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THE UNIVERSITY OF MELBOURNE SEMESTER 2 ASSESSMENT, 2011 DEPARTMENT OF ECONOMICS ECON 20005: COMPETITION AND STRATEGY Student number: .................................... Reading time: 15 minutes Writing time: 2 hours

The exam contributes to a maximum of 100% and a minimum of 70% of the assessment in ECON 20005. If your nal grade is above your assignment average (for submitted assignments), then your nal grade will be your grade for the course. If your nal grade is below you assignment average (for submitted assignments), then your nal grade will contribute to either 70%, 80% or 90% of your nal grade, depending on whether you submitted 3, 2 or 1 assignments on time during the semester. This exam paper has 5 pages and 6 questions. The following items are authorized in the exam room: Foreign language dictionaries No other items are allowed. NO CALCULATORS Instructions You are required to answer ALL questions. There are 120 marks available and writing time of 120 minutes. This should help you allocate your time eciently You must show all of your work to get full or partial credit for your answers. The exam paper is NOT to be removed from the exam room The exam paper will NOT be held in the Baillieu Library Good luck!

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Question 1 (15 marks) a. Find all pure strategy Nash Equilibria of the following two simultaneous- move games. If there is no pure strategy Nash Equilibrium in one of these games, you should explain why not. (i) P2 B 7, 4 11, 2 2, 3

P1 (ii)

a b c

A 9, 3 3, 6 6, 4

C 3, 1 1, 4 8, 5

P1

m n o

p 2, 2 6, 6 10, 10

P2 q 5, 5 5.6, 5.6 3, 3

(i) Find all the pure-strategy Nash Equilibria to this game. (ii) If a Nash Equilibrium is not Sub-game Perfect, explain why not. c. Consider the following game played between two players. Each player chooses 1, 3, 5 or 7 to add to a cumulative total. The cumulative total starts at 0. The players take it in turns to choose one of these numbers, and they are able to view the cumulative total at their turn. The player who causes the cumulative total to equal or exceed 66 is the loser. Consider the player who starts. Explain whether she wins or loses in the Sub-game Perfect Nash Equilibrium. Explain her equilibrium strategy.

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Question 2 (15 marks) This is a penalty kick game in which the goalie has a third option (the option of remaining in the middle and not reacting until the very last moment). We still assume that it is a simultaneousmove game. The game table looks as follows: Goalie M 70, 30 70, 30

Kicker

L R

L 30, 70 90, 10

R 90, 10 30, 70

a. Assume the kicker plays L with probability pL and R with probability 1 pL , where 0 pL 1. Derive the goalies expected payo for each of his pure strategies, and show what the goalies best response is to any possible pL . b. Assume the goalie plays L with probability qL , R with probability qR and M with probability 1 qL qR ,where qL 0,qR 0 and qL + qR 1. Derive the kickers expected payo for each of his pure strategies, and show what the kickers best response is to any possible combination of qL and qR . c. Derive the Nash Equilibrium in mixed strategies.

Question 3 (25 marks) Consider an industry with two rms - Holden and Toyota - that face an inverse demand function P (Q) = 200 Q, where Q is the total quantity produced. Both rms produce at marginal costs of 20 (and have no xed costs). a. Assume that the two rms compete a la Cournot, i.e., that they simultaneously choose the (continuous) quantity to produce. Derive the Nash equilibrium quantities that the rms produce as well as their equilibrium prots. (Remember to show your work.) b. Assume that the two rms compete a la Bertrand, i.e., that they simultaneously choose their (continuous) prices, that consumers buy from the rm that sets the lower price, and that consumers buy the same quantity from both rms if both rms set the same price. Find the unique Nash equilibrium in pure strategies and the corresponding equilibrium prots. Also prove that there cannot exist any other Nash equilibrium. c. Now assume that the government subsidizes Holden with 30 per car that they sell. (In other words, Holden receives from the government 30 per car that they sell.) Again assuming Cournot competition, derive the equilibrium quantities and prots of the two rms. d. Now assume again Bertrand competition, and describe one Nash equilibrium in pure strategies for the case in which the government subsidizes Holden with 30 per car that they sell. Also derive the rms equilibrium prots.

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Question 4 (25 marks) Suppose that a society consists of only two players and that both of them drive a car. Each player must decide whether to put a pollution control device on their car. Installing such a device on a car costs $100 and provides a benet that is worth $70 to each player (both players benet since they both breathe cleaner air). If both players install the device, the air is twice as clean, providing a benet of $140. Each player has two possible actions: Install or Not Install. Assume for the moment that this game is a simultaneous-move one-shot game. a. Construct the game table and nd all pure strategy Nash Equilibria. b. Is this game a Prisoners Dilemma Game? Why/Why not? c. Assume for the remainder of the question that the game is played innitely often, that both players have a discount factor of < 1, and that the pollution device only lasts for one year so that the two players must decide at the start of each year whether to install the device. What innite payo will each player receive if they both play a grim strategy and cooperate forever (by installing the device)? d. What innite payo will a player receive by cheating in this period (and not installing the device) if the opponent plays a grim strategy? e. What values of sustain the collusive outcome of this game? Provide the intuition for your solution. f. Now assume that in each period one of the two players is involved in a deadly car accident with probability 25%. For what values of can the collusive outcome be sustained in this case?

Question 5 (20 marks) Consider a charitable donations game simultaneously played by N = 100 citizens. Each citizen must decide whether to donate to $11 charity or not. If n citizens donate to the charity, then each of the N citizens receives a private benet worth $n2 regardless of whether they donated or not (since they feel good about charity donations in general). If an individual donates, they suer a private nancial cost of $11. Throughout, n must be a whole number from 0 to 100. a. Find all Nash Equilibria number of donors, nne . b. Find the socially optimal number of donors, n . c. What type of Collective-Action problem is this and why? d. Suppose n is currently equal to 0 and that the government can simply convince individuals to donate (say through other means such as tax breaks). How many people does the government have to convince to donate in order for n = N in a Nash Equilibrium?

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Question 6 (20 marks) There are four bidders interested to buy the the DVD Lord of the Rings: Return of the King in an auction. Their valuations V are $5, $10, $20 and $25. Each bidder only knows her own valuation, but all bidders know the distribution function from which all the valuations are drawn. Assume that the bids are continuous variables (from $0 to $100). a. Describe the optimal strategy of a bidder with valuation V in an rst-price sealed-bid auction. What bidder wins in equilibrium and at what price? b. Describe the optimal strategy of a bidder with valuation V in a second-price sealed-bid auction. What bidder wins in equilibrium and at what price?

END OF EXAMINATION

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