1/2(2) + 1/2(3) = 5/2. Letting e = 0, the compatibility constraints 1 provide the conditions that the education levels must fulll in equilibrium: e 3/2 and e 3. For instance, we choose e = 2. Beliefs are (t = 1|e = e ) = 1, (t = 2|e ) = 1/2 and (t = 3|e ) = 1/2. 2. (a) Let the separating equilibrium be one where top plays R, bottom plays L. The beliefs are (top|R) = 1 and (bottom|R) = 1. Player 2, the receiver, plays up in the information set on the right-hand side, and down, on the information set on the left-hand side. Now it is easy to check that player 1s types do not want to deviate: if top type plays L instead, she gets 0 as opposed to 3, while bottom type, if she plays R instead, gets 1 as opposed to 2. (b) Pooling on R: player 2 plays down when sees R since EU (up|R) = 0.4(1) + 0.6(0) = 0.4 < EU (down|R) = 0.4(0) + 0.6(1) = 0.6. Any beliefs about types given L actually support this equilibrium. (c) Mixed strategies equilibrium: Bottom mixes R + (1 )L. Player 2 mixes 1/2up+1/2down when sees R. By applying Bayes rule and forcing it to be equal to 1/2, because this is the value that would make the bottom type want to mix, we have (top|R) = 0.4(1)/(0.4+0.6()) = 1/2. In particular, for player 2, EU (up|R) = P (top|R) and EU (down|R) = 1 P (top|R). Setting these two equal, because we need player 2 to mix 1

after observing R in order for bottom type to want to mix, we obtain that P (top|R) = 1/2. From the Bayes rule equation we solve for above, such that bottom types strategy is 2/3R + 1/3L. Top type always plays R. Player 2 plays 1/2up + 1/2down when sees R and plays down when sees L. Beliefs are (bottom|L) = 1 and (top|R) = 1/2. 3. Given no discounting, and the fact that the plainti gets to make the rst oer, the game ends in the rst day, with the plainti making an oer w and the defendant accepting the oer. In particular, taking into account the legal fees both parties must pay until court day, and the amount the defendant must pay then, which is certain and common knowledge, the plainti will oer 1, 110K and the defendant will accept all oers less than or equal to this amount, and reject all others. 4. One pooling equilibrium of this game would be for the rm to reject all oers w0 > 5 and accept all others, for both types of workers to oer w0 = 5, and to oer w1 = 5 in the following period if reached. Beliefs: (type = 0|w = 5) = 1. Workers do not want to deviate because that would lead to a rejection and a wage of 5 in the following period, which is what they can get now (so they are indierent).

(2,1) L (0,0) 1 {0.6} R

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(2,0)

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