Exercise 23
James has a cup of café latte every morning. His utility from having a good cup of
latte is 20 utils and his utility from having a bad cup of latte is –10 utils.
James visits a new town and he will stay there for two mornings. He finds a café that sells café latte. He wonders if he should give it a try. His prior belief is that with probability 0.25 this café has ‘High’ standard and with probability 0.75 this café has ‘Low’ standard.
If the café has high standard, it will serve good latte and bad latte with probabilities
0.9 and 0.1, respectively.
If the café has low standard, it will serve good latte and bad latte with probabilities
0.1 and 0.9, respectively.
He has another option of going to Costa Coffee to get an okay latte, the utility of
which is 0 utils to him.
Analyse what James will do on the first and second mornings,
(i) 
when he is a myopic optimiser; and 
(ii) 
when he is a dynamic optimiser. 
5
Answer to Exercise 23 (i)
1st period
Myopic optimiser
High
Myopic optimiser:
Good
latte
Bad
latte
Good
latte
Bad
latte
Try: 0.3 x (20) + 0.7 x (– 10) = – 1 utils Not try (Go to Costa): 0 utils
0.25x0.9=0.225
Prob. of
‘Good latte’
0.3
+ 20 utils
0.25x0.1=0.025
0.75x0.1=0.075
Prob. of
‘Bad latte’
0.7
– 10 utils
0.25x0.9=0.675
_{} _{N}_{o}_{t} _{g}_{i}_{v}_{e} _{i}_{t} _{a} _{t}_{r}_{y}
P(HighGood) = P(High & Good)/P(Good) = 0.225/0.3 = 0.75 P(HighBad ) = P(High & Bad )/P(Bad) = 0.025/0.7 = 0.036
6
Case 1: 1st time was good.
P(GH)
P(H)
=0.75
=0.9
Case 2: 1st time was bad.
P(GH)
P(H)
=0.036
=0.9
20 P(H and G) =
0.75x0.9=0.675
–10
P(H and B)=
0.75x0.1=0.075
20 P(L and G)= 0.25x0.1=0. 025
–10
P(L and B)=
0.25x0.9=0.225
20 P(H and G) =
0.036x0.9=0.032
P(H and B)=
0.036x0.1=0.004
–10
20 P(L and G)= 0.964x0.1=0. 096
P(L and B)=
–10
0.964x0.9=0.868
Answer to Exercise 23 (ii)
2nd period
Go:
0.7 x (20)
+ 0.3 x (– 10)
= 11 utils
Not go: 0 utils
Go!
Go:
0.128 x (20) + 0.872 x (– 10)
= – 6.14 utils
Not go: 0 utils
Not go!
7
Answer to Exercise 23 (ii) cont.
1st period
Dynamic optimiser
High
Dynamic optimiser:
Good
latte
Bad
latte
Good
latte
Bad
latte
0.25x0.9=0.225
Prob. of
‘Good latte’
0.3
+ 20 utils & 11 utils
next period
0.25x0.1=0.025
0.75x0.1=0.075
Prob. of
‘Bad latte’
0.7
– 10 utils
& 0 utils
0.25x0.9=0.675
next period
Try: 0.3 x (20 + 11 utils) + 0.7 x (– 10 + 0 utils) = 2.3 utils Not try: 0 + max{0, –1} = 0 utils Give it a try!!
8
Exercise 24
James often feels weak and dizzy so getting some vitamin C from one bottle of apple juice every morning is his daily practice. One day, James wakes up in the morning and finds two bottles of apple juice on the kitchen table. It seems that he forgot to put them in the refrigerator after he came back from shopping last evening. He immediately puts them in the fridge but perhaps it is too late. Last night was particularly warm so there is a 30% chance that the bottles of apple juice have gone bad (B). With probability 70%, they are still drinkable (D).
(The two bottles have the same state.) If James drinks bad apple juice, he will feel sick (S) with
probability 0.7 and he will feel fine (F) with probability 0.3. If the juice is drinkable and he drinks it, he will feel sick with probability 0.1 and will feel fine with probability 0.9. His utility from drinking juice and feeling sick is −30. His utility from drinking juice and feeling fine is 10. His utility from not drinking is 0.
(a) 
What is the probability that James will feel sick after he drinks the first bottle of apple juice? 
(b) 
Given that he feels sick after drinking the first bottle of juice, what is the probability that the juice is bad? 
(c) 
Given that he feels fine after drinking the first bottle of juice, what is the probability that 
the juice is bad? 

(d) 
Should James drink the second bottle of juice? Explain. 
(e) 
Should James drink the first bottle of juice? Explain for (i) when James is a myopic optimiser 
and (ii) when James is a dynamic optimiser.
_{9}
Exercise 24 Answer
1st period
Get sick
Feel
fine
Get sick
Feel
fine
0.3x0.7=0.21
0.3x0.3=0.09
0.7x0.1=0.07
0.7x0.9=0.63
Prob. of
getting sick
0.28
– 30 utils
Prob. of feeling fine
0.72
10 utils
(a) Figure shows the probability tree that James faces in the first period. As the tree shows, he feels sick with probability 0.28.
(b) By Bayes’ rule, it is P(BS) = P(B&S)/P(S) = 0.21/0.28 = 0.75.
(c) By Bayes’ rule, it is P(BF) = P(B&F)/P(F) = 0.09/0.72 = 0.125.
10
Exercise 24 Answer continued
(d) The answer depends on what happens in the first period. Figure 2 shows the probability trees that James faces in the second period. As the tree shows, if he feels sick after drinking the first bottle of juice, the probability that he will feel sick after drinking the second bottle of juice is 0.55. Therefore, his expected utility from drinking the second
bottle is 0.55 × (−30) + 0.45 × (10) = −12 < 0. So he had better not drink the second
bottle. On the other hand, if he feels fine after drinking the first bottle of juice, the probability that he will feel sick after drinking the second bottle of juice is 0.175. Therefore, his expected utility from drinking the second bottle is 0.175×(−30)+0.825×(10) = 3 > 0. So he should choose to drink the second bottle.
(e) 

(i) 
As we saw in part (a), the probability of him feeling sick the first time he drinks the juice is 0.28. If he is a myopic optimiser, he computes 0.28 × (−30) + 0.72 × (10) = −1.2 < 0, so he should not drink the first bottle of juice. 
(ii) 
If he is a dynamic optimiser, he maximises in the first period the total sum of the present 
and future utilities. Hence he computes 0.28 × (−30 + 0) + 0.72 × (10 + 3) = 0.96 > 0, and he tries the first bottle.
11
Exercise 24 Answer continued
Figure 2
12
Exercise 25
Proportion Quality θ
Reservation
value for _{o}_{w}_{n}_{e}_{r}_{s}
25% 
25% 
25% 
25% 
£5K 
£6K 
£8K 
£10K 
£4.0K 
£4.8K 
_{£}_{6}_{.}_{4}_{K} 
£8.0K 
There is a large number of car owners whose car quality is distributed as above.
Suppose that car owners’ reservation value of a car with θ is 0.8θ, so if the price is at least as high as 0.8θ, the owner of that car wants to sell it.
There are many car buyers. They offer price θ for a car with quality θ. In addition, the buyers are riskneutral so if they do not observe the car quality, the price they offer is equal to the expected quality of that car.
The car quality is private information of its owner. To buyers, all cars look the same. Owners observe the buyers’ offer and decide whether to sell or not.
Explain what happens in this environment. What price do buyers offer in the end? Who will exit the market and who will stay in the market?
_{1}_{3}
Exercise 25
Proportion Quality θ
Reservation
value for _{o}_{w}_{n}_{e}_{r}_{s}
25% 
25% 
25% 
25% 
£5K 
£6K 
£8K 
£10K 
£4.0K 
£4.8K 
_{£}_{6}_{.}_{4}_{K} 
£8.0K 
First, buyers offer 0.25 x 5K + 0.25 x 6K + 0.25 x 8K + 0.25 x 10K = £7.25K.
Type θ=10K exits!!
Now the distribution of θ=5K, 6K, 8K is (1/3, 1/3, 1/3).
So, buyers offer
0.333 x 5K + 0.333 x 6K + 0.333 x 8K = £6.333.
Type θ=8K exits!!
Now the distribution of θ=5K, 6K is (0.5, 0.5). So, buyers offer
0.5 x 5K + 0.5 x 6K = £5.5K.
Type θ=5K and 6K stay in the market.
So, in the equilibrium, buyers offer £5.5K, types θ=10K and 8K exit the market and types θ=6K and 5K stay in the market.
14
Exercise 30
• There are 1K passengers every month who buy at most one ticket. Among them, 0.1K are extravagant (‘High type’) and 0.9K are parsimonious (‘Low type’). Types are hidden.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
You are a monopolistic firm that provides flight service from Exeter to Paris.
– Type H:
– Type L:
u _{H} = q – p/2
u _{L} = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q ^{2} .
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative utility. If there are two kinds, they choose whichever is better. Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?
A. Only (.5, .5).
B. Only (.2, .1).
C. (.5, .5) & (.2, .1).
D. (.5, .6) & (.2, .1).
E. (.5, .7) & (.2, .1).
F. (.5, .8) & (.2, .1).
G. Only (.5, .8)
_{1}_{5}
Answer to Exer30
• There are 1K passengers every month who buy at most one ticket. Among them, 0.1K are extravagant (‘High type’) and 0.9K are parsimonious (‘Low type’). Types are hidden.
You are a monopolistic firm that provides flight service from Exeter to Paris.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
– Type H:
– Type L:
u _{H} = q – p/2
u _{L} = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q ^{2} .
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative utility. If there are two kinds, they choose whichever is better. Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?
u
H
from
u
H
from
from
u
L
the 1st
choice
from
the 2nd
choice
u
L
the 1st
choice
the 2nd
choice
The firm’s total profits (£)
A Only (.5, .5) 
0.25 
 
0.50 
 
.1K(0.50.5 ^{2} )K=0.025M 

B Only (.2, .1) 
0.15 
 
0 
 
1K(0.10.2 ^{2} )K = 0.060M 

C (.5, .5) & (.2, .1) 
0.25 
0.15 
0.50 
0 
.1K(0.50.5 ^{2} )K+.9K(0.10.2 ^{2} )K=0.079M 

D (.5, .6) & (.2, .1) 
0.20 
0.15 
0.70 
0 
.1K(0.60.5 ^{2} )K+.9K(0.10.2 ^{2} )K=0.089M 

E (.5, .7) & (.2, .1) 
0.15 
0.15 
0.90 
0 
.1K(0.70.5 ^{2} )K+.9K(0.10.2 ^{2} )K=0.099M 

F (.5, .8) & (.2, .1) 
0.10 
0.15 
1.10 
0 
.1K(0.10.2 ^{2} )K+.9K(0.10.2 ^{2} )K=0.060M 

G 
Only (.5, .8) 
0.10 
 
1.10 
 
.1K(0.80.5 ^{2} )K=0.055M 
16 
Exercise 31 Suppose that the monopolistic airline company in the last exercise solves the profit maximisation problem by using Excel Solver.
Initially, cells B2:B5 are set to zero. But the values of these cells will be changed by the solver. Here, (qH, pH) and (qL, pL) are the ticket plans designed for high and low types, respectively. Cells B6:B10 have some equations, which are
B6: High type’s utility from choosing plan H B7: High type’s utility from choosing plan L B8: Low type’s utility from choosing plan L B9: Low type’s utility from choosing plan H B10: The flight company’s total profits
Q1: Write down the expressions for B6:B10, starting with “= ”.
Q2: Fill in the constraints part in the solver window. (You can omit $ signs.)
17
Exercise 31 Suppose that the monopolistic airline company in the last exercise solves the profit maximisation problem by using Excel Solver.
Initially, cells B2:B5 are set to zero. But the values of these cells will be changed by the solver. Here, (qH, pH) and (qL, pL) are the ticket plans designed for high and low types, respectively. Cells B6:B10 have some equations, which are
B6: High type’s utility from choosing plan H B7: High type’s utility from choosing plan L B8: Low type’s utility from choosing plan L B9: Low type’s utility from choosing plan H B10: The flight company’s total profits
= B3 – B2/2
= B5 – B4/2
= B5 – 2*B4
= B3 – 2*B2
= 0.1*(B2 – B3^2) + 0.9*(B4 – B5^2)
Q1: Write down the expressions for B6:B10, starting with “= ”.
Q2: Fill in the constraints part in the solver window. (You can omit $ signs.)
_{B}_{6} _{≥} _{B}_{7} B6 ≥ 0 B8 ≥ B9 B8 ≥ 0
18
Exercise 32
• There are 1K passengers every month who buy at most one ticket. Among them, 0.4K are extravagant (‘High type’) and 0.6K are parsimonious (‘Low type’). Types are hidden.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
You are a monopolistic firm that provides train service from Exeter to London.
– Type H:
– Type L:
u _{H} = q – p/2
u _{L} = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q ^{2} .
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative utility. If there are two kinds, they choose whichever is better. Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?
A. Only (.5, .5).
B. Only (.2, .1).
C. (.5, .5) & (.2, .1).
D. (.5, .6) & (.2, .1).
E. (.5, .7) & (.2, .1).
F. (.5, .8) & (.2, .1).
G. Only (.5, .8)
_{1}_{9}
Answer to Exer32 You are a monopolistic firm that provides train service from Exeter to London.
• There are 1K passengers every month who buy at most one ticket. Among them, 0.4K are extravagant (‘High type’) and 0.6K are parsimonious (‘Low type’). Types are hidden.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
– Type H:
– Type L:
u _{H} = q – p/2
u _{L} = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q ^{2} .
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative utility. If there are two kinds, they choose whichever is better. Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?
u
H
from
u
H
from
from
u
L
the 1st
choice
from
the 2nd
choice
u
L
the 1st
choice
the 2nd
choice
The firm’s total profits (£)
A Only (.5, .5) 
0.25 
 
0.50 
 
.4K(0.50.5 ^{2} )K=0.1M 

B Only (.2, .1) 
0.15 
 
0 
 
1K(0.10.2 ^{2} )K = 0.060M 

C (.5, .5) & (.2, .1) 
0.25 
0.15 
0.50 
0 
.4K(0.50.5 ^{2} )K+.6K(0.10.2 ^{2} )K=0.136M 

D (.5, .6) & (.2, .1) 
0.20 
0.15 
0.70 
0 
.4K(0.60.5 ^{2} )K+.6K(0.10.2 ^{2} )K=0.176M 

E (.5, .7) & (.2, .1) 
0.15 
0.15 
0.90 
0 
.4K(0.70.5 ^{2} )K+.6K(0.10.2 ^{2} )K=0.216M 

F (.5, .8) & (.2, .1) 
0.10 
0.15 
1.10 
0 
.4K(0.10.2 ^{2} )K+.6K(0.10.2 ^{2} )K=0.060M 

G 
Only (.5, .8) 
0.10 
 
1.10 
 
.4K(0.80.5 ^{2} )K=0.220M 
20 
Prelim: Pareto efficiency
Exercise 33
(1) The following is the preference orders of four students about restaurants for today’s dinner. Note that “>” means “is preferred to” and “=” means “is as good as”. Kerem: Chinese>Indian>Italian>French
Ayse: 
Chinese>Italian>French>Indian 
Ethem: 
Indian>French=Italian>Chinese 
Esra: 
Italian>Chinese>French=Indian 
Select all the Paretooptimal choices.
(2) The following are the preference orderings of a group of three persons. Select the correct statement below. Rupert: football>golf>tennis>rugby> skiing>cricket>basketball Hedwig: golf>football>tennis>skiing>cricket>basketball>rugby Maria: skiing>golf>tennis>cricket> basketball>rugby>football
A. 
Football Paretodominates rugby. 
B. 
Skiing Paretodominates golf. 
C. 
Football Paretodominates golf. 
D. 
Tennis is a Paretooptimal choice. 
E. 
Golf is a Paretooptimal choice. 
Prelim: Pareto efficiency
Exercise 33 (1) Answer: Italian Paretodominates French. So French is not Paretooptimal choice. Italian does not Paretodominate Chinese or Indian due to Kerem. French does not Paretodominate Chinese or Italian due to Ayse and it does not Pareto dominate Indian due to Ethem. Chinese does not Pareto dominate Indian or French or Italian due to Ethem.
Indian does not Paretodominate Italian or Chinese or French due to Ayse.
Therefore, Paretooptimal choices are Italian, Chinese and Indian.
(2) Answer is E. A: Maria likes rugby better than football so football does not Paretodominate rugby. B: Rupert and Hedwig like golf better than skiing so skiing does not Paretodominate golf. C: Hedwig and Maria like golf better than football so football does not Paretodominate golf. D: Tennis is Paretodominated by golf so it is not Paretooptimal.
Exercise 34
Prelim: Commitment
Explain the following situations as an SPE of a twostage dynamic game.
First, formulate a twostage game by specifying players, actions and payoffs. Then
find the SPE of that game. In your answer, draw a game tree.
(i) 
A woodblock (woodcut) artist says “I will make only 100 copies of this woodblock print and sell each for 
£1000.” The art collectors are willing to pay £1000 only 

if he makes only 100 copies and not any more copies. However, they suspect that the artist may make thousands of copies later so they won’t pay £1000. 

(ii) 
Nobita is a lazy boy who does not like studying. He 
used to study for exams simply because he was scared 

of his mother. Doraemon is a new friend of Nobita and can use magic. He wants Nobita to study so he says “Even if you don’t study and get in trouble, I won’t help you.” But Nobita shirks his studies knowing that Doraemon cannot help using his magic to help Nobita whenever he is in trouble. 

(iii) 
In the past, in Japan, it was hard for patients and their family to sue doctors and hospitals if there is any malpractice. The legal environment has been changed so they can take legal actions if they want to. Since 
then many hospitals have been refusing to accept ill
women who are expecting a baby as patients.
^{2}^{3}
Exercise 34
Explain the following situations as an SPE of a twostage dynamic game.
First, formulate a twostage game by specifying players, actions and payoffs. Then
find the SPE of that game. In your answer, draw a game tree.
(i) A woodblock (woodcut) artist says “I will make only 100 copies of this woodblock print and sell each for
£1000.” The art collectors are willing to pay £1000 only
if he makes only 100 copies and not any more copies. However, they suspect that the artist may make thousands of copies later so they won’t pay £1000.
(ii) Nobita is a lazy boy who does not like studying. He
used to study for exams simply because he was scared
of his mother. Doraemon is a new friend of Nobita and can use magic. He wants Nobita to study so he says “Even if you don’t study and get in trouble, I won’t help you.” But Nobita shirks his studies knowing that Doraemon cannot help using his magic to help Nobita whenever he is in trouble.
(iii) In the past, in Japan, it was hard for patients and their family to sue doctors and hospitals if there is any malpractice. The legal environment has been changed so they can take legal actions if they want to. Since
then many hospitals have been refusing to accept ill
women who are expecting a baby as patients.
24
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