Game Theory. Master in Economics. 2013-2014.

Problem Set 4: (Static games with incomplete information).

Exercise 1: Two buyers, J1 and J2 take part in a first-price sealed-bid auction.
The bidders can only bid 100 ! or 200 !. Each of them knows his/her own
valuation and moreover:
J1 believes that J2s value is 200 !.
J2 believes that J1s value is 0 ! with probability " or 300 ! with
probability ".

You are asked to:
a) Represent the decision tree of the game.
b) Determine the strategy set of each buyer.
c) Find Bayesian Nash equilibria.

Exercise 2: In the auction of the previous exercise, assume now that each
bidder knows his own value and moreover:
J1 believes that J2 has a value of 100 ! with probability " and of 200 !
with probability ".
J2 believes that J1 has a value of 0 ! with probability " and of 300 !
with probability ".

You are asked to:
a) Represent the decision tree.
b) Determine the strategy set of each buyer.
c) Find Bayesian Nash equilibria.

Exercise 3: Prove that in a first-price auction with N symmetric buyers whose
valuations are distributed according to F, the symmetric equilibrium strategy can
be written in this way:
dx
v F
x F
v v b
N
v
1
0
) (
) (
) (

!
" #
#
$
%
&
&
'
(
! =
To see that, apply integration by parts to the solution obtained at class.


Exercise 4: Consider a one-object, first-price sealed-bid auction with two
bidders. Their valuations
i
v are independent and uniformly distributed on [0, 1].
The bids are [ ] 1 , 0 ) ( !
i i
v b . Both bidders are risk-adverse and the utility of each
of them is a strictly concave function of the profit:
2 / 1
) ( ) (
i i i i i
b v b v u ! = ! . Prove
that the pair of strategies 3 / 2 ) (
1 1 1
v v b = and 3 / 2 ) (
2 2 2
v v b = form a Bayesian
Nash equilibrium of the game.

Exercise 5: Consider a Cournot duopoly operating in a market with inverse
demand P(Q)=a-Q, where Q=q
1
+q
2
is the aggregate quantity on the market.
Both firms have total costs c
i
(q
i
)=cq
i
, but demand is uncertain: it is high (a=a
H
)
with probability p and low (a=a
L
) with probability 1-p. Furthermore, information is
asymmetric: firm 1 knows whether demand is high or low, but firm 2 does not.
All of this is common knowledge. The two firms simultaneously choose
quantities. What are the strategy spaces of the two firms? Make assumptions
concerning a
H
, a
L
, p and c such that all equilibrium quantities are positive. What
is the Bayesian Nash equilibrium of this game?

Exercise 6: Jerry wants to buy a used car and Freddie offers a fifteen-year-old
sedan for sale. Suppose there is some fixed market price p for fifteen-year old
sedans of this type. Nature first chooses whether the car is a peach or a lemon.
If the car is a peach, then it is worth 3000 ! to Jerry and 2000 ! to Freddie. If
the car is a lemon, then it is worth 1000 ! to Jerry and 0 ! to Freddie. Notice
that, in both cases, Jerry values the car more than does Freddie, so efficiency
requires that the car be traded and the surplus (in each case 1000 !) be divided
between them. But there is incomplete information: Freddie observes natures
choice, whereas Jerry knows only that the car is a peach with probability q.
Then the players simultaneously and independently decide whether to trade (T)
or not (N) at the market price p. If both elect to trade, then the trade takes place.
Otherwise, Freddie keeps the car.

a) Represent the game in its extensive form and in its strategic form.
b) Discuss the existence of (pure-strategy) Bayesian Nash equilibrium,
depending on the values of the probability q and the price p.
c) Is there some situation in which only the lemon is traded? Comment on
the malfunction of the market from the viewpoint of efficiency.