University College, London, Department of Economics Nov 2008

ECON3014: Game Theory

Exercise 4 - Questions

Exercise 1. Two people are involved in a dispute. Person 1 does not know whether person 2 is strong or
weak; she assigns probability to person 2’s being strong. Person 2 is fully informed. Each person can
either …ght or yield. Each person’s preferences are represented by the expected value of a Bernoulli payo¤
function that assigns the payo¤ of 0 if she yields (regardless of the other person’s action) and a payo¤ of 1
if she …ghts and her opponent yields; if both people …ght then their payo¤s are (-1, 1) if person 2 is strong
and (1, -1) if person 2 is weak. Formulate this situation as a Bayesian game and …nd its Nash equilibria if
< 1=2 and if > 1=2.
.

Exercise 2. Firm A (the “acquirer”) is considering taking over …rm T (the “target”). It does not know
…rm T ’s value; it believes that this value, when …rm T is controlled by its own management, is at least $0
and at most $100, and assigns equal probability to each of the 101 dollar values in this range. Firm T will
be worth 50% more under …rm A’s management than it is under its own management. Suppose that …rm
A bids y to take over …rm T; and …rm T is worth x (under its own management). Then if T accepts A’s
o¤er, A’s payo¤ is 3=2x y and T ’s payo¤ is y; if T rejects A’s o¤er, A’s payo¤ is 0 and T ’s payo¤ is x:
Model this situation as a Bayesian game in which …rm A chooses how much to o¤er and …rm T decides the
lowest o¤er to accept. Find the Nash equilibria of this game. Explain why the logic behind the equilibrium
is called adverse selection.

Exercise 3. Consider a public goods provision game, with n individuals. Each individual must choose
whether or not to contribute to the public good, and the public good is provided if and only if at least
one individual contributes. The value of the good is vi to individual i: The quantity vi is independently
and identically distributed across individuals, and is uniformly distributed on [0; 1]: The total payo¤ to
an individual is the value of the good (if provided) minus the cost of provision (which is c if the individual
provides the good, and zero otherwise). Solve for a symmetric Bayesian Nash equilibrium of this game where
each individual provides the good if and only if vi exceeds a critical threshold v : How does the probability
that the good is provided at all vary with n?

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University College, London, Department of Economics
ECON3014: Game Theory

Exercise 4 - Answers

Exercise 1: The following Bayesian game models the situation.

Players: The two people.
States: The set of states is {strong, weak}.
Actions: The set of actions of each player is {…ght, yield}.
Signals: Player 1 receives the same signal in each state, whereas player 2 receives di¤erent signals in
the two states.
Beliefs: The single type of player 1 assigns probability to the state strong and probability 1 to
the state weak. Each type of player 2 assigns probability 1 to the single state consistent with her signal.
Payo¤s: The players’Bernoulli payo¤s are as follows:

‘strong’ …ght yield ‘weak’ claim not

…ght -1, 1 1, 0 claim 1, -1 1, 0
yield 0, 1 0; 0 not 0, 1 0; 0

The best responses of each type of player 2 are indicated by asterisks. Thus if < 1=2; then player
1’s best action is …ght, whereas if > 1=2 her best action is yield. Thus for < 1=2 the game has a unique
Nash equilibrium, in which player 1 chooses …ght and player 2 chooses …ght if she is strong and yield if she
is weak. When > 1=2 the game has a unique Nash equilibrium, in which player 1 chooses yield and player
2 chooses …ght regardless of whether she is strong or weak.

Exercise 2. The game is de…ned as follows.

Players: Firms A and T:
States: The set of possible values of …rm T (the integers from 0 to 100):
Actions: Firm A’s set of actions is its set of possible bids (nonnegative numbers), and …rm T ’s set of
actions is the set of possible cuto¤s (nonnegative numbers) above which it will accept A’s o¤er.
Signals: Firm A receives the same signal in every state; …rm T receives a di¤erent signal in every
state.
Beliefs: The single type of …rm A assigns an equal probability to each state; each type of …rm T
assigns probability 1 to the single state consistent with its signal.

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 Payo¤ functions: If …rm A bids y; …rm T ’s cuto¤ is at most y; and the state is x; then A’s payo¤ is
3=2x y and T ’s payo¤ is y: If …rm A bids y; …rm T ’s cuto¤ is greater than y; and the state is x; then A’s
payo¤ is 0 and T ’s payo¤ is x:
To …nd the Nash equilibria of this game, …rst consider the behavior of each type of …rm T: Type x is
at least as well o¤ accepting the o¤er y as it is rejecting it if and only if y x: Thus type x’s optimal cuto¤
for accepting o¤ers is x; regardless of …rm A’s action. Now consider …rm A. If it bids y then each type x of
T with x < y accepts its o¤er, and each type x of T with x > y rejects the o¤er. Thus the expected value of
the types that accept an o¤er y 100 is 1=2q(y); where q(y) is the largest integer at most equal to y, and
the expected value of the types that accept an o¤er y > 100 is 50: If the o¤er y is accepted then A’s payo¤
is 3=2x y; so that its expected payo¤ is 3=2(1=2q(y)) y if y 100 and 3=2(50) y = 75 y if y > 100:
In both cases this expected payo¤ is negative. (In the …rst case it is approximately 1=4y): Thus …rm A’s
optimal bid is 0! We conclude that the game has a unique Nash equilibrium, in which …rm A bids 0 and the
cuto¤ for accepting an o¤er for each type x of …rm T is x: Even though …rm A can increase …rm T ’s value,
it is not willing to make a positive bid in equilibrium because …rm T ’s interest is in accepting only o¤ers
that exceed its value, so that the average type that accepts an o¤er has a value of only half the o¤er. As A
decreases its o¤er, the value of the average …rm that accepts the o¤er decreases: the selection of …rms that
accept the o¤er is adverse to A’s interest.

Exercise 3. Clearly if c > 1; in equilibrium, no player ever contributes. So, suppose that c < 1: Consider
any player i. If she contributes, her payo¤ is vi c: If she does not contribute her payo¤ is:

vi Prfsome j 6= i contributesg:

In any equilibrium such that each individual j provides the good if and only if vj exceeds a critical threshold
v ; the above payo¤ equals:

= vi Prfvj > v for some j 6= ig

= vi [1 Prfvj v for all j 6= ig]

h i
n 1
= vi 1 (v )

because the equilibrium is symmetric, and the values vj are i.i.d. across j:
Thus, player i contributes to the public good if and only if:
h i
n 1
vi c > vi 1 (v ) :

Because the equilibrium is symmetric, the threshold v is determined by setting equal to v the value vi for
which player i is indi¤erent between contributing or not. Hence v solves:
h i
n 1
v c = v 1 (v ) :

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Simplifying, we conclude that:
p
n
v = c:

The probability that the good is provided at all is:

Prfvi > v for some ig

= 1 Prfvi v for all ig

n
= 1 (v )

= 1 c:

The probability that the good is provided is constant in n: