EC 246: Decisions & Games

Problem Set IV

Problem 1: (A problem on the implications of “common knowledge”)

On an island, there are three people who have blue eyes, and the rest have black eyes. While
each person can see every other person’s eye color, there are no mirrors in the island. The
following law is in effect: “If a person comes to know on a particular day that (s)he has blue
eyes, (s)he must leave the island at dawn the next day. All discussion of eye color among
islanders is forbidden.”
All islanders are absolutely honest, law abiding, and rational. But no one leaves the island.
How is this possible?
Then, a visitor comes to the island on a Monday and makes a public announcement, heard
and understood by all islanders: "At least one of you has blue eyes".
Now, will the blue-eyed people leave the island? If so, on what day(s) of the week?

Problem 2: (The “Travelers’ Dilemma” game developed by Kaushik Basu)

An airline loses two suitcases belonging to two different travelers. Both suitcases happen to
be identical and contain identical antiques. An airline manager tasked to settle the claims of
both travelers explains that the airline is liable for a maximum of $100 per suitcase. In order
to determine an honest appraised value of the antiques, the manager separates both travelers
so they can't confer, and asks them to write down the amount of their value at no less than $2
and no larger than $100. He tells them that if both ‘demand’ the same number, he will treat
that number as the true value of both suitcases and reimburse both travelers that amount.
However, if one demands a smaller number than the other, this smaller number will be taken
as the true value, and both travelers will receive that amount along with a bonus/malus: $2
extra will be paid to the traveler who demanded the lower value and a $2 deduction will be
taken from the person who demanded the higher amount.
If you were one of the travelers, how much would you demand? How would you
“rationalize” your demand?

Problem 3: Consider the complete-information simultaneous-move game described by the

following payoff matrix:

Column
a b c d
x 3, 11 6, 10 9, 5 12, 8
Row
y 6, 6 7, 5 8, 20 14, 25

Is the Nash equilibrium of this game also a dominance-solved equilibrium? If so, what
(common) order of knowledge (about rival rationality) needs to be assumed for the players so
that the players’ Nash Equilibrium strategies are their only “rationalizable” strategies?

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EC 246: Decisions & Games

Problem 4: Adam and Eve have to simultaneously select a ‘location’ to reside in –

Fun-city, or Joy-city, or Sin-city. Individual payoffs, which depend on the location choice of
both, are given by the following payoff matrix:

Eve
Fun Joy Sin
Fun 20, 8 10, 8 5, 10
Adam Joy 12, 6 22, 10 12, 6
Sin 5, 10 10, 8 20, 8

What is the pure-strategy Nash equilibrium of this location choice game?

If rationality is common knowledge between Adam and Eve, identify their “rationalizable”
pure strategies. By what chain of logic can Adam rationalize locating in Sin-city?

Problem 5: (Relation between strictly dominant strategies and maximin strategies)

Consider a two-player simultaneous-move complete-information game between players A
and X. A’s pure strategy set is {a, b, c} and X’s pure strategy set is {x, y, z}; A’s payoff
function is u(.), and X’s payoff function is v(.).
Suppose that a is A’s strictly dominant strategy, i.e., {u(a, x), u(a, y), u(a, z)} strictly vector-
dominates {u(b, x), u(b, y), u(b, z)} and {u(c, x), u(c, y), u(c, z)}. Then prove that a is A’s
“maximin strategy”.