ECON 7732 Problem Set 3

1. Consider a simultaneous move game where an agent chooses the probability of complying
with a regulation, and 1- of violation. The cost of compliance is T. The regulator invests
effort e in inspection, where e 0. The probability of detecting a violator is m = min{e, 1}.
The regulators reward R is stochastic, and takes the value 1 with probability , and
otherwise. The cost of expending effort e to inspect is e2/2. Inspection of a violator leads to
her penalization, where the penalty is denoted as F (> T). The agent and the regulator play a
simultaneous move game in which the latter knows the realized value of R, but not the
former. Find all the possible Bayes-Nash equilibrium of this game, and the conditions under
which they exist.

Answer: Agents BR: = 0 if Em < T/F, [0, 1] if Em = T/F, = 1 if Em > T/F. Regulator
maximizes e(1-)R e2/2, when m = min{(1-)R, 1}= (1-) with probability , and (1-)
otherwise. Then, Em = 7(1-)/8. As shown in class, plotting the agents BR and Em = 7(1-)/8
reveals that, if 8T<7F, * = 1-8T/7F. if 8T7F, * = 0. The corresponding Em* and each m* can
then be derived by plugging in * in the appropriate expressions for Em* and m*s as per above.

2. Consider a Cournot duopoly where each firm has a constant unit cost of production
represented by c. The market demand of the product is represented by p = A Q, where p is
the price, and Q the total industry output. Firm 2 suffers from the following additional
complication: with probability it may suffer a setback and fail to produce any output (in
which case it does not incur any production cost). Firm 1 cannot observe the output of firm 2
in this simultaneous move game. Find the equilibrium outputs.

Answer: With probability 1-, firm 2 produces the profit maximizing output q2=(A-q1-c). To
firm 1, Eq2 = (1-)( A-q1-c). Firm 1 maximizes E(A-q1-q2-c)q1, when q1 = ( A-Eq2-c). From
this and the expression for Eq2, we derive q1 = (1+)(A-c)/(3+), when q2 = (A-c)/(3+).

3. Consider a Cournot duopoly where, in addition to production costs, each firm incurs a fixed
cost F. Firm 1s constant unit cost of production is 1. Firm 2s unit cost is stochastic: it is 1
with probability , and 2 otherwise. (1) Find the Bayes Nash equilibrium of the game for
each of the following values of the fixed cost: (i) F = 2, and (ii) F = 2.7, and the market
demand function as p = 10 Q, where p is the market price, and Q represents the total output
from both firms. (2) With p = A Q, the fixed cost as F for the firms, and the unit costs as
above, find a condition involving F such that the informed firm produces no output in one
state of nature. What is the output of firm 1 if this condition is satisfies, and how does it
compare to its output when firm 2 produces positive outputs in all states of nature?

Answer: I shall work out the answer to the general case (2). Starting with the assumption that
firm 2 produces a positive output in both states of nature, q2i = (A-q1 ci), where cH=2, and
cL=1. Eq2 = (A-q1-3/2) to the uninformed firm 1, and q1 = (AEq21). We can now derive the
equilibrium outputs as q1 = (A-0.5)/3, q2H = (A-11/4)/3, q2L = (A-5/4)/3. As demonstrated in
class, the profits are the respective squares of the outputs (for firm 1 this give the expected profit)
minus any fixed cost. His implies that, if A > 11/4, and (A-11/4)2/9 F, firm 2 produces in both
states of nature, and the equilibrium outputs are as per above.
Suppose that, either A 11/4, or (A-11/4)2/9 < F, or both. Then, start again and find the
equilibrium outputs when firm 2 only produces when the cost is low. Following the exact method
of the previous question, but with c = 1 and = , we derive q1 = 3(A-1)/7, q2 = 2(A-1)/7.
Clearly, if A>1, and 4(A-1)2/49 F, firm 2 produces when its cost is low. If 4(A-1)2/49 < F, firm
1 is a monopoly, and produces (A-1). If A<1, no firm produces a positive output.

4. Find the answer to exercise 3 when F = 9.

Answer: Assume, as in question 2, that A=10. Then, using the expressions derived in question 3,
we find that firm 1 will be a monopoly.

5. Consider an extension of exercise 1 above when (i) R=2 with probability , and R=1
otherwise, and (ii) R=4 with probability , and R=2 otherwise. In each case, find all the
possible Bayes-Nash equilibria, and the conditions under which they exist.

Answer: (i) Here, the agent has the same BR, and m = min{(1-)R, 1}. This means that, for R =
2, m=2(1-) if > , and m=1 if . For R=1, m = 1-. Then, Em = 7(1-)/4 if > , and 1-
/4 if . Em plotted against has a kink at = and Em = 7/8. Then, as the possible plots
of the BRs of the two players show (demonstrated in class) it T/F 7/8, * = 1- 4T/7F. If T/F >
7/8, * = 4(1 T/F).

(ii) Here, when R = 4, m = 4(1-) if > , and 1 when . When R=2, m=2(1-) if > ,
and m=1 if . Em plotted on has two kinks, one at = , and the other at = , and can
be represented as: Em = 1 if , Em = 5/4 /2 if (, ), and 7(1-)/2 if > . Then, if
T/F < 7/8, from T/F = 7(1-)/2 we derive * = 1 2T/7F. If T/F 7/8, * = 5/2 2T/F.

6. Consider a simultaneous move game where an agent chooses the probability of complying
with a regulation, and 1- of violation. The cost of compliance is C. The regulator of type i
chooses either to inspect or not to inspect. His cost of an inspection is ri, which is distributed
uniformly over the interval [0, 1]. Inspection of a violator leads to her penalization, where the
penalty is denoted as F (> C). A regulator obtains the reward R (= 5) upon apprehending a
violator. The agent and the regulator play a simultaneous move game in which the latter
knows the realized value of ri, but not the former. Find the Bayes-Nash equilibrium of this
game.

Answer: As demonstrated in class, m = 5(1-) if > 4/5, and m = 1 if 4/5. Then, * = 1-C/5F
and m* = C/F, and is also the cutoff ri.