Microeconomics Qualifying Exam

16 May 2013
Solutions
Stephen Wolff
June 21, 2013

Exercise 1

Answer the following three questions.

(a) A set N of n agents must choose a pure public outcome x [0, 1]. Agent is utility is described
by his ideal outcome ai :
ui (x) = (x ai )2 .
In words, agent is disutility is the squared distance from the actual public outcome x to his
ideal outcome ai . Find all Pareto-optimal outcomes.
(b) Consider an economy with K commodities, an aggregate endowment RK
+ , and a set
N of n agents, each endowed with preferences over her consumption vector z j . Given a
Pareto-optimal allocation (z j )jN , show the following:
(i) There is at least one agent i who (weakly) prefers his bundle z i to each bundle z j , for
all j N .

(ii) There is at least one agent k such that each agent j N (weakly) prefers her own bundle
to ks bundle.

What assumption on individual preferences (monotone, continuous, convex, etc.) are needed
to ensure this conclusion?
(c) Consider an exchange economy with K commodities, an aggregate endowment RK
+ , and
a set N of n agents, each endowed with convex, monotone, continuous preferences %j over
her own consumption vector z j . That is, each agent j cares only about her own consumption
z j . Assume that all individual preferences and all initial endowments are identical, i.e. %i is
the same as %j for all agents i, j N , and j = n for all agents j N . Show that in every

Please note that these are proposed, not definitive, solutions. Thanks to D. Dong and R. Bajo for several helpful
comments; any remaining errors are my own. Contact Stephen.Wolff@rice.edu with corrections, clarifications, and
comments.

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Pareto-optimal and individually rational allocation (z j )jN , each agent is indifferent between
her bundle z j and her initial endowment. Is this conclusion preserved if preferences are not
necessarily convex?

1.1

Solution to part (a)

Since the agents ideal outcomes ai are real numbers and R is well-ordered, we can rank the agents
ideal outcomes. Let a[i] denote the ith-lowest ideal, so that a[1] . . . a[n] . Similarly, let [i] denote
the agent with ideal outcome a[i] .
Proposition 1.1. The set of Pareto-optimal outcomes is given by the interval [a[1] , a[n] ] [0, 1].

The intersection with [0, 1] is simply to ensure feasibility. If ai [0, 1] for all agents i N , then
the set of Pareto-optimal outcomes is simply [a[1] , a[2] ]. We make this assumption in the proof that
follows; the general proof is identical, just more notationally cumbersome.
Proof. First, consider any outcome x < a[1] . Intuitively, if we move the outcome x closer to a[1] , the
outcome becomes closer to all agents ideals, making all of them strictly better off. More precisely,
denote := a[1] x. Agent is utility under the public outcome x is
ui (x) = (x ai )2 = (a[1] ai )2 .
Now consider the public outcome x0 := a[1] . Agent is utility under x0 is
ui (x0 ) = (x0 ai )2 = (a[1] ai )2
Since a[1] ai for all i N , the quantity a[1] ai 0; since x < a[1] by assumption, it follows that
> 0, so that a[1] ai < a[1] ai 0, and therefore ui (x) < ui (x0 ). Since agent i N was
arbitrary, we conclude that all agents are strictly better off under the public outcome x0 compared
to x, and therefore x is not Pareto-optimal. The proof that any x > a[n] is not Pareto-optimal is
analogous.
Now consider any outcome x [a[1] , a[n] ]; we wish to show that any such outcome is Paretooptimal. Intuitively, if we move the outcome to the left, we make agent [n] strictly worse off;
whereas if we move the outcome to the right, we make agent [1] strictly worse off. More precisely,
consider any other outcome x0 , and denote := x0 x. We consider three cases.

Case 1: = 0. This is the trivial case in which x0 = x; clearly x0 cannot Pareto dominate x.
Case 2: < 0. This is the case in which x0 < x. Consider agent [n]; we have
u[n] (x0 ) = (x0 a[n] )2 = (x + a[n] )2 .

Since x a[n] , we have x a[n] 0; moreover, since < 0, it follows that x + a[n] <
x a[n] 0, and therefore
u[n] (x0 ) = (x + a[n] )2 < (x a[n] )2 = u[n] (x),
so that agent [n] is strictly worse off under x0 compared to x.1 Thus x0 does not Pareto
dominate x.
1

In fact, this argument shows that any agent i N such that a[i] > x will be made strictly worse off by the change
to x0 .

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Case 3: > 0. This is the case in which x0 > x. The proof that x0 does not Pareto dominate x is
analogous to Case 2, with agent [1] in place of agent [n].
In all cases, the new outcome x0 does not Pareto dominate the original outcome x, so we conclude
that x is Pareto-optimal.

1.2

Solution to part (b)

Let (z j )jN be a Pareto-optimal allocation. We prove each subpart in turn.

Proof of (i). Assume for the sake of contradiction that the statement does not hold. That is, for
each agent i N there exists some other agent j N such that z j i z i . It follows from the
properties of directed graphs that there exists a cycle of agents j1 , j2 , . . . , jm (with 1 < m n)
such that
z j1 jm z jm jm1 z jm1 jm2 . . . j2 z j2 j1 z j1 ;
in words, each agent strictly prefers the allocation of the next agent in the cycle to her own
allocation. Thus, by permuting the allocations within this cycle (namely, give agent j1 s allocation
to agent jm , agent jm s allocation to agent jm1 , etc.) and keeping all other allocations outside
the cycle the same, we obtain a feasible allocation that Pareto dominates the original allocation
(z j )jN , contradicting the hypothesis that (z j )jN is Pareto-optimal.
Proof of (ii). Assume for the sake of contradiction that the statement does not hold. That is, for
each agent k N there exists some other agent j N such that z k j z j . The argument now
proceeds analogously to our proof of (i). In particular, there exists a cycle
z j1 j2 z j2 j3 . . . m z jm j1 z j1 ,
and we can permute the allocations within this cycle to obtain a Pareto improvement, a contradiction.
Notice that our proofs in part (b) do not require any assumptions on individual preferences
other than completeness.

1.3

Solution to part (c)

To be completed.

Exercise 2

Consider the following economy, consisting of three goods, two consumers, and two firms. Good
3 is used as an input in the production process and provides no utility to the consumers. Firm
1, which is owned entirely by Alice, has a technology that allows good 3 to be made into good 1
according to the production function
f1 (x3 ) = 3x3 .

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Firm 2, owned entirely by Bob, uses good 3 to make good 2 according to the production function
f2 (x3 ) = 4x3 .
Consumers initial endowments of goods are A = B = (0, 0, 5), and their utility functions are
uA (x1 , x2 , x3 ) = .4 ln(x1 ) + .6 ln(x2 ),

uB (x1 , x2 , x3 ) = .5 ln(x1 ) + .5 ln(x2 ).

Compute the Walrasian equilibria of this economy.

2.1

Solution

We begin by reminding ourselves of the following definition (see Mas-Colell et al. (1995), p 579).
Definition 2.1. Given a private-ownership economy


{(X i , ui )}iI , {Y j }jJ , {( i , i )}iI ,

the allocation (x, y) and price vector p constitute a Walrasian equilibrium if the following three
conditions hold.
1. Each firm j J is solving its profit-maximization problem, given p:
p y j p yj ,
yj Y j .

2. Each consumer i I is solving her utility-maximization problem, given p:

X
xi arg max ui (xi ) | p xi p i +
ji p y j .

xi X i
jJ

3. Markets clear, given p:

X
iI

xi =

X
iI

i +

yj .

jJ

Remark 2.1. We make the following two observations, which will simplify the subsequent analysis.
First, note that both firms have a constant returns to scale (CRS) production function and no sunk
costs. It follows that profit-maximizing firms will either earn zero or infinite profit, so that in
particular both firms must earn zero profit in any Walrasian equilibrium. Second, note that (i)
both consumers have utility functions that are strongly monotone in goods 1 and 2; (ii) neither
consumer obtains any utility from good 3; and (iii) if either x1 = 0 or x2 = 0 for a consumer,
then her utility is . From (i) it follows that in any Walrasian equilibrium, p1 , p2 > 0 and the
budget constraint of each consumer holds with equality. From (ii) it follows that xi3 = 0 for both
consumers in any Walrasian equilibrium.2 From (iii) it follows that xi` > 0 for goods ` = 1, 2, for
both consumers i = A, B, in any Walrasian equilibrium, provided that their budget set contains
such a point.3 As a corollary, note that (iii) implies that both firms have strictly positive output,
and therefore demand strictly positive amounts of good 3, in any Walrasian equilibrium.
2

If xi3 > 0 for consumer i, she could strictly increase her utility by selling xi3 at the market price p3 and using the
proceeds p3 xi3 to purchase a strictly positive amount of goods 1 or 2 (or both).
3
Let B i (p) = {x X i | p x p i + i } denote agent is budget set. Provided there exists some bundle
x X i such that x1 , x2 > 0, since ui (x) > = ui (x0 ) for any x0 such that x01 = 0 or x02 = 0, agent i always strictly
prefers such an interior bundle x to any boundary bundle x0 .

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We begin with the firms. Firm 1s profit-maximization problem is

max [p1 f1 (y3 ) p3 y3 ] = max [(3p1 p3 )y3 ] .
y3 0

y3 0

Solving the first-order condition for p1 , we find

1
p1 p3 .
3

(2.1)

Similarly, firm 2s profit-maximization problem is

max [p2 f2 (y3 ) p3 y3 ] = max [(4p2 p3 )y3 ] .
y3 0

y3 0

Solving the first-order condition for p2 , we find

1
p2 p3 .
4

(2.2)

In Remark 2.1 we argued that in equilibrium, both firms are demanding a strictly positive amount
of good 3; therefore (2.1) and (2.2) hold with equality. Normalizing the price of good 3 to p3 = 1,
we obtain the equilibrium price vector (unique up to normalization) of
1 1
p = ( , , 1).
3 4

(2.3)

Next we turn to the consumers. In Remark 2.1 we argued that in equilibrium, (i) all budget
constraints hold with equality, (ii) xi3 = 0 for both consumers i = A, B, and (iii) xi` > 0 for ` = 1, 2
for both consumers i = A, B (i.e., the solution is interior in (x1 , x2 ) space); we also argued that
the profit of both firms must be 0. Using these results and the equilibrium prices found in (2.3),
consumer As utility-maximization problem writes as
max [.4 ln x1 + .6 ln x2 ]

x1 ,x2 0

s.t.

1
1
x1 + x2 = 5.
3
4

Solving the budget constraint for x2 in terms of x1 and substituting the resulting expression into
the objective function, we obtain



4
max .4 ln x1 + .6 ln 20 x1 .
x1 0
3
Taking the first-order condition (which is satisfied with equality, since the solution is interior), we
have
2
43
1

= 0,
A
set
3
5
5x1
20 34 xA
1
which solving for xA
1 yields
xA
1 = 6.
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A
Substituting this solution into consumer As budget constraint and solving for xA
2 gives x2 = 12.
Similarly, consumer Bs utility-maximization problem writes as

max [.5 ln x1 + .5 ln x2 ]

x1 ,x2 0

1
1
x1 + x2 = 5.
3
4
Proceeding in the same manner as above, we can simplify the maximization problem to



4
max .5 ln x1 + .5 ln 20 x1 .
x1 0
3
s.t.

The first-order condition (satisfied with equality) is

1
1
41
= 0,

B
set
3 2 20 34 xB
2x1
1
which solving for xB
1 yields
xB
1 =

15
.
2

Substituting this solution into consumer Bs budget constraint gives xB

2 = 10.
We can infer the firms input-output vectors from the aggregate consumption, which is x =
xA + xB = (13.5, 22, 0), and the production functions. Since only firm 1 produces good 1 and only
firm 2 produces good 2, we have
x1 = f1 (x13 )
x2 = f2 (x23 )

13.5 = 3x13
22 = 4x23

x13 = 4.5
x23 = 5.5.

Note that the total input of good 3 is x3 = 4.5+5.5 = 10, and aggregate endowment is = (0, 0, 10).
To summarize, the Walrasian equilibrium of this economy (unique up to normalization of prices)
is


1 1
A
B
1
2
x = (6, 12, 0), x = (7.5, 10, 0), y = (13.5, 0, 4.5), y = (0, 22, 5.5), p =
, ,1 .
3 4

Exercise 3

A pure exchange economy has 1000 people and one consumption good. There are two possible
states of the word for the future (date 1). If state A occurs, then each person will have an initial
endowment of 10 units of the consumption good. If state B occurs, then each person will have
an initial endowment of 20 units of the consumption good. Each person is an expected utility
maximizer, with von NeumannMorgenstern utility
ui (cA , cB ) = i ln(cA ) + (1 i ) ln(cB ),

where i is person is subjective probability that event A happens, and cA , cB denote consumption
in states A and B, respectively.
Before the future state is realized (i.e., at date 0), people can trade in a full set of Arrow (statecontingent) securities. Let pA (respectively, pB ) denote the (date-0) price of the Arrow security
that pays 1 in state A (state B).
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(a) Let the Arrow security for state B be the numeraire. Find the demand of person i for the
Arrow security corresponding to state A as a function of pA and i .
(b) What is the competitive equilibrium price for the Arrow security corresponding to state A?

3.1

Solution to part (a)

Agent is utility-maximization problem (UMP) is



max i ln cA + (1 i ) ln cB

s.t. pA cA + pB cB pA A + pB B
cA , cB 0.

Note that, provided i (0, 1), agent is utility is strongly monotone in both state-contingent
consumption goods. Thus, when i (0, 1), the budget constraint holds with equality. Moreover, if cA = 0 or cB = 0, then agent is utility is . Thus, provided her budget set has a
nonempty interior, agent i will choose cA , cB > 0. Normalizing pB := 1 as suggested, solving the
budget constraint for cB and substituting the result into the objective function, and dropping the
nonnegativity constraints on consumption, agent is UMP becomes


max i ln cA + (1 i ) ln (pA A + B pA cA ) .
The first-order condition (with respect to cA ) is
i
(1 i )pA

= 0,
cA pA A + B pA cA set
where the equality follows since agent is budget set has nonempty interior,4 and therefore cA > 0.
Solving for cA , we find
cA =

i
(pA A + B );
pA

(3.1)

plugging in the given endowment i = (A , B ) = (10, 20) gives

cA =

i
(10pA + 20).
pA

Remark 3.1. As a quick check, lets analyze expression (3.1) for agent is consumption of the
i
state-contingent good A. The expression shows that each agent i spends a fixed fraction pA of her
total wealth pA A + B on good A. Mathematically,
1
cA
=
(pA A + B ),
i

pA
4

In particular, each agent i is assumed to have endowment i = (10, 20), and therefore her budget set is the closed
B
B
triangle in R2 defined by the points (0, 0), ( 10pAp+20p
, 0), and (0, 10pAp+20p
).
A
B

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which is strictly greater than 0 provided that B > 0, as assumed, and pA is bounded above, as
we show in part (b). This makes sense: Agent is consumption of good A increases as she assigns
more probability i to state A occurring. Second,
cA
i B
= 2 ,
pA
pA
which is strictly less than 0 under the same assumptions as previously stated. This also makes
sense: As the price of good A increases, agent is consumption of the good decreases.

3.2

Solution to part (b)

Let I denote the set of consumers. By definition, in any competitive equilibrium all markets clear.
In particular, the market for the state-contingent consumption good A clears, i.e.
X
X
i
ciA =
A
.
(3.2)
iI

iI

i = for all i I. Consumer is demand ci for good A is given by (3.1).

By assumption, A
A
A
Substituting these results into (3.2), we have

X i
X
(pA A + B ) =
A .
pA
iI

iI

Solving this expression for pA , we obtain

pA =

B
P

i
,
i
iI (1 )
P

iI

(3.3)

or with the given values (recall that |I| = 1000 by assumption),

P
20 iI i
P
pA =
10(1000 iI i )
Remark 3.2. Returning to expression (3.3), observe that pA equals the ratio of the (common)
endowment in state B to state A, times the ratio of the sum of probabilities assigned to state
A to the sum of probabilities assigned to state B. Note that pA increases (i) as relatively more
aggregate weight is assigned to state A than state B (agents place a greater premium on the good as
state A becomes more likely in aggregate), and (ii) as the relative endowment in state A decreases
(relatively less good A is available compared to good B, so agents bid up its price).
As a final remark, notice the role of the common-endowment assumption in our analysis in part
i or i varied among agents, then we would have obtained
(b). If A
B
P
i
i B
.
pA = P iI
i i
iI (1 )A

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Exercise 4

One dollar is placed in a pot in period 0; its value will diminish by a discount factor each
period. (Thus, after k periods, the pot is worth k to both players.) Starting with player 1, the two
players alternate moves. When it is player is move, she has two choices: she can stop the game, in
which case she collects 40% of the pot and the remaining 60% goes to her opponent; or she can let
her opponent have the next move. The game continues until someone stops; if neither player ever
stops, both players receive a payoff of 0.
(a) Show that if is small enough, the only Nash equilibrium of the game is that player 1 chooses
to stop the game immediately. Specify what is meant by small enough.
(b) Is there any value of such that, in some Nash equilibrium, someone stops the game after
each player has declined to do so at least once?
(c) Show that if is large enough, there is a subgame perfect Nash equilibrium in which player 1
does not stop the game, and player 2 does on the next turn. Specify what is meant by large
enough.

4.1

Solution to part (a)

Player 1 stopping the game immediately (i.e., in period 0) is the unique Nash equilibrium outcome
if and only if, no matter what strategy player 2 uses, stopping the game immediately is player 1s
unique best response. Among all of player 2s possible strategies, the ones that yield player 1 the
greatest utility are those in which player 2 stops the game on his first move (i.e., in period 1). Thus
player 1 stopping the game immediately is the unique Nash equilibrium if and only if
.4 > .6

2
< .
3

Remark 4.1. When = 32 , both players are indifferent between stopping the game in a given
period and letting their opponent stop the game in the next period. It follows that the strategy
profile in which player 1 passes in each period she moves and player 2 stops the game in period
1 (and takes either action in subsequent periods) is a Nash equilibrium, as is the strategy profile in
which player 1 stops the game in period 0 and threatens to pass in each subsequent period and
player 2 plans to stop the game in period 1 (and again takes either action in subsequent periods).
Thus when = 23 , there are Nash equilibrium outcomes in which player 1 stops and does not stop
the game immediately.

4.2

Solution to part (b)

No. Assume for the sake of contradiction that there did exist a Nash equilibrium in which someone
stopped the game after each player has declined to do so at least once. Intuitively, the player who
stops the game can strictly increase her payoff by stopping the game in the earlier period when
she declined to stop the game. Since a strictly profitable unilateral deviation exists, the original
strategy profile cannot be a Nash equilibrium.
More precisely, let t1 and t2 denote the first period in which player 1 and 2, respectively, decline
to stop the game; note that in any profile in which both players have declined to stop the game at
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least once, we must have t1 = 0 and t2 = 1. Suppose that player 1 stops the game in period t > 1.
Her payoff is then .4 t . However, if she deviates and stops the game in period 0, then her payoff
is .4. Provided that < 1, this deviation is strictly profitable, and therefore the original strategy
profile cannot be a Nash equilibrium. The argument if player 2 stops the game is analogous.

4.3

Solution to part (c)

We remind ourselves of the definition of subgame-perfect Nash equilibrium.

Consider the strategy profile in which player 1 passes after every history and player 2 stops the
game after every history. By the one-shot deviation principle, this strategy profile is a subgameperfect Nash equilibrium if (and only if) there are no strictly profitable one-shot deviations for
either player. If player 1 one-shot deviates after any history ht , she will stop the game in that
period t and obtain payoff .4 t (if that history realizes); if she does not deviate, then player 2s
strategy specifies that he stops the game in the next period, yielding player 1 a payoff of .6 t+1
(again, if that history realizes). Thus player 1s deviation is not strictly profitable provided that
.4 t .6 t+1

2
.
3

If player 2 one-shot deviates after any history ht , he will not stop the game in that period t, player
1s strategy specifies that she passes in period t + 1 (regardless of player 2s actions), and player 2
returns to his original strategy in period t + 2, so he stops the game then and receives payoff .4 t+2
(if that history realizes); if he does not deviate, then he stops the game in period t and receives
payoff .4 t (again, if that history realizes). Provided that < 1, not deviating always strictly
dominates deviating for player 2.
We conclude that there are no profitable one-shot deviations, and hence the proposed strategy
profile is a subgame-perfect Nash equilibrium, if 23 .

Exercise 5

Bob has just insulted Mob in a bar, and Mob will challenge Bob to a fight. Mob must decide
whether to challenge Bob immediately or to leave and challenge him in a couple of hours in a quiet
place. Then Bob must decide whether to run away or accept the fight. On a day when he uses
drugs, Mob is strong and beats Bob; on a drug-free day, Mob is weak and loses to Bob.
The payoffs are as follows. For Mob, 5 if Bob runs (either in the bar or outside); 10 (respectively,
10) if they fight outside and he wins (respectively, loses); and 20 (respectively, 30) if they fight
in the bar and he wins (respectively, loses). For Bob, 10 if he runs (either in the bar or outside);
3 (respectively, 6) if they fight outside and he wins (respectively, loses); and 5 (respectively, 15)
if they fight in the bar and he wins (respectively, loses).
Mob knows whether he took drugs today. Bob does not know, but he was told by the bar owner
that Mob uses drugs on average one day out of three.
(a) Describe this game in extensive form, then in matrix form. Eliminate dominated strategies,
if any.
(b) Find all Bayesian Nash equilibria of this game.

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5, 10
Rb

20, 15

5, 10

30, 5

Fb B [2.1] Rb
Bd

[1.1] M

d ( 31 )

Od

2
P0 nd ( 3 )

Fb
Bnd
M [1.2]
Ond

B [2.2]

Ro

Fo

Ro

Fo

5, 10

10, 6

5, 10

10, 3

Figure 5.1: Extensive form of the game in Exercise 5. Player labels: P0 denotes Nature, M
denotes Mob, and B denotes Bob. Payoffs are listed as (Mobs payoffs, Bobs payoffs). Numbers in
parentheses after Natures actions denote probabilities; numbers in square brackets denote labels
for information sets.
Bd Bnd
Bd Ond
Od Bnd
Od Ond

Rb Ro
5, 10
5, 10
5, 10
5, 10

Rb Fo
5, 10

5, 43
20 , 26
3
3

,
0
10
3

Fb Ro
5
40
3 , 3
10, 35
3
55
3 ,0
5, 10

Fb Fo
5
40
3 , 3
0, 3
4
50
3 ,3

10
3 ,0

Figure 5.2: Normal form of the game in Exercise 5; payoffs listed in the form (Mobs payoff, Bobs
payoff). Best responses are indicated by an asterisk ( ) next to the corresponding payoff.

5.1

Solution to part (a)

Remark 5.1. Note that a strategy for Mob specifies two actions: whether to fight in the bar (B)
or outside (O) on days when he has taken drugs, and whether to fight in the bar or outside on
days when he has not taken drugs. Denote the conditioning events drugs and no drugs by
subscripts d and nd, respectively, on Mobs actions. Similarly, a strategy for Bob specifies two
actions: whether to fight (F ) or run (R) when the fight occurs in the bar, and whether to fight
or run when the fight occurs outside. Denote the conditioning events bar and outside by
subscripts b and o, respectively, on Bobs actions.
Throughout this exercise we will present payoffs in the order (Mobs payoffs, Bobs payoffs).
We will assume that Mob must set his strategy before knowing whether he will take drugs that day
(this assumption was implicit when we remarked that a strategy for Mob specifies two actions),
and that the probabilities given by the bar owner are accurate.
The extensive form of the game is presented in Figure 5.1. The corresponding normal form,
obtained from a weighted sum of the payoffs of the respective strategy profiles (with weight 13 on
drug payoffs and weight 32 on no drug payoffs), is given in Figure 5.2.
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Analyzing the normal form in Figure 5.2, we observe that Bobs pure strategy Rb Ro is strictly
dominated by Fb Fo ; also, Fb Ro is weakly dominated by Fb Fo . Less obviously, Mobs pure strategy
4 6
OO (p) := p B O + (1 p) O B
Od Ond is dominated by the mixed strategy M
d nd
d nd for any p [ 5 , 7 ];
4 6
the dominance is weak in the full 4 4 game, and strict for p ( 5 , 7 ) in the 4 3 reduced
game obtained by eliminating Bobs strictly dominated pure strategy Rb Ro . The computations are
presented in Appendix A.

5.2

Solution to part (b)

Remark 5.2. Since Bobs pure strategy Rb Ro is strictly dominated, it will never be used in any
(Bayesian) Nash equilibrium, and so we may restrict our attention to the 4 3 reduced game
obtained by eliminating Rb Ro . Moreover, in part (a) we found that Bobs pure strategy Fb Ro is
weakly dominated by Fb Fo ; since Bobs payoff from Fb Fo is strictly better than his payoff from Fb Ro
against all of Mobs strategies except Bd Bnd (for which Bobs payoffs from Fb Fo and Fb Ro are equal),
it follows that Bob will strictly prefer Fb Fo to Fb Ro whenever Mob plays Bd Bnd with probability
less than 1. That is, provided Mob mixes nontrivially in equilibrium, we may further eliminate
Bobs pure strategy Fb Ro and analyze the 4 2 reduced game without any loss of generality.
We present two methods for finding Bayesian Nash equilibria: analysis of the payoff matrix to
obtain BNE in mixed strategies (from which the realization-equivalent behavior strategies can be
inferred), and analysis of the extensive form to obtain BNE in behavior strategies directly.
Mixed-Strategy Approach We begin by looking for pure-strategy Bayesian Nash equilibria
(BNE). Analyzing the pattern of best responses in Figure 5.2,5 we find no pure-strategy BNE.
Better yet, we can show that Mob cannot use a pure strategy in any BNE.
In any BNE, given Bobs strategy, Mob is playing a best response, corresponding to choosing
the pure strategy (or mixture of pure strategies) that maximizes his own payoff. Graphing Mobs
payoff as a function of the probability that Bob places on Rb Fo as shown in Figure 5.3, Mobs
best response corresponds to the upper envelope. We find two points where two or more of Mobs
pure strategies intersect along this upper envelope: (i) = 47 , where Bd Bnd and Bd Ond yield the
same payoff; and (ii) = 23 , where Bd Bnd and Od Bnd yield the same payoff.
First consider intersection (i) between Mobs pure strategies Bd Bnd and Bd Ond . In order for
(i)
Bob to be indifferent between his two pure strategies Rb Fo and Fb Fo , Mobs mixture M :=
Bd Bnd + (1 ) Bd Ond must satisfy
(i)

(i)

uB (M , Rb Fo ) = uB (M , Fb Fo )
 
 
4
5
(10) + (1 )
=
+ (1 )(3);
3
3
(i)

(i)

solving for , we obtain = 16 . Thus the strategy profile (i) := (M , B ), where

(i)

M :=

1
5
Bd Bnd + Bd Ond ,
6
6

(i)

B :=

4
3
Rb Fo + Fb Fo ,
7
7

5
Note that the payoff line corresponding to Mobs pure strategy Od Ond lies everywhere below the upper envelope.
This illustrates our assertion in part (a) that Od Ond is a dominated strategy.

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Figure 5.3: Mobs expected payoff from each of his four pure strategies as a function of , when
Bob uses the mixed strategy Rb Fo + (1 ) Fb Fo .
is a BNE. The realization-equivalent behavior strategy profile is




1
5
4
3
(i)
(i)

M := Bd , Bnd + Ond ,

B :=
Rb + Fb , Fo ,
6
6
7
7
25
and the associated payoffs are ( 20
7 , 9 ).
Next consider intersection (ii) between Mobs pure strategies Bd Bnd and Od Bnd . From Figure
5.2, we observe that for both of these pure strategies, Bobs pure strategy Fb Fo strictly dominates
Rb Fo (in fact, Fb Fo is Bobs unique best response to either of these two pure strategies). In
particular, Bob will never want to put positive probability on Rb Fo , so 23 Rb Fo + 13 Fb Fo cannot
be an equilibrium response to any valid mixture of Bd Bnd and Od Bnd .6
We conclude that the unique BNE of this game is (i) , detailed above.

Behavior-Strategy Approach As in the mixed-strategy approach, we begin by checking for

pure-strategy Bayesian Nash equilibria (BNE). Analyzing the pattern of best responses in the
payoff matrix in Figure 5.2, we find that no pure-strategy BNE exist.
Thus we look for BNE in behavior strategies involving strict mixing in at least one information
set for each player. To do this, we assign general probabilities to the actions in each information set,
6

If we were to follow the analysis performed for intersection (i), we would proceed as follows: In order for Bob to
(ii)
be indifferent between his two pure strategies Rb Fo and Fb Fo , Mobs mixture M := Bd Bnd + (1 ) Od Bnd
must satisfy
(ii)

(ii)

uB (M , Rb Fo ) = uB (M , Fb Fo )

26
5
4
(10) + (1 )
=
+ (1 )
;
3
3
3
solving for , we obtain = 6. Since this is not a valid probability, we conclude that Mob cannot mix over his two
pure strategies Bd Bnd and Od Bnd in such a way that Bob is indifferent between Rb Fo and Fb Fo .

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and derive conditions on these probabilities such that the opponent is indifferent between certain
of his pure strategies (and hence willing to mix).
Prior to assigning general probabilities, however, let us see if we can simplify our analysis by
eliminating dominated actions in a given information set. Consider information set [2.2] in Figure
5.1. Given that Bob finds himself in information set [2.2], Fo is strictly dominant to Ro given his
beliefs about the probabilities on Natures actions (d, nd) (indeed, given any valid probabilities for
these beliefs). Thus Bob will play Fo with probability 1 at information set [2.2]. We can check that
there are no other dominated actions.
Let d and nd denote the probability that Mob plays Bd and Bnd , respectively; let b denote
the probability that Bob plays Rb . For Bob to be willing to play a strictly mixed strategy at
information set [2.1], it must be the case that the expected payoffs from the actions over which
he mixes are equal, given Mobs strategy (i.e., the probabilities d and nd ) and his beliefs about
the probabilities on Natures actions (d, nd). Let 2.1.d and 2.1.nd denote the left and right node,
respectively, in information set [2.1]. Then the condition that Bobs expected payoffs from his two
pure actions Rb and Fb are equal, conditional on being in information set [2.1], writes as
E[uB ((d , nd ), Rb ) | [2.1]] = E[uB ((d , nd ), Fb ) | [2.1]]

10 = P(2.1.d)uB (Bd , Fb ) + P(2.1.nd)uB (Bnd , Fb )

The second line follows from the fact that, conditional on being in information set [2.1], Mob must
have played Bd or Bnd , so the payoffs are those corresponding to actions in information set [2.1];
moreover, if Bob plays Rb , then his payoff is 10 with probability 1. Using Bayes rule to compute
the probability of being at each node in information set [2.1], conditional on being in information
set [2.1], we obtain
10 =

1
3 d
(15)
1
2
3 d + 3 bd

2
3 nd
(5).
1
2
3 d + 3 bd

Moving the denominator to the left and multiplying both sides by 3, we obtain

which simplifies to

10d 20nd = 15d + 10nd ,

d = 6nd .

(5.1)

We next find conditions on b such that Mob is willing to mix at information sets (nodes) [1.1]
and [1.2]. For Mob to be willing to mix at information set [1.1], we must have
E[uM (Bd , (b , 1)) | [1.1]] = E[uM (Od , (b , 1)) | [1.1]]
b (5) + (1 b )(20) = 10
2
b = .
3

(5.2)

For Mob to be willing to mix at information set [1.2], we must have

E[uM (Bnd , (b , 1)) | [1.1]] = E[uM (Ond , (b , 1)) | [1.1]]
b (5) + (1 b )(30) = 10
4
b = .
7
14

(5.3)

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4
21

1
7

4
7

3
7

4
63

B [2.1]

4
7

1
[1.1] M

1
3

0
0
0

P0

2
3

3
7

1
6

M [1.2]
5
6

B [2.2]
1

1
21

1
5
9

Figure 5.4: Extensive form of the game in Exercise 5, depicting the probabilities over outcomes
induced by the unique BNE
. Player labels: P0 denotes Nature, M denotes Mob, and B denotes
Bob. Numbers on branches indicate the probability with which those branches are played; numbers
at terminal nodes indicate the probability that outcome is realized; numbers in square brackets
denote labels for information sets.
Note that (5.2) and (5.3) are mutually exclusive. This does not mean that one (or both) of our
computations are wrong, but rather that Mob is willing to strictly mix at at most one of his two
information sets (exactly one when one of (5.2) and (5.3) hold).
In particular, if b = 23 , so that Mob is willing to mix at information set [1.1], then the expected
payoff from his actions in information set [1.2] satisfy
E[uM (Bnd , (b , 1)) | [1.2]] =

20
> 10 = E[uM (Ond , (b , 1)) | [1.2]],
3

so that Mob strictly prefers Bnd to Ond . That is, b = 32 implies nd = 1. However, result (5.1)
then implies that d = 6, which is not a valid probability. It follows that b = 23 does not yield a
valid BNE.
If b = 47 , so that Mob is willing to mix at information set [1.2], the the expected payoff from
his actions in information set [1.1] satisfy
E[uM (Bd , (b , 1)) | [1.1]] =

80
> 10 = E[uM (Od , (b , 1)) | [1.1]],
7

so that Mob strictly prefers Bd to Od . That is, b = 74 implies d = 1. Result (5.1) then implies
that nd = 16 . Combining these results, we conclude that the unique BNE is
= (
M ,
B ), where




1
5
4
3

M := Bd , Bnd + Ond ,

B :=
Rb + Fb , Fo .
6
6
7
7
A game tree depicting the probabilities over outcomes induced by the strategy profile
is presented
20
25
in Figure 5.4. The payoffs associated with this BNE are ( 7 , 9 ).
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Exercise 6

Consider the following interaction between a seller and a buyer. There is an object worth a to the
seller and b to the buyer. Both a and b are i.i.d. on the interval [0, 300], with uniform distribution.
The players play a sealed-bid double auction game: they independently and simultaneously send
an ask price x (seller) and an offer price y (buyer). If x > y, then no trade takes place; if x y,
then trade takes place at the price p = x+y
2 .
(a) Given [0, 300], consider the following pair of strategies:
(
(

if a [0, ],
0
x(a) =
y(b) =
300 if a (, 300];

if b [0, ),

if b [, 300].

Show that the strategy pair (x, y) constitutes a Bayesian Nash equilibrium. Show that the
2 (300)
2
for the buyer and 2(300)
for the seller. Compute the total welfare
expected gain is (300)
2
2(300)2
loss (compared to the first-best) and show that it is never less than 25%.
(b) Consider the following take-it-or-leave-it mechanism. The seller chooses a price x [0, 300],
which the buyer than accepts or rejects. Compute the unique Bayesian Nash equilibrium,
and compare its welfare loss to that found in part (a).
(c) Consider the following mechanism. The seller and buyer independently submit bids x and y,
respectively. Then
trade occurs at price

trade occurs at price

y
2
x
2

if y 3x and x + y 300;

+ 150 if y

x
3

+ 200 and x + y > 300;

no trade occurs, and no money changes hands, in all other cases.

Show that sincerely reporting ones valuation (i.e., the strategies x(a) = a and y(b) = b for all
a, b [0, 300]) is a Bayesian Nash equilibrium. Compare the welfare loss of this mechanism
to those found in parts (a) and (b).

6.1

Solution to part (a)

Remark 6.1. Before we begin the mathematical analysis, lets ask ourselves what is happening with
the economics. The mechanism in part (a) operates as follows: If the sellers reported valuation
is higher than the buyers reported valuation, then no trade takes place; if the sellers reported
valuation is less than or equal to the buyers reported valuation, then trade takes place at the
average of the reported values. The given strategy profile has the seller report a fixed valuation
whenever her true valuation does not exceed , and has her report the maximum possible valuation
300 if her true valuation exceeds ; similarly, it has the buyer report the lowest possible valuation 0
if his true valuation is less than , and has him report when his true valuation is at least . Note
that in this strategy profile, the seller never reports a valuation less than , and the seller never
reports a valuation greater than . Given the mechanism and the other players strategy, it seems
reasonable that each players strategy is a best response. Our job is to prove this mathematically.

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To show that the given strategy pair (x, y) is a Bayesian Nash equilibrium, we must prove that
x is a best response to y given the sellers belief about the buyers valuation, and vice versa. Here
we perform a relatively simple checking procedure; a more general approach is detailed in Appendix
B.
First, fix the buyers strategy y, and consider the seller. If trade takes place, then the sellers
payoff is p a; if trade does not take place, then the sellers payoff is 0.7 If the buyer realizes
a valuation b [0, ), then he submits an offer price of y(b) = 0, so that by the rules of the
mechanism, trade takes place if and only if x(a) 0, in which case the price is p = x(a)+0
0 and
2
the sellers payoff is p a. Since a 0, we have p a 0, so trade is not optimal for the seller in
this case;8 the seller can preclude trade from occurring by submitting any ask price x(a) > 0.
If the buyer realizes a valuation b [, 300], then he submits an offer price of y(b) = . By the
rules of the mechanism, trade takes place if and only if the seller submits any ask price x(a) ,
in which case the price is p = x(a)+
and the sellers payoff is p a. If trade takes place, then the
2
seller wants to maximize the price she receives, which corresponds to maximizing the ask price she
submits subject to the condition that the mechanism specifies trade, given the buyers offer price.
As we noted, trade takes place if x(a) , so the seller maximizes p by setting x(a) = (yielding
p = ) when trade occurs. Given that the buyer submits an offer price of , trade is only profitable
to the seller if p a 0, i.e. if a p = . In particular, when a > , the seller never wants
trade to take place.9 Given y, she can preclude trade from occurring by submitting any ask price
x(a) > whenever a > .
The results of the previous two paragraphs show that the following strategy is a best response
of the seller to the buyers strategy y:
(

if a [0, ],
x(a) =
pS (a) if a (, 300].
In particular, setting pS (a) = 300 for all a (, 300] works.
Next, fix the sellers strategy x, and consider the buyer. The analysis follows the same line of
reasoning that we used for the seller. If trade takes place, then the buyers payoff is b p; if trade
does not take place, then the buyers payoff is 0. If the seller realizes a valuation a (, 300], then
she submits an ask price of x(a) = 300, so that by the rules of the mechanism trade takes place if
and only if y(b) 300, in which case the price is p = 300+y(b)
300 and the buyers payoff is b p.
2
Since b 300, we have b p 0, so trade is not optimal for the buyer in this case; the buyer can
preclude trade from occurring by submitting any offer price y(b) < 300.
If the seller realizes a valuation a [0, ], then she submits an ask price of x(a) = , so that
by the rules of the mechanism, trade takes place if and only if y(b) , in which case the price is
p = +y(b)
and the buyers payoff is bp. If trade takes place, then the buyer wants to minimize the
2
7

These payoffs may seem surprising for example, why isnt the sellers payoff a when she keeps the object?
The answer lies in our point of reference. If we assume the seller possesses the object before entering the mechanism,
then when trade takes place she gains p and loses a, so her payoff is p a; and when trade does not take place,
she gains nothing and loses nothing, so her payoff is 0. (These are the payoffs given in the text.) If we assume the
mechanism designer possesses the object prior to the mechanism, then when trade takes place the seller gains p and
loses nothing, so her payoff is p; and when trade does not take place, she receives the object, so her payoff is a. In
either case, we obtain the expected utility given in (B.1), up to a constant (namely, a).
8
When a = 0 (which occurs with probability 0), the seller is indifferent between trade at price p = 0 and no trade.
9
Suppose a > . Given the buyers strategy y, the maximum offer price is , so for trade to take place the seller
must submit an ask price x(a) , in which case the price is p x(a)+
< a, so that the sellers payoff p a < 0.
2

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price he pays, which corresponds to minimizing the offer price he submits subject to the condition
that the mechanism specifies trade, given the sellers ask price. The buyer minimizes p by setting
y(b) = (yielding p = ) when trade occurs. Given that the seller submits an ask price of , trade
is only profitable to the seller if b p 0, i.e. if b p = . In particular, when b < , the buyer
never wants trade to take place.10 Given x, he can preclude trade from occurring by submitting
any offer price y(b) < whenever b < .
Thus, a best response of the buyer to the sellers strategy x is
(
0
if b [0, ),
y(b) =
pB (b) if b [, 300].
In particular, setting pB (b) = 0 for all b [0, ) works.
We have shown that the strategies x and y are mutual best responses; thus, (x, y) is a Bayesian
Nash equilibrium. Let A = B = [0, 300] denote the set of valuations of the seller and buyer,
respectively. The set T := {(a, b) A B | x(a) y(b)} in which trade takes place is shown in
Figure 6.1(a). The sellers expected surplus from the strategy profile (x, y) under this mechanism
is
Z Z
1T (x(a), y(b))(p a) dFB (b) dFA (a)
E[uS (x, y)] =
A B



Z Z 300
1
1
=
( a)
db
da
300
300
0

Z
300
=
( a) da
3002
0
2 (300 )
=
.
(6.1)
2(300)2
Similarly, the buyers expected surplus from the strategy profile (x, y) under this mechanism is
Z Z
E[uB (x, y)] =
1T (x(a), y(b))(b p) dFA (a) dFB (b)
B A



Z 300 Z
1
1
da
db
=
(b )
300
300

0
Z 300

=
(b ) db
3002
(300 )2
=
.
(6.2)
2(300)2
Whenever trade occurs, the total surplus generated equals the sum of the buyers and the sellers
surplus; for this mechanism, this sum is
(b p) + (p a) = b a.
10

Suppose b < . Given the sellers strategy x, the minimum ask price is , so for trade to take place the buyer
must submit an ask price y(b) , in which case the price is p +y(b)
> b, so that the buyers payoff is
2
b p < 0.

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(a)

(b)

(c)

Figure 6.1: Regions of trade (shaded) for the three mechanisms described in Exercise 6.
From an efficiency standpoint, trade should take place whenever the buyers valuation (weakly)
exceeds the sellers valuation, i.e. whenever b a. Graphically, this condition is satisfied by all
points in the closed triangular region above (and including) the 45-degree line. Welfare loss arises
when there are regions in which trade should take place but does not. For the mechanism in part
(a), welfare loss arises from the two smaller triangular regions above the 45-degree line in Figure
6.1(a).
We can compute the expected welfare loss of the mechanism (a) under the strategy profile
(x, y) with parameter let us denote it L((a) , (x, y), ) in two ways. One is by directly
computing the integrals over the regions in which welfare loss arises:
Z Z
Z 300 Z 300
(a)
L( , (x, y), ) =
(b a) dFB (b) dFA (a) +
(b a) dFB (b) dFA (a)
0
a

a


1
1 3 1
2 300 + 30000
3
=
=

+
(300

)
.
3002 6
6
600
Alternatively, we can compute the total expected surplus from the first-best (in which trade takes
place if and only if it is efficient),
S

fb

Z
0

300 Z 300
a

(b a) dFB (b) dFA (a) = 50,

and subtract off the total expected surplus generated by the mechanism (a) under the strategy
profile (x, y) with parameter , found by summing (6.1) and (6.2),
S((a) , (x, y), ) =

(300 )
;
600

the difference is the expected welfare loss,

L((a) , (x, y), ) = S f b S((a) , (x, y), ) = 50

19

(300 )
2 300 + 30000
=
.
600
600

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Note that the expected welfare loss is a convex quadratic in ; the minimizing value of is found
by setting the first derivative equal to zero and solving for :
1
(2 300) = 0
set
600

= 150,

corresponding to the minimum value

L((a) , (x, y), 150) =

25
.
2

As a fraction of the total possible (i.e. first-best) expected welfare, this minimum expected welfare
1
loss is 25/2
50 = 4 , as we wished to show.

6.2

Solution to part (b)

Given a price x(a), the buyers best response is to accept if b x(a),11 and to reject otherwise;
denote this strategy by y. Knowing this, the sellers expected utility from naming the price x(a)
[0, 300] is
Z
E[uS (x, y) | a] =
1T (x(a), y(b))(x(a) a) dF (b),
B

where T := {(a, b) | x(a) y(b)}, as in part (a); note that here, x(a) is a constant for each given
a A. The integral becomes


Z 300
1
1
(x(a) a)
E[uS (x, y) | a] =
db =
(x(a) a)(300 x(a)).
300
300
x(a)
This is a concave quadratic in x(a); it is maximized when
1
(2x(a) + 300 + a) = 0
set
300

a
x(a) = 150 + .
2

Thus the unique Bayesian Nash equilibrium is

a
x(a) = 150 + ,
2

y(b) =

(
accept

if b < x(a),

reject

if b x(a).

The total expected welfare (see Figure 6.1(b)) is

Z 300 Z 300
25
S((b) , (x, y)) =
(b a) dFB (b) dFA (a) = .
2
0
150+a
Equivalently, the expected welfare loss of this mechanism is
L((b) , (x, y)) = S f b S((b) , (x, y)) =

75
,
2

three times greater than the minimum expected welfare loss of the mechanism (a) under the
strategy profile (x, y) and the expected-welfare-maximizing parameter value = 150.
11

Since, given a cdf with no mass points, the indifference case b = x occurs with probability zero, we need not
concern ourselves with indifference.

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6.3

Micro Qual Solutions

16 May 2013

Solution to part (c)

To be completed.
As in part (a), we check that the proposed strategy profile (x, y) is a Bayesian Nash equilibrium
of the mechanism (c) . Let us start with the seller. Suppose that the buyer is using the sincere
strategy y(b) = b for all b [0, 300].

Exercise 7

Consider the following interaction among two agents, indexed by i = 1, 2. Each agent has two
types, i.e. i {0, 1} for i = 1, 2. The types (1 , 2 ) {0, 1} {0, 1} are uniformly distributed (i.e.,
each pair of types is realized with probability 41 ). A decision a {0, 1} must be made. The agents
preferences are as follows: agent 1 is happy if and only if |1 2 | = a, whereas agent 2 is happy if
and only if 1 + 2 = a. Each agent receives utility 1 if she is happy, and 0 otherwise.
The decision maker must choose the outcome a; he does not know the realized types, and he
cannot use monetary transfers. We assume that the decision maker must choose a = 1 if he learns
that 1 = 2 = 1, and a = 0 if he learns that 1 = 2 = 0.
(a) Describe the utilities in a table, as suggested in Figure 7.1.

Agent 1s payoffs:

Agent 2s payoffs:

1 = 0
1 = 1

2 = 0
?
?
a=0

2 = 1
?
?

1 = 0
1 = 1

2 = 0
?
?
a=0

2 = 1
?
?

1 = 0
1 = 1

2 = 0
?
?
a=1

2 = 1
?
?

1 = 0
1 = 1

2 = 0
?
?
a=1

2 = 1
?
?

Figure 7.1: Payoffs for the game in Exercise 7.

There are four states of the world, namely (0, 0), (0, 1), (1, 0), (1, 1); label these states as 1, 2, 3, 4,
respectively. In a direct revelation mechanism, each agent reports her type, and then a deterministic
decision is made (i.e. a = 0 or a = 1). There are 16 such mechanisms, represented as a sequence of
0s and 1s in the four states. For example, the mechanism (0, 0, 1, 0) selects a = 1 if and only if the
reported state is 3, i.e. (1 , 2 ) = (1, 0). Because we impose the decision in two of the four states
of the world, we are left with a choice of four mechanisms.
(b) Which of those mechanisms are incentive compatible (i.e., each agent has a dominant strategy
to report her true type)?
(c) Which mechanism (or mechanisms) are most favorable (in terms of expected utility) to agent
1? to agent 2?

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Solution to part (a)

The utilities are described in Figure 7.2. Note that the players payoffs agree everywhere except in
the state (1 = 1, 2 = 1).

Agent 1s payoffs:

1 = 0
1 = 1

2 = 0
1
0
a=0

2 = 1
0
1

1 = 0
1 = 1

2 = 0
0
1
a=1

2 = 1
1
0

Agent 2s payoffs:

1 = 0
1 = 1

2 = 0
1
0
a=0

2 = 1
0
0

1 = 0
1 = 1

2 = 0
0
1
a=1

2 = 1
1
0

Figure 7.2: Payoffs for the game in Exercise 7.

7.2

Solution to part (b)

There are two commonly used notions of incentive compatibility. The stronger notion12 requires
that, for each agent, truth-telling be a dominant strategy, i.e. a best response regardless of the
strategy used by the other agent(s). We use this stronger notion in what follows.
Using the notation described in the statement of Exercise 7, the four mechanisms we have to
consider (respecting the decision imposed in states (0, 0) and (1, 1)) can be described as
(0, 0, 0, 1),

(0, 0, 1, 1),

(0, 1, 0, 1),

(0, 1, 1, 1).

(7.1)

Denote these mechanisms by 1 , . . . , 4 , respectively. Let ui (k (10 , 20 ); (1 , 2 )) denote the payoff

to agent i under mechanism k when the reported type profile is (10 , 20 ) and the true type profile is
(1 , 2 ). Let is denote agent is sincere strategy in which she always truthfully reports her type,
and let im denote agent is misreport strategy in which she always lies about her type.
Consider the scenario under 1 in which agent 1s true type is 1 = 0 and agent 2 uses his
sincere strategy. Agent 1s expected payoff when she truthfully reports her type is




E[u1 (1s , 2s ) | 1 = 0] = P(2 = 0)u1 1 (0, 0); (0, 0) + P(2 = 1)u1 1 (0, 1); (0, 1)
1
1
1
1
1
= u1 (0; (0, 0)) + u1 (0; (0, 1)) = (1) + (0) = ,
2
2
2
2
2
whereas her expected payoff if she misreports her type is




E[u1 (1m , 2s ) | 1 = 0] = P(2 = 0)u1 1 (1, 0); (0, 0) + P(2 = 1)u1 1 (1, 1); (0, 1)
1
1
1
1
= u1 (0; (0, 0)) + u1 (1; (0, 1)) = (1) + (1) = 1.
2
2
2
2
12
The weaker notion of incentive compatibility is a Bayesian Nash equilibrium notion of incentive compatibility; a
mechanism is incentive compatible if truthfully reporting ones type is a best response, given that the other agent(s)
is truthfully reporting her type.

22

Department of Economics
Rice University

Micro Qual Solutions

16 May 2013

We see that agent 1 has a strict incentive to misreport her type when she is type 1 = 0 and agent
2 uses his sincere strategy. Thus truth-telling is not a dominant strategy for agent 1 in mechanism
1 . An analogous argument shows that truth-telling is not a dominant strategy for agent 1 in
mechanism 4 .13
To be completed.

7.3

Solution to part (c)

The short answer is that each agents expected utility depends on the strategy used by her opponent.
We consider two approaches to providing a response to which mechanism is most favorable: we
find each agents maximum payoff under each mechanism provided that (i) her opponent always
truthfully reports her type, and (ii) that the agents play a Bayesian Nash equilibrium.
Mutual truth-telling is a Bayesian Nash equilibrium of mechanism 4 = (0, 1, 1, 1), guaranteeing
both players an ex ante expected payoff of
X
E[ui (1s , 2s )] =
P()ui (4 (); )

1
1
1
1
= ui (0; (0, 0)) + ui (1; (0, 1)) + ui (1; (1, 0)) + ui (1; (1, 1))
4
4
4
4
3
= .
4
To be completed.

References
Mas-Colell, Andreu, Whinston, Michael D., & Green, Jerry R. 1995. Microeconomic Theory. New
York: Oxford University Press.

Computations for Mixed-Strategy Dominance (Exercise 5)

OO (p) := p B O + (1 p) O B , we
To show that Mobs pure strategy Od Ond is dominated by M
d nd
d nd
OO (p), s )] E[u (O O , s )]
solve the four inequalities implied by the requirement that E[uM (M
B
M
d nd B
13

More precisely, consider the scenario under 4 in which agent 1s true type is 1 = 1 and agent 2 uses his
misreporting strategy. Agent 1s expected payoff when she truthfully reports her type is
`

E[u1 (1s , 2m ) | 1 = 1] = P(2 = 0)u1 4 (1, 1); (1, 0) + P(2 = 1)u1 4 (1, 0); (1, 1)
1
1
1
1
1
= u1 (1; (1, 0)) + u1 (1; (1, 1)) = (1) + (0) = ,
2
2
2
2
2
whereas her expected payoff if she misreports her type is
`

E[u1 (1m , 2m ) | 1 = 1] = P(2 = 0)u1 1 (0, 1); (1, 0) + P(2 = 1)u1 4 (0, 0); (1, 1)
1
1
1
1
= u1 (1; (1, 0)) + u1 (0; (1, 1)) = (1) + (1) = 1.
2
2
2
2

23

Department of Economics
Rice University

Micro Qual Solutions

16 May 2013

for all of Bobs pure strategies sB . In particular, the three nontrivial conditions are
 
20
10
6
p(5) + (1 p)

p
3
3
7


8
55
5

p
p(10) + (1 p)
3
17


50
10
4
p(0) + (1 p)

p ;
3
3
5
the final condition, for sB = Rb Ro , is always trivially satisfied. The conditions are simultaneously
satisfied for all p [ 45 , 76 ].
Since Mobs pure strategy Bd Bnd is also not a best response to any of Bobs pure strategies,
BB (q) := q B O
we might suspect that Bd Bnd is dominated by M
d nd + (1 q) Od Bnd for some
BB (p), s )]
q Q [0, 1]. Solving the four inequalities implied by the requirement that E[uM (M
B
E[uM (Bd Bnd , sB )] for all of Bobs pure strategies sB , we obtain the three nontrivial conditions
 
20
1
q(5) + (1 q)
5

q
3
7


55
40
3
q(10) + (1 q)

q
3
3
17


50
40
1
q(0) + (1 q)

q ;
3
3
5
the final condition, for sB = Rb Ro , is always trivially satisfied. Since
never simultaneously satisfied.

1
7

< 51 , the conditions are

General Approach to Mechanism Design (Exercise 6)

Let A = B = [0, 300] denote the set of valuations of the seller and buyer, respectively; let x : A A
and y : B B denote generic strategies for the seller and buyer, respectively; and let T A B
denote the set of valuation pairs (a, b) for which the mechanism specifies that trade takes place.
First consider the seller. If trade takes place, then the sellers payoff is p a; if trade does not
take place, then the sellers payoff is 0.14 Thus, given her valuation a, the expected payoff to the
seller from the strategy x when the buyer uses strategy y is
Z
E[uS (x, y) | a] =
[1T (x(a), y(b))(p a) + (1 1T (x(a), y(b)))0] dFB (b)
B
Z
=
1T (x(a), y(b))(p a) dFB (b).
(B.1)
B

14

These payoffs may seem surprising for example, why isnt the sellers payoff a when she keeps the object?
The answer lies in our point of reference. If we assume the seller possesses the object before entering the mechanism,
then when trade takes place she gains p and loses a, so her payoff is p a; and when trade does not take place,
she gains nothing and loses nothing, so her payoff is 0. (These are the payoffs given in the text.) If we assume the
mechanism designer possesses the object prior to the mechanism, then when trade takes place the seller gains p and
loses nothing, so her payoff is p; and when trade does not take place, she receives the object, so her payoff is a. In
either case, we obtain the expected utility given in (B.1), up to a constant (namely, a).

24

Department of Economics
Rice University

Micro Qual Solutions

16 May 2013

For the mechanism in part (a), T = {(a, b) | x(a) y(b)} and p = x(a)+y(b)
. Also, b U[0, 300],
2
1
independent of the sellers valuation, so we have dFB (b) = 300 db. The sellers problem is to choose
a strategy x that maximizes (B.1), given the buyers strategy y. Our approach will be to maximize
this integral pointwise, i.e. for each value of the buyers valuation b B. Essentially, the seller
wants to set 1T (x(a), y(b)) = 0 if the integrand p a is nonpositive for every possible choice of
x(a); and set 1T (x(a), y(b)) = 1, and choose x(a) to maximize the integrand p a, otherwise.
Consider the particular buyers strategy y specified in (a). If b [0, ), then y(b) = 0; for these
values of b, trade takes place if and only if x(a) = 0, in which case p = 0. Given any a > 0, the
seller strictly prefers not to trade (corresponding to setting the integrand of (B.1) equal to 0) than
to trade (setting the integrand equal to p a < 0). Given a = 0, which occurs with probability
0, the seller is indifferent between not trading and trading. Given the buyers particular strategy
y, trade will never take place for b [0, ) provided the seller always reports a strictly positive
valuation. That is, if x(a) > 0 for all a A, then the integrand in (B.1) is 0 for all b [0, ). If
b [, 300], then y(b) = , and therefore p = x(a)+
. The sellers problem is therefore to maximize
2
the expected payoff


Z 300
x(a) +
1
E[uS (x, y) | a] =
1T (x(a), )
a
db.
2
300

The integrand is nonnegative when

x(a) +
a0
2

x(a) 2a .

The seller will want to set 1T (x(a), ) = 1, and maximize x(a) to maximize the price she receives,
whenever this inequality is satisfied. However, remember that the mechanism specifies that trade
takes place if and only if the sellers reported valuation does not exceed the buyers reported
valuation. The buyers reported valuation is y(b) = for all b [, 300], which gives us a second
inequality,
x(a) .
Combining these two results, we have that the sellers best response is to trade whenever 2a
x(a) . It follows that the sellers best response is to report the maximum value at which trade
still occurs, i.e. x(a) = , for all a . When a > , the sellers best response is to report any
valuation that guarantees trade does not occur; x(a) = 300 is one such report.
The analysis for the buyer is similar. The buyers expected utility, given his valuation b, is
Z
E[uB (x, y) | b] =
1T (x(a), y(b))(b p) dFS (a).
A

Given the sellers particular strategy x specified in part (a), this expression becomes


Z
+ y(b)
1
E[uB (x, y) | b] =
1T (, y(b)) b
da
2
300
0


Z 300
300 + y(b)
1
+
1T (300, y(b)) b
da.
2
300

25

(B.2)

Department of Economics
Rice University

Micro Qual Solutions

16 May 2013

In the first integral, trade takes place if and only if y(b) x(a) = ; and the integrand is nonnegative
if and only if b +y(b)
0, which rearranges to y(b) 2b . Combining these two results, we
2
have
y(b) 2b .

(B.3)

The buyer maximizes his payoff when the price is as low as possible, which corresponds to choosing
the minimum reported valuation y(b) such that trade takes place, namely, y(b) = . This reported
valuation satisfies the upper bound of (B.3) provided b . Turning our attention to the second
integral in (B.2), we obtain the inequalities
300 y(b) 2b 300,
which is satisfied for the minimizing reported valuation y(b) = 300 if and only if b 300. It follows
that a best response for the buyer to the particular seller strategy y is
(
0 if b [0, ),
x(b) =
if b [, 300].
To summarize, we have found that x is a best response to y, and that y is a best response to
x, given the beliefs about the distribution of types. That is, (x, y) is a Bayesian Nash equilibrium,
as we wished to show.

26