Koç University

Department of Economics

ECON/MGEC 333
Game Theory And Strategy
Midterm Examination II Solutions

Levent Koçkesen December 26, 2007

1. (30pts.) Consider the following extensive form game, where b is a non-negative number:

Out In

2
0, 2
A F

1 1

a f a f

1, 1 1 − b, b b, 1 − b −1, −1

(a) (15pts.) What are the subgame perfect equilibria of this game if b = 0?

Solution
((In, a), A), ((In, a), F ), ((Out, a), F ), ((In, f ), A)
(b) (15pts.) For what range of b, the unique subgame perfect equilibrium is ((Out, f ), F )?

Solution
b ≤ −1

1
2. (30pts.) Consider the following game played between a boss (B) and an employee (E). The boss offers a
wage, w ≥ 0, and after observing the wage offer the employee decides how much effort, e ≥ 0, to expend.
The payoff functions of the boss and the employee are given as
√
uB (w, e) = 2 e − w
e2
uE (w, e) = w − + αwe
2
where α ≥ 0.
(a) (15pts.) What is the optimal effort choice of the employee as a function of wage?

Solution
For any w, the employee chooses e ≥ 0 to maximize

e2
w− + αwe
2
The first order condition for this problem is given by

−e + αw = 0

The second derivative of the objective function with respect to e is equal to −1, and hence the second
order condition is satisfied. Therefore, the employee’s optimal effort choice is given by

e∗ (w) = αw

(b) (15pts.) What are the subgame perfect equilibrium choices of wage and effort as a function of α?

Solution
Given the optimal effort choice found in the previous part, the boss chooses w to maximize
√
2 αw − w

The first order condition is given by r

α
−1=0
w
which is solved as w = α. Since the second order condition is also satisfied the unique subgame
perfect equilibrium outcome is given by

e∗ (w) = α2 , w∗ = α

2
3. (40pts.) Consider the following Bertrand duopoly model. The demand function for firm i = 1, 2 as a
function of the price choices of the two firms, P1 and P2 , is given by

2 − Pi if Pi < Pj ,

Qi (P1 , P2 ) = 2−P2
i
if Pi = Pj ,

0 if Pi > Pj


Suppose that costs are equal to zero so that the profit function of firm i is given by

πi (P1 , P2 ) = Pi Qi (P1 , P2 ).

Let P m = 1 be the monopoly price, i.e., P m is the maximand of P (2 − P ). Consider now the infinitely
repeated version of this game, where in each period t = 1, 2, . . . firms simultaneously choose prices. The
payoff of firm i to any infinite sequence of profits {πit } is given by the normalized discounted sum of
payoffs
X∞
(1 − δ) δ t−1 πit ,
t=1

where δ ∈ (0, 1).

Consider the following strategy profile. Choose P m in the first period and after any history in which both
firms have always played P m . After any other history choose a price of zero. For what range of δ, if any,
this strategy profile is a subgame perfect equilibrium of this infinitely repeated game?

Solution
Let’s check if firm 1’s strategy is optimal after every history. It is enough to check two types of histories:
(1) Both firms have always played P m .
Playing the strategy yields:
(P m , P m ), (P m , P m ), . . .
and the corresponding sequence of payoffs
1 1
, ,...
2 2
The normalized discounted sum of this sequence is 21 .
There are many possible one-shot deviations (OSD) all of which lead to a payoff of zero in the future
periods. It is sufficient to consider the best OSD, which is the one that maximizes the current payoff
given that the other firm’s price is equal to 1. Firm 1 can get a payoff arbitrarily close to 1 by setting a
price smaller than but arbitrarily close to 1. Therefore, the best OSD leads to a payoff arbitrarily close
to (1 − δ).
The strategy is optimal after any such history if and only if
1
≥1−δ
2
or
1
δ≥
2
(2) All the other histories.
After any such history firm 2 will set the price to zero forever and firm 1 will get a zero payoff every period
irrespective of what it does. Therefore, there is no profitable OSD after such histories.
Symmetric considerations for firm 2, therefore, show that the strategy profile is SPE if and only if
1
δ≥
2