ECON-602 Problem Set 2 - Solutions

1. Gibbons 3.2 Since the information about demand is private to rm 1, we can model this fact as though it has two types high or low. Firm 2 has only one type. The rms actions are the choice of quantities, and the amount of output can take any nonnegative values. Therefore, the strategy space is R2 + for rm 1 and R+ for rm 2. To nd the Bayesian Nash equilibrium for this game rst consider the problem for rm 1. It knows the market demand, and wants to maximize its payo for each state, q1 (a) = arg max q1 (a c q1 q2 )
q1

yielding,
cq2 H q1 = aH 2 cq2 L q1 = aL 2

q1 (a) =

when a = aH , when a = aL .

For rm 2, since it is uncertain about the market demand, it maximizes its expected payo,
H L q2 = arg max{q2 (aH c q1 q2 ) + (1 )q2 (aL c q1 q2 )} q2

or,
H L )c (aH q1 ) + (1 )(aL q1 2

q2 =

Then, the equilibrium can be found by solving the above best responses simultaneously.
H q1 =

(3 )aH (1 )aL 2c , 6 (2 + )aL aH 2c , 6 aH + (1 )aL c . 3 1

L q1 =

q2 =

L Since the output level is least in case for q1 , we need to assume (2 + )aL > aH + 2c in order for all equilibrium quantities to be positive.

Gibbons 3.4 In this question, there are two possible payo structures. Player 1 knows what the payos are, whereas player 2 does not. You can say then that player 1 has two types, and player 2 has only one type. Lets call player 1s types (1 , 2 ), corresponding to Game 1, and Game 2 respectively. This implies that a BNE must be a strategy prole {s 1 (1 ), s1 (2 ), s2 }. We know that player 1s possible strategies are: {(T, T ), (T, B ), (B, T ), (B, B )}, and player 2s possible strategies are {T, B }. We can compute the payo matrix for this game as given below L (T,T) (T,B) (B,T) (B,B)
1 1 2, 2 1 1 2, 2

R 0,0 1, 1 0,0 1, 1

0, 0 0, 0

Comparing payos, we can nd the Nash equilibria for this game (and hence the BNE). These are: [(T, T ), L], [(T, B ), R] and [(B, B ), R].

2. Fudenberg and Tirole 6.1 (a) We look for an equilibrium where each player contributes if his cost is less than or equal to . For players i to prefer contributing i i the player with cost must be exactly indierent. We must have

= P rob(No other player contributes) = (1 P ( ))I 1 Comparing the values of the left and right sides at and 1, we see that there is at least one solution in (, 1). Such a is a Bayesian equilibrium. (b) Suppose K 2, and suppose that all players other than player i play the strategy of never contributing. Regardless of player i s action, the project will not be completed. Thus, player is payos are 0 and i to not contributing and contributing. Not contributing is a best response.

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We can also nd symmetric Bayesian equilbrium where player i contributes i i . Again we solve for the which makes a player with cost exactly indierent, i.e. his cost must be the benet from the added probability of having the project completed. Player i benets from contributing i exactly k 1 others have cost below , i.e. = I 1 k1 have a solution. where I 1 k1 P ( )k1 (1 P ( ))I k

denotes the binomial coecient. The equation above need not always

Fudenberg and Tirole 6.2 (b) We look for a symmetric equilibrium where player i enters i i .This will be an equilibrium when type is exactly indierent, which holds i (m )(1 P ( )) + (d )P ( ) = 0 m m d

P ( ) =

This has exactly one root as the LHS is increasing, the RHS is decreasing and comparing values at = 0 and = m shows there to be at least one solution. The argument above show there is a unique symmetric equilibrium. Any asymmetric equilib rium must be of the form: Firm i enters if i . To have an equilibrium we need.
P (1 )= m 2 m d m 1 m d

P (2 )=

Together these imply i = m (m d )P (m (m d )P (i )). If this has a unique solution, then the equilibrium is unique.

Fudenberg and Tirole 6.4 (a) In the second price auction suppose your opponent bids b and you have value . The payo is to bidding

= u( b) u( = u(0)

if b if < b

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) to u() (for ) they are Comparing the payos u(

u(0) vs u(0) u( b) vs u(0) u( b) vs u( b)

if b b if if b

is dominated by . similarly it is dominated to bid < , This shows that bidding so all bidders bid their true valuation. These are the same bids as under risk neutrality so the revenue collected is the same. (b) As in example 6.6 the equilibrium must be of the form: type bids and type chooses (s) on (, s]. s from a distribution F For the mixed strategy to be a best response type must be indierent between all possible bids. (s)) + p(1 F (s))u(0) = constant u( s)(p + pF Setting s = we see that the constant is u( )p + pu(0). Solving, (s) = F p u( ) u( s) p u( s) u(0)

From equation (6.10) of example 6.6 we can see that the solution with risk neutrality is F (s) = As u() is concave, u decreasing so u(c) u(b) u(b) u(a) < cb ba when a < b < c. Taking c = , b = s and a = 0 gives, p s p s

(s) < F

p ( ) ( s) p s

u( s) u(0) u( s) u(0)

= F (s) FOSD F . Hence F

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3. Consider the following model of an auction for an indivisible object. There are two bidders 1 i = 1, 2 with private i.i.d. valuations vi {0, 1}. We also know that pr[vi = 1] = pr[vi = 0] = 2 for i = 1, 2. Only bids of 0 or 1 are allowed. (a) Assume that the object is allocated using a second price rule. That is, the highest bidder wins and pays the second highest bid. Ties are broken assigning the object with equal probability to either bidder. Show that there is no Bayesian Nash equilibrium in which both bidders always bid 0, regardless of their valuations. To show that bidding zero regardless of the valuations is not an equilibrium all we need is a counter-example. Let vi = 1. By the equilibrium strategies we know that P r(bj = 0) = 1, so 1 1 EU [bi = 0] = P r(bj = 0) (1 0) = 2 2 EU [bi = 1] = P r(bj = 0)(1 0) = 1 Player i has incentive to deviate and bid 1, instead of zero. Hence there is no equilibrium in which both bidders always bid 0, regardless of the valuations. (b) Now assume that the object is allocated using a rst price rule. That is, the highest bidder wins and pays his own bid. Ties are broken assigning the object with equal probability to either bidder. Show that there is a Bayesian Nash equilibrium of this new game in which both bidders always bid 0, regardless of their valuations. Since the bidders are symmetric, we can consider bidder 1 and it will hold for bidder 2. Again, by the equilibrium strategies we know that P r(b2 = 0) = 1, so Case 1. v1 = 0 1 1 EU [b1 = 0] = P r(b2 = 0) (0 0) + P r(b2 = 0) (0) = 0 2 2 EU [b1 = 1] = P r(b2 = 0)(0 1) = 1 Case 2. v1 = 1 1 1 1 EU [b1 = 0] = P r(b2 = 0) (1 0) + P r(b2 = 0) (0) = 2 2 2 EU [b1 = 1] = P r(b2 = 0)(1 1) = 0 For vi = 0, 1, EU [b1 = 0] > EU [b1 = 1]. Hence each player bidding 0 regardless of valuation is a BNE.

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