ECON 7732 Advanced Micro II

Problem set I

1. An agent is supposed to comply with a regulation. Her compliance cost is C. The agent and
the regulator play a simultaneous move game, where the agent chooses to comply with
probability , and the regulator decides to inspect with probability m. Apprehending a
violator gets the regulator the gross reward R (>2), where 2 the inspection cost. With
probability (exogenously given), the regulator can mistakenly penalize a compliant agent
(and earn this reward, but there is no intentional wrong penalization). If penalized, the agent
pays F. A violator who is not penalized earns the payoff zero. Choosing not to inspect gives
zero payoff to the regulator. Find the mixed strategy equilibrium of this game.

2. Each of two firms has one job opening. There are two workers, each of whom possesses one
indivisible unit of labor. Firm i offers the wage Wi for i = 1 or 2, with 0 < W1/2 < W2 < 2W1.
Assume that W1 is not equal to W2. The magnitudes of the wages are exogenous to the
model, and should be regarded as constants. In this game, a worker has only one chance to
apply to a firm, but is free to choose the firm to apply to. If only one worker applies to a
given firm, the worker gets the job. If both workers apply to the same firm, the firm
randomly picks one worker, and the other remains unemployed (earning zero). Workers
simultaneously decide which firm to apply to on the basis of expected payoffs. Note that, if
both workers apply to firm i, their payoffs are expected amounts, each equaling W i/2. What
is the normal form representation of this simultaneous move game with the two workers as
the players? Find all the pure strategy Nash equilibria of this one period game. Can you find
all the mixed strategy Nash Equilibrium of this game?

3. An employer engages a worker to work in a project that yields a return Y (= 2) if the worker
invests an indivisible unit of labor in it, and zero otherwise. The opportunity cost of a unit of
labor is v, which is strictly less than W, the fixed wage. Unless the worker is detected to
have been idle, he is paid the wage W (even in the event of zero return from the project).
The employer needs to monitor the worker to detect whether he is working, i.e. investing in
the required unit of labor. With e representing the amount of effort spent in monitoring
activities (a decision variable of the employer), the probability of apprehending an idle
e
worker is given by the function: m(e) = . The opportunity cost of e is ce, and e can take
e 1
any non negative value. Assume that W = 1, and that and that W > max{v, c}. An idle
worker, if apprehended, gets a payoff of zero. In the simultaneous move game where the
employer chooses e, and the worker chooses to invest the required labor with probability p,
find expressions for the equilibrium values of e and p. Under what condition(s) will you
have (i) p = 1, (ii) p = 0 in equilibrium?

4. To comply with a certain regulation, an agent has to invest an amount of funds (denoted K)
in purchasing the compliance technology, subsequent to which the technology has to be
operated at a cost c(K), where c(K) < 0, and c(K) > 0. Let c(0) = Co where Co is strictly
greater than zero, and c(Ko) = 0 at some K = Ko. In a two-period model, K in chosen by the
agent in period 1. Period two constitutes a simultaneous move game between the agent and a
 regulator where the agent chooses , the probability of incurring the operational cost c(K)
and complying with the regulation, while the regulator chooses e, the level of enforcement
activity. The probability of apprehending a violator is given by the function m(e) = min{e,
1}, while the regulation costs are represented by 0.5e2. Upon apprehension, a violator pays
the regulator $1, which is the sole source of revenue to the latter. The agent minimizes
expected cost, while the regulator maximizes net expected profit.
Given K, discuss the equilibrium of the second period subgame with the help of an
appropriate diagram that depicts the best reply functions of the players. With K*, * and e*
denoting the choices in the SPNE of the two-period game,

(I) Examine the validity of the claim: there exists an SPNE where * = 1.

(II) Let K1 satisfy 1 + c(K) = 0. Is K1 greater than, equal to, or less than K* if
we have c(Ko) = -0.5 and Ko = 0.9? Justify your answer conclusively.

(III) Under what condition(s), if any, can we have K1 = K*?

5. Consider a two-period oligopoly consisting of three firms. Firm 1 chooses the output to
produce in the first period, while firms 2 and 3 make simultaneous production decisions in
the second period. The total output of the industry is then sold to consumers at price p = A
(x1 + x2 + x3), where xi denotes the output of the i-th firm. The cost function of each firm is
C = cxi. Find the Subgame Perfect Nash Equilibrium of this game.

6. Two partners can contribute towards starting a project, which results in a payoff to each of
them. The project costs R. To decide on the respective amounts to contribute, the two
partners play a game, where person 1 makes her contribution in period 1, followed by the
contribution of person 2 in period 2. Let j denote the contribution of the j-th person. If 1 +
2 R, the project is initiated, and the players earn their net payoffs of - i for i = 1 and 2.
If, however, 1 + 2 is strictly less than R, there is no revenue from the project, and each
player earns i. Develop a condition involving R and , which, if satisfied, results in the
Subgame Perfect Nash Equilibrium where each player makes a positive contribution, and the
project is initiated. What is the equilibrium contribution of each player if this condition is
satisfied?

7. Person 1 owns a firm which yields a net payoff of P to him. Consider a two-period game
where, in the first period, person 1 offers a share s of the firms returns to person 2, who, in
period 2, decides to invest K [0, +) dollars in the firm. With this additional investment,
the firm yields = 2 K + P. The net payoff of person 1, then, is (1 s), while that of
person 2 is s - K. Find the equilibrium values of s and K in the Subgame Perfect Nash
Equilibrium of this game. (Keep in mind that person 1 has the option of offering s = 0;
similarly, once a positive s is announced, 2 is free to choose K = 0, and receive sP). Specify
the condition(s) under which s and K will be strictly positive.

8. An agent is supposed to comply with a regulation. Her compliance cost is C-K2 (incurred in
the next period) if she spends $K ( 0) in installing compliance technology in the first period.
The second period compliance cost has a lower bound of zero. In the second period, the
agent and the regulator play a simultaneous move game where the agent chooses to comply
with probability , and the regulator decides to inspect with probability . Apprehending a
violator gets the regulator the payoff R, where R is the gross reward. Let r denote the
inspection cost, with R > r > 0. With probability , the regulator can mistakenly penalize a
compliant agent (who pays the fine, and the regulator is rewarded). The penalty, gross of
other costs, is F (> 0). A violator cannot escape the penalty if inspected. An agent who is
not penalized earns the payoff zero. Similarly, choosing not to inspect gives zero payoff to
the regulator. Find (i) the mixed strategy equilibrium of the second period subgame, and (ii)
the optimal value of K chosen in the first period.