Economics 440/640 Problem Set 2 Answers

All questions are equally weighted.

Question 1. Gibbons 1.6
Profit for firm 1 is
2 π1 = q1 ∗ P (Q) − c1 q1 = q1 (a − c1 − q2 ) − q1 .

The firm’s profit is maximized at dπ1 = 0 = a − c1 − q2 − 2q1 dq1
∗ q1 (q2 ) = ∗ Firm 2’s q2 just reverses the indexes:

a − c1 − q 2 2

a − c2 − q 1 . 2 This gives us two equations and two unknowns (the quantity choices of each firm). Solving
∗ q2 (q1 ) =

q1 = q1 3q1 4 q1

a − c1 1 a − c2 − q 1 − 2 2 2 a − c1 a − c2 q 1 − + = 2 4 4 a − 2c1 + c2 = 4 a − 2c1 + c2 = 3

Again, the solution for firm 2 just reverses the indexes. As long as q1 ≥ 0 and q2 ≥ 0 our solution is satisfactory. If however a + c1 < 2c2 the solution for q2 will be negative. Firms cant produce negative output! Thus in these cases the other firm operates as a monopolist: q1 = (a − c1 )/2.

Question 2. Gibbons 1.8
With two candidates, the PSNE is x1 = x2 = 0.5. With three candidates, x1 = x2 = 0.3, x3 = 0.7 is a NE. Player 1 or 2 could move to x3 − and get all votes in [0.5, 0.7], which would still lose, 1

or move to x3 + and get all votes in [0.7, 1], which would still lose to the politician that did not move, who would then get all votes in [0, 0.5].

Question 2. Gibbons 3.6
The problem asks you to show that in there are n bidders, then the strategy of bidding bi = (n − 1)vi /n is a symmetric BNE. Given that everyone plays this strategy, the probability of bi being the winning bid is Pr(bi > max{bj |j = i}) = Pr(bi > b1 ) ∗ Pr(bi > b2 ) ∗ . . . = Pr(bi > (n − 1)v1 /n) ∗ Pr(bi > (n − 1)v2 /n) ∗ . . . = Pr(v1 < nbi /(n − 1)) ∗ Pr(v2 < nbi /(n − 1)) ∗ . . . = nbi n−1
n−1

The first step follows because for bi to be the maximum bid, it must be greater than each other bid. Using this result, we can rewrite πi as πi = Pr(bi > max{bj |j = i})(vi − bi ) = nbi (vi − bi ) n−1 n−1 nn−1 bi vi − nn−1 bn i = n − 1 (n − 1)
n−1

and use the first order condition to find b∗ i (vi ):
−2 n−1 (n − 1)nn−1 bn vi − nn bi ∂πi i =0 = ∂bi (n − 1)n−1

so (n − 1)vi − nbi = 0 (n − 1)vi b∗ . i (vi ) = n

Question 4. Evolution and Institutions.
Consider a simple game where in each time period, two citizens meet, and play the following pairwise contest game. Citizens are paired randomly together and choose whether to support the 2

party, or defect. If both express their loyalty, they each receive a payoff, normalized to 0. If they both “defect” they both receive a payoff of a > 0. But if one defects, and the other chooses the party line, the defector receives −b < 0, and the party liner receives 0. Defect Defect Party Line A) Find the Nash equilibria of the game. B) Let x1 be the proportion of the population playing defect and x2 be the proportion of the population playing “party line.” Derive the replicator dynamics of the game, plot the dynamics, and find all fixed points of the game, and find the Nash equilibria. C) Suppose b is chosen endogenously by the government, and that higher b are more costly. How might the government respond to changes in x1 , or to temporary or permanent changes in other parameters of the game? The government prefers for x1 to be low. Answer (A): There are two PSNE: (D, D) and (P, P ). There is also a MSNE in which both players play D with probability p, given by ap − b(1 − p) = 0 p(a + b) = b p = Answer (B): Using the formula from January 28, x ˙ 1 = x1 (1 − x1 )(u(D, x ¯) − u(P, x ¯)) = x1 (1 − x1 )(ax1 − b(1 − x1)) so
x ˙1

Party Line −b, 0 0, 0

a, a 0, −b

b . a+b

0

b a+b

1

x1

3

b Answer (C): The government prefers for x1 to be low. If x1 > 0, the government can set a+ so b that it is to right of x1 and then x1 will fall over time. It will want to set it significantly to the right, b perhaps close to the x1 which minimizes x ˙ 1 , because x ˙ 1 ≈ 0 around a+ . b

Question 5. Double Auction.
A buyer and a seller are considering trading an object. The value of the object to the buyer is vb = 1 with probability 2/5 4 with probability 3/5

which is known only to the buyer, and the value of the object to the seller is vs = 0 with probability 5/9 3 with probability 4/9

They decide whether to trade by simultaneously naming prices pB and pS . If pB > pS , they exchange the good at the average price named, while if pB < pS , they do not exchange the good. A) Write the players’ payoffs as a function of their type and the other player’s strategy. B) Find a Bayesian Nash equilibrium of this game. Answer (B): Consider the following potential equilibrium: ps (vs = 0) = pb (vb = 1) = 1/2 and ps (vs = 3) = pb (vb = 4) = 7/2. We must check that these prices maximize utility for each type conditional on what the other role’s types ask or demand. Low value seller: vs = 0 sellers get utility us (p, vs = 0) = Pr(p < pb ) ∗ (p − 0) For ps less than the lowest buyer price, Pr(ps < pb ) = 1. More generally,   if p > 7/2 0 Pr(p < pb ) = 3/5 if 1/2 > p ≥ 7/2 .   1 if p ≤ 1/2 Using this, us (p, vs = 0) = Pr(p < pb ) ∗ p is   if p > 7/2 0 us = (3p)/5 if 1/2 > p ≥ 7/2 .   p if p ≤ 1/2 4

Hence the low value sellers can do better asking for p = 7/2, which generates expected utility 21/10 than p = 1/2, which generates expected utility 1/2 (note that this holds true for any p ≤ 1, i.e., any p the low value buyers are willing to pay. This suggests that the following set of strategies may be an equilibrium: pb (vb = 1) = 1/2 and ps (vs = 0) = ps (vs = 3) = pb (vb = 4) = 7/2. Under these new strategies, clearly the high value seller is maximizing utility and we have just established that the low value seller is maximizing utility. What about the buyers? Low value buyer: vb = 1 buyers cannot get the object at less than p = 7/2 > vb = 1 so they will never purchase. High value buyer: vb = 4 buyers get utility ub (p, vb = 4) = Pr(p ≥ ps ) ∗ (4 − p) which is ub = 0 4−p if p < 7/2 if p ≥ 7/2

The maximum of this function is p = 7/2, so high value buyers offering p = 7/2 is an equilibrium.

Problem Set II Answers version 1.0 (4/5/13)

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