Strategy: An Introduction to Game Theory Third Edition Instructor’s Manual Joel Watson with Jesse BullStrategy: An Introduction to Game Theory, Third Edition, Instructor's Manual, ver~ sion 06/25/2013, © Copyright 2002, 2008, 2010, 2011, 2013 by Joel Watson, This document is avail- able, with the permission of W. W. Norton & Company, for use by textbook adopters in conjunction with the textbook. Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.This Instructor's Manual has four parts. Part [ contains some notes on outlining and preparing a game-theory course that is based on the textbook. Part I contains more detailed (but not overblown) materials that are organized by textbook chapter. Part TIT comprises solutions to the exercises in the textbook, except those with sohitions, provided in the book. Part IV contains some sample examination questions. Please report any typographical errors to Joel Watson (jwatson@uesd. free to suggest new material to include in the i have a good example, application, or experiment that yo others, please send it to us. 1). Also feel tructor’s manual or Web site. If you don’t mind sharing with Acknowledgments Bull and Watson thank Pierpaolo Battigalli, Kristy Buzard, Takako Fujiwara-Greve, Michael Herron, David Miller, Wilfried Pauwels, David Reinstein, Christopher Sny- der, Igor Vaynman, and Charles Wilson for identifying some typographical e ceatlier versious of this manual. rors in Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.Contents I General Materials II Chapter-Specific Materials 1 Introduction 2 The Extensive Form 3 > Strategies and the Normal Form 4 Beliefs, Mixed Strategies, and Expected Payoff 5 General Assumptions and Methodology 6 Dominance and Best Response 7 Rationalizability and Iterated Dominance 8 Location, Partnership, and Social Unrest 9 Nash Equilibrium 10 Oligopoly, Tariffs, Crime, and Voting 11 Mixed-Strategy Nash Equilibrium 12 Strictly Competitive Games and Security Strategies 13 Contract, Law, and Enforcement in Static Settings 14 Details of the Extensive Form 15 Sequential Rationality and Subgame Perfection 16 Topics in Industrial Organization 17 Parlor Games Instructor's Manual for Strategy: ‘An Intuction to Game Theory 12 13 18 24 23 24 29 32 34 35 37 38 4 43 45 46 Copyright 2002, 2008, 2010, 2013 by Joe! Watson. For instructors only; do not astbutecon ENTS 18 Bargaining Problems 19 Analysis of Simple Bargaining Games 20 Games with Joint Decisions; Negotiation Equilibrium 21 Unverifiable Investment, hold up, Options, and Ownership 22 Repeated Games and Reputation 23 Collusion, Trade Agreements, and Goodwill 24 Random Events and Incomplete Information 25 Risk and Incentives in Contracting 26 Bayesian Nash Equilibrium and Rationalizability 27 Lemons, Auctions, and Information Aggregation 28 Perfect Bayesian Equilibrium 29 Job-Market Signaling and Reputation 30 Appendices III Solutions to the Exercises 2 The Extensive Form 3. Strategies and the Normal Form 4 Beliefs, Mixed Strategies, and Expected Payoffs 6 Dominance and best response 7 Rationalizability and Iterated Dominance Instructor's Manual for Strategy: ‘An Intuction to Game Theory 48 50 60 63 65 66 68 70 7 72 73 76 79 80 81 Copyright 2002, 2008, 2010, 2013 by Joe! Watson. For instructors only; do not astbuteco NTS 8 Location, Partnership, and Social Unrest 9 Nash Equilibrium 10 Oligopoly, Tariffs, Crime, and Voting 11 Mixed-Strategy Nash Equilibrium 12 Strictly Competitive Games and Security Strategies 13 Contract, Law, and Enforcement in Static Settings 14 Details of the Extensive Form 15 Sequential Rationality and Subgame Perfection 16 Topics in Industrial Organization 17 Parlor Games 18 Bargaining Problems 19 Analysis of Simple Bargaining Games 20 Games with Joint Decisions; Negotiation Equilibrium 21 Unverifiable Investment, Hold Up, Options, and Ownership 22 Repeated Games and Reputation 23 Collusion, Trade Agreements, and Goodwill 24 Random Events and Incomplete Information 25 Risk and Incentives in Contracting 26 Bayesian Nash Equilibrium and Rationalizability Instructor's Manual for Strategy: ‘An Intuction to Game Theory 83 86 89 95 102 103 108 110 14 ur 119 121 123 127 131 135 138 140 142 Copyright 2002, 2008, 2010, 2013 by Joe! Watson. For instructors only; do not astbuteCONTENTS 6 27 Lemons, Auctions, and Information Aggregation 145 28 Perfect Bayesian Equilibrium 148 29 Job-Market Signaling and Reputation 151 30 Appendix B 155 IV Sample Questions 156 Instructors Manual for Stategy Copyright 2002, 2008, 2010, 2018 by Joe! Watson. ‘An Intuction to Game Theory For instructors only; do not astbutePart TI Solutions to the Exercises ‘This part contains sohutions to all of the exercises in the texthook. Although we worked diligently on these solutions, there are bound to be a few typos here and there. Please report any instances where you think you have found a substantial Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuction to Game Theory For instructors only; do not astbute2 The Extensive Form ‘The order does not matter as it is a simultaneous-move game. Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.2 THE EXTENSIVE FORM um“ 6. 1 Y % coy 00,1 Ye 1.0 0.0.1 A i 1,10 Y + 110 Q Instructors Manual for Stategy ‘Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.2 THE EXTENSIVE FORM cy Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.3 Strategies and the Normal Form No, “not hire” does not describe a strategy for the manager. A strat- egy for the manager must specify an action to be taken in every conti gency. However, “not hire” does not specify any action contingent upon the worker being hired and exerting a specific level of effort. 4. Player 2 has four strategies: {(¢, f),(c,9), (d, f). (d.9)} N = {1,2}. $1 = (0,00). Player 2's strategy must specify a choice of quantity for each possible quantity player 1 can choose. Thus, player 2's strategy space Sp is the set of funetions from [0,00) to [0, 0°). x Some possible extensive forms are shown in (a) and (b) that follow. (a) 76 Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.3. STRATEGIES AND THE NORMAL FORM 7 Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.3. STRATEGIES AND THE NORMAL FORM 8 (b) H ‘There are two information sets for Jerry. There are 16 strategy profiles. Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.Beliefs, Mixed Strategies, and Expected Payoffs (a) \2 i\_*_¥ H L | Qe | 10d (b) Player 1's expected payoff of playing H is 2. His expected payoff of playing L is 5. For 2 =5, player 1 is indifferent. between playing H or L. (6) Player 1's expected payoff of playing L is 20/3 Note that all of these, except “Pigs,” are symmetric games. Matching Pennies: w(o1, 02) = wo(o1,02) = 0. Prisoners’ Dilemma: (01, 02) = ua(o,02) = 1 1/2. Battle of the Sexes: 1u,(0,0) Hawk-Dove/Chicken: (01,0: Coordination: u1(01,02) = ua(o1, 02) = 1/2. wa(01, 02 (01,02 Pareto Coordination: (01,02) = w(o1,0: Pigs: ws(01,02) = 3 ua(a,02) = uppose this is not the case so that, for alls; € Sy, wi(si,Ba) <5. ce us(oi, 0-1) = 5, it must be that DY ofsiuico(si), 04 AS However, this is not possible since uj(s;,-:) <5 for all s: € S;. So we have a contradiction. 9 Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.6 Dominance and best response (a) To determine the BR set, we must determine which strategy of player 1 yields the highest payoff given her belief about player 2's strategy selec- tion. Thus, we compare the payoff to each of her possible strates w:(U,42) = 1/3(10) + 0 + 1/3(3) = 13/3 uu (M,f2) = 1/3(2) + 1/3(10) + 1/3(6) 1u,(D,62) = 1/3(3) + 1/3(4) + 1/3(6) = 13/3 BR,(62) = {M}. (b) BR(A1) = {LR}. (c) BRy(9) = {UM}. (d) BR2(61) = {C}. 4. (a) First we find the expected payoff to each strategy: u,(U,@2) = 2/6 + 0 + 4(1/2) = 7/3; wi(M, 2) = 3(1/6) + 1/2 = 1; and w(D,%) = 1/6 + 1 4 1 = 13/6. As the strategy U yields a higher expected payoff to player 1, ne 2, BRy(92) = {U}. (b) BR,(6,) = {R} (c) BRy(O») att) (d) BRi(6.) = {U, D}. (c) BRs(0,) = {L, R} 6. No. This is because 1/2 A 1/2 B dominates C. i M is dominated by (1/3.2/3,0) 8. From Exercise 3, BR, (qe) = 20 ~ q2/2. 80 UD = [0,20] 10. Yes, every strategy of player 2 that specifies RM and/or RM is weakly dominated but not dominated. Note that strategy A'AMR! is not weakly dominated. 80. Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.7 Rationalizability and Iterated Dominance For “give in” to be rationalizable, it must be that # < 0. ‘The man- ager must believe that the probability that the employee plays “settle” is (weakly) greater than 1/2 R= {(7-00, 6:00, 6:00)} No. It may be that s1 is rationalizable because itis a best response to some other rationalizable strategy of player 2, say So, and just also happens to. be a best response to 5 x R = {(0,0,0,0,0,0,0,0,0,0)}. Note that player wt» = (a — 10 — 1)s10 and that a — 11 < 0 since a is at most 10. So player 10 has a single strategy, 0. Given this, we know a will be at most 9 (if fone except player 10 selects 10). Thus, @ — 10 <0, and so player 9 must select 0. By induction, every player selects 0. undominater (a) Player #’s optimal choice is to select 5; = BR(@.) = $a,. This should be clear from the definition of payoffs; one can also use calculus to show this. So we have BR;(40) = 60. (b) Since the players must pick numbers between 20 and 60, a; must also be in this interval. Notably, 20 is the lowest possible value of a, 80 the lowest possible “target” value for player i is 3 -20 = 30. Thus, BR,(a_.) € [30,60]. Furthermore, for every s; € [30,60] there is a value of a; between 20 and 60 that makes s the best response. We conclude that UD, = [30,60] for each player i (c) From part (b), we know that the set of strategies that survive in the first round of iterated dominance is F! = (30, 60] for each player i. By the same logic, strategies in the interval (30,45) are removed in the second round, which leaves R? = [45,60]. In the third round, everything below 60 is deleted. To see this, recall that 60 is the highest possible choice, so 81 Instructor's Manual for Strategy: Copyright 2002, 2008, 2010, 2013 by Joe! Watson. ‘An Intuetion to Game Theory For instructors only; do not stibut.