ECON 1870, Spring 2013 Game Theory and Applications to Economics Problem Set 3 Due Wednesday, February 27 at 4:00pm.

1. (30 points) Consider the following dynamic game. (P1=Player 1; P2=Player 2.)

P1

P2 L R L

P2 R

2 1
Figure 1:

0 0

 1 1

3 2

(a) (5 points) How many subgames are there in this game? Which ones? (b) (5 points) What are each player's strategies? (c) (5 points) Express the game in matrix form. (d) (5 points) Find the Nash equilibria (NE) in pure strategies. (e) (5 points) Find the subgame perfect Nash equilibria (SPNE). (f) (5 points) What keeps some NE from being SPNE? 2. (25 points) Solve exercise 2.4 in Gibbons. 3. (15 points) Solve exercise 2.6 in Gibbons. 4. (20 points) This problem analyzes the scal and monetary policies carried out by the Treasury and the Fed, respectively. Suppose that the utility function of citizens is
2 d2 , 2 2 where Y denotes the GDP, represents the ination, d is the public debt, and > 0 and > 0 are uC = Y

parameters capturing how much agents in this economy dislike ination and debt. The Treasury likes having a big economy, dislikes debt, and doesn't care about ination, so its utility function is
uT = Y d2 . 2

In turn, the Fed only cares about the economy's stability, not its size; hence its utility function is
u F = 2 d2 . 2 2

The behavior of the macroeconomic variables is as follows. The GDP increases with the level of public debt (because the government spends more money) and decreases with the interest rate i (because a higher interest rate reduces investments); that is,
Y = d i.

The ination increases with the public debt (because more spending by the government boosts the aggregate demand, which puts pressure on prices) and decreases with the interest rate (because more people would keep their money in the bank instead of spending or investing), such that
= d i,

where > 1 represents the eectiveness of the monetary policy to reduce ination. The Treasury's scal policy is the level of public debt, d. The Fed carries out its monetary policy by determining the interest rate, i. The choices are made by each of these two entities sequentially. (a) (8 points) Solve for the SPNE interest rate and public debt assuming that the Treasury chooses rst (for simplicity, focus on interior solutions only). What are the equilibrium GDP and ination? What's the citizens' utility? (b) (8 points) Redo the previous item, but now assuming that the Fed moves rst. (c) (4 points) What system is preferable from the citizens' perspective? 5. (10 points) Innitely repeated duopoly: We have seen that in duopoly settings the prot that each rm receives when they play the Cournot game is less than the prot they would receive if they could collude and jointly maximize prots (eectively acting as a monopoly). In a repeated and symmetric duopoly, the payo to each of the rms is j if they produce the amount that maximizes joint prot, and c if they produce the Cournot level of output. The maximum payo that one rm can get when the other rm is producing the joint prot maximizing output is d . Firms discount the future at a rate < 1. The rms adopt the punishment strategy of reverting to the Cournot game if either player defects from playing the joint prot maximizing strategy. What is the smallest needed to maintain cooperation? Hint:

n=0

xn =

1 1x

for |x| < 1.