ECON-602

Problem Set 2 - Solutions

1. Gibbons 3.2

Since the information about demand is private to firm 1, we can model this fact as though it
has two types high or low. Firm 2 has only one type. The firms actions are the choice of
quantities, and the amount of output can take any nonnegative values. Therefore, the strategy
space is R2+ for firm 1 and R+ for firm 2.

To find the Bayesian Nash equilibrium for this game first consider the problem for firm 1. It
knows the market demand, and wants to maximize its payoff for each state,

q1 (a) = arg max q1 (a c q1 q2 )

q1

yielding,

(
q1H = aH cq
2
2
when a = aH ,
q1 (a) =
q1L = aL cq
2
2
when a = aL .

For firm 2, since it is uncertain about the market demand, it maximizes its expected payoff,

q2 = arg max{q2 (aH c q1H q2 ) + (1 )q2 (aL c q1L q2 )}

q2

or,

(aH q1H ) + (1 )(aL q1L ) c

q2 =
2
Then, the equilibrium can be found by solving the above best responses simultaneously.

(3 )aH (1 )aL 2c
q1H = ,
6

(2 + )aL aH 2c
q1L = ,
6
aH + (1 )aL c
q2 = .
3

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 Since the output level is least in case for q1L , we need to assume (2 + )aL > aH + 2c in order
for all equilibrium quantities to be positive.

Gibbons 3.4

In this question, there are two possible payoff structures. Player 1 knows what the payoffs
are, whereas player 2 does not. You can say then that player 1 has two types, and player 2
has only one type. Lets call player 1s types (1 , 2 ), corresponding to Game 1, and Game 2
respectively. This implies that a BNE must be a strategy profile {s1 (1 ), s1 (2 ), s2 }.

We know that player 1s possible strategies are: {(T, T ), (T, B), (B, T ), (B, B)}, and player 2s
possible strategies are {T, B}. We can compute the payoff matrix for this game as given below

L R

1 1
(T,T) 2, 2 0,0

1 1
(T,B) 2, 2 1, 1

(B,T) 0, 0 0,0

(B,B) 0, 0 1, 1

Comparing payoffs, we can find the Nash equilibria for this game (and hence the BNE). These
are: [(T, T ), L], [(T, B), R] and [(B, B), R].

2. Fudenberg and Tirole 6.1

(a) We look for an equilibrium where each player contributes if his cost is less than or equal to
. For players i to prefer contributing iff i the player with cost must be exactly
indifferent. We must have

= P rob(No other player contributes)

= (1 P ( ))I1

Comparing the values of the left and right sides at and 1, we see that there is at least
one solution in (, 1). Such a is a Bayesian equilibrium.
(b) Suppose K 2, and suppose that all players other than player i play the strategy of never
contributing. Regardless of player i0 s action, the project will not be completed. Thus,
player is payoffs are 0 and i to not contributing and contributing. Not contributing is
a best response.

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 We can also find symmetric Bayesian equilbrium where player i contributes iff i .
Again we solve for the which makes a player with cost exactly indifferent, i.e. his
cost must be the benefit from the added probability of having the project completed.
Player i benefits from contributing iff exactly k 1 others have cost below , i.e.
!
I 1
= P ( )k1 (1 P ( ))Ik
k1
!
I 1
where denotes the binomial coefficient. The equation above need not always
k1
have a solution.

Fudenberg and Tirole 6.2 (b)

We look for a symmetric equilibrium where player i enters iff i .This will be an equilibrium
when type is exactly indifferent, which holds iff

(m )(1 P ( )) + (d )P ( ) = 0

m
P ( ) =
m d
This has exactly one root as the LHS is increasing, the RHS is decreasing and comparing values
at = 0 and = m shows there to be at least one solution.

The argument above show there is a unique symmetric equilibrium. Any asymmetric equilib-
rium must be of the form: Firm i enters if i . To have an equilibrium we need.

m 2
P (1 ) =
m d

m 1
P (2 ) =
m d

Together these imply i = m (m d )P (m (m d )P (i )). If this has a unique

solution, then the equilibrium is unique.

Fudenberg and Tirole 6.4

(a) In the second price auction suppose your opponent bids b and you have value . The payoff
to bidding is

u( = u( b) if b
= u(0) if < b

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 Comparing the payoffs u() to u() (for ) they are

u(0) vs u(0) if b
u( b) vs u(0) if b
u( b) vs u( b) if b

This shows that bidding is dominated by . similarly it is dominated to bid < ,

so all bidders bid their true valuation. These are the same bids as under risk neutrality so
the revenue collected is the same.
(b) As in example 6.6 the equilibrium must be of the form: type bids and type chooses
s from a distribution F (s) on (, s].

For the mixed strategy to be a best response type must be indifferent between all possible
bids.

u( s)(p + pF (s)) + p(1 F (s))u(0) = constant

Setting s = we see that the constant is u( )p + pu(0). Solving,

p u( ) u( s)
 
F (s) =
p u( s) u(0)

From equation (6.10) of example 6.6 we can see that the solution with risk neutrality is

p s
 
F (s) =
p s
0
As u() is concave, u decreasing so

u(c) u(b) u(b) u(a)

<
cb ba

when a < b < c. Taking c = , b = s and a = 0 gives,

p ( ) ( s) u( s) u(0)
  
F (s) <
p s u( s) u(0)
= F (s)

Hence F FOSD F .

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3. Consider the following model of an auction for an indivisible object. There are two bidders
i = 1, 2 with private i.i.d. valuations vi {0, 1}. We also know that pr[vi = 1] = pr[vi = 0] = 21
for i = 1, 2. Only bids of 0 or 1 are allowed.

(a) Assume that the object is allocated using a second price rule. That is, the highest bidder
wins and pays the second highest bid. Ties are broken assigning the object with equal
probability to either bidder. Show that there is no Bayesian Nash equilibrium in which
both bidders always bid 0, regardless of their valuations.

To show that bidding zero regardless of the valuations is not an equilibrium all we need is a
counter-example. Let vi = 1. By the equilibrium strategies we know that P r(bj = 0) = 1,
so

1 1
EU [bi = 0] = P r(bj = 0) (1 0) =
2 2

EU [bi = 1] = P r(bj = 0)(1 0) = 1

Player i has incentive to deviate and bid 1, instead of zero. Hence there is no equilibrium
in which both bidders always bid 0, regardless of the valuations.

(b) Now assume that the object is allocated using a first price rule. That is, the highest
bidder wins and pays his own bid. Ties are broken assigning the object with equal proba-
bility to either bidder. Show that there is a Bayesian Nash equilibrium of this new game
in which both bidders always bid 0, regardless of their valuations.

Since the bidders are symmetric, we can consider bidder 1 and it will hold for bidder 2.
Again, by the equilibrium strategies we know that P r(b2 = 0) = 1, so

Case 1. v1 = 0

1 1
EU [b1 = 0] = P r(b2 = 0) (0 0) + P r(b2 = 0) (0) = 0
2 2
EU [b1 = 1] = P r(b2 = 0)(0 1) = 1

Case 2. v1 = 1

1 1 1
EU [b1 = 0] = P r(b2 = 0) (1 0) + P r(b2 = 0) (0) =
2 2 2
EU [b1 = 1] = P r(b2 = 0)(1 1) = 0

For vi = 0, 1, EU [b1 = 0] > EU [b1 = 1]. Hence each player bidding 0 regardless of
valuation is a BNE.

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