Practice Questions: Game Theory

1.
Consider two firms, X and Y, that produce super computers. Each can produce the next
generation super computer for the military (M) or for civilian research (C). However, only one can
successfully produce for both markets simultaneously. Also, if one produces M, the other might not be
able to successfully produce M, because of the limited market. The following payoff matrix illustrates the
problem.

Firm Y
Firm X

M
C

M
2, 1
1, 1

C
2, 2
3, 2

a. Find the Nash equilibrium, and explain why it is a Nash equilibrium.

b. If Firm X were unsure that the management of Firm Y were rational, what would Firm X choose to do
if it followed a maximin strategy? What would both firms do if they both followed a maximin strategy?

2.
The widget market is controlled by two firms: Acme Widget Company and Widgetway
Manufacturing. The structure of the market makes secret price cutting impossible. Each firm announces a
price at the beginning of the time period and sells widgets at the price for the duration of the period. There
is very little brand loyalty among widget buyers so that each firm's demand is highly elastic. Each firm's
prices are thus very sensitive to inter-firm price differentials. The two firms must choose between a high
and low price strategy for the coming period. Profits (measured in thousands of dollars) for the two firms
under each price strategy are given in the payoff matrix below. Widgetway's profit is before the comma,
Acme's is after the comma.

Acme
Widgetway

Low Price
High Price

Low Price
60, 60
-20, 250

High Price
250, -20
130, 130

a. Does either firm have a dominant strategy? What strategy should each firm follow?
b. Assume that the game is to be played an infinite number of times. (Or, equivalently, imagine that
neither firm knows for certain when rounds of the game will end, so there is always a positive chance that
another round is to be played after the present one.) Would the tit-for-tat strategy would be a reasonable
choice? Explain this strategy.
c. Assume that the game is to be played a very large (but finite) number of times. What is the
appropriate strategy if both firms are always rational?

Answers
1. Solution:
a.
The Nash equilibrium occurs at the bottom right on the C,C position. In this position,
each firm does its best given what the other firm does.
b.
Firm X would find the maximum of the minimum payoffs. If Firm X chose M, the
minimum payoff for X would be 2. If Firm X chose C, then the minimum payoff for X
would be 1. Thus, the maximum would be 2. Firm X should choose M. If both firms
followed a maximin strategy, then the top right corner 2,2 would be the outcome.

2. Solution:
a.
Each firm's dominant strategy is the low price. This follows from the realization that
each player is better off with the low price strategy regardless of the opponent's strategy.
b.
With an infinite number of trials, a tit-for-tat strategy is appropriate. Under tit-for-tat,
each player chooses the high price so long as his rival cooperates by also choosing the
high price. Once the rival cuts prices, the other player retaliates. If the rival raises price
back to the high price, the firm follows suit.
c.
A finite number of periods implies a low price for every period. The process begins
when each player realizes its opponent cannot retaliate after the last period so that the low
price is rational for the last period. This in turn makes the low price rational for the next
to last period and so on.