Answer 1

(a) The game does not have valid information structure. P1 does not know its payoff for its
second move. P2 also does not have complete information about its payoff of its first move.

(b) Imperfect information: It involves uncertainties of the current state of the play such as action
taken by other players.

Incomplete information: It involves uncertainties regarding the rules of the game such as utilities
of other players. For example, when one or more player unaware of the payoff of other player
then the game is said to have incomplete information.

(c) Nash equilibria of sequential games of perfect and complete information is Nash equilibria of
the strategic representation of the extensive form of game where as SPNE is the Nash equilibria
of every subgame in the extensive form of game of complete information. Every SPNE is Nash
equilibria but not all Nash are SPNE.

(d) The expected payoff = $100,000p + $40,000 (1 – p)

= 40,000 + 60,000p

These H type of worker will be driven out of the market if the expected payoff just calculated
is less than the alternate pay of higher H type of worker, that is if

40,000 + 60,000p < 80,000

⇒ 60,000p < 40,000

⇒ p < 2/3

Answer 2

(a) There are three information sets in this game and all three sets corresponds to the nodes
where player 2 is supposed to move.

In a sequential game of imperfect information, a strategy is a contingency plan each player

chooses an element from its action set while each player move is required on those information
sets. Another way to describe this is that the strategy of a player is considered to be a function
from information sets of the player to an action in each information set.

(b)

For the subgame, the payoff table is:

P2
l r
A 5, 5 0, 6
P1
B 6, 0 1, 1

B is the dominant strategy for P1 and r is the dominant strategy for P2. So, Nash equilibrium is
{(A, r)} with payoff (1, 1).

For the subgame,

The payoff table is:

P2
l’ r'
A’ 5, 1 0, 0
P1
B’ 0, 0 1, 5

The Nash equilibrium is {(A’, l’), (B’, r’)}

P2
L R
a 1, 1 2, 0
P1
b 0, 2 5, 1

For P2, L is the dominant strategy. When P2 chooses L, P1 chooses a. So, the Nash equilibrium
is {(a, L)} with payoff (1,1)

P2
L R
a 1, 1 2, 0
P1
b 0, 2 1, 5
For P1, a is the dominant strategy. When P1 chooses a, P2 chooses L. So, the Nash equilibrium
is {(a, L)} with payoff (1,1).

(c) Yes, this game supports SPNE in mixed strategy as the individual subgames have Nash
equilibria in mixed strategy.

(d)

The same game of perfect information is shown above.

SPNE outcome (aB, Lr) is shown in the diagram with payoff (1, 1).
Answer 3

(a)

Clearsmooth
Advertise Do not advertise
Advertise $2m, $2m $7m, $0m
Glassworks
Do not advertise $0m, $7m $5m, $5m

(Do not advertise, Do not advertise) is their cooperative strategy.

(Advertise, Advertise) is their defective strategy.

The Dominating strategy for Glassworks is to advertise and dominating strategy for Clearsmooth
is also advertise. So, the Nash equilibrium is (Advertise, Advertise).

(b) This game is similar to the prisoner’s dilemma and can be solved in a similar manner. For
finitely repeated game, we will use backward induction. As the game will be finitely repeated for
5 years, the players will try to maximize their payoff in the final year. As a result, both the firm
will use defecting strategy: (Advertise, Advertise) in the year 5. Once they think that their profit
is known and fixed for 5th year, they will try to maximize in the year 4 and both will follow the
strategy of advertising. Backward, it will continue to be so in the 1st year. So, the subgame
perfect Nash equilibrium for each of the five years for both firms is to follow the advertising
strategy in every year.

(c) The grim strategy for both the firm is to:

(i) Do not advertise in the first year

(ii) If your competitor ever chooses to advertise, you choose advertise in every subsequent
year.

If both the firms do not deviate, then payoff for each firm will be $5 million each year and that
will be the outcome of the equilibrium path.
If Clearsmooth deviates in the first year and Glassworks does not, payoff of Clearsmooth will be
$7 million in the first year and $2 million in each of the subsequent year. And, the payoff for
Glassworks will be $0 million in the first year and $2 million in each of the subsequent year.

(d)

Present value of payoff for each firm if cooperates = 5 + 5δ + 5δ2 + 5δ3 + … … = 5/(1 – δ)

Present value of payoff for deviating firm if it deviates in the first year =

7 + 2δ + 2δ2 + 2δ3 + … …

= 5 + 2 + 2δ + 2δ2 + 2δ3 + … …

= 5 + 2/(1 – δ)

= (5 - 5δ + 2)/(1 – δ)

= (7 – 5δ)/(1 – δ)

There will not be any incentives of deviation if 5/(1 – δ) ≥ (7 – 5δ)/(1 – δ)

⇒ 5 ≥ 7 – 5δ [As δ > 1)

⇒ 5δ ≥ 7 – 5

⇒ δ ≥ 0.4

So, for discount factor of at least 0.4 will sustain cooperation between the firms as a subgame-
perfect Nash equilibrium.

(e) Deviation from cooperation will result in $2 million gain for the current year and loss of $3
million is of the two subsequent years. If we don’t consider time value of money, the equilibrium
path will be not to advertise by each firm. Payoff for each firm will be $5 million for each year
starting from the current year. If Clearsmooth deviate in the first year, both the firms will
advertise in the next two years and end up with $2 million each.

(f) For the Nash equilibrium for part (e) that sustain cooperation between the firms,

2 ≥ 3δ + 3δ2.
Answer 4

(a) The game belongs to games of imperfect information. Particularly, the game is based on
Spencer’s work on Signaling games.

(b) The receiver is of a single type drawn from a degenerate (with probability one) prior
distribution. The sender could be of two types, t1 and t2, having probabilities of ¼ and ¾
respectively.

(c) There is no proper subgame for this signaling game as both the information sets of receivers
is connected to the first move of the sender with no immediate nodes seen in between.

(d)

Receiver
aa af fa ff

UU 5.0, 0.5 5, 0.5 3.0, 0.5 3.0, 0.5

UR 2.75, 0.5 1.25, 1.25 2.25, -0.25 0.75, 0.5
Sender RU 4.75, 0.5 4.25, -0.25 3.25, 1.25 2.75, 0.5
RR 2.5, 0.5 0.5, -0.5 2.5, 0.5 0.5, 0.5

For (UU, af)

Payoff, u1 = 5 × (1/4) + 5 × (3/4) = 5 and u2 = 2 × (1/4) = 0.5

For (RU, af), u1 = 2 × (1/4) + 5 × (3/4) = 4.25 and u2 = -1 × (1/4) + 0 × (3/4) = -0.25

For (RU, fa), u1 = 4 × (1/4) + 3 × (3/4) = 3.25 and u2 = 2 (1/4) + 1 (3/4) = 1.25

For (RR, af), u1 = 2 × (1/4) + 0 × (3/4) = 0.5, and u2 = -1 × (1/4) +1(3/4) = - 0.5

For (RR, fa), u1 = 4 × (1/4) + 2 (3/4) = 2.5 and u2 = 2 × (1/4) = 0.5

(e)

Receiver
aa af fa ff

UU 5.0, 0.5+ 5, 0.5 + 3.0, 0.5 3.0, 0.5+

UR 2.75, 0.5 1.25, 1.25 2.25, -0.25 0.75, 0.5
Sender RU 4.75, 0.5 4.25, -0.25 3.25, 1.25+ 2.75, 0.5
RR 2.5, 0.5 0.5, -0.5 2.5, 0.5 0.5, 0.5

The candidates for perfect Bayesian equilibrium are (UU, aa), (UU, af), (UU, ff), and (RU, fa).

(f)

A chosen separate candidate for equilibrium is (RU, fa).

There is a single separating equilibrium in this game (RU, fa). We need to derive the
receiver’s beliefs via Bayes’ rule and ensure that each players’ strategies are sequentially
rational given these beliefs.
1. Beliefs:
• Information set IU: The posterior beliefs in IU is that the sender is of type
t1 with probability p = 1 since only t1 chooses message U in equilibrium.

• Information set IR: The posterior beliefs in IR is that the sender is of type
t1 with probability q = 0 since only t2 chooses message R in equilibrium.
2. Sequential rationality:
• Receiver: f must be the best response in IU and a must be the best response
in IR, given the receiver’s beliefs.
u2(f; U) = 1 ≥ u2(a; U) = 0 ) f is sequentially rational in IU.
u2(f; R) = 0 ≤ u2(a; R) = 1 ) a is sequentially rational in IR.
• Sender: U must be a best response for type t1 and R must be a best response
for type t2, given that the receiver plays fa and holds beliefs p and q.
Type t1: u1(U; f) = 1 ≥ u1(R; a) = 0 ) U is sequentially rational for t1.
Type t2: u1(U; f) = 0 ≤ u1(R; a) = 1 ) R is sequentially rational for t2.

Therefore, {f(UR; fa); p = 1; q = 0} is a PBNE of this signaling game.