Problem Set 4 – BIE Game Theory

1. (Creating & Solving Extensive Form Games) Consider a two-player game in which
Player 1 chooses first A or B, Player 2 then chooses C or D, and Player 1 then moves a
second time and chooses E or F . The payoffs are as follows:

Players’ strategies Player 1 Payoff Player 2 Payoff

AE, C 12 10

AF, C 9 6

AE, D 7 9

AF, D 6 4

BE, C 14 2

BF, C 5 2

BE, D 9 14

BF, D 4 11

(a) (10 points) Draw the extensive form.

(b) (10 points) Find all of the SPE of this game using backward induction.

The only SPE is (AE, C).

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2. (Simultaneous vs. sequential moves) Consider the Hawk-Dove game with the follow-
ing payoff matrix:

Player 2
Dove H awk
Dove (3, 3) (1, 5)
Player 1
H awk (5, 1) (0, 0)

(a) (5 points) How many Nash equilibria in pure strategies are there? Specify them.
There are two PSNE: (Hawk,Dove) and (Dove,Hawk).
(b) (10 points) Now suppose this game is played sequentially, with player 1 moving
first and player 2 moving second. What is/are the subgame perfect equilibria?
The only SPE is (Hawk, Dove Hawk).

(c) (5 points) Explain in words why you think the SPE in the sequential move game
differ from the NE in the simultaneous move game.
The simultaneous move game is a game of anti-coordination. If one player believes
that her opponent will play Hawk, then she prefers to play Dove, and vice versa.
If this game is played sequentially, player 1 can use her first move to ensure that
player 2 plays Dove. Therefore, she can assure her favoured Nash equilibrium
outcome because of her first-mover advantage.

3. (Principal-agent problem) An absentee landlord owns a farm and hires a labourer to

p
work it. The output of the farm as a function of the effort level, e, of the worker is e.

2
The landlord can not directly observe the effort level supplied by the worker, but she
does get to write a contract ahead of time, specifying the share α of future output that
will be kept by the worker. After observing α, the worker gets to choose his effort level e.
p
Effort is costly to the worker. Given α and e, the landlord’s utility is v(α, e) = (1 − α) e
(the output less the worker’s share), and the worker’s utility (which could, in principle,
p
be negative) is u(α, e) = α e − e (her share of output minus her effort cost). Assume
that 0 ≤ α ≤ 1 and 0 ≤ e ≤ 1.

(a) (25 points) What is the worker’s optimal level of effort given the share α she gets
to keep? (hint: find the worker’s best-response function)
The worker’s best-response function, bW (α) (optimal e given α) is given by her
FOC:

α
p − 1 =0
2 e
p α
⇐⇒ e =
2
 α 2
⇐⇒ bW (α) =
2

(b) (25 points) Knowing the worker’s optimal level of effort, what is the choice of α
of the landlord? (hint: remember the landlord maximises his objective function
given a constraint on the worker’s optimal effort)
The landlord’s maximisation problem given the worker’s best-response in the sec-
ond stage is given by
p
max (1 − α) e
α
 α 2
s.t. e= .
2
Substituting the worker’s best-response for e, this simplifies to
α
max(1 − α)
α 2
 
α − α2
⇐⇒ max .
α 2

Solving for the FOCs,

1
α∗ = .
2

(c) (10 points) Given the landlord’s choice of α, what is the induced effort of the worker ?

3
Substituting α* = 1/2 into bw(α), we get that e* = 1/16 .
worker?
Substituting α∗ = 1
2 into bW (α), we get that e∗ = 1
16 .