1/3/11 Exercises in Game Theory by Rod Garratt and John Wooders This document contains questions that are

appropriate for advanced undergraduate classes or graduate classes in game theory. They have each been used at least once in graduate game theory courses taught by us at the University of Arizona and the University of California, Santa Barbara. We created each of the questions, although some are based on published works or the research of our colleagues.1 The questions are grouped according to the equilibrium concepts they use. Answers and recommendations for extensions are available upon request. Nash Equilibrium, Subgame Perfect Equilibrium 1. There are two baseball teams that are preparing for a three game series. Each team has three pitchers. Team 1 has an Ace, a mediocre pitcher and a scrub. Team 2 has two mediocre pitchers and a scrub. A pitcher can only be used once in the series. The probabilities of winning the game depending on the pitcher match-ups are as follows. Match up Ace versus mediocre pitcher Ace versus scrub Mediocre pitcher versus scrub Same versus same Outcome Ace wins with probability .7 Ace wins with probability .9 Mediocre pitcher wins with probability .6 Each wins with probability .5

Assume a win is worth 1 and a loss is worth 0. (a) Suppose the three games are played sequentially. The pictures for each game are chosen simultaneously, but after a game is played it is common knowledge what pitchers were used. Remember each team can only use each pitcher once. Write out the extensive form of the game. (The extensive form has 18 terminal nodes.) (b) Calculate the set of subgame perfect equilibria. (c) Draw the normal form representation of the extensive form. Find all the Nash equilibria. (d) Would either team prefer a system whereby each teams pitcher choices for the entire series had to be posted simultaneously before the series began? (e) Compare the set of Nash equilibria of the game to the set of subgame perfect equilibria.

2. One day, long ago, two women and a baby were brought before King Salmon. Each claimed to be the true mother of the baby. King Salmon pondered dividing the baby in half and giving an equal share to each mother, but decided that in the interest of the baby he would use game theory to resolve the dispute instead. Here is what the king knew. One of the women is the true mother but he does not know which one. It is common knowledge among the two women who the true mother is. The true mother places a value vT on having the baby and 0 on not having it. The woman who is not the true mother places a value of vF on having the baby and 0 on not having it. Assume vT > vF, so that the true mother values the baby more. The king proposed the following game to determine who would get to keep the baby. One woman is chosen to go first. She is player 1, the other woman is player 2. She must announce mine if she wants to claim to be the real mother and hers is she wants to claim that the other women (player 2) is the true mother. If she says hers the baby goes to player 2 and the game ends. If she says mine, player two get s to move. Player 2 announces MINE or HERS. If player 2 says MINE, she gets the baby and pays King Salmon an amount v, where v is between vF < v < vT. Meanwhile, Player 1 also has to pay King Salmon an amount > 0. If player 2 says HERS, Player 1 gets the baby and player 2 makes no payments to King Salmon. (a) Draw the extensive form of this game assuming first that the true mother is player 1, and second that the true mother is player 2. (b) Assume the mothers play the unique Subgame Perfect Equilibrium. Show that the true mother receives the baby regardless of which mother is player 1. (c) Draw the normal form representation of each of the extensive forms. Are there any Nash equilibria in which the true mother does not receive the baby? If so, why does this happen under Nash equilibria but not under Subgame perfect equilibria. 3. Two firms, A and B, produce a homogeneous good that they sell in two markets, 1 and 2. Each firm has the cost function C (q1j + q 2j ) = 1 2 (q1j + q 2j ) 2 , where q1j and q 2j are the quantities firm j = A,B sells in market 1 and market 2, respectively. The inverse demand function is the same in each market and is given by P(Qi ) = 20-Qi, where Q i = qiA + qiB for i = 1,2.
B (a) Write firm A's profit (from sales in both markets) as a function of q1A , q 2A , q1B , q 2 . (b) Consider the case where the firms sell the good in both markets simultaneously. Write down the strategy set for firm j. Find the Nash equilibrium. (c) Consider the case where the two markets are open sequentially. Both firms sell output in market 1 and then, after seeing the sales in market 1, both firms sell output in market 2. Define a strategy for firm j. Find the unique subgame-perfect equilibrium. Provide intuition as to why in subgame-perfect equilibrium both firms do better in this case than in the previous case.

4. In professional baseball there is an interesting arbitration process. If the team and the player cannot agree on the terms of the players contract then each side submits a salary to the arbitrator. The arbitrator chooses one salary or the other (not a compromise) and that salary becomes binding. Suppose it is common knowledge that the arbitrator has in mind a salary of $V and that he will choose whichever of the salaries proposed by the team and the player is closest to $V.

(a) Draw the reaction correspondences for the team and the player and identify the Nash equilibrium. (b) Now suppose both the player and the team believe the arbitrator will choose a salary at random between L and H (all possibilities are equally likely) and select whichever of the salaries proposed by the team and the player is closest to it. Find a Nash equilibrium. Is the Nash equilibrium unique?
5. Consider and industry in which there are two firms, a manufacturer and a retailer. The manufacturer moves first, choosing a wholesale price pW for its product. The (monopolistic) retailer observes pW and then decides what quantity q to buy from the manufacturer to then resell to the public. If the retailer sells q units of output then the retail price is pR = A q where A > 0. Assume for simplicity that manufacturing costs are zero and the retailer's only costs are the payments to the manufacturer. Hence, if the wholesale price is pW and the retailer chooses to buy and then sell q units, then the profits of the manufacturer and retailer are, respectively, M ( pW , q) = pW q and R ( pW , q) = ( A q )q pW q .

(a) Find the subgame perfect equilibrium of this game. (b) In the subgame perfect equilibrium what is each firm's profit? (c) Suppose that the two firms merge to become a single firm that maximizes joint profits: M ( pW , q) + R ( pW , q) . What happens to the retail price as a result of the merger? How does the profit of the merged firm compare to the sum of the profits in part (b)?
6. On the hit TV show Survivor Thailand two tribes competed in a game they called Thai 21. The game starts with 21 flags in a circle. The teams take turns removing flags from the circle until they are all gone. The team that removes the last flag wins immunity. At each turn teams must remove 1, 2 or 3 flags. Team 1 moves first. Analyze this game. Which team should win? Does either team have a strategy that would guarantee victory?

7. Consider a game with two periods, 0 and 1, and two players, Player and League. The league must test the Player for steroids in one and only one period. Steroids last 1 period, and are only detectable in the period taken. The players strategy set outlining his actions in the two periods is {Take Take, Take Dont, Dont Take, Dont Dont}. The Leagues strategy set is {0,1}, where 0 = test in period 0, and 1 = test in period 1. The Player payoff equals 1 per period playing baseball not on steroids and 2 per period if on steroids. A player caught taking steroids is immediately barred from playing baseball (i.e., does not receive the payoff in the period caught or the next period if applicable). In addition, he pays a fine F. Leagues payoff equals 0 if the player takes steroids and gets away with it, E if the player takes steroids and gets caught, and 2 if the player never takes steroids.

(a) Compute the subgame perfect equilibrium when E > 0. I.e., the league prefers to catch a player who takes steroids. (b) Compute the subgame perfect equilibrium when E < 0. I.e., the league prefers not to catch a player who takes steroids. (c) Discuss how the leagues preferences over catching guilty players affect the equilibrium outcome. Correlated Equilibrium 8. Every day Abe drives from his house in the north to his job in the south along route 66. Bob drives from his house in the west to his job in the east along route 99. The two roads intersect in the middle of nowhere. There are currently no stop signs or traffic lights. Abe and Bob like to get to work without delays, but they are averse to crashing. This means that they prefer to drive through the intersection without stopping if they can get through safely. Stopping and then proceeding safely through the intersection is preferred by both to crashing. The situation is summarized in the normal form game below. Bob Go -100, -100 5, 10

Abe

Go Stop

Stop 10, 5 5, 5

What are the Nash equilibria of the game? Write down the probability distribution function over strategy profiles corresponding to the mixed strategy Nash equilibrium. Explain how the introduction of a traffic light can be viewed as an instance of a correlated equilibrium. Give a correlated equilibrium for this problem. Find the Pareto efficient correlating device.

Bayesian Equilibrium 9. A version of the wallet game goes like this. There are two players. Each player is asked to look inside his or her wallet and see how much money is there. Then, there is a firstprice sealed-bid auction to win the amount of money contained in both wallets. Thus each player makes a bid, to win the total amount in both wallets, knowing the amount in his or her own wallet but not the amount in the other players wallet. Suppose that it is common knowledge that each player has either $0 or $3 in his or her wallet, and that each possibility is equally likely. (a) Suppose players can only make bids in $1 increments. Find a pure strategy Bayesian equilibrium. (b) Suppose players bids can be any Real number. Show that there does not exist a pure-strategy Bayesian equilibrium. Find a Bayesian equilibrium in mixed strategies. (c) Assuming again that each players bid can be any Real number determine whether there can be an equilibrium in which a player who has $0 in her wallet bids a positive amount.
10. Two individuals each have $1 deposited in a bank and must simultaneously decide whether to withdraw their $1 or leave it deposited in the bank. The bank has invested all money in a risky, illiquid asset. If one or both players attempt to withdraw their $1, the bank will have to liquidate the asset for one-half the initial value and the proceeds will be divided among the claimants. Since there are two players, that means $2 would be liquidated for $1, which would be divided 1 way (if one claimant) or 2 ways (if two claimants). If neither player withdraws their $1, the money will remain invested and each player will either gain 20 cents or lose 20 cents depending on the success or failure of the bank's risky investment. Success occurs with probability p and failure occurs with probability 1-p. The game is described below. Player 1 chooses either withdraw or not withdraw (w or n, respectively) and player 2 simultaneously chooses either withdraw or not withdraw (W or N, respectively).

Player 2 Player 1 w N W N .5, .5 1, 0 0, 1 1.2, 1.2 Success (Prob. = p) Player 1 w n

Player 2 W N .5, .5 1, 0 0, 1 .8, .8 Failure (Prob. = 1-p)

(a) Describe the set of pure-strategy Nash equilibria for each value of p in the interval [0,1]. (b) Identify which equilibria are efficient.

11. Consider the game in question 10 but suppose now that player 1 is informed about the outcome of the bank's investment before she decides whether to withdraw or not withdraw. Player 2 still only knows the probability of success or failure. These facts are common knowledge. Suppose the game is still played simultaneously. (a) Describe the set of pure-strategy Bayesian equilibria for each value of p in the interval [0,1]. (b) Briefly comment on how private information affects the outcome of this game.

Perfect Bayesian Equilibrium 12. There are two types of assistant professors high ability (t = H) and low ability (t = L). A professor knows his own ability, but his department does not know his ability. A randomly selected assistant professor is of high ability with probability p, where .5>>0. Consider the following game played by an assistant professor and his department. The professor moves first, choosing a number of papers n 0 to write. The economics department observes the number of papers written and then decides whether to grant tenure = 1 or deny tenure = 0. The utility function of the assistant professor is given by - n if t = H UP(t,n,) = - n if t = L

where > > 0. The utility function of the department is given by 1 if = 1 and if t = H -1 if = 1 and if t = L 0 if = 0

UD(t,n,) =

Let (tn) denote the departments belief that the professor is of type t given that he has written n papers. In the following, we are concerned only with pure strategy equilibria. (a) Define perfect Bayesian equilibrium for this game. (b) Give a perfect Bayesian pooling equilibrium. (c) Characterize the perfect Bayesian pooling equilibria: Is the assistant professor tenured? Does he write any papers? (d) Give a perfect Bayesian separating equilibrium. (e) Characterize the perfect Bayesian separating equilibria: How does the number of papers written depend on the professors type? Which type of professor gets tenure? Over all separating equilibria, what is the smallest number of papers for which the professor is tenured?

13. Consider the set-up in question 12, only now assume that an assistant professor will not decide on a number of papers to produce, but rather whether to attempt to get tenure or not attempt to get tenure. Under the former strategy the assistant professor puts forth a fixed effort that leads to a number of papers based on a probability distribution function determined by her type. The cost of her fixed effort may also depend on her type. The latter strategy involves putting forth no effort and writing no papers. The department knows the density function of both the high type and low type and so will decide to tenure or deny tenure based on its belief that type equals high given the number of papers. [Suggested by students in Econ 210B, UCSB, Fall 2003] 14. Once there was an evil lord that visited a poor serf each fall and demanded half of his harvest. Both the lord and the serf knew that a good harvest produced 10 bushels of potatoes and that a bad harvest produced only 6. In addition, it was common knowledge that the probability of a good harvest was 0.6. The serf knew which type of harvest had occurred. The lord was told the type of harvest by the serf, and had to decide whether or not to believe him. If he believed the serf he took the potatoes he was offered and left. If he didn't believe the serf, he took what the serf offered and punished him for lying by burning down his house. The serf kept potatoes in the cellar of his house. Hence, the truth would be revealed once the house had burnt down and his potato holdings were exposed. Punishing a dishonest serf gave the lord an added boost of pleasure equal to c > 0. On the other hand, if the fire revealed that the serf had been telling the truth, the lord's happiness was diminished by c. While the lord felt bad when he was wrong, he would not compensate the serf by giving the serf some of his crop back. Also, neither the serf nor the lord liked baked potatoes, so any potatoes that were hidden in the seller were worthless if the house was burned. The payoffs of this signaling game are shown below.

0, 3 + c Bad 7, 3 Lord 0, 3 - c Bad 3, 3 [.4] [.6]

Serf Good Good N Bad Good Lord

0, 5 - c

5, 5

0, 5 + c

1, 5

(a) Find all the pure-strategy perfect Bayesian equilibria. Are there any separating equilibria? Are there any pooling equilibria? (b) Do any of the pooling equilibria fail the (weak) intuitive criterion?

(c) Suppose the lord can commit to a strategy in advance. Namely, the lord can announce in advance what he will do in response to each message by the serf, and the announcement is credible. What strategy for the lord maximizes his expected payoff?
15. Once upon a time a signaling game was played between a princesses and a frog. The frog was the Sender. He could either say he was a prince or a frog. The princess was the receiver. She could either kiss the frog, in which case he might turn into a prince. Or, she could eat him. It was well known that 10% of the frogs in the kingdom were actually princes who had had a spell cast upon them. Only frogs that were actually princes would turn into princes when kissed by a princess. Here are some common facts about frogs and princesses that will help you understand the payoffs of the signaling game. Frogs like to kiss princesses and don't like to be eaten. Frogs who are really princes especially like to kiss princesses (because then frogs turn into princes). Frogs who are not really princes cannot say Prince without taking costly lessons in elocution. Princesses like to eat frogs, but they prefer to kiss frogs who are really princes. Princesses don't like to kiss frogs who are not princes. Payoffs that are consistent with these facts are shown below.
Kis Ki s s

10, 100

Sender Frog Prince [0.1] Prince

10, 100

-10, 5

t Ea

Eat

-10, 5

Princess 10, -10

Kis s

Nature [0.9] Frog Frog Prince Sender

Princess
Ki s s

5, -10

0, 5

Ea t

Eat

-10, 5

(a) Find all the pure-strategy perfect Bayesian equilibria. Are there any separating equilibria? Are there any pooling equilibria? (b) Let's imagine what might happen if the princesses did not always interpret the sender's signal correctly. Suppose that with probability 2/5 the princess hears Frog when the sender says Prince. (This means she hears Prince when the sender says Prince with probability 3/5.) Suppose she always hears Frog when the sender says Frog. Now is there a separating equilibrium? Moral Hazard 16. Sam is employed in the investment department at the Clampett Oil company. His job is to decide where to drill for oil. Sam can come up with a recommendation by spending a lot of time researching the terrain and analyzing rock samples, or he can throw a dart at the map. If he does his homework there is a 70% chance that the company will earn $250 thousand and a 30% chance it will lose $50 thousand. If he throws a dart, a $250

thousand gain and a $50 thousand loss are equally likely. It takes 400 hours to do adequate research before deciding where to drill. It takes 0 hours to throw a dart at a map. The gross expected benefit to Sam's employer when Sam works h hours is the expected gain conditional on h. Sam's utility function over income (w) measured in thousands of dollars and hours worked is U(w,h) = w.5 - h/200. If Sam chooses not to work for Clampett Oil he can achieve a reservation utility of 8 as a professional dart player. (a) Sam's employer cannot tell whether Sam's recommendation is based on research or dart throwing. However, his employer can write a contract to pay Sam that is contingent on the outcome of the drilling. Find the minimum cost of inducing Sam to work 400 hours before making a recommendation on where to drill. Find the minimum cost of inducing Sam to work 0 hours before making a recommendation. (b) Clampett Oil cannot select a drilling location without Sam. Sam has hidden all the maps. What contract should they give him? How many hours will Sam work? (c) Suppose that after receiving Sams recommendation Clampett Oil can check whether Sams map has any dart holes in it. In other words, suppose contracts can be written in terms of Sams effort level (either 400 hours or 0 hours). What contract would Clampett Oil offer Sam?

Question 2 is based on a 1999 GEB paper by Motty Perry and Philip J. Reny entitled, A General Solution to King Solomons Dilemma. Question 5 is based on an unpublished working paper by Cheng-Zhong Qin. Question 9 is based on the set-up used in an in-class experiment designed by Mark Walker and the description of the Wallet Game found in Paul Klemperers 1998 EER paper entitled, Auctions with Almost Common Values: The Wallet Game and its Applications. Questions 10 an 11 are based on Todd Keister and Rod Garratts 2010 JEBO paper entitled Bank Runs as Coordination Failures: An Experimental Study.