14.

12 Game Theory, Fall 2001

14.12 Game Theory

Fall 2001
Announcement
The final exam is on Friday, Dec. 21, 9:00-12:00 in Walker. The conflict exam will be on Thursday,
December 20, 9:00-12:00 in E51-085.

Faculty
Professor: Muhamet Yildiz myildiz@mit.edu (Office hours: M 4:00-5:30, E52-251a, 253-5331)
TA: Kenichi Amaya kamaya@mit.edu (Office hours: T 4:00-6:00, E52-303, 253-3591)
TA: Astrid Dick astrida@mit.edu

Schedule
Class: Room E51-372
Recitation: F10 or F3, Room E51-085

Handouts
● syllabus
● Lecture notes 1
● Lecture notes 2
● Lecture notes 3
● Lecture notes 4
● Lecture notes 5
● Lecture notes 6
● Review notes 1
● Review notes 2
● Review notes 3 (11/30)

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 14.12 Game Theory, Fall 2001

Lecture Slides
Some of the slides for lectures 1,2, and 6 are not included, as they are made by another program.
● Slides 1

● Slides 2
● Slides 3
● Slides 4
● Slides 5
● Slides 6
● Slides for lecture 8
● Slides for lecture 9
● Slides for lecture 10
● Slides for lecture 12
● Slides for lecture 13
● Slides for lecture 15-18
● Slides for lecture 19-21

Homeworks
● Homework 1 (due 9/26)
● Solutions for homework 1
● Homework 2 (due 10/3)
● Solutions for homework 2
● Homework 3 (due 10/29)
● Solutions for homework 3 Revised
● Homework 4 (due 11/7)
● Solutions for homework 4
● Homework 5 (due 12/7)
● Solutions for homework 5 Revised

Homework Grading Policies

● You may turn in assignments during the lecture on the day they are due. After the lecture,
assignments may be placed in a designated box that will be set out outside E52-303 until 5:30 p.

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 14.12 Game Theory, Fall 2001

m. Do not leave assignments in the professor or T. A.'s office or mailbox.

● You are permitted to discuss course material, including homework, with other students in the
class. However, you must turn in your own individual solutions to each homework set.
● You need to explain how you come up with the answers.Correct answers without proper
explanations will receive no credit.

Exams
● Midterm 1 (10/10)
● Midterm 1 solutions
● Midterm 1 Grade Distribution
● Midterm 2
● Midterm 2 Solutions New!
● Midterm 2 Grade Distribution New!
● Grade distribution of the average of midterm 1 and 2 New!
● Mock Final New!
● Mock Final solutions New!
● Final exam solutions New!
● Final exam grade distribution New!
● Final grade+quiz distribution New!

● Final grade distribution New!

Past years' exams

Midterm 1
● 1995
● 1995 (Solutions)
● 1997
● 1999
● 2000
● 2000 (Solutions)

Midterm 2

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14.12 Game Theory, Fall 2001

● 1996
● 1997
● 1999 Mock Midterm
● 2000 (11/16)
● 2000 (11/17)
● Some previous midterm questions (including some questions from files above)
● Solutions for Question 7 (or 8)

Final
● 2000
● 2000 solutions
● 2000 make-up

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Frxuqrw roljrsro|/ Ehuwudqg gxrsro| dqg lq wkh frpprqv sureohp1
Wkh ghqlwlrq deryh fryhuv rqo| wkh sxuh vwudwhjlhv1 Zh fdq ghqh wkh Qdvk htxl0
oleulxp iru pl{hg vwudwhjlhv e| fkdqjlqj wkh sxuh vwudwhjlhv zlwk wkh pl{hg vwudwhjlhv1
Djdlq jlyhq wkh pl{hg vwudwhj| ri wkh rwkhuv/ hdfk djhqw pd{lpl}hv klv h{shfwhg sd|r
ryhu klv rzq +pl{hg, vwudwhjlhv17

H{dpsoh Frqvlghu wkh Edwwoh ri wkh Vh{hv djdlq zkhuh zh orfdwhg wzr sxuh vwudw0
hj| htxloleuld1 Lq dgglwlrq wr wkh sxuh vwudwhj| htxloleuld/ wkhuh lv d pl{hg vwudwhj|
htxloleulxp1

PdqqZrpdq rshud edoohw

rshud 4/7 3/3
edoohw 3/3 7/4

Ohw*v zulwh ^ iru wkh suredelolw| wkdw P jrhv wr rshud> zlwk suredelolw|   ^c kh jrhv
wr edoohw1 Li zh zulwh R iru wkh suredelolw| wkdw Z jrhv wr rshud/ zh fdq frpsxwh khu
7
Lq whupv ri eholhiv/ wklv fruuhvsrqghv wr wkh uhtxluhphqw wkdw/ li l dvvljqv srvlwlyh suredelolw| wr wkh
hyhqw wkdw m pd| sod| d sduwlfxodu sxuh vwudwhj| vm / wkhq vm pxvw eh d ehvw uhvsrqvh jlyhq m*v eholhiv1

49
h{shfwhg xwlolw| iurp wklv dv

L2 ER( ^ ' R^2 Ershud/rshud n R E  ^ 2 Eedoohw/rshud

n E  R ^2 Ershud/edoohw n E  R E  ^ 2 Eedoohw/edoohw
' R d^2 Ershud/rshud n E  ^ 2 Eedoohw/rshudo
n E  R d^2 Ershud/edoohw n E  ^ 2 Eedoohw/edoohwo
' R d^e n E  ^ fo n E  R df^ n  E  ^o
' Rde^o n E  R d  ^o 

Qrwh wkdw wkh whup de^o pxowlsolhg zlwk R lv khu h{shfwhg xwlolw| iurp jrlqj wr rshud/ dqg
wkh whup pxowlsolhg zlwk E  R lv khu h{shfwhg xwlolw| iurp jrlqj wr edoohw1 L2 ER( ^ lv
vwulfwo| lqfuhdvlqj zlwk R li e^ :   ^ +l1h1/ ^ : *D,> lw lv vwulfwo| ghfuhdvlqj zlwk R li
e^   ^/ dqg lv frqvwdqw li e^ '   ^1 Lq wkdw fdvh/ Z*v ehvw uhvsrqvh lv R '  ri
^ : *D/ R ' f li ^ *D/ dqg R lv dq| qxpehu lq dfc o li ^ ' *D1 Lq rwkhu zrugv/ Z
zrxog fkrrvh rshud li khu h{shfwhg xwlolw| iurp rshud lv kljkhu/ edoohw li khu h{shfwhg
xwlolw| iurp edoohw lv kljkhu/ dqg fdq fkrrvh dq| ri rshud ru edoohw li vkh lv lqglhuhqw
ehwzhhq wkhvh wzr1
Vlploduo| zh frpsxwh wkdw ^ '  lv ehvw uhvsrqvh li R : e*D> ^ ' f lv ehvw uhvsrqvh
li R e*D> dqg dq| ^ fdq eh ehvw uhvsrqvh li R ' e*D1 Zh sorw wkh ehvw uhvsrqvhv lq wkh
iroorzlqj judsk1
q

(A, B, C) are all equilibria

1/5 B

0 C 1 p
4/5

Wkh Qdvk htxloleuld duh zkhuh wkhvh ehvw uhvsrqvhv lqwhuvhfw1 Wkhuh lv rqh dw +3/3,/
zkhq wkh| erwk jr wr edoohw/ rqh dw +4/4,/ zkhq wkh| erwk jr wr rshud/ dqg wkhuh lv rqh

4:
dw +728/428,/ zkhq Z jrhv wr rshud zlwk suredelolw| 728/ dqg P jrhv wr rshud zlwk
suredelolw| 4281
Qrwh krz zh frpsxwh wkh pl{hg vwudwhj| htxloleulxp +iru 5 {5 jdphv,1 Zh fkrrvh 4*v
suredelolwlhv vr wkdw 5 lv lqglhuhqw ehwzhhq klv vwudwhjlhv/ dqg zh fkrrvh 5*v suredelolwlhv
vr wkdw 4 lv lqglhuhqw1

4;
 47145 Jdph Wkhru| Ohfwxuh Qrwhv
Ohfwxuhv 90;
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Lq wkhvh ohfwxuhv zh dqdo|}h g|qdplf jdphv +zlwk frpsohwh lqirupdwlrq,1 Zh uvw

dqdo|}h wkh shuihfw lqirupdwlrq jdphv/ zkhuh hdfk lqirupdwlrq vhw lv vlqjohwrq/ dqg
ghyhors wkh qrwlrq ri edfnzdug lqgxfwlrq1 Wkhq/ frqvlghulqj pruh jhqhudo g|qdplf
jdphv/ zh zloo lqwurgxfh wkh frqfhsw ri wkh vxejdph shuihfwlrq1 Zh h{sodlq wkhvh
frqfhswv rq hfrqrplf sureohpv/ prvw ri zklfk fdq eh irxqg lq Jleerqv1

4 Edfnzdug lqgxfwlrq
Wkh frqfhsw ri edfnzdug lqgxfwlrq fruuhvsrqgv wr wkh dvvxpswlrq wkdw lw lv frpprq
nqrzohgjh wkdw hdfk sod|hu zloo dfw udwlrqdoo| dw hdfk qrgh zkhuh kh pryhv  hyhq li
klv udwlrqdolw| zrxog lpso| wkdw vxfk d qrgh zloo qrw eh uhdfkhg1 Phfkdqlfdoo|/ lw lv
frpsxwhg dv iroorzv1 Frqvlghu d qlwh krul}rq shuihfw lqirupdwlrq jdph1 Frqvlghu dq|
qrgh wkdw frphv mxvw ehiruh whuplqdo qrghv/ wkdw lv/ diwhu hdfk pryh vwhpplqj iurp wklv
qrgh/ wkh jdph hqgv1 Li wkh sod|hu zkr pryhv dw wklv qrgh dfwv udwlrqdoo|/ kh zloo fkrrvh
wkh ehvw pryh iru klpvhoi1 Khqfh/ zh vhohfw rqh ri wkh pryhv wkdw jlyh wklv sod|hu wkh
kljkhvw sd|r1 Dvvljqlqj wkh sd|r yhfwru dvvrfldwhg zlwk wklv pryh wr wkh qrgh dw
kdqg/ zh ghohwh doo wkh pryhv vwhpplqj iurp wklv qrgh vr wkdw zh kdyh d vkruwhu jdph/
zkhuh rxu qrgh lv d whuplqdo qrgh1 Uhshdw wklv surfhgxuh xqwlo zh uhdfk wkh ruljlq1
H{dpsoh= frqvlghu wkh iroorzlqj zhoo0nqrzq jdph/ fdoohg dv wkh fhqwlshghv jdph1
Wklv jdph looxvwudwhv wkh vlwxdwlrq zkhuh lw lv pxwxdoo| ehqhfldo iru doo sod|huv wr vwd|
 Wkhvh qrwhv gr qrw lqfoxgh doo wkh wrslfv wkdw zloo eh fryhuhg lq wkh fodvv1 L zloo dgg wkrvh wrslfv
odwhu1

4
lq d uhodwlrq/ zkloh d sod|hu zrxog olnh wr h{lw wkh uhodwlrq/ li vkh nqrzv wkdw wkh rwkhu
sod|hu zloo h{lw lq wkh qh{w gd|1

4 D 5 d 4 k
   +5/8,

G g B

+4/4, +3/7, +6/6,

Lq wkh wklug gd|/ sod|hu 4 pryhv/ fkrrvlqj ehwzhhq jrlqj dfurvv +k, ru grzq +B,1 Li
kh jrhv dfurvv/ kh zrxog jhw 5> li kh jrhv grzq/ kh zloo jhw 61 Khqfh/ zh uhfnrq wkdw kh
zloo jr grzq1 Wkhuhiruh/ zh uhgxfh wkh jdph dv iroorzv=

4 D 5 d
  +6/6,

G g

+4/4, +3/7,

Lq wkh vhfrqg gd|/ sod|hu 5 pryhv/ fkrrvlqj ehwzhhq jrlqj dfurvv +@, ru grzq +_,1 Li
vkh jrhv dfurvv/ vkh zloo jhw 6> li vkh jrhv grzq/ vkh zloo jhw 71 Khqfh/ zh uhfnrq wkdw
vkh zloo jr grzq1 Wkhuhiruh/ zh uhgxfh wkh jdph ixuwkhu dv iroorzv=

5
 4 D
 +3/7,

+4/4,

Qrz/ sod|hu 4 jhwv 3 li kh jrhv dfurvv +,/ dqg jhwv 4 li kh jrhv grzq +(,1 Wkhuhiruh/
kh jrhv grzq1 Wkh htxloleulxp wkdw zh kdyh frqvwuxfwhg lv dv iroorzv=

4 D 5 d 4 k
   +5/8,

G g B

+4/4, +3/7, +6/6,

Wkdw lv/ dw hdfk qrgh/ wkh sod|hu zkr lv wr pryh jrhv grzq/ h{lwlqj wkh uhodwlrq1
Ohw*v jr ryhu wkh dvvxpswlrqv wkdw zh kdyh pdgh lq frqvwuxfwlqj rxu htxloleulxp1
Zh dvvxphg wkdw sod|hu 4 zloo dfw udwlrqdoo| dw wkh odvw gdwh/ zkhq zh uhfnrqhg wkdw kh
jrhv grzq1 Zkhq zh uhfnrqhg wkdw sod|hu 5 jrhv grzq lq wkh vhfrqg gd|/ zh dvvxphg
wkdw sod|hu 5 dvvxphv wkdw sod|hu 4 zloo dfw udwlrqdoo| rq wkh wklug gd|/ dqg dovr dvvxphg
wkdw vkh lv udwlrqdo/ wrr1 Rq wkh uvw gd|/ sod|hu 4 dqwlflsdwhv doo wkhvh1 Wkdw lv/ kh lv
dvvxphg wr nqrz wkdw sod|hu 5 lv udwlrqdo/ dqg wkdw vkh zloo nhhs eholhylqj wkdw sod|hu
4 zloo dfw udwlrqdoo| rq wkh wklug gd|1
Wklv h{dpsoh dovr looxvwudwhv dqrwkhu qrwlrq dvvrfldwhg zlwk edfnzdug lqgxfwlrq 
frpplwphqw +ru wkh odfn ri frpplwphqw,1 Qrwh wkdw wkh rxwfrphv rq wkh wklug gd|
+l1h1/ +6/6, dqg +5/8,, duh erwk vwulfwo| ehwwhu wkdq wkh htxloleulxp rxwfrph +4/3,1 Exw
wkh| fdqqrw uhdfk wkhvh rxwfrphv/ ehfdxvh sod|hu 5 fdqqrw frpplw wr jr dfurvv/ zkhqfh
sod|hu 4 h{lwv wkh uhodwlrq lq wkh uvw gd|1 Wkhuh lv dovr d ixuwkhu frpplwphqw sureohp
lq wklv h{dpsoh1 Li sod|hu 4 zkhuh deoh wr frpplw wr jr dfurvv rq wkh wklug gd|/ sod|hu

6
5 zrxog ghqlwho| jr dfurvv rq wkh vhfrqg gd|/ zkhqfh sod|hu 4 zrxog jr dfurvv rq wkh
uvw1 Ri frxuvh/ sod|hu 4 fdqqrw frpplw wr jr dfurvv rq wkh wklug gd|/ dqg wkh jdph
hqgv lq wkh uvw gd|/ |lhoglqj wkh orz sd|rv +4/3,1
Dv dqrwkhu h{dpsoh/ ohw xv dsso| edfnzdug lqgxfwlrq wr wkh Pdwfklqj Shqqlhv zlwk
Shuihfw Lqirupdwlrq=
(-1, 1)
Head
2
O Tail
(1, -1)
Head

Tail (1, -1)

Head
2
O
Tail

(-1, 1)

Li sod|hu 4 fkrrvhv Khdg/ sod|hu 5 zloo Khdg> dqg li 4 fkrrvhv Wdlo/ sod|hu 5 zloo suhihu
Wdlo/ wrr1 Khqfh/ wkh jdph lv uhgxfhg wr
(-1,1)

Head

Tail (-1,1)

Lq wkdw fdvh/ Sod|hu 4 zloo eh lqglhuhqw ehwzhhq Khdg dqg Wdlo/ fkrrvlqj dq| ri wkhvh
wzr rswlrq ru dq| udqgrpl}dwlrq ehwzhhq wkhvh wzr dfwv zloo jlyh xv dq htxloleulxp zlwk
edfnzdug lqgxfwlrq1
Dw wklv srlqw/ |rx vkrxog vwrs dqg vwxg| wkh Vwdfnhoehuj gxrsro| lq Jle0
erqv1 \rx vkrxog dovr fkhfn wkdw wkhuh lv dovr d Qdvk htxloleulxp ri wklv jdph lq zklfk

7
wkh iroorzhu surgxfhv wkh Frxuqrw txdqwlw| luuhvshfwlyh ri zkdw wkh ohdghu surgxfhv/
dqg wkh ohdghu surgxfhv wkh Frxuqrw txdqwlw|1 Ri frxuvh/ wklv lv qrw frqvlvwhqw zlwk
edfnzdug lqgxfwlrq= zkhq wkh iroorzhu nqrzv wkdw wkh ohdghu kdv surgxfhg wkh Vwdfnho0
ehuj txdqwlw|/ kh zloo fkdqjh klv plqg dqg surgxfh d orzhu txdqwlw|/ wkh txdqwlw| wkdw
lv frpsxwhg gxulqj wkh edfnzdug lqgxfwlrq1 Iru wklv uhdvrq/ zh vd| wkdw wklv Qdvk
htxloleulxp lv edvhg rq d qrq0fuhgleoh wkuhdw +ri wkh iroorzhu,1
Edfnzdug lqgxfwlrq lv d srzhuixo vroxwlrq frqfhsw zlwk vrph lqwxlwlyh dsshdo1 Xq0
iruwxqdwho|/ zh fdqqrw dsso| lw eh|rqg shuihfw lqirupdwlrq jdphv zlwk d qlwh krul}rq1
Lwv lqwxlwlrq/ krzhyhu/ fdq eh h{whqghg eh|rqg wkhvh jdphv wkurxjk vxejdph shuihfwlrq1

5 Vxejdph shuihfwlrq
D pdlq surshuw| ri edfnzdug lqgxfwlrq lv wkdw/ zkhq zh frqqh rxuvhoyhv wr d vxejdph
ri wkh jdph/ wkh htxloleulxp frpsxwhg xvlqj edfnzdug lqgxfwlrq uhpdlqv wr eh dq htxl0
oleulxp +frpsxwhg djdlq yld edfnzdug lqgxfwlrq, ri wkh vxejdph1 Vxejdph shuihfwlrq
jhqhudol}hv wklv qrwlrq wr jhqhudo g|qdplf jdphv=

Ghqlwlrq 4 D Qdvk htxloleulxp lv vdlg wr eh vxejdph shuihfw li dq rqo| li lw lv d Qdvk

htxloleulxp lq hyhu| vxejdph ri wkh jdph1

Zkdw lv d vxejdphB Lq dq| jlyhq jdph/ wkhuh pd| eh vrph vpdoohu jdphv hpehgghg>
zh fdoo hdfk vxfk hpehgghg jdph d vxejdph1 Frqvlghu/ iru lqvwdqfh/ wkh fhqwlshghv
jdph +zkhuh wkh htxloleulxp lv gudzq lq wklfn olqhv,=

4 D 5 d 4 k
   +5/8,

G g B

+4/4, +3/7, +6/6,

Wklv jdph kdv wkuhh vxejdphv1 Khuh lv rqh vxejdph=

8
 4 k
 +5/8,

+6/6,

Wklv lv dqrwkhu vxejdph=

5 d 4 k
  +5/8,

g B

+3/7, +6/6,

Dqg wkh wklug vxejdph lv wkh jdph lwvhoi1 Zh fdoo wkh uvw wzr vxejdphv +h{foxglqj
wkh jdph lwvhoi, surshu1 Qrwh wkdw/ lq hdfk vxejdph/ wkh htxloleulxp frpsxwhg yld
edfnzdug lqgxfwlrq uhpdlqv wr eh dq htxloleulxp ri wkh vxejdph1
Qrz frqvlghu wkh pdwfklqj shqq| jdph zlwk shuihfw lqirupdwlrq1 Lq wklv jdph/ zh
kdyh wkuhh vxejdphv= rqh diwhu sod|hu 4 fkrrvhv Khdg/ rqh diwhu sod|hu 4 fkrrvhv Wdlo/
dqg wkh jdph lwvhoi1 Djdlq/ wkh htxloleulxp frpsxwhg wkurxjk edfnzdug lqgxfwlrq lv d
Qdvk htxloleulxp dw hdfk vxejdph1
Qrz frqvlghu wkh iroorzlqj jdph1

9
 1

E X
1
(2,6)
T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Zh fdqqrw dsso| edfnzdug lqgxfwlrq lq wklv jdph/ ehfdxvh lw lv qrw d shuihfw lqiru0
pdwlrq jdph1 Exw zh fdq frpsxwh wkh vxejdph shuihfw htxloleulxp1 Wklv jdph kdv
wzr vxejdphv= rqh vwduwv diwhu sod|hu 4 sod|v H> wkh vhfrqg rqh lv wkh jdph lwvhoi1 Zh
frpsxwh wkh vxejdph shuihfw htxloleuld dv iroorzv1 Zh uvw frpsxwh d Qdvk htxloleulxp
ri wkh vxejdph/ wkhq {lqj wkh htxloleulxp dfwlrqv dv wkh| duh +lq wklv vxejdph,/ dqg
wdnlqj wkh htxloleulxp sd|rv lq wklv vxejdph dv wkh sd|rv iru hqwhulqj lq wkh vxejdph/
zh frpsxwh d Qdvk htxloleulxp lq wkh uhpdlqlqj jdph1
Wkh vxejdph kdv rqo| rqh Qdvk htxloleulxp/ dv W grplqdwhv E= Sod|hu 4 sod|v W
dqg 5 sod|v U/ |lhoglqj wkh sd|r yhfwru +6/5,1

T
B

2
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(0,1) (3,2) (-1,3) (1,5)

Jlyhq wklv/ wkh uhpdlqlqj jdph lv

:
 1

E X

(3,2) (2,6)

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1
E
X
1
(2,6)
T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Qrwh wkdw wkhuh duh rwkhu Qdvk Htxloleuld> rqh ri wkhp lv ghslfwhg ehorz1
1
E
X
1
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2
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(0,1) (3,2) (-1,3) (1,5)

\rx vkrxog eh deoh wr fkhfn wkdw wklv lv d Qdvk htxloleulxp1 Exw lw lv qrw vxejdph
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;
 Qrz/ frqvlghu wkh iroorzlqj jdph/ zklfk lv hvvhqwldoo| wkh vdph jdph dv deryh/ zlwk
d voljkw glhuhqfh wkdw khuh sod|hu 4 pdnhv klv fkrlfhv dw rqfh=
X
1 (2,6)

T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Qrwh wkdw wkh rqo| vxejdph ri wklv jdph lv lwvhoi/ khqfh dq| Qdvk htxloleulxp lv
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deryh lv vxejdph shuihfw1 Lq wkh qhz jdph lw wdnhv wkh iroorzlqj irup=

X
1 (2,6)

T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Dw wklv srlqw |rx vkrxog vwrs uhdglqj dqg vwxg| wdulv dqg lpshuihfw
lqwhuqdwlrqdo frpshwlwlrq1

6 Vhtxhqwldo Edujdlqlqj
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4 dffhswv ru uhmhfwv wkh rhu1 Li sod|hu 4 dffhswv wkh rhu/ wkh rhu lv lpsohphqwhg/
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dffhswlqj dqg uhmhfwlqj dq| rhu wkdw jlyhv klp 31 Dvvxph wkdw kh dffhswv wkh rhu
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li wkh| gr qrw djuhh rq wkh uvw gd|/ rq wkh vhfrqg gd|/ sod|hu 5 wdnhv wkh hqwluh groodu/
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uhmhfwhg1
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43
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 14.12 Review Notes 1
Kenichi Amaya∗
September 14, 2001

1 Why do we learn game theory?

Economic agents’ (e.g., consumers, firms, government) behavior is described
as a maximization problem (utility maximization, profit maximization). For
example, consider a firm’s profit maximization problem.

Perfect competition Under perfect competition, a firm takes the price as

given, and choose the quantity to sell.

max pq − c(q)
q

⇒ FOC p = c0 (q) = M C.

Monopoly A monopolist choose the price, and the quantity to sell is deter-
mined by the demand curve D(p).

max pD(p) − c(D(p))

p

⇒ FOC pD0 (p) + D(p) = c0 (D(p))D(p).

In the examples above, the firm is the only decision maker and everything
other than the choice variables (q in perfect competition and q in monopoly) are
exogenously given. Therefore we can solve for the optimal value of the choice
variable.
Consider the Cournot Duopoly. Firm 1 chooses the quantity to sell q1 , and
Firm 2 chooses q2 . Let P (q) be the inverse demand curve, where q = q1 + q2 .
Firm 1 maximizes its profit:

max P (q1 + q2 )q1 − c1 (q1 ).

q1
∗ E52-303, kamaya@mit.edu

1
Firm 2 maximizes its profit:

max P (q1 + q2 )q2 − c2 (q2 ).

q2

To solve for the optimal q1 , we need to know what q2 is. But to know the
optimal q2 , we need to know what q1 is. This goes forever and we can never
solve it mathematically. We need some theory to solve it: Game theory.
Game theory is a tool to analyze people’s behavior under strategic environ-
ment: An agent’s payoff depends not only on his decisions but also other agents’
decisions.
Other examples includes:
• Employer — Employee (Wage scheme — Effort)
• Government — Firm (Regulation — Business strategy)
• U.S. Government — Japanese government (Trade policy)

2 Decision making under uncertainty

In the environment of games, economic agents often faces uncertainty. They
must choose among alternatives which gives different probability distribution
over outcomes. We often call outcomes of lotteries prizes We call these alterna-
tives lotteries. For example:
1
Lottery 1 gives you beer with probability 2 and chocolate with probability 12 .
1
Lottery 2 gives you beer with probability 3 and coffee with probability 23 .
We want to have a utility function U (·) such that

U (lottery 1) ≥ U (lottery 2)

if and only if the agent prefers lottery 1 to lottery 2, i.e.,

lottery 1  lottery 2.

The basic theory of choice implies there exists such a utility function if  is a
preference relationship, i.e., it is complete and transitive

Completeness For all p, q ∈ P , p  q or q  p.

Transitivity If p  q and q  r, then p  r.

2
 But thinking directly about this function U is too messy! It is more conve-
nient if we have a function u such that
1 1
U (lottery 1) = u(beer) + u(chocolate),
2 2
1 2
U (lottery 2) = u(beer) + u(cof f ee).
3 3
But can we really find such an convenient function u? Actually, it is known that
we can find u if the agent’s preference  over lotteries satisfies the following
condition, in addition to completeness and transitivity.

Independence For any p, q, r ∈ P , and any a ∈ (0, 1],

ap + (1 − a)r  aq + (1 − a)r ⇔ p  q.

Continuity For any p, q, r ∈ P , if p  r, then there exist a, b ∈ (0, 1) such that

ap + (1 − p)r  q  bp + (1 − b)r.

Furthermore, if a von-Neuman Morgenstern utility function u represents ,

then its affine transformation u0 = au + b where a > 0 also represents .

3 Attitudes toward risk

Suppose now the prizes of lotteries are money. Lottery A gives you 50 dollars for
sure (a degenerated lottery). Lottery B gives you 100 dollars with probability
1 1
2 and 0 with probability 2 . Which do you prefer? The two lotteries give you
the same expected amount of money, 50 dollars, so your choice reflects whether
you like risk or not.
If you prefer Lottery A, then we can say you are risk averse. Your vNM
utility function satisfies
1 1
u(50) > u(0) + u(100).
2 2
This is true if your vNM utility function is concave (u00 < 0 if u is twice differ-
entiable). In general, if your vNM utility function is concave, you always prefer
getting the avarage for sure to getting some risky lottery.
In contrast, if your vNM utility function is concave, you always prefer getting
some risky lottery to getting the avarage for sure. In this case, you are called
risk loving.
If your vNM utility function is linear, you are indifferent between getting
some risky lottery and getting the avarage for sure. In this case, you are called
risk neutral.

3
4 Modelling games
When we write down a game which represents some economic environment,
the payoffs of the game are vNM utilities of the players, not the actual money
amount received. In this way, we can assume the players maximize their ex-
pected payoffs. The only case where the payoffs of a player is equal to the
actual money amount received is the case where the player is risk neutral. Ac-
tually, in many textbook modelling we find the players are assumed to be risk
neutral and therefore maximize expected revenue.

4
 14.12 Review Notes
Dynamic games with incomplete information
Kenichi Amaya∗
November 30, 2001

1 Perfect Bayesian equilibrium

• s = (s1 , · · · , sn ): strategy profile.
• A belief at an information set is a probability distribution over decision
nodes in the information set.
• A belief system µ is the collection of beliefs at all information sets.

Definition A pair of strategy profile and a belief system (s, µ) is a Perfect

Bayesian (Nash) equilibrium (PBE) if

1. Given their beliefs, the players’ strategies must be sequentially ratio-

nal. That is, at each information set the action taken by the player
with the move (and the player’s subsequent strategy) must be opti-
mal given the player’s belief at that information set and the other
players’ subsequent strategies.
2. Beliefs are determined by Bayes’ rule and the players’ equilibrium
strategies wherever possible.

Note 1: When you are asked to describe a PBE, you need to show not only
the strategy profile but also the belief system. (However, you usually don’t need
to describe the belief at a singleton information set because it is obvious).
Note 2: PBE is a stronger concept than subgame perfect Nash equilibrium.
Therefore, the strayegy profile of a PBE is a subgame perfect Nash equilibrium.
∗ E52-303, kamaya@mit.edu

1
2 How do we find PBE?
Here is an abstract procedure of looking for PBE.

1. Using sequential rationality and Bayes rule, determine strategies and be-
liefs wherever possible. If you can determine strategies and beliefs every-
where, that’s it.
2. When you can’t do more, make an assumption about a strategy at any
information set. Then, using sequential rationality and Bayes rule, deter-
mine strategies and beliefs wherever possible.
3. You may be able to determine strategies and beliefs everywhere, i.e., to
find an equilibrium. Then, change your assumption and look for another
equilibrium.
4. You may reach a contradiction. In this case, the assumption was wrong.
Change your assumption.
5. When you can’t do more only with the assumption you made, make a
further assumption.

The idea we use in finding a mixed strategy Nash equilibrium applies here
too: The mixing probability must be such that the other player is indifferent
between the strategies he is mixing.

2
 14.12 Economic Applications of
Game Theory
Professor: Muhamet Yildiz
Lecture: MW 2:30-4:00 @4-153?
Office Hours: M 4-5:30 @E52-251a
TA: Kenichi Amaya
F 10,3 @E51-85
Office Hours:TBA
Web: http://web.mit.edu/14.12/www/

Name of the game

Game Theory = Multi-person decision theory
• The outcome is determined by the actions
independently taken by multiple decision
makers.
• Strategic interaction.
– Need to understand what the others will do
– … what the others think that you will do
– …

1
Hawk-Dove game

V − c V − c  (V,0)
 , 
 2 2 

(0,V) (V/2,V/2)

Chicken

(-1,-1) (1,0)

(0,1) (1/2,1/2)

2
 Stag Hunt

(2,2) (4,0)

(0,4) (6,6)

Quiz Problem
• Without discussing with anyone, each student
is to write down a real number xi between 0
and 100 on a paper and submit it to the TA.
• The TA will then compute the average
x1 + x2 +  + xn
x= .
n
• The students who submit the number that is
closest to x / 3 will share 100 points equally;
the others will get 0.

3
 14.12 Game Theory

Lecture 2: Decision Theory

Muhamet Yildiz

Road Map
1. Basic Concepts (Alternatives, preferences,…)
2. Ordinal representation of preferences
3. Cardinal representation – Expected utility
theory
4. Applications: Risk sharing and Insurance
5. Quiz

1
 Basic Concepts: Alternatives
• Agent chooses between the alternatives
• X = The set of all alternatives
• Alternatives are
– Mutually exclusive, and
– Exhaustive
• Example: Options = {Tea, Coffee}
X = {T, C, TC, NT} where
T= Tea, C = Coffee, TC = Tea and Coffee,
NT = Neither Tea nor Coffee

Basic Concepts: Preferences

• TeX
• TeX –ordinal representation

2
 Examples
• Define a relation among the students in this
class by
– x T y iff x is at least as tall as y;
– x M y iff x’s final grade in 14.04 is at least as
high as y’s final grade;
– x H y iff x and y went to the same high school;
– X Y y iff x is strictly younger than y;
– x S y iff x is as old as y;

Exercises
• Imagine a group of students sitting around a
round table. Define a relation R, by writing
x R y iff x sits to the right of y. Can you
represent R by a utility function?
• Consider a relation } among positive real
numbers represented by u with u ( x ) = x .
2

Can this relation be represented byu * ( x ) = x ?

What about u **( x) = 1/ x ?

3
• TeX – OR Theorem
• TeX – Cardinal representation
• VNM Axioms
• Theorem

A Lottery

4
 Two Lotteries

$1M
$1000 .00001
.3
.3
$10

.99999
.4 $0
$0

Exercise
• Consider an agent with VNM utility
function u with u ( x ) = x .
2

Can his preferences be represented by VNM

utility function u * ( x ) = x ?
What about u **( x) = 1/ x ?

5
 Attitudes towards Risk
p x
• A fair gamble: px+(1-p)y = 0.
1-p y

• An agent is said to be risk neutral iff he is

indifferent towards all fair gambles. He is said
to be (strictly) risk averse iff he never wants to
take any fair gamble, and (strictly) risk seeking
iff he always wants to take fair gambles.

A utility function
EU
u

A
u(pW1+(1- p)W2)
C
EU(Gamble)
B

W1 pW1+(1-p)W2 W2

6
• An agent is risk-neutral iff he has a linear
utility function, i.e., u(x) = ax + b.
• An agent is risk-averse iff his utility
function is concave.
• An agent is risk-seeking iff his utility
function is convex.

Risk Sharing
• Two agents, each having a utility function u
with u ( x ) = x and an “asset:” .5
$100

.5 $0
• For each agent, the value of the asset is

• Assume that the value of assets are

independently distributed.

7
• If they form a mutual fund so that each
agent owns half of each asset, each gets
$100
1/4
1/2 $50

1/4
$0

Insurance
• We have an agent with u(x ) = x and
.5 $1M

.5 $0
• And a risk-neutral insurance company with
lots of money, selling full insurance for
“premium” P.

8
 Lecture 3
Decision Theory/Game Theory

14.12 Game Theory

Muhamet Yildiz

Road Map
1. Basic Concepts (Alternatives, preferences,…)
2. Ordinal representation of preferences
3. Cardinal representation – Expected utility theory
4. Applications: Risk sharing and Insurance
5. Quiz
6. Representation of games in strategic
and extensive forms
7. Quiz?

1
 A Lottery

Two Lotteries

$1M
$1000
.00001
.3
.3
$10

.99999
.4 $0
$0

2
 Exercise
• Consider an agent with VNM utility
function u with u ( x ) = x .
2

Can his preferences be represented by VNM

utility function u * ( x ) = x ?
What about u **( x) = 1/ x ?

Attitudes towards Risk

p x
• A fair gamble: px+(1-p)y = 0.
1-p y

• An agent is said to be risk neutral iff he is

indifferent towards all fair gambles. He is said
to be (strictly) risk averse iff he never wants to
take any fair gamble, and (strictly) risk seeking
iff he always wants to take fair gambles.

3
 A utility function
EU
u

A
u(pW1+(1- p)W2)
C
EU(Gamble)
B

W1 pW1+(1-p)W2 W2

• An agent is risk-neutral iff he has a linear

utility function, i.e., u(x) = ax + b.
• An agent is risk-averse iff his utility
function is concave.
• An agent is risk-seeking iff his utility
function is convex.

4
 Risk Sharing
• Two agents, each having a utility function u
with u ( x ) = x and an “asset:” .5
$100

.5 $0
• For each agent, the value of the asset is

• Assume that the value of assets are

independently distributed.

• If they form a mutual fund so that each

agent owns half of each asset, each gets
$100
1/4
1/2 $50

1/4
$0

5
 Insurance
• We have an agent with u(x ) = x and
.5 $1M

.5 $0
• And a risk-neutral insurance company with
lots of money, selling full insurance for
“premium” P.

Quiz Problem
• Without discussing with anyone, each student
is to write down a real number xi between 0
and 100 on a paper and submit it to the TA.
• The TA will then compute the average
x1 + x2 +  + xn
x= .
n
• The students who submit the number that is
closest to x / 3 will share 100 points equally;
the others will get 0.

6
 Multi-person Decision Theory
• Who are the players?
• Who has which options?
• Who knows what?
• Who gets how much?

Knowledge
Common Knowledge: x is
1. If I know something, it
common knowledge iff
must be true.
2. If I know x, then I know •Each player knows x
that I know x. •Each player knows that each
3. If I don’t know x, then I player knows x
know that I don’t know x.
• Each player knows that each
4. If I know something, I
player knows that each player
know all its logical
knows x
implications.
•Each player knows that each
player knows that each player
knows that each player knows x
•… ad infinitum

7
 Representations of games

Normal-form representation
Definition (Normal form): A game is any list
G = (S1 , l , S n ; u1 , l , u n )

where, for each i ∈ N = {1,2,l, n},

• Si is the set of all strategies available to i,
• ui : S1 × m × Sn → ℜ is the VNM utility function of
player i.
Assumption: G is common knowledge.
Definition: A player i is rational iff he tries to
maximize the expected value of ui given his beliefs.

8
 Chicken

(-1,-1) (1,0)

(0,1) (1/2,1/2)

Extensive-form representation
Definition: A tree is a set of nodes connected with
directed arcs such that
1. For each node, there is at most one incoming
arc;
2. each node can be reached through a unique path;

9
 A tree?

A tree??

B B

A
A

D
C
C

10
 A tree
Non-terminal
Terminal Nodes
nodes

Extensive form – definition

Definition: A game consists of
– a set of players
– a tree
– an allocation of each non-terminal node to a
player
– an informational partition (to be made precise)
– a payoff for each player at each terminal node.

11
 Information set
An information set is a collection of nodes
such that
1. The same player is to move at each of
these nodes;
2. The same moves are available at each of
these nodes.
An informational partition is an allocation
of each non-terminal node of the tree to an
information set.

A game
1
L R

(2,2) 2
l r u
1 (0,0)
1
λ Ρ
ρ Λ

(1,3) (3,1) (3,3) (1,1)

12
 Another Game
1 x

T B

2
L R L R

The same game

1 x

T B

L R
R L

13
 Strategy
A strategy of a player is a complete
contingent-plan, determining which action
he will take at each information set he is to
move (including the information sets that
will not be reached according to this
strategy).

Matching pennies with perfect information

2’s Strategies:
HH = Head if 1 plays Head,
1 Head if 1 plays Tail;
HT = Head if 1 plays Head,
Head Tail Tail if 1 plays Tail;
2 TH = Tail if 1 plays Head,
2 Head if 1 plays Tail;
head tail head tail TT = Tail if 1 plays Head,
Tail if 1 plays Tail.
(-1,1) (1,-1) (1,-1) (-1,1)

14
 Matching pennies with perfect information

2
1
HH HT TH TT

Head

Tail

Matching pennies with Imperfect

information
1 2
1
Head Tail
Head Tail
2 Head (-1,1) (1,-1)
head tail head tail
Tail (1,-1) (-1,1)
(-1,1) (1,-1) (1,-1) (-1,1)

15
 A game with nature
Left (5, 0)

1
Head
1/2 Right (2, 2)
Nature
(3, 3)
1/2 Left
Tail 2

Right
(0, -5)

A centipede game
1 A 2 α 1 a
(1,-5)

D δ d

(4,4) (5,2) (3,3)

16
 Lecture 4
Representation of Games &
Rationalizability
14.12 Game Theory
Muhamet Yildiz

Road Map
1. Representation of games in strategic
and extensive forms
2. Dominance
3. Dominant-strategy equilibrium
4. Rationalizability

1
 Normal-form representation
Definition (Normal form): A game is any list
G = (S1 , l , S n ; u1 , l , u n )

where, for each i ∈ N = {1,2,l, n},

• Si is the set of all strategies available to i,
• ui : S1 × m × Sn → ℜ is the VNM utility function of
player i.
Assumption: G is common knowledge.
Definition: A player i is rational iff he tries to
maximize the expected value of ui given his beliefs.

Chicken

(-1,-1) (1,0)

(0,1) (1/2,1/2)

2
 Extensive-form representation
Definition: A tree is a set of nodes connected with
directed arcs such that
1. For each node, there is at most one incoming
arc;
2. each node can be reached through a unique path;

A tree
Non-terminal
Terminal Nodes
nodes

3
 Extensive form – definition
Definition: A game consists of
– a set of players
– a tree
– an allocation of each non-terminal node to a
player
– an informational partition (to be made precise)
– a payoff for each player at each terminal node.

Information set
An information set is a collection of nodes
such that
1. The same player is to move at each of
these nodes;
2. The same moves are available at each of
these nodes.
An informational partition is an allocation
of each non-terminal node of the tree to an
information set.

4
 A game
1
L R

(2,2) 2
l r u
1 (0,0)
1
λ Ρ
ρ Λ

(1,3) (3,1) (3,3) (1,1)

Another Game
1 x

T B

2
L R L R

5
 The same game
1 x

T B

L R
R L

Strategy
A strategy of a player is a complete
contingent-plan, determining which action
he will take at each information set he is to
move (including the information sets that
will not be reached according to this
strategy).

6
 Matching pennies with perfect information
2’s Strategies:
HH = Head if 1 plays Head,
1 Head if 1 plays Tail;
HT = Head if 1 plays Head,
Head Tail Tail if 1 plays Tail;
2 TH = Tail if 1 plays Head,
2 Head if 1 plays Tail;
head tail head tail TT = Tail if 1 plays Head,
Tail if 1 plays Tail.
(-1,1) (1,-1) (1,-1) (-1,1)

Matching pennies with perfect information

2
1
HH HT TH TT

Head

Tail

7
 Matching pennies with Imperfect
information
1 2
1
Head Tail
Head Tail
2 Head (-1,1) (1,-1)
head tail head tail
Tail (1,-1) (-1,1)
(-1,1) (1,-1) (1,-1) (-1,1)

A game with nature

Left (5, 0)

1
Head
1/2 Right (2, 2)
Nature
(3, 3)
1/2 Left
Tail 2

Right
(0, -5)

8
 Mixed Strategy
Definition: A mixed strategy of a player is a
probability distribution over the set of his strategies.

Pure strategies: Si = {si1,si2,…,sik}

A mixed strategy: σi: S → [0,1] s.t.
σi(si1) + σi(si2) + … + σi(sik) = 1.

If the other players play s-i =(s1,…, si-1,si+1,…,sn), then

the expected utility of playing σi is
σi(si1)ui(si1,s-i) + σi(si2) ui(si2,s-i) + … + σi(sik) ui(sik,s-i).

How to play

9
 Dominance
s-i =(s1,…, si-1,si+1,…,sn)
Definition: A pure strategy si* strictly
dominates si if and only if
u i ( si* , s − i ) > u i ( si , s − i ) ∀ s−i .

A mixed strategy σi* strictly dominates si iff

σ i ( si1 )ui ( si1 , s−i ) + m + σ i ( sik )ui ( sik , s−i ) > ui ( si , s−i ) ∀si
A rational player never plays a strictly
dominated strategy.

Prisoners’ Dilemma
2
1 Cooperate Defect

Cooperate (5,5) (0,6)

Defect (6,0) (1,1)

10
 A game
2
1 L m R

T (3,0) (1,1) (0,3)

M (1,0) (0,10) (1,0)

B (0,3) (1,1) (3,0)

Weak Dominance
Definition: A pure strategy si* weakly dominates si
if and only if

u i ( si* , s − i ) ≥ u i ( si , s − i ) ∀ s−i .
and at least one of the inequalities is strict. A mixed
strategy σi* weakly dominates si iff
σ i ( si1 )ui ( si1 , s−i ) +  + σ i ( sik )ui ( sik , s−i ) > ui ( si , s−i ) ∀si
and at least one of the inequalities is strict.
If a player is rational and cautious (i.e., he assigns
positive probability to each of his opponents’
strategies), then he will not play a weakly
dominated strategy.

11
 Dominant-strategy equilibrium
Definition: A strategy si* is a dominant
strategy iff si* weakly dominates every
other strategy si.

Definition: A strategy profile s* is a

dominant-strategy equilibrium iff si* is a
dominant strategy for each player i.

If there is a dominant strategy, then it will be

played, so long as the players are …

Prisoners’ Dilemma
2
1 Cooperate Defect

Cooperate (5,5) (0,6)

Defect (6,0) (1,1)

12
 Second-price auction
• N = {1,2} buyers;
• The value of the house
for buyer i is vi;
• Each buyer i
simultaneously bids bi;
• i* with bi* = max bi gets
the house and pays the
second highest bid
p = maxj≠ibj.

Question
What is the probability that an nxn game has a
dominant strategy equilibrium given that the
payoffs are independently drawn from the
same (continuous) distribution on [0,1]?

13
 (2n-2)
(1/n)
1

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
1 2 3 4 5 6 7 8 9 10

Assume: Players are

rational and player 2
A game knows that 1 is rational.
1 is rational and 2 knows this:
2 L m R
1
L m R
T (3,0) (1,1) (0,3)
T (3,0) (1,1) (0,3)
B (0,3) (1,1) (3,0)
M (1,0) (0,10) (1,0) And 2 is rational:

B (0,3) (1,1) (3,0) L R

T (3,0) (0,3)
B (0,3) (3,0)

14
 Rationalizability
Eliminate all the strictly
dominated strategies.

Yes Any dominated strategy

In the new game?

No
Rationalizable strategies

The play is rationalizable, provided that …

Simplified price-competition
Firm 2
High Medium Low
Firm 1

High 6,6 0,10 0,8

Medium 10,0 5,5 0,8

Low 8,0 8,0 4,4

Dutta

15
A strategy profile is rationalizable when …

• Each player’s strategy is consistent with his

rationality, i.e., maximizes his payoff with respect
to a conjecture about other players’ strategies;
• These conjectures are consistent with the other
players’ rationality, i.e., if i conjectures that j will
play sj with positive probability, then sj maximizes
j’s payoff with respect to a conjecture of j about
other players’ strategies;
• These conjectures are also consistent with the
other players’ rationality, i.e., …
• Ad infinitum

16
 Lecture 5
Nash equilibrium & Applications

14.12 Game Theory

Muhamet Yildiz

Road Map
1. Rationalizability – summary
2. Nash Equilibrium
3. Cournot Competition
1. Rationalizability in Cournot Duopoly
4. Bertrand Competition
5. Commons Problem
6. Quiz
7. Mixed-strategy Nash equilibrium

1
 Dominant-strategy equilibrium
s-i =(s1,…, si-1,si+1,…,sn)
Definition: si* strictly dominates si iff
u i ( si* , s − i ) > u i ( si , s − i ) ∀ s−i ;
si* weakly dominates si iff u i ( s , s − i ) ≥ u i ( si , s − i ) ∀s−i
*
i
and at least one of the inequalities is strict.
Definition: A strategy si* is a dominant strategy iff
si* weakly dominates every other strategy si.
Definition: A strategy profile s* is a dominant-
strategy equilibrium iff si* is a dominant strategy
for each player i.
Examples: Prisoners’ Dilemma; Second-Price auction.

Question
What is the probability that an nxn game has a
dominant strategy equilibrium given that the
payoffs are independently drawn from the
same (continuous) distribution on [0,1]?

2
 (2n-2)
(1/n)
1

0.9

0.8

0.7

0.6

0.5

0.4

0.3

0.2

0.1

0
1 2 3 4 5 6 7 8 9 10

Rationalizability
Eliminate all the strictly
dominated strategies.

Yes Any dominated strategy

In the new game?

No
Rationalizable strategies

The play is rationalizable, provided that …

3
 Simplified price-competition
Firm 2
High Medium Low
Firm 1

High 6,6 0,10 0,8

Medium 10,0 5,5 0,8

Low 8,0 8,0 4,4

Dutta

A strategy profile is rationalizable when …

• Each player’s strategy is consistent with his

rationality, i.e., maximizes his payoff with respect
to a conjecture about other players’ strategies;
• These conjectures are consistent with the other
players’ rationality, i.e., if i conjectures that j will
play sj with positive probability, then sj maximizes
j’s payoff with respect to a conjecture of j about
other players’ strategies;
• These conjectures are also consistent with the
other players’ rationality, i.e., …
• Ad infinitum

4
 Stag Hunt

(2,2) (4,0)

(0,4) (6,6)

A summary
• If players are rational (and cautious), then they
play the dominant-strategy equilibrium whenever
it exists
– But, typically, it does not exist
• If it is common knowledge that players are
rational, then they will play a rationalizable
strategy-profile
– Typically, there are too many rationalizable strategies
• Now, a stronger assumption: The players are
rational and their conjectures are mutually known.

5
 Nash Equilibrium
Definition: A strategy-profile s* =(s1*,…,sn*) is a
Nash Equilibrium iff, for each player i, and for
each strategy si, we have

u i ( s1* , l , si*−1 , si* , si*+1 , l , s n* )

≥ u i ( s1* , l , si*−1 , si , si*+1 , l , s n* ),
i.e., no player has any incentive to deviate if he
knows what the others play.
??If players are rational, and their conjectures about
what the others play are mutually known, then
they must be playing a Nash equilibrium.

Stag Hunt

(2,2) (4,0)

(0,4) (6,6)

6
 Economic Applications
1. Cournot (quantity) Competition
1. Nash Equilibrium in Cournot duopoly
2. Nash Equilibrium in Cournot oligopoly
3. Rationalizability in Cournot duopoly
2. Bertrand (price) Competition
3. Commons Problem

Cournot Oligopoly
• N = {1,2,…,n} firms;
• Simultaneously, each firm i P
produces qi units of a good at
marginal cost c, 1
• and sells the good at price
P = max{0,1-Q}
where Q = q1+…+qn.
• Game = (S1,…,Sn; π1,…,πn)
Q
where Si = [0,∞∞),
1
πi(q1,…,qn) = qi[1-(q1+…+qn)-c] if q1+…+qn < 1,
-qic otherwise.

7
 Cournot Duopoly -- profit

qj=0.2
Profit c=0.2
0

qi(1-qj-c)
-cqi

-0.2
0 1
(1-qj-c)/2 1-qj-c

C-D – best responses

q2
• qiB(qj) = max{(1-qj-c)/2,0};
• Nash Equilibrium q*: q1=q1B(q2)

q1* = (1-q2*-c)/2;
q2* = (1-q1*-c)/2; q*
1− c
• q1* = q2* = (1-c)/3 2 q2=q2B(q1)

q1

1-c

8
 Cournot Oligopoly --Equilibrium
• q>1-c is strictly dominated, so q ≤ 1-c.
• πi(q1,…,qn) = qi[1-(q1+…+qn)-c] for each i.
• FOC: ∂π ( q , , q ) ∂[ qi (1 − q1 −  − qn − c )]
i 1 n
=
∂qi q=q * ∂qi q = q*

= (1 − q1* −  − qn* − c ) − qi* = 0.

• That is, 2q1* + q2* +  + qn* = 1 − c

q1* + 2q2* +  + qn* = 1 − c

q1* + q2* +  + nqn* = 1 − c
• Therefore, q1*=…=qn*=(1-c)/(n+1).

Cournot oligopoly – comparative statics

P

n=1

n=2
n=3
n=4
Q
c
1

9
 Rationalizability in Cournot Duopoly
q2

1-c

Assume that
players are
rational. 1− c
2

q1

1− c
2
1-c

Players are rational:

q2

1-c
Assume that
players know
this.
1− c
2

q1

1− c
2
1-c

10
 Players are rational and know
that players are rational
q2

1-c
Assume that
players know
this.
1− c
2

q1

1− c
2
1-c

Players are rational; players know that players

are rational; players know that players know
that players
q
are rational
2

1-c
Assume that
players know
this.
1− c
2

q1

1− c
2
1-c

11
 Rationalizability in Cournot duopoly
• If i knows that qj ≤ q, then qi ≥ (1-c-q)/2.
• If i knows that qj ≥ q, then qi ≤ (1-c-q)/2.
• We know that qj ≥ q0 = 0.
• Then, qi ≤ q1 = (1-c-q0)/2 = (1-c)/2 for each i;
• Then, qi ≥ q2 = (1-c-q1)/2 = (1-c)(1-1/2)/2 for each i;
• …
• Then, qn ≤ qi ≤ qn+1 or qn+1 ≤ qi ≤ qn where
qn+1 = (1-c-qn)/2 = (1-c)(1-1/2+1/4-…+(-1/2)n)/2.
• As n→∞, qn → (1-c)/3.

Bertrand (price) competition

• N = {1,2} firms.
• Simultaneously, each firm i sets a price pi;
• If pi < pj, firm i sells Q = max{1 – pi,0}
unit at price pi; the other firm gets 0.
• If p1 = p2, each firm sells Q/2 units at price
p1, where Q = max{1 – p1,0}.
• The marginal cost is 0.
 p1 (1 − p1 ) if p1 < p2

π 1 ( p1 , p2 ) =  p1 (1 − p1 ) / 2 if p1 = p2

 0 otherwise.

12
 Bertrand duopoly -- Equilibrium
Theorem: The only Nash equilibrium in the “Bertrand
game” is p* = (0,0).

Proof:
1. p*=(0,0) is an equilibrium.
2. If p = (p1,p2) is an equilibrium, then p = p*.
1. If p = (p1,p2) is an equilibrium, then p1 = p2...
• If pi > pj= 0, for sufficiently small ε>0, pj’ = ε is a better
response to pi for j. If pi > pj> 0, pi’ = pj is a better response
for i.
2. Given any equilibrium p = (p1,p2) with p1 = p2, p = p*.
• If p1 = p2>0, for sufficiently small ε>0, pj’ = pj - ε is a better
response to pj for i.

Commons Problem
• N = {1,2,…,n} players, each with unlimited
money;
• Simultaneously, each player i contributes xi
≥ 0 to produce y = x1+…xn unit of some
public good, yielding payoff
Ui(xi,y) = y1/2 – xi.

13
 Quiz
Each student i is to submit a real number xi.
We will pair the students randomly. For
each pair (i,j), if xi ≠ xj, the student who
submits the number that is closer to
(xi+xj)/4 gets 100; the other student gets 20.
If xi = xj, then each of i and j gets 50.

14
 Lectures 6-7
Nash Equilibrium
&
Backward Induction

14.12 Game Theory

Muhamet Yildiz

Road Map
1. Bertrand Competition
2. Commons Problem
3. Mixed-strategy Nash equilibrium
4. Bertrand competition with costly search
5. Backward Induction
6. Stackelberg Competition
7. Sequential Bargaining

1
 Bertrand (price) competition
• N = {1,2} firms.
• Simultaneously, each firm i sets a price pi;
• If pi < pj, firm i sells Q = max{1 – pi,0}
unit at price pi; the other firm gets 0.
• If p1 = p2, each firm sells Q/2 units at price
p1, where Q = max{1 – p1,0}.
• The marginal cost is 0.
 p1 (1 − p1 ) if p1 < p2

π 1 ( p1 , p2 ) =  p1 (1 − p1 ) / 2 if p1 = p2
 0 otherwise.


Bertrand duopoly -- Equilibrium

Theorem: The only Nash equilibrium in the “Bertrand
game” is p* = (0,0).

Proof:
1. p*=(0,0) is an equilibrium.
2. If p = (p1,p2) is an equilibrium, then p = p*.
1. If p = (p1,p2) is an equilibrium, then p1 = p2...
• If pi > pj= 0, for sufficiently small ε>0, pj’ = ε is a better
response to pi for j. If pi > pj> 0, pi’ = pj is a better response
for i.
2. Given any equilibrium p = (p1,p2) with p1 = p2, p = p*.
• If p1 = p2>0, for sufficiently small ε>0, pj’ = pj - ε is a better
response to pj for i.

2
 Commons Problem
• N = {1,2,…,n} players, each with unlimited
money;
• Simultaneously, each player i contributes xi
≥ 0 to produce y = x1+…xn unit of some
public good, yielding payoff
Ui(xi,y) = y1/2 – xi.

Stag Hunt

(2,2) (4,0)

(0,4) (5,5)

3
 Equilibrium in Mixed Strategies
What is a strategy?
– A complete contingent-plan of a player.
– What the others think the player might do under
various contingency.
What do we mean by a mixed strategy?
– The player is randomly choosing his pure
strategies.
– The other players are not certain about what he
will do.

Stag Hunt

(2,2) (4,0)

(0,4) (5,5)

4
Mixed-strategy equilibrium in Stag-Hunt game
5

• Assume: Player 2 thinks that, 4.5

with probability p, Player 1 4

targets for Rabbit. What is the 3.5

best probability q she wants to 3

play Rabbit?
2.5 4 - 2p

• His payoff from targeting 1.5

Rabbit: 1 5(1-p)

0.5
U2(R;p) = 2p + 4(1-p) 0
0 0.2 0.4 0.6 0.8 1
= 4-2p.
• From Stag:
U2(R;p) = 5(1-p)  0 if p < 1/3

• She is indifferent iff q ( p ) =  q ∈ [0,1] if p = 1/3
BR

4-2p = 5(1-p) iff p = 1/3.  1 if p > 1/3



Best responses in Stag-Hunt game

q

1/3

p
1/3

5
 Bertrand Competition with costly search
• N = {F1,F2,B}; F1, F2 Game:
are firms; B is buyer 1. Each firm i chooses price
• B needs 1 unit of good, p i;
worth 6; 2. B decides whether to
• Firms sell the good; check the prices;
Marginal cost = 0. 3. (Given) If he checks the
• Possible prices P = prices, and p1≠p2, he buys
{1,5}. the cheaper one;
• Buyer can check the otherwise, he buys from
prices with a small cost any of the firm with
c > 0. probability ½.

Bertrand Competition with costly

search
F2 F2
High Low F1 High Low
F1

High High

Low Low

Check Don’t Check

6
 Mixed-strategy equilibrium
• Symmetric equilibrium: Each firm charges
“High” with probability q;
• Buyer Checks with probability r.
• U(check;q) = q21 + (1-q2)5 – c = 5 - 4 q2 – c;
• U(Don’t;q) = q1 + (1-q)5 = 5 - 4 q;
• Indifference: 4q(1-q) = c; i.e.,
• U(high;q,r) = 0.5(1-r(1-q))5;
• U(low;q,r) = qr1 + 0.5(1-qr)
• Indifference = r = 4/(5-4q).

Dynamic Games of Perfect

Information
&
Backward Induction

7
 Definitions
Perfect-Information game is a game in which all
the information sets are singleton.
Sequential Rationality: A player is sequentially
rational iff, at each node he is to move, he
maximizes his expected utility conditional on that
he is at the node – even if this node is precluded
by his own strategy.
In a finite game of perfect information, the common
knowledge of sequential rationality gives
“Backward Induction” outcome.

A centipede game
1 A 2 α 1 a
(1,-5)

D δ d

(4,4) (5,2) (3,3)

8
 Backward Induction
Take any pen-terminal node

Pick one of the payoff vectors (moves) that

gives ‘the mover’ at the node the highest payoff

Assign this payoff to the node at the hand;

Eliminate all the moves and the

terminal nodes following the node
Yes
Any non-terminal
node
No
The picked moves

Battle of The Sexes with perfect information

1

T B

2 2

L R L R

(2,1) (0,0) (0,0) (1,2)

9
 Note

• There are Nash equilibria that are different

from the Backward Induction outcome.
• Backward Induction always yields a Nash
Equilibrium.
• That is, Sequential rationality is stronger
than rationality.

Matching Pennies (wpi)

Head
Tail
2
2
head tail head tail

(-1,1) (1,-1) (1,-1) (-1,1)

10
 Stackelberg Duopoly
Game:
N = {1,2} firms w MC = 0; P
1. Firm 1 produces q1 units
1
2. Observing q1, Firm 2 produces
q2 units
3. Each sells the good at price
P = max{0,1-(q1+q2)}.
Q
1
πi(q1, q2) = qi[1-(q1+q2)] if q1+ q2 < 1,
0 otherwise.

“Stackelberg equilibrium”
P
• If q1 > 1, q2*(q1) = 0.
• If q1 ≤ 1, q2*(q1) = (1-q1)/2. 1
• Given the function q2*, if q1 ≤ 1
π1(q1;q2*(q1)) = q1[1-(q1+ (1-q1)/2)]

= q1 (1-q1)/2;
0 otherwise.
• q1* = ½. 1

• q2*(q1*) = ¼.

11
 Sequential Bargaining

D • N = {1,2}
1
• X = feasible
expected-utility
pairs (x,y ∈X )
• Ui(x,t) = δitxi
• d = (0,0) ∈ D
disagreement
payoffs
1

Timeline – 2 period
At t = 1, At t = 2,
– Player 2 offers some (x2,y2),
– Player 1 offers some (x1,y1),
– Player 1 Accept or Rejects the
– Player 2 Accept or Rejects the
offer
offer
– If the offer is Accepted, the
– If the offer is Accepted, the
game ends yielding payoff
game ends yielding (x1,y1),
δ(x2,y2).
– Otherwise, we proceed to date
– Otherwise, the game end
2.
yielding d = (0,0).

1 (0,0)
2 2 (x2,y2)
1 (x1,y1) Reject
Reject
Accept (δx2,δy2)
Accept (x1,y1)

12
 1 (0,0)
2 2 (x2,y2)
1 (x1,y1) Reject
Reject
Accept (δx2,δy2)
Accept (x1,y1)

At t = 2,
•Accept iff y2 ≥ 0.
•Offer (0,1).
At t = 1,
•Accept iff x2 ≥ δ.
•Offer (1−δ,δ).

Timeline – 2n period
T = {1,2,…,2n-1,2n}
If t is odd,
– Player 1 offers some
(xt,yt),
– Player 2 Accept or
Rejects the offer
– If the offer is Accepted,
the game ends yielding
δt(xt,yt),
– Otherwise, we proceed
to date t+1.
If t is even
– Player 2 offers some
(xt,yt),
– Player 1 Accept or Rejects
the offer
– If the offer is Accepted,
the game ends yielding
payoff (xt,yt),
– Otherwise, we proceed to
date t+1, except at t = 2n,
when the game end
yielding d = (0,0).

13
 Equilibrium
• Scientific Word

14
 Lectures 8
Subgame-perfect Equilibrium
&
Applications

14.12 Game Theory

Muhamet Yildiz

Road Map
1. Subgame-perfect Equilibrium
1. Motivation
2. What is a subgame?
3. Definition
4. Example
2. Applications
1. Bank Runs
2. Tariffs & Intra-industry trade
3. Quiz

1
 A game
1

E X
1
(2,6)
T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Sequential Bargaining

D • N = {1,2}
1
• X = feasible
expected-utility
pairs (x,y ∈X )
• Ui(x,t) = δitxi
• d = (0,0) ∈ D
disagreement
payoffs
1

2
 Timeline – ∞ period
T = {1,2,…, n-1,n,…}
If t is odd,
– Player 1 offers some
(xt,yt),
– Player 2 Accept or
Rejects the offer
– If the offer is Accepted,
the game ends yielding
δt(xt,yt),
– Otherwise, we proceed
to date t+1.
If t is even
– Player 2 offers some
(xt,yt),
– Player 1 Accept or Rejects
the offer
– If the offer is Accepted,
the game ends yielding
payoff (xt,yt),
– Otherwise, we proceed to
date t+1.

Backward induction
• Can be applied only in perfect information
games of finite horizon.

How can we extend this notion to infinite

horizon games, or to games with imperfect
information?

3
 A subgame
A subgame is part of a game that can be
considered as a game itself.
• It must have a unique starting point;
• It must contain all the nodes that follow the
starting node;
• If a node is in a subgame, the entire
information set that contains the node must
be in the subgame.

A game
1 A 2 α 1 a
(1,-5)

D δ d

(4,4) (5,2) (3,3)

4
 And its subgames

1 a 2 α 1 a
(1,-5) (1,-5)

d δ d

(3,3) (5,2) (3,3)

A game
1

E X
1
(2,6)
T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

5
 Definitions
A substrategy is the restriction of a strategy to
a subgame.
A subgame-perfect Nash equilibrium is a
Nash equilibrium whose substrategy profile
is a Nash equilibrium at each subgame.

Example
1

E X
1
(2,6)
T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

6
A “Backward-Induction-like” method
Take any subgame with no proper subgame

Compute a Nash equilibrium for this subgame

Assign the payoff of the Nash equilibrium to

the starting node of the subgame

Eliminate the subgame

Yes Any non-terminal

node
No
The moves computed as a part of
any (subgame) Nash equilibrium

Theorem

In a finite, perfect-information game, the set

of subgame-perfect equilibria is the set of
strategy profiles that are computed via
backward induction.

7
A subgame-perfect equilibrium?

X
1 (2,6)

T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Bank Run
1
R > D > r > D/2
W DW
2

W DW
DW W
1
(r,r) (D,2r-D) (2r-D,D)
W DW
2

W DW
DW W

(R,R) (2R-D,D) (D,2R-D) (R,R)

8
 Lectures 9
Applications of Subgame-perfect
Equilibrium
&
Forward Induction

14.12 Game Theory

Muhamet Yildiz

Road Map

1. Applications
1. Tariffs & Intra-industry trade
2. Infinite horizon bargaining – Single-
deviation principle
2. Forward Induction – Examples
3. Finitely Repeated Games
4. Quiz

1
 Single-Deviation principle
Definition: An extensive-form game is continuous at
infinity iff, given any ε > 0, there exists some t such
that, for any two path whose first t arcs are the same,
the payoff difference of each player is less than ε.
Theorem: Let G be a game that is continuous at infinity.
A strategy profile s = (s1,s2,…,sn) is a subgame-perfect
equilibrium of G iff, at any information set, where a
player i moves, given the other players strategies and
given i’s moves at the other information sets, player i
cannot increase his conditional payoff at the
information set by deviating from his strategy at the
information set.

Sequential Bargaining

D • N = {1,2}
1
• D = feasible
expected-utility
pairs (x,y ∈D )
• Ui(x,t) = δitxi
• d = (0,0) ∈ D
disagreement
payoffs
1

2
 Timeline – ∞ period
T = {1,2,…, n-1,n,…}
If t is odd,
– Player 1 offers some
(xt,yt),
– Player 2 Accept or
Rejects the offer
– If the offer is Accepted,
the game ends yielding
δt(xt,yt),
– Otherwise, we proceed
to date t+1.
If t is even
– Player 2 offers some
(xt,yt),
– Player 1 Accept or Rejects
the offer
– If the offer is Accepted,
the game ends yielding
payoff δt(xt,yt),
– Otherwise, we proceed to
date t+1.

SPE of ∞-period bargaining

Theorem: At any t, proposer offers the other
player δ/(1+δ), keeping himself 1/(1+δ),
while the other player accept an offer iff he
gets δ/(1+δ).
“Proof:” Single-deviation principle: Take any
date t, at which i offers, j accepts/rejects.
According to the strategies in the
continuation game, at t+1, j will get 1/(1+δ).
Hence, j accepts an offer iff she gets at least
δ/(1+δ). i must offer δ/(1+δ).

3
 Forward Induction
Strong belief in rationality: At any history
of the game, each agent is assumed to be
rational if possible. (That is, if there are two
strategies s and s’ of a player i that are
consistent with a history of play, and if s is
strictly dominated but s’ is not, at this
history no player j believes that i plays s.)

Table for the bidding game

Ui = 20(2+2minjbidj – bidi)

min 1 2 3
bid
1 60 - -

2 40 80 -

3 20 60 100

4
 Nash equilibria of bidding game
• 3 equilibria: s1 = everybody plays 1; s2 = everybody
plays 2; s3 = everybody plays 3.
• Assume each player trembles with probability ε < 1/2,
and plays each unintended strategy w.p. ε/2, e.g., w.p.
ε/2, he thinks that such other equilibrium is to be played.
– s3 is an equilibrium iff

– s2 is an equilibrium iff

– s1 is an equilibrium iff

0.8

0.6

0.4

0.2

0.047
0

-0.2
n
(1-ε/2) -1/2
-0.4

-0.6

-0.8 n n
(1-ε) +(1-ε/2) -1

-1
0 0.032 0.05 0.1 0.15 0.2

5
 Bidding game with entry fee
Each player is first to decide min 1 2 3
whether to play the Bid
bidding game (E or X); if 1 60 - -
he plays, he is to pay a fee 2 40 80 -
p > 60.
3 20 60 100

For each m =1,2,3, ∃SPE: (m,m,m) is played in the bidding

game, and players play the game iff 20(2+m) ≥ p.
Forward induction: when 20(2+m) < p, (Em) is strictly dominated
by (Xk). After E, no player will assign positive probability to
min bid ≤ m. FI-Equilibria: (Em,Em,Em) where 20(2+m) ≥ p.
What if an auction before the bidding game?

Burning Money
1
0 D BB BS SB SS

B S B S 0B
B 3,1 0,0 B 2,1 -1,0 0S
S 0,0 1,3 S -1,0 0,3 DB

DS

O T H E R

6
 Repeated Games

Entry deterrence
1 Enter 2 Acc.
(1,1)

X Fight

(0,2) (-1,-1)

7
 Entry deterrence, repeated twice

1 Enter 2 Acc. 1 Enter 2 Acc.

(2,2)

X Fight X Fight
Acc. 2 Enter 1
(1,3) (1,3) (0,0)
1 Enter 2 Acc.
Fight X (0,0)

X Fight
(-1,1) (0,4)

(-1,1) (-2,-2)

8
Lectures 10 -11
Repeated Games

14.12 Game Theory

Muhamet Yildiz
 Road Map
1. Forward Induction – Examples
2. Finitely Repeated Games with observable actions
1. Entry-Deterrence/Chain-store paradox
2. Repeated Prisoners’ Dilemma
3. A general result
4. When there are multiple equilibria
3. Infinitely repeated games with observable actions
1. Discounting / Present value
2. Examples
3. The Folk Theorem
4. Repeated Prisoners’ Dilemma, revisited –tit for tat
5. Repeated Cournot oligopoly
4. Infinitely repeated games with unobservable actions
 Forward Induction
Strong belief in rationality: At any history
of the game, each agent is assumed to be
rational if possible. (That is, if there are two
strategies s and s’ of a player i that are
consistent with a history of play, and if s is
strictly dominated but s’ is not, at this
history no player j believes that i plays s.)
 Bidding game with entry fee
Each player is first to decide min 1 2 3
whether to play the Bid
bidding game (E or X); if 1 60 - -
he plays, he is to pay a fee 2 40 80 -
p > 60.
3 20 60 100

For each m =1,2,3, ∃SPE: (m,m,m) is played in the bidding

game, and players play the game iff 20(2+m) ≥ p.
Forward induction: when 20(2+m) < p, (Em) is strictly dominated
by (Xk). After E, no player will assign positive probability to
min bid ≤ m. FI-Equilibria: (Em,Em,Em) where 20(2+m) ≥ p.
What if an auction before the bidding game?
 Burning Money
1
0 D BB BS SB SS

B S B S 0B
B 3,1 0,0 B 2,1 -1,0 0S
S 0,0 1,3 S -1,0 0,3 DB

DS

O T H E R
Repeated Games
 Entry deterrence
1 Enter 2 Acc.
(1,1)

X Fight

(0,2) (-1,-1)
 Entry deterrence, repeated twice,
many times
1 Enter 2 Acc. 1 Enter 2 Acc.
(2,2)

X Fight X Fight
Acc. 2 Enter 1
(1,3) (1,3) (0,0)
1 Enter 2 Acc.
Fight X (0,0)

X Fight
(-1,1) (0,4)

(-1,1) (-2,-2)
What would happen if repeated n times?
Prisoners’ Dilemma, repeated twice,
many times
• Two dates T = {0,1};
• At each date the prisoners’ dilemma is played:

C D
C 5,5 0,6
D 6,0 1,1

• At the beginning of 1 players observe the strategies at 0.

Payoffs= sum of stage payoffs.
 Twice-repeated PD
1
C D
2
C D C D

1 1 1 1
D C D C
C C D D
2 2 2 2

C D C D C D C D D C D
D C D C C

10 5 11 6 5 0 6 1 11 6 12 7 6 1 7 2
10 11 5 6 11 12 6 7 5 6 0 1 6 7 1 2

What would happen if T = {0,1,2,…,n}?

 A general result
• G = “stage game” = a finite game
• T = {0,1,…,n}
• At each t in T, G is played, and players remember
which actions taken before t;
• Payoffs = Sum of payoffs in the stage game.
• Call this game G(T).
Theorem: If G has a unique subgame-perfect
equilibrium s*, G(T) has a unique subgame-
perfect equilibrium, in which s* is played at each
stage.
 With multiple equilibria
T = {0,1} s* =
•At t = 0, each i play Mi;
2
1 L M2 R •At t = 1, play (B,R) if (M1,M2)
at t = 0, play (T,L) otherwise.
T 1,1 5,0 0,0
M1 0,5 4,4 0,0 L M2 R
B 0,0 0,0 3,3 T 2,2 6,1 1,1
M1 1,6 7,7 1,1
B 1,1 1,1 4,4
 Infinitely repeated Games with
observable actions
• T = {0,1,2,…,t,…}
• G = “stage game” = a finite game
• At each t in T, G is played, and players
remember which actions taken before t;
• Payoffs = Discounted sum of payoffs in the
stage game.
• Call this game G(T).
 Definitions
The Present Value of a given payoff stream π =
(π0,π1,…,πt,…) is
PV(π;δ) = Σ∞t=1 δtπt = π0 + δπ1 + … + δtπt +…
The Average Value of a given payoff stream π is
(1−δ)PV(π;δ) = (1−δ)Σ∞t=1 δtπt
The Present Value of a given payoff stream π at t is
PVt(π;δ) = Σ∞s=t δs-t πs = πt + δπt+1 + … + δsπt+s +…
 Infinite-period entry deterrence

1 Enter 2 Acc.
(1,1) Strategy of Entrant:
Enter iff
X Fight
Accomodated before.
Strategy of Incumbent:
(0,2) (-1,-1)
Accommodate iff
accomodated before.
Incumbent: Entrant:
• V(Acc.) = VA = 1/(1−δ); • Accommodated
• V(Fight) = VF = 2/(1−δ); – Enter => 1+VAE
• Case 1: Accommodated before. – X => 0 +VAE
– Fight => -1 + δVA • Not Acc.
– Acc. => 1 + δVA. – Enter =>-1+VFE
• Case 2: Not Accommodated – X => 0 +VFE
– Fight => -1 + δVF
– Acc. => 1 + δVA
– Fight Ù -1 + δVF ≥ 1 + δVA
ÙVF − VA = 1/(1−δ) ≥ 2/δ
Ùδ ≥ 2/3.
 Infinitely-repeated PD

C D • VD = 1/(1−δ);
C 5,5 0,6 • VC = 5/(1−δ) = 5VD;
D 6,0 1,1 • Defected before (easy)
• Not defected
A Grimm Strategy: – D =>
Defect iff someone – C =>
defected before. –CÙ
 Tit for Tat
• Start with C; thereafter, play what the other
player played in the previous round.
• Is (Tit-for-tat,Tit-for-tat) a SPE?

• Modified: Start with C; if any player plays

D when the previous play is (C,C), play D
in the next period, then switch back to C.
 Folk Theorem
Definition: A payoff vector v = (v1,v2,…,vn) is feasible
iff v is a convex combination of some pure-strategy
payoff-vectors, i.e.,
v = p1u(a1) + p2u(a2) +…+ pku(ak),
where p1 + p2 +…+ pk = 1, and u(aj) is the payoff
vector at strategy profile aj of the stage game.
Theorem: Let x = (x1,x2,…,xn) be s feasible payoff
vector, and e = (e1,e2,…,en) be a payoff vector at
some equilibrium of the stage game such that xi > ei
for each i. Then, there exist δ < 1 and a strategy
profile s such that s yields x as the expected
average-payoff vector and is a SPE whenever δ > δ.
 Folk Theorem in PD
C D • A SPE with PV
C 5,5 0,6 (1.1,1.1)?
D 6,0 1,1 – With PV (1.1,5)?
– With PV (6,0)?
– With PV (5.9,0.1)?
 Infinitely-repeated
Cournot oligopoly
• N firms, MC = 0; P = max{1-Q,0};
• Strategy: Each is to produce q = 1/(2n); if any
firm defects produce q = 1/(1+n) forever.
• VC =
• VD =
• V(D|C) =
• Equilibrium Ù
 1

0.95

0.9

0.85

0.8

0.75

0.7

0.65

0.6

0.55

0.5
0 20 40 60 80 100
 1

0.95

0.9

0.85

0.8

0.75

0.7

0.65

0.6

0.55

0.5
0 200 400 600 800 1000
 IRCD (n=2)
• Strategy: Each firm is to produce q*; if any one
deviates, each produce 1/(n+1) thereafter.
• VC = q*(1-2q*)/(1-δ);
• VD = 1/(9(1-δ));
δ
• VD|C = max q(1-q*-q) +δVD = (1 − q *) / 4 +
2

9(1 − δ )
• Equilibrium iff
q * (1 − 2q *) ≥ (1 − δ )(1 − q *) / 4 + δ / 9
2

• Ù 9 − 5δ
q* ≥
3(9 − δ )
 x = δ, y = (3-5/3 δ)/(9-δ )
0.4

0.3

0.2
y

0.1

0
0 0.2 0.4 0.6 0.8 1
x
 Carrot and Stick
Produce ¼ at the beginning; at ant t > 0, produce ¼ if both
produced ¼ or both produced x at t-1; otherwise, produce
x.
Two Phase: Cartel & Punishment
VC = 1/8(1-δ). Vx = x(1-2x) + δVC.
VD|C = max q(1-1/4-q) + δVX = (3/8)2 + δVX
VD|x = max q(1-x-q) + δVX = (1-x)2/4 + δVX
VC ≥ VD|C Ù VC ≥ (3/8)2 + δ2VC + δ x(1-2x)
Ù (1-δ2) VC - (3/8)2 ≥ δ x(1-2x) Ù(1+δ)/8 - (3/8)2 ≥ δ x(1-2x)
VX ≥ VD|C Ù (1-δ)Vx ≥ (1-x)2/4 Ù (1-δ)(x(1-2x) + δ/8(1-δ)) ≥ (1-x)2/4
Ù (1-δ)x(1-2x) + δ/8 ≥ (1-x)2/4
2x2 – x + 1/8 – 9/64δ ≥ 0
(9/4-2δ)x2 – (3-2δ)x +δ/8(1-δ) ≤ 0
 Lectures 12-13
Incomplete Information
Static Case

14.12 Game Theory

Muhamet Yildiz

Road Map
1. Examples
2. Bayes’ rule
3. Definitions
1. Bayesian Game
2. Bayesian Nash Equilibrium
4. Mixed strategies, revisited
5. Economic Applications
1. Cournot Duopoly
2. Auctions
3. Double Auction

1
 Incomplete information

We have incomplete (or asymmetric)

information if one player knows something
(relevant) that some other player does not
know.

An Example
W ork (1, 2)
W
Firm H ire
Shirk
H igh p (0, 1)

N ature D o not (0, 0)

hire
W ork (1, 1)
W
Low 1-p H ire
Shirk
(-1, 2)
D o not
hire (0, 0)

2
 The same example
Work (1, 2)
W
High p (0, 1)
Nature Shirk
Hire hire

Firm Work (1, 1)

Low
1-p
W
Do not Shirk
(-1, 2)
(0, 0)

Another Example Buy (p, 2-p)

B

p Don’t
Seller (0, 0)
p’ (p’,2-p’)
High 0.5 Buy

Nature B
Don’t (0, 0)
Buy (p, 1-p)
B
Low .5 p
What would you ask Don’t (0,0)
if you were to choose
p’ Buy (p’, 1-p’)
p from [0,4]?
B
Don’t (0, 0)

3
 Same “Another Example”
Buy (p, 2-p)
B
High 0.5
Don’t
Nature (0, 0)
Buy (p’,2-p’)
p
Low .5
B
Seller Don’t (0, 0)
Buy (p, 1-p)
B
p’ Nature High 0.5
What would you ask Don’t (0,0)
if you were to choose
Buy (p’, 1-p’)
p from [0,4]? Low .5
B
Don’t (0, 0)

Bayes’ Rule

Prob(A and B)
• Prob(A|B) =
Prob(B)
• Prob(A and B) = Prob(A|B)Prob(B) = Prob(B|A)Prob(A)

Prob(B|A)Prob(A)
• Prob(A|B) =
Prob(B)

4
 Example
p • Prob(Work|Success) =
Work Success
µ µp/[µp + (1−µ)(1-p)]
1-p • Prob(Work|Failure) =
1-p (1-µ)p/[µ(1−p) + (1−µ)p]

Shirk Failure
1−µ p

0.9
P(W|S)
0.8

0.7
P (w|S ),P (W|F)

0.6

0.5
P(W|F)
0.4

0.3

0.2

0.1

0
0 0.2 0.4 0.6 0.8 1
µ

5
 Bayesian Game (Normal Form)
A Bayesian game is a list
G = {A1,…,An;T1,…,Tn;p1,…,pn;u1,…,un}
where
• Ai is the action space of i (ai in Ai)
• Ti is the type space of i (ti)
• pi(t-i|ti) is i’s belief about the other players
• ui(a1,…,an;t1,…,tn) is i’s payoff.

An Example
Work (1, 2)
W TFirm={tf};
Firm Hire TW = {High,Low}
Shirk AFirm = {Hire, Don’t}
High p (0, 1) AW = {Work,Shirk}
Nature Do not (0, 0) pF(High) = p
hire pF(Low) = 1-p
Work (1, 1)
W
Low 1-p Hire
Shirk
(-1, 2)
Do not
hire (0, 0)

6
 Bayesian Nash equilibrium
A Bayesian Nash equilibrium is a Nash equilibrium of
a Bayesian game.
Given any Bayesian game G =
{A1,…,An;T1,…,Tn;p1,…,pn;u1,…,un}
a strategy of a player i in a is any function si:Ti → Ai;
A strategy profile s* = (s1*,…, s1*) is a Bayesian Nash
equilibrium iff si*(ti) solves
max ∑ u (s (t ),..., s (t ), a , s (t ),..., s (t ); t )p (t | ti )
* * * *
i 1 1 i −1 i −1 i i +1 i +1 n n i −i
ai ∈Ai t− i ∈T− i

i.e., si* is a best response to s-i*.

An Example
Work (1, 2)
W TFirm={tf};
Firm Hire TW = {High,Low}
Shirk AFirm = {Hire, Don’t}
High p (0, 1) AW = {Work,Shirk}
Nature Do not (0, 0) pF(High) = p >1/2
hire pF(Low) = 1-p
Work (1, 1)
W sF* = Hire,
Low 1-p Hire
sF* (High) = Work
Shirk sF* (Low) = Shirk
(-1, 2)
Do not
hire (0, 0) Another equilibrium?

7
 Stag Hunt, Mixed Strategy

(2,2) (4,0)

(0,4) (6,6)

Mixed Strategies
• t and v are iid with uniform
distribution on [−ε,ε].
• t and v are privately known by
1 and 2, respectively, i.e., are
types of 1 and 2, respectively.
2+t,2+v 4+t,0 • Pure strategy:
– s1(t) = Rabbit iff t > 0;
0,4+v 6,6 – s2(v) = Rabbit iff t > 0.
• p = Prob(s1(t)=Rabbit|v) =
Prob(t > 0) = 1/2.
U1(R|t) = t +2q+4(1-q) = t + 4 – 2q • q = Prob(s2(v)=Rabbit|t) =
U1(S|t) = 6(1-q); 1/2.
U1(R|t) > U1(S|t)
t+4–2q > 6(1-q)

t > 6-6q+2q-4 = 2 – 4q = 0.

8
 Economic Applications
with Incomplete
Information
14.12 Game Theory
Muhamet Yildiz

Road Map
1. Cournot duopoly with Incomplete Informa-
tion
2. A ¿rst price auction
3. A double auction
4. Quiz

1
1 Cournot duopoly with
Incomplete Information
 Demand:
 E' ' @  '
where ' ' ^ n ^2.
 The marginal cost of Firm 1 = S common
knowledge.
 Firm 2’s marginal cost:
SM with probaility w,
Su with probaility   w
its private information.
 Each ¿rm maximizes its expected pro¿t.

2
1.1 Bayesian Nash Equilibrium
Firm 2 of high type:
4@ E  SM ^2 ' 4@ d@  ^  ^2  SM o ^2
^5 ^5

@  ^  SM
^2ESM 
' (*)
2
Firm 2 of low type:

4@ d@  ^  ^2  Suo ^2,

^5
@  ^  Su
^2ESu '  (**)
2
Firm 1:

4@ w d@  ^  ^2ESM   So ^
^4
n E  w d@  ^  ^2ESu  So ^

w d@  ^2ESM   So n E  w d@  ^2ESu  So
^ '
2
(***)

3
 Solve *, **, and *** for ^c ^2ESuc ^2ESM .
3 4 5 6 3 4
^ 2 w w @S
C ^2ESM  D ' 7  2 f 8 C @  SM D (
^2ESu  f 2 @  Su

@  2SM n S E  wESM  Su

^2ESM  ' n
 S
 @  2Su n S wESM  Su
^2 ESu ' 
 S
@  2S n wSM n E  wSu
^ '


4
2 A First-price Auction
 One object, two bidders
  ' Valuation of bidder i iid with uniform
distribution over dfc o.
 Simultaneously, each bidder  submits a bid
K, then the highest bidder wins the object
and pays her bid.
 The payoffs: ;
?   K if K : K c
EKc K2c c 2 ' lK l
if K ' K c
= 2
f if K K 

 Objective of :
4@ . dEKc K2c c 2o
Kl
where
. do ' E  K hiK : K E j

n E  K hiK ' K E j
2

5
2.1 Symmetric, linear equilib-
rium

K ' @ n S 
Then,
hiK ' K E j ' f
Equilibrium condition: @  K  .
Hence,

. do ' E  K hiK  @ n S j

K  @
' E  K hi  j
S
K  @
' E  K  
S
FOC:
 ln@
if   @
K ' 2 (1)
@ if  @
Therefore,


K ' 
2
6
2.2 Any symmetric equilibrium

K ' K E
Hence,

. do ' E  K hiK  KE j

' E  K hi  K EKj
' E  KK EK 
FOC (Y*YK ' f):

 _K EK
K EK n E  K ' f
_K

 n E  K E 3 ' f
K E
K3 E  n K E ' 
_ dK E o
' 
_
K E  ' 2*2 n SJ?r|
K E ' *2 n SJ?r|*
K Ef ' f, =: cons = 0.
K E ' *2

7
3 Double Auction
1. Simultaneously, Seller names Rr and Buyer
names RK.
a. If RK Rr, then no trade
Re nRv
b. if RK  Rr, trade at price R ' 2
.
2. Valuations are private information: K, r
iid w/ uniform on dfc o.
3. Payoffs: 
K  RenR v
if RK  Rr
K ' 2
f otherwise
 RenRv
 r if RK  Rr
r ' 2
f otherwise
4. The buyer’s
 problem: 
RK n RrEr
4@ . K  G RK  RrEr 
Re 2

5. The seller’s
 problem: 
Rr n RKEK
4@ .  r G RKEK  Rr 
Rv 2

8
 An Equilibrium:

f if K  f
RK ' c
f otherwise

f if r  f
Rr ' 
 otherwise

vb
v b /v s

Trade

Efficient
X
not to trade

0 vS
Inefficient
lack of trade

9
Equilibrium with linear strategies:
RK ' @K n SKK
Rr ' @r n Srr
RK  @r
RK  Rr Er ' @r n Srr +, r  
Sr

Rr  @K
Rr  RK EK ' @K n SKK +, K  
SK

10
  
RK n RrEr
. dKo ' . K  G RK  RrEr
2
] e v
s d 
fv RK n RrEr
' K  _r
f 2
] e vk
RK n @r n Srr l
s d
fv
' K  _r
f 2
  ] sedv
RK  @r RK n @r Sr fv
' K   r_r
Sr 2 2 f
 2
RK  @r  RK n @r  Sr RK  @r
' K  
Sr  2 e Sr
RK  @r RK n @r RK  @r
' K  
Sr  2  e
RK  @r RK n @r
' K  
Sr e
F.O.C. (4@ Re . dKo):
 RK n @r ERK  @r
K   'f
Sr e eSr
i.e.,
2 
RK ' K n @r (2)
 
11
 Similarly,
 
Rr n RKEK
. dro ' .  r G RKEK  Rr
2
]  k l
Rr n @K n SKK
'  r _K
sv de 2
 fe k l ] 
Rr  @K Rr n @K SK
'   r n K_K
SK 2 2 f e
sv d

 k l
e
Rr  @K Rr n @K
'   r
# SK 2 $
2
SK Rr  @K
n 
e SK
  
Rr  @K Rr n @K SK Rr  @K
'   r n n
 SK   2 e  e
Rr  @K Rr n @K SK
'   r n
SK e e

12
 F.O.C.
 (4@ Rv . dro):  
 Rr n @K   Rr  @K
  r n n  'f
SK e e e SK
 
Rr n @K SK 
  r n n ESK  ERr  @K ' fc
e e e

Rr @K SK  @K n SK
'  n r  n ESK n @K ' r n
2 e e e 2

i.e.,
2 @K n SK
Rr ' r n  (3)
 
 @K ' @r*
 @r ' @K* n 2*b
 Hence, b@r ' @r n 2,
 @r ' *e @K ' *2.
2 
RK ' K n (4)
 2
2 
Rr ' r n  (5)
 e

13
 We have trade iff
RK  Rr
iff
2  2 
K n  r n
 2  e
iff  
    
K  r   ' ' 
2 e 2 2S e

3/4

ps

1/4

pb
1/12

14
 Lectures 15-18
Dynamic Games with
Incomplete Information

14.12 Game Theory

Muhamet Yildiz

Road Map
1. Examples
2. Sequential Rationality
3. Perfect Bayesian Nash Equilibrium
4. Economic Applications
1. Sequential Bargaining with incomplete
information
2. Reputation

1
 An Example
Work (1, 2)
W
Firm Hire
Shirk
High 0.7 (0, 1)
Nature Do not (0, 0)
hire
Work (1, 1)
W
Low 0.3 Hire
Shirk
(-1, 2)
Do not
hire (0, 0)

What is wrong with this equilibrium?

Work (1, 2)
W
Firm Hire
Shirk
High .7 (0, 1)
Nature Do not (0, 0)
hire
Work (1, 1)
W
Low .3 Hire
Shirk
(-1, 2)
Do not
hire (0, 0)

2
What is wrong with this equilibrium?
X
1 (2,6)

T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Beliefs
X
• Beliefs of an agent at a given
1 (2,6)
information set is a
probability distribution on T
the information set. B
• For each information set, we
µ 1−µ
must specify the beliefs of 2
the agent who moves at that
L R L R
information set.
(0,1) (3,2) (-1,3) (1,5)

3
 Sequential Rationality
A player is said to be sequentially rational
iff, at each information set he is to move, he
maximizes his expected utility given his
beliefs at the information set (and given that
he is at the information set) – even if this
information set is precluded by his own
strategy.

An Example
Work (1, 2)
W
Firm Hire
Shirk
High 0.7 (0, 1)
Nature Do not (0, 0)
hire
Work (1, 1)
W
Low 0.3 Hire
Shirk
(-1, 2)
Do not
hire (0, 0)

4
 Another example
X
1 (2,6)

T
B

2
L R L R
(0,1) (3,2) (-1,3) (1,5)

Example

T
B

.1 .9
2
L R L R
(0,10) (3,2) (-1,3) (1,5)

5
 “Consistency”
Definition: Given any (possibly mixed)
strategy profile s, an information set is said
to be on the path of play iff the
information set is reached with positive
probability if players stick to s.
Definition: Given any strategy profile s and
any information set I on the path of play of
s, a player’s beliefs at I is said to be
consistent with s iff the beliefs are derived
using the Bayes’ rule and s.

Example

T
B

2
L R L R
(0,10) (3,2) (-1,3) (1,5)

6
 Example
1

E X
2
2
T 0
B 0

3
L R L R

1 3 0 0
2 3 1 1
1 3 2 1

“Consistency”
• Given s and an information set I, even if I is
off the path of play, the beliefs must be
derived using the Bayes’ rule and s
“whenever possible,” e.g., if players tremble
with very small probability so that I is on
the path, the beliefs must be very close to
the ones derived using the Bayes’ rule and
s.

7
 Example
1

E X
2
2
T 0
B 0

3
L R L R

1 3 0 0
2 3 1 1
1 3 2 1

Perfect Bayesian Nash Equilibrium

A Perfect Bayesian Nash Equilibrium is a pair
(s,b) of strategy profile and a set of beliefs
such that
1. Strategy profile s is sequentially rational
given beliefs b, and
2. Beliefs b are consistent with s.
Nash Subgame-perfect
Bayesian Nash Perfect Bayesian

8
 Example
1

E X
2
2
T 0
B 0

3
L R L R

1 3 0 0
2 3 1 1
1 3 2 1

Beer – Quiche
0 1
1 du l 1
el e
beer quiche du

2 t {.1} don 3
’
0 don tw
’t
0

1 0
0 ts
0
el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

9
 Example
1 2 1
(1,-5)
.9

(4,4) (5,2) (3,3)

.1
1 2 1
(0,-5)

(-1,4) (0,2) (-1,3)

Sequential Bargaining
1. 1-period bargaining – 2 types
2. 2-period bargaining – 2 types
3. 1-period bargaining – continuum
4. 2-period bargaining – continuum

10
 Sequential bargaining 1-p
• A seller S with valuation 0
H L
• A buyer B with valuation v; S
– B knows v, S does not
– v = 2 with probability π
– = 1 with probability 1-π p p
• S sets a price p ≥ 0; N
Y N Y
• B either
– buys, yielding (p,v-p) 0
p 0 p
– or does not, yielding (0,0). 2-p 0 1-p 0

Solution
1. B buys iff v ≥ p;
1. If p ≤ 1, both types buy:
S gets p. 1
2. If 1 < p ≤ 2, only H-type
buys: S gets πp.
3. If p > 2, no one buys. 1 2
2. S offers
• 1 if π < ½,
• 2 if π > ½.

11
 Sequential bargaining 2-period
1. At t = 0, S sets a price
• A seller S with valuation p0 ≥ 0;
0 2. B either
• A buyer B with valuation – buys, yielding (p0,v-p0)
v; – or does not, then
– B knows v, S does not 3. At t = 1, S sets a price
– v = 2 with probability π p0 ≥ 0;
– = 1 with probability 1-π 4. B either
– buys, yielding (δp0,δ(v-p0))
– or does not, yielding (0,0)

Solution, 2-period
1. Let µ = Pr(v = 2|history at t=1).
2. At t = 1, buy iff v ≥ p;
3. If µ > ½, p1 = 2
4. If µ < ½, p1 = 1.
5. If µ = ½, mix between 1 and 2.
6. B with v=1 buys at t=0 if p0 ≤ 1.
7. If p0 > 1, µ = Pr(v = 2|p0,t=1) ≤ π.

12
 Solution, cont. π <1/2
1. µ = Pr(v = 2|p0,t=1) ≤ π <1/2.
2. At t = 1, buy iff v ≥ p;
3. p1 = 1.
4. B with v=2 buys at t=0 if
(2-p0) ≥ δ(2−1) = δ Ù p0 ≤ 2−δ.
5. p0 = 1:
π(2−δ) + (1−π)δ = 2π(1−δ) + δ < 1−δ+δ = 1.

Solution, cont. π >1/2

• If v=2 is buying at p0 > 2−δ, then
– µ = Pr(v = 2|p0 > 2−δ,t=1) = 0;
– p1 = 1;
– v = 2 should not buy at p0 > 2−δ.
• If v=2 is not buying at 2> p0 > 2−δ, then
– µ = Pr(v = 2|p0 > 2−δ,t=1) = π > 1/2;
– p1 = 2;
– v = 2 should buy at 2 > p0 > 2−δ.
• No pure-strategy equilibrium.

13
Mixed-strategy equilibrium, π >1/2
1. For p0 > 2−δ, µ(p0) = ½;
2. β(p0) = 1- Pr(v=2 buys at p0)
β ( p0 )π 1 1−π
µ= = ⇔ β ( p0 )π = 1 − π ⇔ β ( p0 ) = .
β ( p0 )π + (1 − π ) 2 π
3. v = 2 is indifferent towards buying at p0:
2- p0 = δγ(p0) Ù γ(p0) = (2- p0)/δ
where γ(p0) = Pr(p1=1|p0).

Sequential bargaining, v in [0,1]

• 1 period:
– B buys at p iff v ≥ p;
– S gets U(p) = p Pr(v ≥ p);
– v in [0,a] => U(p) = p(a-p)/a;
– p = a/2.

14
Sequential bargaining, v in [0,1]
• 2 periods: (p0,p1)
– At t = 0, B buys at p0 iff v ≥ a(p0);
– p1 = a(p0)/2;
– Type a(p0) is indifferent:
a(p0) – p0 = δ(a(p0) – p1 ) = δa(p0)/2
Ùa(p0) = p0/(1-δ/2)
• S gets  p   p 
2

1 − 0
 p0 +  0 
 1 − δ / 2   2 −δ 
• FOC: 2 p0 2 p0 (1 − δ / 2 )
2
1− + = 0 ⇒ p0 =
1−δ / 2 2 −δ 2(1 − 3δ / 4 )

Reputation

15
 Centipede Game
1 2 1 1 2 1 2 100
100
…

1 0 2 98 97 99 98
1 3 2 98 100 99 101

Centipede Game – with doubt

197 5 4 3 2 1 =n
{.999}
1 2 2 1 2 1 2 100
µ5 µ3 µ1 100
…

1 0 96 98 97 99 98
1 3 99 98 100 99 101

1 2 2 1 2 1 2 0
{.001} 100
…

-1 0 0 -1 0 -1 0
1 3 99 98 100 99 101

16
 Facts about the Centipede
• Every information set of 2 is reached with positive
probability.
• 2 always goes across with positive probability.
• If 2 strictly prefers to go across at n, then
– she must strictly prefer to go across at n+1,
– her posterior at n is her prior.
• For any n > 2, 1 goes across with positive
probability. If 1 goes across w/p 1 at n, then 2’s
posterior at n-1 is her prior.

If 2’s payoff at any n is x and 2 is mixing,

then
x = µn(x+1) + (1- µn)[(x-1)pn +(1-pn)(x+1)]
= µn(x+1) + (1- µn)[ (x+1) -2pn]
= x+1 - 2pn(1- µn)
Ù(1- µn) pn= 1/2
µn µn
µn −1 = = = 2 µn
µn + (1 − µn )(1 − pn ) µn + (1 − µn ) − pn (1 − µn )
µn −1
µn =
2

17
 0.5

0.45

0.4

0.35

0.3

0.25
Go Across
0.2

0.15

0.1

0.05
Mix
0
0 20 40 60 80 100

18
 Lecture 19-21

14.12 Game Theory

Muhamet Yildiz

Road Map
• Market for Lemons (Adverse Selection)
• Insurance Market (Screening)
• Signaling – theory
• Job Market Signaling

1
 Example for Adverse selection
• A buyer and a seller, who owns an object.
• The value of the object is
– v for the seller,
– v+b for the buyer.
• v is uniformly distributed on [0,1]. Seller
knows v. b > 0 is a known constant.
• Buyers offers a price p; seller decides on
whether to sell.

Solution
• Seller sells at p iff p ≥ v;
• Buyer’s payoff:
p
1  p
U ( p ) = ∫ (v + b − p )dv = p 2 + p (b − p ) = p b − 
0
2  2
• Buyer offers p = 2b.

2
 Example for Adverse selection
• A buyer and a seller, who owns an object.
• The value of the object is
– v for the seller,
– 3v/2 for the buyer.
• v is uniformly distributed on [0,1]. Seller
knows v.
• Buyers offers a price p; seller decides on
whether to sell.

Solution
• Seller sells at p iff p ≥ v;
• Buyer’s payoff:
p
3  3 p 
U ( p ) = ∫  v − p dv = p − p  = − p2 / 4
0
2  2 2 
• Buyer offers p = 0.

3
 Market for Lemons
• Two types of cars: Lemons and Peaches.
– A Peach is worth $2500 to seller, $3000 to buyer;
– A lemon is worth $1000 to seller, $2000 to buyer;
• Each seller knows whether his car is a Peach
or Lemon; buyers cannot tell.
• There are 200 Lemons and 100 Peaches.
• Equilibrium: a market clearing price p.

Demand/Supply – Market for Lemons

P Supply

2000

1000

200 300 Q

4
 Quiz
• The students are grouped in pairs;
• In each pair, one is assigned to be seller, the other one
is buyer. The buyer is given a valuation v, an integer
between 20 and 40 with uniform distribution.
– Buyer offers a price p;
– seller accepts or rejects;
– If seller accepts, seller gets p, buyer gets 20+v-p.
– If seller rejects, w/probability 0.1 each gets 20; w/p
0.95 we proceed to next date, and
– Seller offers a price p;
– If buyer accepts, seller gets p, buyer gets 20+v-p;
otherwise each gets 20.

Insurance with adverse selection

• Two states: s1, s2.
• A risk averse agent with
– risky endowment (Y1,Y2) where Y1 > Y2, and
– Utility function u.
• Two types:
– High risk: U(y1,y2) = (1−πH)u(y1) + πHu(y2)
– Low risk: U(y1,y2) = (1−πL)u(y1) + πLu(y2), where πH > πL.
• A risk neutral insurance company offers a menu
((y1H,y2H), (y1L,y2L)) of insurance policies, and the risk
averse agent either chooses one of the policies in the
menu or rejects the offer.
• Agent knows his type, the company does not.

5
 High-risk Agent

Y2

Y1

Low-risk Agent

Y2

Y1

6
 High- and Low-risk Agent

Y2

Y1

Optimal menu

Y2

Y1

7
 Signaling Games

Beer – Quiche
0 1
1 du l 1
el e
beer quiche du

2 t {.1} don 3
’
0 don tw
’t
0

1 0
0 ts
0
el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

8
 Signaling Game -- Definition
• Two Players: (S)ender, (R)eceiver
1. Nature selects a type ti from T = {t1,…,tI}
with probability p(ti);
2. Sender observes ti, and then chooses a
message mj from M = {m1,…,mI};
3. Receiver observes mj (but not ti), and then
chooses an action ak from A = {a1,…,aK};
4. Payoffs are US(ti,mj,ak) and US(ti,mj,ak).

Beer – Quiche
0 1
1 du l 1
el e
beer quiche du

2 t {.1} don 3
’
0 don tw
’t
0

1 0
0 ts
0
el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

9
 Types of Equilibria
• A pooling equilibrium is an equilibrium in
which all types of sender send the same
message.
• A separating equilibrium is an equilibrium in
which all types of sender send different
messages.
• A partially separating/pooling equilibrium is
an equilibrium in which some types of sender
send the same message, while some others
sends some other messages.

A Pooling equilibrium
0 1
1 du l 1
el e
beer quiche du

2 t {.1} don 3
’
0 don tw
’t
0

1 0
0 ts
0
el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

10
 A Separating equilibrium
0 1
1 du l 1
el e
beer quiche du

0.5 ’ t {.1} don 3

0 don tw
’t
0

1 0
0 ts
0

el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

A Mixed equilibrium
0 1
1 du l 1
el e
beer quiche du

2 ’ t {.1} don 3
0 don tw
’t
0

1 0
0 ts
0
el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

11
 Job Market Signaling

Model
• A worker
– with ability t = H or t = L (his private information)
– Pr(t = H) = q,
– obtains an observable education level e,
– incurring cost c(t,e) where c(H,e) < c(L,e), and
– finds a job with wage w(e), where he
– produces y(t,e).
• Firms compete for the worker: in equilibrium,
w(e) = µ(H|e)y(H,e) + (1– µ(H|e))y(L,e).

12
 Equilibrium
(eH, eL, w(e), µ(H|e)) where
• et = argmaxe w(e) – c(t,e) for each t;
• w(e) = µ(H|e)y(H,e) + (1– µ(H|e))y(L,e);
qPr(eH = e)
• µ(H|e) =
qPr(eH = e) + (1-q)Pr(eL = e)
whenever well-defined.

If t were common knowledge

w

)
y (t,e
) =
w (e

e
e*(t)

13
 No need to imitate
w , e)
y (H

(L,e)
y

e
e*(L) e*(H)

No need to imitate w(.)

w H, e)
y (

(L,e)
y

e
e*(L) e*(H)

14
 want to imitate
w , e)
y (H

(L,e)
y

e
e*(L) e*(H)

A pooling equilibrium , e)
y( H
w ,e)
(L
q) y
(1-
e)+
qy (H ,

(L,e)
y

e
e*(L) e*(H)

15
A separating equilibrium
w , e)
y (H

(L,e)
y

e
eL=e*(L) e*(H) eH

An intuitive separating equilibrium

w , e)
y ( H

(L,e)
y

e
eL=e*(L) eH

16
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5
 14.12 Solutions for Homework 1
Kenichi Amaya1
September 28, 2001

Question 1
(a)

Remember that a binary relation  is a preference relation if it is complete

and transitive
Completeness For all x, y ∈ X, x  y or y  x.
Transitivity If x  y and y  z, then x  z.
The relation defined here is complete, but it is not transitive. We can show this
by a counterexample. Suppose x = 0, y = .5, and z = 1. Then, x  y because
x = 0 = y − 12 , and y  z because y = 12 = z − 12 , but we don’t have x  z
because x = 0 < 12 = z − 12 . Therefore,  is not a preference relation.

(b)

xy
⇔ x ≥ y − 1/2 and y < x − 1/2
⇔ x > y + 1/2

Suppose x  y and y  z. Then, x > y + 1/2 and y > z + 1/2. This implies
that
x > y + 1/2 > (z + 1/2) + 1/2 > z + 1/2.
Therefore  is transitive.
We can show that ∼ is not transitive by using the same counterexample used
in (a). Suppose x = 0, y = .5, and z = 1. Since x = 0 = y − 12 , x  y and
y  x, therefore x ∼ y. Since y = 12 = z − 12 , y  z and z  y, therefore y ∼ z.
However, we don’t have x  z because x = 0 < 12 = z − 12 . Therefore x ∼ z is
not satisfied.

(c)

If we had x, y ∈ X = {0, 1, 2, · · ·},

x  y ⇔ x ≥ y − 1/2 ⇔ x ≥ y.

Then both completeness and transitivity are satisfied, so  is a preference rela-

tion.
1 E52-303, kamaya@mit.edu, 253-3591

1
Question 2
Since the agent is risk neutral, his von-Neuman Morgenstern utility function is
represented by the amount of money he receives (or any affine transformation
of it).
(a)
If he doesn’t buy the security, the amount of money he has at date 1 is 0 for
sure, so the expected utility is 0. If he buys the security at price p, the amount
of money he has at date 1 is 100 − p, 50 − p, or −p, each with probability 1/3,
and thus the expected utility is
1 1 1
(100 − p) + (50 − p) + (−p).
3 3 3
He wants to buy this security if and only if this expected utility is higher than
or equal to 0, the expected utility from not buying.
1 1 1
(100 − p) + (50 − p) + (−p) ≥ 0 ⇔ p ≤ 50.
3 3 3
Therefore πS = 50.
(b)
If the agent exercises the option, he will pay K and receive the dividend d,
so he will receive net payment of d − K. If he doesn’t exercise the option, he
receives 0. Therefore he will excercise if and only if d − K ≥ 0. His utility is
represented by
u(d) = max{0, d − K} − p,
where p is the price of the option.
(c)
Case 1 K > 100
In this case, the agent will never exercise the option, so he ends up with
receiving 0 no matter what the dividend is. Therefore he wants to pay for
this option no more than 0.
Case 2 50 < K ≤ 100
If d = 100, the agent will exercise the option and receive net payment of
100 − K. However, if d = 0 or 50, he won’t exercise the option and receive
0. Therefore, he wants to buy this option if
1 2
(100 − K − p) + (−p) ≥ 0
3 3
1
⇔ p ≤ (100 − K).
3

2
Case 3 0 ≤ K ≤ 50
If d = 50 or 100, the agent will exercise the option and receive net payment
of d − K. However, if d = 0, he won’t exercise the option and receive 0.
Therefore, he wants to buy this option if
1 1 1
(100 − K − p) + (50 − K − p) + (−p) ≥ 0
3 3 3
2
⇔ p ≤ 50 − K.
3

To summarise,

 0 if K > 100
1
πO = 3 (100 − K) if 50 < K ≤ 100
50 − 23 K if 0 ≤ K ≤ 50


Question 3

Here is an example.
L R
s 4,0 0,0
s’ 0,0 6,0
s” 1,1 1,1

The mixed strategy 12 s + 12 s0 gives player 1 expected utility of 2 if player 2

plays l and expected utility of 3 if player 2 plays r.

Question 4

The intuition tells us only 0 would be selected, but actually, all strategies
except 100 are rationalizable! The reason is that a player’s objective is just
to win the game, i.e., to name closer number to one third of the average than
everyone else, and not to name exactly one third of the average. For example,
if everybody else is naming 100, you can win by naming any number below 100,
even 99 wins. The proof is given in the answer 1.
But if, not like this game, a player’s objective is to name exactly one third
of the average, our first intuition works. The proof for this case is given in the
answer 2.

Answer 1

If 0 ≤ x < 100, x is the best response to all other players’ playing x0 , where
x < x0 < 100 and x0 is close enough to x. To see this, if a player plays x and all
others plays x0 , x̄/3 < x (because x0 is close enough to x), therefore she is the

3
only winner. Since she can do no better than being the only winner, x is the
best response.
For any 0 ≤ x < 100, we can find a sequence x < x1 < x2 < · · · < 100 such
that x is a best response to everyone else’s playing x1 , x1 is a best response to
everyone else’s playing x2 , and so on.
Naming 100 is not a best response to anything. The only case a player wins
is when everyone is naming 100, but even in this case, she can be the only winner
by naming a smaller number.
To conclude, x is rationalizable if and only if 0 ≤ x < 100.

Answer 2

Suppose the award is 100 − |x − x̄3 |, so that a player always want to name
exactly x̄3 .
Given that 0 ≤ xi ≤ 100 for all i, x̄3 always lies between 0 and 33.33 · · ·. So
x > 33.33 · · · is never best response, i.e., it is not rationalizable.
As long as everyone is naming 0 ≤ xi ≤ 33.33 · · ·, x̄3 always lies between 0
and 11.11 · · ·. So x > 11.11 · · · is never best response, i.e., it is not rationalizable.
Repeating this procedure forever, any number greater than 0 is not ratio-
nalizable.
If everyone else is naming 0, the best response is to name 0 as well. Therefore
0 is rationalizable.
To conclude, x = 0 is the only rationalizable strategy.
Bonus: In the discussion above, the number of players played no role at all.

Question 5
(a)

l r
LλΛ 2,2 2,2
LλP 2,2 2,2
Lλu 2,2 2,2
LρΛ 2,2 2,2
LρP 2,2 2,2
Lρu 2,2 2,2
RλΛ 1,3 3,3
RλP 1,3 1,1
Rλu 1,3 0,0
RρΛ 3,1 3,3
RρP 3,1 1,1
Rρu 3,1 0,0

(b)

4
First, RρΛ weakly dominates all other strategies of player 1. We eliminate them
and then we have the following game.
l r
RρΛ 3,1 3,3
Now, l is weakly dominated by r, so we eliminate l and we have
r
RρΛ 3,3

5
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4
 14.12 Solutions for Homework 2
Kenichi Amaya1
October 5, 2001

Question 1
(a)

L R
T 1,1 1,0
B 0,1 0,10000

Fact: The set of rationalizable strategies is same as the set of strategies

which survives iterated elimination of strictly dominated strategies.
Step 1: For player 1, B is strictly dominated by T. Now we have
L R
T 1,1 1,0
Step 2: For player 2, R is strictly dominated by L. Now we have
L
T 1,1
Therefore, the rationalizable strategies are T for player 1 and L for player 2.

(b)

There was a typo in the problem. If player 2 intends to play L, L is played

with probability 1 − , and R is played with probability . Of course, if you
interpreted the problem differently, you will get credit as long as you are solving
the problem consistently with your interpretation.
We can write a new game which represents this situation as following: We
look for the players’ expected payoffs as functions of the intended play. If player
1 intends to play T and player intends to play L, what are the expected payoffs?
(T,L) is realized with probability (1 − )2 , (T,R) and (B,L) are realized each
with probability (1 − ), and (B,R) is realized with probability 2 . Therefore,
the expected payoff of player 1 is

(1 − )2 · 1 + (1 − ) · 1 + (1 − ) · 0 + 2 · 0 = 1 −  = .999.

In the same way, player 2’s expected payoff is

(1 − )2 · 1 + (1 − ) · 0 + (1 − ) · 1 + 2 · 10000 = (1 − ) + 2 · 10000 = 1.009

Therefore we must have

1 E52-303, kamaya@mit.edu, 253-3591

1
 L R
T .999, 1.009
B
In the same way, we can calculate expected payoffs for the remaining of the
payoff matrix and we have
L R
T .999, 1.009 .999, 9.991
B .001, 10.999 .001, 9980.01
For player 1, B is strictly dominated by T, and for player 2, L is strictly
dominated by R. Now we have
R
T .999, 9.991
Therefore, the rationalizable strategies are T for player 1 and R for player
2.
(c)
For player 1, the possibility that opponent trembles doesn’t affect her optimal
choice because T gives higher payoff than B no matter what the opponent is
doing.
For player 2, in the case of (a), the large payoff differnce between (B,L)
and (B,R) didn’t matter because he was sure B is never played. However,
when we introduce trembles, this large payoff difference matters with positive
probability even though player 2 knows that player 1 never intends to play B.
In this situation, the payoff difference between (T,L) and (T,R) is so small that
it is outweighed by the payoff differnce between (B,L) and (B,R).
Question 2
Fact All the Nash equilibrium strategies are rationalizable, and therefore
survives iterated elimination of strictly dominated strategies. When we look for
Nash equilibria, we can first eliminate strictly dominated strategies and then
find Nash equilibria of the game left.
L M R
A 3,1 0,0 1,0
B 0,0 1,3 1,1
C 1,1 0,1 0,10
Step 1 For player 1, C is strictly dominated by 12 A + 12 B. Now we have
L M R
A 3,1 0,0 1,0
B 0,0 1,3 1,1

2
Step 2 For player 2, R is stricly dominated by 12 L + 12 M . Now we have

L M
A 3,1 0,0
B 0,0 1,3
Step 3 In the game left, (A,L) and (B,M) are pure strategy Nash equilibria,
because players are taking best response to each other.
Step 4 We want to find the mixed strategy equilibrium. Let (pA + (1 −
p)B, qL + (1 − q)M ) be the equilibrium. First, player 1 must be indifferent
between playing A and B, which implies

3q = 1(1 − q),

where the LHS is the expected payoff of playing A and the RHS is that of B,
when player 2 is playing the equilibrium strategy. This implies
1
q= .
4
Next, player 2 must be indifferent between playing L and M, implying

1p = (1 − p)3
3
p= .
4
To conclude, the Nash equilibria are; (A,L), (B,M), and ( 34 A+ 14 B, 14 L+ 34 M ).

Question 3

This question is hard!

Notice that in the Cournot model with fixed cost, there can be equilibria
where not every firm is producing. For example, if there are two firms, there
can be an equilibrium where one firm is producing the monopoly quiantity and
the other firm is producing nothing. (Of course, whether this is actually a Nash
equilibrium or not depends on the cost and demand structure.) To see why this
can be an equilibium, consider each firm’s best response. If the opponent firm
is producing the monopoly quantity, the revenue from selling some amount can
not cover the fixed cost, if the fixed cost is large enough, and thus producing
nothing is the best response. On the other hand, if the opponent is producing
nothing, you can get a revenue equal to the monopoly profit, which is higher
than the fixed cost.
It is hard to characterize all the equilibria, so we limit attention to pure
strategy equilibria which are symmetric in the sense that all the producing
firms are choosing the same quantity. (Keep in mind that there might be other
equilibria! Actually, it is not very hard to show that all pure strategy equilibria
are symmetric. This would be a good exercise.)

3
 First, consider the equilibrium where all firms are producing q ∗ . What we
need is that q ∗ is a best response to all other firms choosing q ∗ . The profit of
firm i when it is producing qi and all other firms are producing q ∗ is

πi (qi , q ∗ ) = (max{1 − (qi + (1 − n)q ∗ ), 0} − c)qi − F. (1)

In the equilibrium all firms must be getting positive revenue (because there is
fixed cost), so it must be 1 − (qi + (n − 1)q ∗ ) > 0. Therefore

πi (qi , q ∗ ) = (1 − (qi + (n − 1)q ∗ ) − c)qi − F. (2)

Taking first order condition,

1 − (n − 1)q ∗ − c
qi = . (3)
2
In the symmetric equilibium, we must have qi = q ∗ , thus
1−c
q∗ = . (4)
n+1
For this quantity to be actually construct equilibrium, each firm must be getting
nonnegative profit. Plugging this into (2),
 1 − c 2
πi = − F. (5)
n+1

Therefore there exists an equilibrium where all firms are producing q ∗ = n+1
1−c
if
1−c 2
and only if ( n+1 ) ≥ F and c ≤ 1.
Next consider an equilibrium where only k < n firms are producing q ∗ . We
need to check incentives of firms which are producing and incentives of firms
which are not producing.
For a firm which is producing, qi = q ∗ must be a best response to k − 1 of
other firms producing q ∗ and the rest producing zero. The firm’s profit when
producing qi is

πi (qi , q ∗ ) = (max{1 − (qi + (1 − k)q ∗ ), 0} − c)qi − F. (6)

Notice this is same as equation (1), n being replaced by k. Therefore the same
argument as above holds.
1−c
q∗ = , (7)
k+1
1−c 2
For this to be an equilibrium, we need ( k+1 ) ≥ F and c ≤ 1.
However, this is not a sufficient condition. It must also be true that for non-
producing firms, not producing is actually the best response. From the point

4
of view of a non-producing firm i, k other firms are producing q ∗ . By the same
argument above, if this firm does choose to produce, the optimal amount is
1 − kq ∗ − c
qi∗ = , (8)
2
and the payoff is
 1 − kq ∗ − c 2
πi = − F. (9)
2
∗
If this profit is positive, the firm wants to produce qi rather than producing
 ∗
2
nothing. Therefore, we need 1−kq2 −c ≤ F , i.e.,
 1 − c 2
≤ F. (10)
2(k + 1)
Finally, consider an equilibrium where no firm produces. This is the case
where c ≥ 1 or where even the monopoly profit is less than the fixed cost. That
is,
 1 − c 2
≤ F. (11)
2
Question 4
Each player i = 1, · · · , n chooses his price of meal pi . The payoff of player i
is
Pn
√ j=1 pj
ui = pi −
P n
√ pi j6=i pj
= pi − − .
n n
Taking first order condition,
1 1
√ =
2 pi n
n2
pi = .
4
This gives the best response, but actually this optimum does not depend on
what other players are doing, which means that it is the dominant strategy.
To conclude, the Nash equilibrium is
n2
pi = ∀i.
4
Notice if n = 1 then p = 12 . This is the efficient choice, because there is no
externality. If n → ∞, then pi → ∞. This is because every marginal increase
in the price of the meal will splitted by all the people and the marginal increase
of the payment of the player herself converges to 0.

5
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5
 14.12 Solutions for Homework 3
Kenichi Amaya1
November 2, 2001
Question 1
We solve this problem by backward induction. First, we solve for the quan-
tity choice (stage 2) given the entrance decision, and then we solve for the
entrance decision (stage 1).
Stage 2 Suppose m firms has entered in stage 1. Assuming 1 − Q ≥ 0 in
equilibrium (we check this is actually true later), each firm i maximizes
πi = qi (1 − Q)
X
= qi (1 − qj − qi ).
j6=i

Notice, since the fixed cost F was payed in stage 1 already, i.e., it is
already sunk, the firm doesn’t care about it any more. Taking first order
condition, P
1 − j6=i qj
qi = .
2
Assuming the equilibrium is symmetric (qi is same for all i),
1 − (m − 1)qi
qi = ,
2
implying
1
qi = .
m+1
(It is not hard to prove the equilibrium is actually symmetric.) Now we
can confirm that our assumption 1 − Q ≥ 0 is actually satisfied because
m
Q = mqi = < 1.
m+1
The equilibrium payoff of each firm is
1
π= .
(m + 1)2

Stage 1 Let π(m) be the profit (gained in stage 2) of each firm when m firms
are entering. As we solved above,
1
π(m) = .
(m + 1)2
There are three possible classes of equilibria:
1 E52-303, kamaya@mit.edu, 253-3591

1
 1. All n firms enter.
2. No firm enters
3. k firms enter, where 0 < k < n.
The first class of equilibrium exists if it is better to enter and gain π(n)−F
than to exit and gain 0. That is,

π(n) − F ≥ 0,
1
≥ F.
(n + 1)2

The second class of equilibrium exists if it is better to exit and get 0 than
to enter to be the only entering firm and gain π(1) − F . That is,

π(1) − F < 0,
1
≤ F.
4

To see when the third class of equilibrium exists, we need to check the
incentives of the firms which are entering and the firms which are not
entering.
Let’s consider the incentive of an entering firm first. It gets π(k) − F if it
enters, and gets 0 if it exits. Therefore, there is no incentive to deviate if

π(k) − F ≥ 0,
1
≥ F.
(k + 1)2

Next consider the incentive of an exiting firm. It gets 0 if it exits. If

it enters, it gets π(k + 1) − F because k other firms are also entering.
Therefore, there is no incentive to deviate if

π(k + 1) − F ≤ 0,
1
≤ F.
(k + 2)2

Notice, the argument above says nothing about which k firms enter. If
the condition above is satisfied, any selection of k firms constitutes an
equilibrium.

To summarize, let’s formally describe the equilibrium strategies. Remember,

we need to describe all the contingent plans for stage 2, even for the information
sets which are not achieved on the equilibrium path.
The equilibrium strategies are as the following.

2
 1. • All firms enter in stage 1.
1
• If m firms enter in stage 1, each entering firm produces m+1 in stage
2.
1
The equilibrium payoff is (n+1) 2 −F for every firm. This equilibrium exists
1
if and only if (n+1)2 ≥ F .

2. • No firm enter in stage 1.

1
• If m firms enter in stage 1, each entering firm produces m+1 in stage
2.
The equilibrium payoff is 0 for every firm. This equilibrium exists if and
only if 14 ≤ F .
3. • k firms enter in stage 1, where 0 < k < n.
1
• If m firms enter in stage 1, each entering firm produces m+1 in stage
2.
1
The equilibrium payoff is (k+1) 2 − F for every entering firm, and 0 for
1
every exiting firm. This equilibrium exists if and only if (k+1) 2 ≥ F and
1
(k+2)2 ≤ F .

Question 2
(a)

1

A
X
A N

A


U2
A
(2,2)
@
x
@ n

@


R1
@
(2,2) @
L @ R
@
R2
@

A
A
l
A r l
A r

A
A


U
A 

AU
(3,3) (0,0) (0,0) (1,1)

We can solve for subgame perfect equilibria by backward induction. This

game has three subgames: the whole game itself, a subgame starting from player

3
2’s first decision node, and a subgame starting from player 1’s second decision
node.
First we look at the subgame starting from player 1’s second decision node.
This subgame is equivalent to the following nomal form game:
l r
L 3,3 0,0
R 0,0 1,1

Obviously, pure strategy equilibria are (L,l) and (R,r).

If (L,l) is played in this subgame, player 2 chooses n at his first decision
node, because he gets payoff of 2 by playing x and 3 by playing n. Given this,
player 1 chooses N at her first decision node because she gets payoff of 2 by
playing X and 3 by playing N. Therefore, player 1’s strategy (N,L) and player
2’s strategy (n,l) constitute a subgame perfect Nash equilibrium.
If (R,r) is played in the subgame starting from player 1’s second decision
node, player 2 chooses x at his first decision node, because he gets payoff of 2
by playing x and 1 by playing n. Given this, player 1 is indifferent between X
and N at her first decision node because she gets payoff of 2. Therefore, player
1’s strategy (X,R) and player 2’s strategy (x,r) constitute a subgame perfect
Nash equilibrium, and player 1’s strategy (N,r) and player 2’s strategy (x,r)
constitute another subgame perfect Nash equilibrium.
To conclude, there are three subgame perfect Nash equilibria:
1. Player 1: (N,L), Player 2: (n,l)
2. Player 1: (X,R), Player 2: (x,r)
3. Player 1: (N,R), Player 2: (x,r)

(b)

Let’s apply the forward induction argument here.

Suppose player 1’s second decision node is reached. This means that player
2 has chosen N at his first decision node, i.e., his strategy is either (n,l) or
(n,r) (or any mixture of them). Should player 1 think that player 2 is choosing
(n,r)? Player 2 can get payoff of 0 or 1 by playing (n,r), whereas he can get 2
for sure by playing (x,l) or (x,r). In other words, (n,r) is a strictly dominated
strategy. If player 1 knows player 2 is rational, she must know that there is no
reason player 2 play (n,r). Therefore, given player 2 has played N at his first
decision node, player 1 must conclude player 2 is choosing (X,l), and choose the
best response to it, namely L. To conclude, in any subgame perfect equilibrium
which is consistent with common knowlegde of rationality, player 1’s choice at
his second decision node must be L.
Therefore, only the first equilibrium (N,L), (n,l) is consistent.

4
Question 3
(a)

The monopoly price is pm = 21 . Construct the following “trigger strategy”.

• Start with playing pm , and play pm if everybody has played pm all the
time.
• Play 0 if anybody has played something different from pm at least once.
By the single deviation principle, it is sufficient to check incentives to devi-
ate only once, in order to check when this is actually a subgabe perfect Nash
equilibrium.
Firstly, check the incentive when nobody has deviated from pm before. If a
firm plays pm , as suggested by the strategy, then everyone will be playing pm
all the time in future, and a firm’s profit per period is

pm (1 − pm ) 1
= ,
2 8
and the present discounted sum of the profit sequence from today is
1 1 1 1 1
+ δ + δ2 + · · · = .
8 8 8 1−δ8
If the firm is to deviate, the best it can do today is to set a price slightly less
than pm and get the whole monopoly profit
1
pm (1 − pm ) = .
4
If the firm does deviate, everyone will be playing 0 from the next period, yielding
per period payoff of zero. Therefore, the present discounted sum of the profit
sequence from today is
1 1
+ δ0 + δ 2 0 + · · · = .
4 4
The firm has no incentive to deviate if and only if
1 1 1
≥
1−δ8 4
1
δ≥ .
2
Secondly, check the incentive when somebody has ever deviated from pm
before. In this case, a firm’s action today doesn’t affect it’s future payoff because
everyone will be playing 0 in future no matter what happens today. Therefore
it is sufficient to check if the firm can increase the present period profit by
deviating. If it plays p = 0, as suggested by the strategy, it gets a payoff of 0.

5
If it deviates and plays p > 0, it gets a payoff of 0 again because all consumers
buy from the other firm which is choosing p = 0. Therefore it can’t benefit from
deviating.
To conclude, the trigger strategy constitutes a subgame perfect Nash equi-
librium if δ ≥ 21 .

(b)

When there are n firms, we can use the trigger strategy constructed in part
(a) again. As we did in part (a), we check incentives to deviate before and after
any deviation.
Firstly, check the incentive when nobody has deviated from pm before. If a
firm plays pm , as suggested by the strategy, then everyone will be playing pm
all the time in future, and a firm’s profit per period is
pm (1 − pm ) 1
= ,
n 4n
and the present discounted sum of the profit sequence from today is
1 1 1 1 1
+δ + δ2 + ··· = .
4n 4n 4n 1 − δ 4n
If the firm is to deviate, the best it can do today is to set a price slightly less
than pm and get the whole monopoly profit
1
pm (1 − pm ) = .
4
If the firm does deviate, everyone will be playing 0 from the next period, yielding
per period payoff of zero. Therefore, the present discounted sum of the profit
sequence from today is
1 1
+ δ0 + δ 2 0 + · · · = .
4 4
The firm has no incentive to deviate if and only if
1 1 1
≥
1 − δ 4n 4
n−1
δ≥ .
n
To check the incentive when somebody has ever deviated from pm before,
the same argument as in part (a) holds.
To conclude, the trigger strategy constitutes a subgame perfect Nash equi-
librium if δ ≥ n−1
n .

Question 4
(a)

6
 To begin with, let’s find the subgame perfect Nash equilibrium of the stage
game. We do this by backward induction. The long run firm, observing the
short run firm’s quantity xt , chooses its quantity yt to maximize its profit

πtL = yt (1 − (xt + yt )).

Solving first order condition, the optimum is

1 − xt
yt∗ (xt ) = .
2
The short run firm chooses its quantity xt to maximize its profit

πtS = xt (1 − (xt + yt )),

knowing that if it choose xt , the long run firm reacts with

1 − xt
yt∗ (xt ) = .
2
Therefore, the short run firm’s objective function can be rewritten as a function
of xt ;
1 − xt
πtS = xt (1 − (xt + )).
2
Solving first order condition, the optimum is
1
x∗t = .
2
Therefore, the subgame perfect Nash equilibrium of the stage game is
1 1 − xt
x∗t = , yt∗ (xt ) = .
2 2
Now let’s solve for the subgame perfect Nash equilibrium of the finitely
repeated game. Since it is finite, we can use backward induction. At the last
period, t = T , the players don’t care about future and they concern only about
the payoff of that period. Therefore they must play the subgame perfect Nash
equilibrium of the stage game, regardless of what happened in the past. At time
t = T − 1, the players know that the actions today doesn’t affect tomorrow’s
outcome, so they concern only about the payoff of that period. Therefore they
must play the subgame perfect Nash equilibrium of the stage game, regardless
of what happened in the past. We can repeat the same argument until we reach
the very first period.
Therefore, the subgame perfect Nash equilibrium of the repeated game is
1 1 − xt
x∗t = , yt∗ (xt ) = for all t,
2 2
regardless of the history.

7
(b)

Construct the following trigger strategy.

Long rum firm • Start with playing the following strategy:

1/2 if xt ≤ 1/2
(∗) yt (xt ) =
1 − xt if xt ≥ 1/2

Keep playing this strategy as long it has not deviated from it.
1−xt
• Play yt∗ (xt ) = 2 if it has deviated from (*) at least once.
Short run firms • Play xt = 1/4 if the long run firm has not deviated from
(*) before.
1
• Play xt = 2 if the long run firm has deviated from (*) at least once.
To see this is actually a subgame perfect Nash equilibrium, let’s check in-
centives to deviate.
Firstly, consider the long run firm’s incentive when it has never deviated
from (*) before.

Case 1: xt ≤ 1/2 If it follows the strategy and choose yt = 1/2, the present
period profit of the long run firm is
1 1
(1 − ( + xt )).
2 2
Starting from the next period, the outcome will be xt = 1/4 and yt = 1/2
every period, and the long run firm’s per period profit is 1/8 and therefore
the present discounted value of the profit sequence is
1 1 δ
(1 − ( + xt )) + .
2 2 8(1 − δ)
If it is to deviate, the best it can do today is to play
1 − xt
yt =
2
and get payoff of
(1 − xt )2
.
4
However, starting from next period, the outcome will be xt = 1/2 and
yt = 1/4 and the long run firm’s per period profit is 1/16. Therefore the
present discounted value of the profit sequence is

(1 − xt )2 δ
+ .
4 16(1 − δ)

8
 If δ = 0.99,

1 1 δ (1 − xt )2 δ
(1 − ( + xt )) + > + ,
2 2 8(1 − δ) 4 16(1 − δ)

(check it!), and therefore it is better to follow the equilibrium strategy

than to deviate.
Case 2: xt ≥ 1/2 If it follows the strategy, pt = 0 and today’s payoff is 0, and
the outcome will be xt = 1/4 and yt = 1/2 every period, starting the
next period. The long run firm’s per period profit is 1/8 and therefore the
present discounted value of the profit sequence is
δ
.
8(1 − δ)
1−xt
If it is to deviate, the best it can do today is to play yt = 2 and get
(1−xt )2
payoff of 4 . However, starting from next period, the outcome will be
xt = 1/2 and yt = 1/4 and the long run firm’s per period profit is 1/16.
Therefore the present discounted value of the profit sequence is

(1 − xt )2 δ
+ .
4 16(1 − δ)

This value is the largest when xt = 1/2 and is equal to

1 δ
+ .
16 16(1 − δ)

If δ = 0.99, it is better to follow the equilibrium strategy than to deviate

(check it!).

Secondly, consider the long run firm’s incentive when it has deviated from
(*) before. According to the strategy strategy profile, future outcomes don’t
depend on today’s behavior. Therefore the long run firm cares only about its
payoff today. Actually, by following the strategy, it is taking best response to
the short run firm.
Finally, consider the short run firm’s incentives. Since they never care about
future payoff, it must be playing a best response to the long run firm’s strategy,
which is actually true. (Check it!)

(c)

In the equilibrium we saw in part (b), the per period profit on the equilibrium
path were 1/8 for the long run firm and 1/16 for the short run firms.

9
 If there is a subgame perfect Nash equilibrium where xt = yt − 1/4 on th
eequilibrium path, then the per period profit on the equilibrium path are 1/8
for the long run firm and 1/8 for the short run firms.
Construct the following trigger strategy, which is different from (b) only in
(*) where xt = 1/4:

Long rum firm • Start with playing the following strategy:


 1/4 if xt = 1/4
(∗) yt (xt ) = 1/2 if xt ≤ 1/2 and xt 6= 1/4
1 − xt if xt ≥ 1/2


Keep playing this strategy as long it has not deviated from it.
1−xt
• Play yt∗ (xt ) = 2 if it has deviated from (*) at least once.
Short run firms • Play xt = 1/4 if the long run firm has not deviated from
(*) before.
1
• Play xt = 2 if the long run firm has deviated from (*) at least once.

The incentive of the long run firm when it is supposed to play (*) and
xt = 1/4 is satisfied because it gets current payoff of 1/8, which is same as part
(b), and what it can get by deviating is same as in part (b). The incentive
problem of the long run firm is same as in (b).
The incentives of the short run firms are also satisfied because the payoff
from following the strategy is larger than part (b) and payoff when deviating is
same as in (b).

10
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4
 14.12 Solutions for Homework 4
Kenichi Amaya1
November 9, 2001

Question 1
(a)

Action spaces A1 = A2 = {B, S}.

Type spaces T1 = {α}, T2 = {β1 , β2 }. Since player 1 has no private informa-
tion, we can model it so that her type can take only one value. Player 2
knows that the game above is played when his type is β1 and he knows
that the game below is played when his type is β2 .
Belief Player i’s belief µi (tj |ti ) is the probability that player j’s type is tj
conditional on that player i’s type is ti . In this model, since it is assumed
that the types are independent,
1
µ1 (β1 |α) = µ1 (β2 |α) = ,
2
µ2 (α|β1 ) = µ2 (α|β2 ) = 1.

vNM utility function ui (a1 , a2 , t1 , t2 ) is the vNM utility when player 1’s ac-
tion is a1 , player 2’s action is a2 , player 1’s type is t1 and player 2’s type
is t2 .

u1 (B, B, α, β1 ) = 2, u2 (B, B, α, β1 ) = 1,
u1 (B, S, α, β1 ) = 0, u2 (B, S, α, β1 ) = 0,
u1 (S, B, α, β1 ) = 0, u2 (S, B, α, β1 ) = 0,
u1 (S, S, α, β1 ) = 1, u2 (S, S, α, β1 ) = 2,
u1 (B, B, α, β2 ) = 2, u2 (B, B, α, β2 ) = 0,
u1 (B, S, α, β2 ) = 0, u2 (B, S, α, β2 ) = 2,
u1 (S, B, α, β2 ) = 0, u2 (S, B, α, β2 ) = 1,
u1 (S, S, α, β2 ) = 1, u2 (S, S, α, β2 ) = 0.

(b)

First consider player 1’s incentive. Since she doesn’t know the game which
is being played, she maximizes her expected payoff.
If she plays B, with probability 1/2 the top game is being played and player
2 chooses B and thus she gets a payoff of 2, and with probability 1/2 the bottom
game is being played and player 2 chooses S and thus she gets a payoff of 0.
1 E52-303, kamaya@mit.edu, 253-3591

1
Therefore her expected payoff is 1. If she plays S, with probability 1/2 the top
game is being played and player 2 chooses B and thus she gets a payoff of 0,
and with probability 1/2 the bottom game is being played and player 2 chooses
S and thus she gets a payoff of 1. Therefore her expected payoff is 1/2.
Therefore B is actually player 1’s best response against player 2’s strategy.
Next consider player 2’s incentive. When he knows that the top game is
being played, B is the best response given player 1 is choosing B. When he
knows that the bottom game is being played, S is the best response given player
1 is choosing B.
Therefore choosing B when the top game is being played and choosing S when
the bottom game is being played is actually player 2’s best response against
player 1’s strategy.
Since both players are taking a best response to each other, the strategy
profile constitutes a Bayesian Nash equilibrium.
Question 2
Each player’s action is the choice of price. A price can take any nonnegative
real number. Therefore the action space is R+ for both players.
Player i’s type is her private information. In this model, bi is player i’s type.
bi is either bH or bL . Therefore, the type space of each player is {bH , bL }.
Player i’s belief µi (bj |bi ) is the probability that player j’s type is bj condi-
tional on that player i’s type is bi . In this model, since it is assumed that the
types are independent,

θ if bj = bH
µi (bj |bi ) = .
1 − θ if bj = bL
(von Neuman Morgenstern) utility in this model is the profit of each player
(assuming the firms are risk neutral) as a function of the actions and types of
both players:
ui (pi , pj , bi , bj ) = pi (a − pi − bi pj ).
Player i’s strategy specifies what action to take for any realization of her
type. In this model, it is a two dimensional vector (pi (bH ), pi (bL )), where pi (bH )
is the price when its type is bH and pi (bL ) is the price when its type is bL . The
2
strategy space is R+ for each i.
A strategy profile {(p∗1 (bH ), p∗1 (bL )), (p∗2 (bH ), p∗2 (bL ))} constitutes a Bayesian
Nash equilibrium if each p∗i (bi ) is a best response, i.e., a maximizer of player i’s
expected payoff, conditional on that her type is bi and the opponent is choosing
strategy (p∗j (bH ), p∗j (bL )). That is:
p∗1 (bH ) = argmaxp1 θp1 (a − p1 − bH p∗2 (bH )) + (1 − θ)p1 (a − p1 − bH p∗2 (bL )),
p∗1 (bL ) = argmaxp1 θp1 (a − p1 − bL p∗2 (bH )) + (1 − θ)p1 (a − p1 − bL p∗2 (bL )),
p∗2 (bH ) = argmaxp2 θp2 (a − p2 − bH p∗1 (bH )) + (1 − θ)p2 (a − p2 − bH p∗1 (bL )),
p∗2 (bL ) = argmaxp2 θp2 (a − p2 − bL p∗1 (bH )) + (1 − θ)p2 (a − p2 − bL p∗1 (bL )).

2
Taking first order conditions,
a − bH (θp∗2 (bH ) + (1 − θ)p∗2 (bL ))
p∗1 (bH ) = ,
2
a − bL (θp∗2 (bH ) + (1 − θ)p∗2 (bL ))
p∗1 (bL ) = ,
2
a − bH (θp∗1 (bH ) + (1 − θ)p∗1 (bL ))
p∗2 (bH ) = ,
2
∗ ∗
a − bL (θp1 (bH ) + (1 − θ)p1 (bL ))
p∗2 (bL ) = .
2
Since the game is symmetric, let’s look for a symmetric equilibrium where
p∗1 (bH ) = p∗2 (bH ) = p∗H and p∗1 (bL ) = p∗2 (bL ) = p∗L . Then the conditions are
reduced to
a − bH (θp∗H + (1 − θ)p∗L )
p∗H = ,
2
a − bL (θp∗H + (1 − θ)p∗L )
p∗L = .
2
Solving these, we get

a bH
p∗H = (1 − ),
2 2 + θbH + (1 − θ)bL
a bL
p∗L = (1 − ).
2 2 + θbH + (1 − θ)bL
Question 3
Consider the following incomplete information game.
H T
H 1 + α, −1 + β −1 + α, 1
T −1, 1 + β 1, −1
Here, α is player 1’s type, β is player 2’s type, α and β are independent draw
from uniform distribution in the interval [0, 1], and  > 0 is a constant.
The interpretation is like this: Player 1 (2) can get an extra payoff of α
(β) by playing head, in addition to the payoff generated from the original game.
This extra payoff is her private information.
Notice, as we converge  to 0, the game converges to the original game.
From the construction, player 1 (2) is more tempted to play H if she has a
higher value of α (β). Observing this, try to find the pure strategy Bayesian
Nash equilibrium of the following form.
• Player 1 chooses H if α ≥ ᾱ and chooses L if α ≤ ᾱ, where ᾱ ∈ [0, 1] is a
constant.

3
 • Player 2 chooses H if β ≥ β̄ and chooses L if β ≤ β̄, where β̄ ∈ [0, 1] is a
constant.
This strategy profile is actually a Bayesian Nash equilibrium if player 1 with
cutoff type ᾱ and player 2 with cutoff type β̄ are indifferent between choosing
H and T.
According to the strategy, the probability that player 2 plays H is 1 − β̄, and
the probability that player 2 plays L is β̄. Therefore, if player 1 of type ᾱ plays
H, her expected payoff is

1(1 − β̄) + (−1)β̄ + ᾱ,

and if she plays T, she gets

(−1)(1 − β̄) + 1β̄.

Therefore, we need

1(1 − β̄) + (−1)β̄ + ᾱ = (−1)(1 − β̄) + 1β̄. (1)

We do the same thing for player 2 with type β̄. According to the strategy,
the probability that player 1 plays H is 1 − ᾱ, and the probability that player 1
plays L is ᾱ. Therefore, if player 2 of type β̄ plays H, his expected payoff is

(−1)(1 − ᾱ) + 1ᾱ + β̄,

and if she plays T, she gets

1(1 − ᾱ) + (−1)ᾱ.

Therefore, we need

(−1)(1 − ᾱ) + 1ᾱ + β̄ = 1(1 − ᾱ) + (−1)ᾱ. (2)

Solving (1) and (2), we get

8 − 2
ᾱ = , (3)
16 + 2
8 + 2
β̄ = . (4)
16 + 2
Now, as we converge  to 0, i.e., as we converge the game to the complete
information game, both ᾱ and β̄ converge to 1/2. Therefore, in the limit, both
players are choosing H and T with probability 1/2, which is equivalent to the
mixed strategy equilibrium of the complete information game.

Question 4

4
 Let i = 1, · · · , n be the index of bidders, vi be bidder i’s valuation of the
good, and bi be player i’s bid. We denote player i’s strategy by a function xi (vi ),
meaning that player i bids bi = xi (vi ) when her valuation is vi .
We want to show that the strategy profile

(n − 1)vi
xi (vi ) = for all i
n
constitutes a Bayesian Nash equilibrium. Since the game is symmetric and strat-
egy profile is symmetric, it is sufficient to check one player’s incentive because
every player is facing the same incentive problem.
We are going to show that if player i’s valuation is vi and all other players
are taking the strategy
(n − 1)vj
xj (vj ) = ,
n
then the bid which maximizes her expected payoff is

(n − 1)vi
bi = xi (vi ) = .
n
First consider the probability of winning the auction by bidding bi . She wins
if and only if all other players’ bids are less than bi , i.e.,

(n − 1)vj
xj (vj ) = ≤ bi for all j 6= i.
n
This is equivalent to
nbi
vj ≤ for all j 6= i.
n−1
Since
nbi nbi
P rob(vj ≤ )=
n−1 n−1
for all j because vj is uniformly distributed in [0.1],

nbi
P rob(win) = P rob(vj ≤ for all j 6= i)
n−1
nbi n−1
= P rob(vj ≤ )
n−1
nbi
n−1
= .
n−1
Therefore, the expected payoff from bidding bi is
nbi
n−1
Ui = (vi − bi )P rob(win) = (vi − bi ) .
n−1

5
Taking first order condition,
∂Ui nbi
n−2 n nbi
n−1
= (vi − bi )(n − 1) − = 0,
∂bi n−1 n−1 n−1
nbi
(vi − bi )n = ,
n−1
(n − 1)vi
bi = .
n
Therefore, the strategy of player i

(n − 1)vi
bi = xi (vi ) =
n
is actually the best response to other player’s playing

(n − 1)vj
xj (vj ) = .
n
Q.E.D.

6
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 14.12 Game Theory
Fall 2001
Problem Set 5 Solutions

December 14, 2001

1. The possibilities are: Pooling on A, pooling on D, and hybrid equilibria (since

there are only two possible actions for player 1, but three possible types of
player 1). Let us write the strategies in the form (t11 , t21 , t31 ; t12 , t22 , t32 ) for
player 1, where ti j indicates the action taken by type i at the jth move, and
(a) for the strategy of player 2, which gets to move only once and has only one
information set. The only equilibrium here is (A, A, D; d, a, d) and (δ). Player
2 moves δ since u2 (α) = 5/6(3) + 1/6(−5) = 5/3 < 2 = u2 (δ) – note how
beliefs are updated. Finally, each type of player 1 does not have an incentive
to deviate: top type is getting 5 as opposed to 4 (if deviates and plays D);
middle type is getting 0 as opposed to -1 (if deviates and plays D); bottom
type is getting 0 as opposed to -1 (if deviates and plays A).
2. In the second stage of the game, it is clear that each type will always play the
static best response: a = 2 type will fight and a = −1 type will accomodate.
The possibilities for the first stage are:

(a) Pooling on Fight: If π = 0.4, then at t = 2, given no updating of beliefs

(so that µ(a = 2|F ) = π), the entrant stays out since EU (Enter) =
2π − 1 = −0.2 < 0 = EU (Out). Then, in t = 1, incumbents pool on
fight. The PBE equilibrium is [(F, F ; F, A), (O, O, E)], where we write
the strategy for player 1 as (t11 , t21 ; t12 , t22 ) where ti j is the action taken
by type i in stage j and for player 2 as (a1 , a21 , a22 where a1 refers to the
first information set in t = 1, and the other two refer to the information
sets in t = 2: a21 being the information set after the incumbent fights in
the first period, and a22 being the information set after the incumbent
fights in the first period. Beliefs are not updated on a21 and off the
equilibrium belief on a22 is µ(a = −1|accomodate) = 1.
(b) Separating equilibrium: If π = 0.9, then entrant always enters since
EU (Enter) = 2π − 1 = 0.8 > 0 = EU (Out), a=2 type fights and a=-
1 type accomodates. The PBE is [(F, A; F, A), (E, O, E)]. Beliefs are
updated such that at a22 we have µ(a = −1|accomodate) = 1 and at a21
we have µ(a = 2|f ight) = 1.

1
 If the game is repeated 100 times a similar structure applies.

3. In t = 1, buyer of type 1 will accept if and only if:

0.9(1 − p1 ) ≥ 0, that is p1 ≤ 1
0.9(2 − p1 ) ≥ 0, that is p1 ≤ 2
and seller will offer p1 ≥ 0.
If seller offers 1 ≤ p1 ≤ 2, then type 1 rejects the offer and type 2 accepts it:
EU (seller) = (1 − π)(0) + p1 π = p1 π
or simply 2π, which is the value that maximizes the seller’s utility.
If seller offers 0 ≤ p1 ≤ 1 then both types accept the offer:
EU (seller) = p1 (1 − π) + p1 π = p1
or simply 1, which is the value that maximizes the seller’s utility.
If π > 1/2, then seller offers p1 = 2 in t = 1 and she accepts offers in t = 0
p0 ≥ 0.9 since if she waits until t = 1 she can get 0.9(1)=0.9 . If π < 1/2, then
seller offers p1 = 1 and she accepts offers in t = 0 p0 ≥ 1.8 since in t = 1 she
can get 0.9(2)=1.8.

4. • Proposed pooling strategy of Sender: Suppose there is an equilibrium in

which the Sender’s strategy is (R, R), where (m0 , m00 ) means that type t1
chooses m0 and type t2 chooses m00 .
• Receiver’s belief at R: Then the Receiver’s information set corresponding
corresponding to R is on the equilibrium path, so the Receiver’s belief
(p, 1 − p) at this information set is determined by Bayes’rule and the
Sender’s strategy: p = .5, the prior distribution (since there is no updat-
ing of belief in pooling).
• Receiver’s best response at R: Given this belief, the Receiver’s best re-
sponse following R is to play d since
u2 (u|R) = 1(.5) + 0(.5) = .5 < u2 (d|R) = 0(.5) + 2(.5) = 1
• Receiver’s belief and best response at information set for L: To determine
whether both Sender types are willing to choose R, we need to specify
how the Receiver would react to L. In particular, we need to pin down the
beliefs such that u2 (u|L) > u2 (d|L) in order for the Sender’s willingness
to choose R. The Receiver’s belief at the information set corresponding
to L needs to be, in order for u to be the best response, q ≥ 1/3. Thus, if
there is an equilibrium in which the Sender’s strategy is (R, R) then the
Receiver’s strategy must be (d, u) where (a0 , a00 ) means that the Receiver
plays a0 following R and a00 following L.
• Pooling perfect Bayesian equilibrium: [(R, R), (d, u), p = .5, q] for q ≥
1/3.

5. Part a.

2
 • Pooling on R: Beliefs on the equilibrium path: µ(t1 |R) = .5
Receiver’s best response: u2 (u|R) = .5(2) = 1 > u2 (d|R) = .5(1) = .5
Sender’s payoff: ut1 (R) = 2,ut2 (R) = 1.
Any play by Receiver after observing L sustains (R, R).
PBE: [(R, R), (u, u), q > 1/2], [(R, R), (u, d), q < 1/2], [(R, R), (u, αu +
(1 − α)d), q = 1/2]
• Pooling on L: Not an equilibrium, since t2 will always want to play R.
• t1 plays R, t2 plays L: Then both of the Receiver’s information sets are
on the equilibrium path, so both beliefs are determined by Bayes’ rule
and the Sender’s strategy: µ(t1 |R) = 1, µ(t2 |L) = 1.
Receiver’s best response: (u, d)
t2 , however, will always play R.
• t1 plays L, t2 plays R: µ(t1 |L) = 1, µ(t2 |R) = 1.
Receiver’s best response: (u, d)
Sender’s payoff: ut1 (L) = 1,ut2 (R) = 1.
PBE: [(L, R), (u, d)]

Part b.

• Pooling on R: Beliefs on the equilibrium path: µ(t1 |R) = .5

Receiver’s best response: u2 (u|R) = .5(2) = 1 > u2 (d|R) = .5(1) = .5
Sender’s payoff: ut1 (R) = 0,ut2 (R) = 1.
However, this is not an equilibrium since t1 would always play L.
• Pooling on L: Beliefs on the equilibrium path: µ(t1 |R) = .5
Receiver’s best response: u2 (u|L) = .5(3) = 1.5 > u2 (d|L) = .5(1) +
.5(1) = 1
Sender’s payoff: ut1 (L) = 3,ut2 (L) = 3.
Receiver’s belief and best response at information set for R: u2 (u|R) =
2(1 − p) > u2 (d|R) = p when p < 2/3.
PBE: [(L, L), (u, u), p < 2/3]
• t1 plays R, t2 plays L: Then both of the Receiver’s information sets are
on the equilibrium path, so both beliefs are determined by Bayes’ rule
and the Sender’s strategy: µ(t1 |R) = 1, µ(t2 |L) = 1.
Receiver’s best response: (d, u)
No deviations are profitable.
PBE: [(R, L), (d, u)]
• t1 plays L, t2 plays R: µ(t1 |L) = 1, µ(t2 |R) = 1.
Receiver’s best response: (d, u)
No deviations are profitable.
PBE: [(L, R), (d, u)]

3
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 Grade Distribution For Midterm 1
Average = 67.96 Std.Dev.= 18.05

100
Assuming that you will exhibit similar performance in the future,
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90 if you got above 50, you will probably get B(+/-) or above;
if you got below 40, you should reconsider ...

80

70

60
grade

50

40

30

20

10

0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46
rank
 14.12 Game Theory — Midterm II
10/10/2001

Prof. Muhamet Yildiz

Instructions. This is an open book exam; you can use any written material. You have one
hour and 20 minutes. Each question is 25 points. Good luck!

1. Consider the following game:

X E
1
5/2 L R
5/2
2
l r
r l

3 0 2 2
3 2 0 2

Compute all the pure-strategy subgame-perfect equilibria. Use a forward induction

argument to eliminate one of these equilibria.

2. Below, there are pairs of stage games and strategy profiles. For each pair, check whether
the strategy profile is a subgame-perfect equilibrium of the game in which the stage
game is repeated infinitely many times. Each agent tries to maximize the discounted
sum of his expected payoffs in the stage game, and the discount rate is δ = 0.99.

(a) Stage Game:

1\2 L M R
T 2,-1 0,0 -1,2
M 0,0 0,0 0,0
B -1,2 0,0 2,-1
Strategy profile: Until some player deviates, player 1 plays T and player 2
alternates between L and R. If anyone devites, then each play M thereafter.
(b) Stage Game:
1\2 A B
A 2,2 1,3
B 3,1 0,0
Strategy profile: The play depends on three states. In state S0 , each player
plays A; in states S1 and S2 , each player plays B. The game start at state S0 . In
state S0 , if each player plays A or if each player plays B, we stay at S0 , but if a
player i plays B while the other is playing A, then we switch to state Si . At any
Si , if player i plays B, we switch to state S0 ; otherwise we state at state Si .

1
3. Consider the following first-price, sealed-bid auction where an indivisible good is sold.There
are n ≥ 2 buyers indexed by i = 1, 2, . . . , n. Simultaneously, each buyer i submits a
bid bi ≥ 0. The agent who submits the highest bid wins. If there are k > 1 play-
ers submitting the highest bid, then the winner is determined randomly among these
players – each has probability 1/k of winning. The winner i gets the object and pays
his bid bi , obtaining payoff vi − bi , while the other buyers get 0, where v1 , . . . , vn are
independently and identically distributed with probability density function f where
½ 2
3x x ∈ [0, 1]
f (x) =
0 otherwise.

(a) Compute the symmetric, linear Bayesian Nash equilibrium.

(b) What happens as n → ∞?

[Hint: Since v1 , v2 , . . . , vn is independently distributed, for any w1 , w2 , . . . , wk , we have

Pr(v1 ≤ w1 , v2 ≤ w2 , . . . , vk ≤ wk ) = Pr(v1 ≤ w1 ) Pr(v2 ≤ w2 ) . . . Pr(vk ≤ wk ).]

4. This question is about a thief and a policeman. The thief has stolen an object. He
can either hide the object INSIDE his car on in the TRUNK. The policeman stops the
thief. He can either check INSIDE the car or the TRUNK, but not both. (He cannot
let the thief go without checking, either.) If the policeman checks the place where the
thief hides the object, he catches the thief, in which case the thief gets -1 and the police
gets 1; otherwise, he cannot catch the thief, and the thief gets 1, the police gets -1.

(a) Compute all the Nash equilibria.

(b) Now imagine that we have 100 thieves and 100 policemen, indexed by i =
1, . . . , 100, and j = 1, . . . , 100. In addition to their payoffs above, each thief i
gets extra payoff bi form hiding the object in the TRUNK, and each policeman j
gets extra payoff di from checking the TRUNK. We have

b1 < b2 < · · · < b50 < 0 < b51 < · · · < b100 ,
d1 < d2 < · · · < d50 < 0 < d51 < · · · < d100 .

Policemen cannot distinguish the thieves from each other, nor can the thieves
distinguish the policemen from each other. Each thief has stolen an object, hiding
it either in the TRUNK or INSIDE the car. Then, each of them is randomly
matched to a policeman. Each matching is equally likely. Again, a policeman
can either check INSIDE the car or the TRUNK, but not both. Compute a
pure-strategy Bayesian Nash equilibrium of this game.

2
The game for problem 1.

X E
1
5/2 L R
5/2
2
l r
r l

3 0 2 2
3 2 0 2

X E
1
5/2 L R
5/2
2
l r
r l

3 0 2 2
3 2 0 2

3
 14.12 Game Theory — Midterm II
10/10/2001

Prof. Muhamet Yildiz

Instructions. This is an open book exam; you can use any written material. You have one
hour and 20 minutes. Each question is 25 points. Good luck!

1. Consider the following game:

2

X E
1
5/2 L R
5/2
2
l r
r l

3 0 2 2
3 2 0 2

Compute all the pure-strategy subgame-perfect equilibria. Use a forward induction

argument to eliminate one of these equilibria.
Answer: There are two pure strategy Nash equilibria in the proper subgame, yielding
subgame-perfect equilibria:

2 2

X E X E
1 1
5/2 L R 5/2 L R
5/2 5/2
2 2
l r l r
r l r l

3 0 2 2 3 0 2 2
3 2 0 2 3 2 0 2

For player 2, Er is strictly dominated by Xr, while El is not dominated. Hence, if player
1 keeps believing that 2 is rational whenever it is possible, then when he sees that 2
played E, he ought to believe that 2 plays strategy El – not the dominated strategy
Ex. In that case, 1 would play L, and 2 would play E. Therefore, the equilibrium on
the left is eliminated.

1
2. Below, there are pairs of stage games and strategy profiles. For each pair, check whether
the strategy profile is a subgame-perfect equilibrium of the game in which the stage
game is repeated infinitely many times. Each agent tries to maximize the discounted
sum of his expected payoffs in the stage game, and the discount rate is δ = 0.99.

(a) Stage Game:

1\2 L M R
T 2,-1 0,0 -1,2
M 0,0 0,0 0,0
B -1,2 0,0 2,-1
Strategy profile: Until some player deviates, player 1 plays T and player 2
alternates between L and R. If anyone deviates, then each play M thereafter.
Answer: It is subgame perfect. Since (M,M) is a Nash equilibrium of the stage
game, we only need to check if any player wants to deviate when player 1 plays
T and player 2 alternates between L and R. In this regime, the present value of
player 1’s payoffs is
2 δ 2−δ
V1L = − = >0
1−δ 1−δ 1−δ
when 2 is to play L and
2δ 1 2δ − 1
V1R = − = = 98
1−δ 1−δ 1−δ
when 2 is to play R. When 2 plays L, 1 cannot gain by deviating. When 2 plays
R, the best 1 gets by deviating is

2 + 0 < 98

(when he plays B). The only possible profitable deviation for player 2 is to play
R when he is supposed to play left. In that contingency, if he follows the strategy
he gets V1R = 98; if he deviates, he gets 2 + 0 < V1R .
(b) Stage Game:
1\2 A B
A 2,2 1,3
B 3,1 0,0
Strategy profile: The play depends on three states. In state S0 , each player
plays A; in states S1 and S2 , each player plays B. The game start at state S0 . In
state S0 , if each player plays A or if each player plays B, we stay at S0 , but if a
player i plays B while the other is playing A, then we switch to state Si . At any
Si , if player i plays B, we switch to state S0 ; otherwise we state at state Si .
Answer: It is not subgame-perfect. At state S2 , player 2 is to play B, and we
will switch to state S0 no matter what 1 plays. In that case, 1 would gain by
deviating and playing A (in state S2 ).

2
3. Consider the following first-price, sealed-bid auction where an indivisible good is sold.
There are n ≥ 2 buyers indexed by i = 1, 2, . . . , n. Simultaneously, each buyer i
submits a bid bi ≥ 0. The agent who submits the highest bid wins. If there are k > 1
players submitting the highest bid, then the winner is determined randomly among
these players – each has probability 1/k of winning. The winner i gets the object and
pays his bid bi , obtaining payoff vi − bi , while the other buyers get 0, where v1 , . . . , vn
are independently and identically distributed with probability density function f where
½ 2
3x x ∈ [0, 1]
f (x) =
0 otherwise.

(a) Compute the symmetric, linear Bayesian Nash equilibrium.

Answer: We look for an equilibrium of the form

bi = a + cvi

where c > 0. Then, the expected payoff from bidding bi with type vi is

U (bi ; vi ) = (vi − bi ) Pr (bi > a + cvj ∀j 6= i)

Y
= (vi − bi ) Pr (bi > a + cvj )
j6=i
Y µ ¶
bi − a
= (vi − bi ) Pr vj <
j6=i
c
Y µ bi − a ¶3
= (vi − bi )
j6=i
c
µ ¶3(n−1)
bi − a
= (vi − bi )
c
for bi ∈ [a, a + c]. The first order condition is
µ ¶3(n−1) µ ¶3(n−1)−1
∂U (bi ; vi ) bi − a 1 bi − a
=− + 3 (n − 1) (vi − bi ) = 0;
∂bi c c c
i.e., µ ¶
bi − a 1
− + 3 (n − 1) (vi − bi ) = 0;
c c
i.e.,
a + 3 (n − 1) vi
bi = .
3 (n − 1) + 1
Since this is an identity, we must have
a
a= =⇒ a = 0,
3 (n − 1) + 1
and
3 (n − 1)
c= .
3 (n − 1) + 1

3
 (b) What happens as n → ∞?
Answer: As n → ∞,
bi → vi .
In the limit, each bidder bids his valuation, and the seller extracts all the gains
from trade.

[Hint: Since v1 , v2 , . . . , vn is independently distributed, for any w1 , w2 , . . . , wk , we have

Pr(v1 ≤ w1 , v2 ≤ w2 , . . . , vk ≤ wk ) = Pr(v1 ≤ w1 ) Pr(v2 ≤ w2 ) . . . Pr(vk ≤ wk ).]

4. This question is about a thief and a policeman. The thief has stolen an object. He
can either hide the object INSIDE his car on in the TRUNK. The policeman stops the
thief. He can either check INSIDE the car or the TRUNK, but not both. (He cannot
let the thief go without checking, either.) If the policeman checks the place where the
thief hides the object, he catches the thief, in which case the thief gets -1 and the police
gets 1; otherwise, he cannot catch the thief, and the thief gets 1, the police gets -1.

(a) Compute all the Nash equilibria.

Answer: This is a matching-pennies game. There is a unique Nash equilibrium,
in which Thief hides the object INSIDE or the TRUNK with equal probabilities,
and the Policeman checks INSIDE or the TRUNK with equal probabilities.
(b) Now imagine that we have 100 thieves and 100 policemen, indexed by i =
1, . . . , 100, and j = 1, . . . , 100. In addition to their payoffs above, each thief i
gets extra payoff bi form hiding the object in the TRUNK, and each policeman j
gets extra payoff dj from checking the TRUNK. We have
b1 < b2 < · · · < b50 < 0 < b51 < · · · < b100 ,
d1 < d2 < · · · < d50 < 0 < d51 < · · · < d100 .
Policemen cannot distinguish the thieves from each other, nor can the thieves
distinguish the policemen from each other. Each thief has stolen an object, hiding
it either in the TRUNK or INSIDE the car. Then, each of them is randomly
matched to a policeman. Each matching is equally likely. Again, a policeman
can either check INSIDE the car or the TRUNK, but not both. Compute a
pure-strategy Bayesian Nash equilibrium of this game.
Answer: A Bayesian Nash equilibrium: A thief i hides the object in
INSIDE if bi < 0
TRUNK if bi > 0;
a policeman j checks
INSIDE if dj < 0
TRUNK if dj > 0.
This is a Bayesian Nash equilibrium, because, from the thief’s point of view the
policeman is equally likely to to check TRUNK or INSIDE the car, hence it is the
best response for him to hide in the trunk iff the extra benefit from hiding in the
trunk is positive. Similar for the policemen.

4
 14.12 Midterm 2 Grade Distribution

100

90

80

70

60
grade

50

40

30

20

10

0
1

11

13

15

17

19

21

23

25

27

29

31

33

35

37

39

41

43

45
Rank
 14.12 Grade Distribution (Midterm 1 + Midterm 2)/2

100

90

80

70
grade

60

50

40

30

20
1

11

13

15

17

19

21

23

25

27

29

31

33

35

37

39

41

43

45
rank
 14.12 Game Theory — Final
12/10/2001

Prof. Muhamet Yildiz

Instructions. This is an open book exam; you can use any written material. You have 2
hours 50 minutes. Each question is 20 points. Good luck!

1. Consider the following extensive form game.

O I

2 2
2 L R

1
L R L R

3 0 0 1
1 0 0 3

(a) Find the normal form representation of this game.

(b) Find all rationalizable pure strategies.
(c) Find all pure strategy Nash equilibria.
(d) Which strategies are consistent with all of the following assumptions?
(i) 1 is rational.
(ii) 2 is sequentially rational.
(iii) at the node she moves, 2 knows (i).
(iv) 1 knows (ii) and (iii).

2. This question is about a milkman and a customer. At any day, with the given order,

• Milkman puts m ∈ [0, 1] liter of milk and 1 − m liter of water in a container and
closes the container, incurring cost cm for some c > 0;
• Customer, without knowing m, decides on whether or not to buy the liquid at
some price p. If she buys, her payoff is vm − p and the milkman’s payoff is p − cm.
If she does not buy, she gets 0, and the milkman gets −cm. If she buys, then she
learns m.

1
 (a) Assume that this is repeated for 100 days, and each player tries to maximize the
sum of his or her stage payoffs. Find all subgame-perfect equilibria of this game.
(b) Now assume that this is repeated infinitely many times and each player tries to
maximize the discounted sum of his or her stage payoffs, where discount rate is
δ ∈ (0, 1). What is the range of prices p for which there exists a subgame perfect
equilibrium such that, everyday, the milkman chooses m = 1, and the customer
buys on the path of equilibrium play?

3. For the game in question 3.a, assume that with probability 0.001, milkman strongly
believes that there is some entity who knows what the milkman does and will punish
him severely on the day 101 for each day the milkman dilutes the milk (by choosing
m < 1). Call this type irrational. Assume that this is common knowledge. For
v > p > c, find a perfect Bayesian equilibrium of this game.
Bonus: [10 points] Discuss what would happen if the irrational type were known to
dilute the milk by accident with some small but positive probability.

4. Find a perfect Bayesian equilibrium of the following game.

-1 1
1 du 1
el el
beer quiche du
{.1} don
0 ’t 3
0 don tw
’t
0

1 0
0 ts
0
el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

5. A risk-neutral entrepreneur has a project that requires $100,000 as an investment, and

will yield $300,000 with probability 1/2, $0 with probability 1/2. There are two types
of entrepreneurs: rich who has a wealth of $1,000,000, and poor who has $0. For some
reason, the wealthy entrepreneur cannot use his wealth as an investment towards this
project. There is also a bank that can lend money with interest rate π. That is, if
the entrepreneur borrows $100,000 to invest, after the project is completed he will pay
back $100, 000 (1 + π) – if he has that much money. If his wealth is less than this
amount at the end of the project, he will pay all he has. The order of the events is as
follows:

• First, bank posts π.

2
 • Then, entrepreneur decides whether to borrow ($100,000) and invest.
• Then, uncertainty is resolved.

(a) Compute the subgame perfect equilibrium for the case when the wealth is common
knowledge.
(b) Now assume that the bank does not know the wealth of the entrepreneur. The
probability that the entrepreneur is rich is 1/4. Compute the perfect Bayesian
equilibrium.

3
 14.12 Game Theory — Final
12/10/2001

Prof. Muhamet Yildiz

Instructions. This is an open book exam; you can use any written material. You have 2
hours 50 minutes. Each question is 20 points. Good luck!

1. Consider the following extensive form game.

O I

2 2
2 L R

1
L R L R

3 0 0 1
1 0 0 3

(a) Find the normal form representation of this game.

A:
L R
OL 2,2 2,2
OR 2,2 2,2
IL 3,1 0,0
IR 0,0 1,3
(b) Find all rationalizable pure strategies.

L R
OL 2,2 2,2
OR 2,2 2,2
IL 3,1 0,0

(c) Find all pure strategy Nash equilibria.

L R
OL 2,2 2,2
OR 2,2 2,2
IL 3,1 0,0

1
 (d) Which strategies are consistent with all of the following assumptions?
(i) 1 is rational.
(ii) 2 is sequentially rational.
(iii) at the node she moves, 2 knows (i).
(iv) 1 knows (ii) and (iii).
ANSWER: By (i) 1 does not play IR. Hence, by (iii), at the node she moves, 2
knows that 1 does not play IR, hence he knows IL. Then, by (ii), 2 must play L.
Therefore, by (i) and (iv), 1 must play IL. The answer is (IL,L).

2. This question is about a milkman and a customer. At any day, with the given order,

• Milkman puts m ∈ [0, 1] liter of milk and 1 − m liter of water in a container and
closes the container, incurring cost cm for some c > 0;
• Customer, without knowing m, decides on whether or not to buy the liquid at
some price p. If she buys, her payoff is vm − p and the milkman’s payoff is p − cm.
If she does not buy, she gets 0, and the milkman gets −cm. If she buys, then she
learns m.

(a) Assume that this is repeated for 100 days, and each player tries to maximize the
sum of his or her stage payoffs. Find all subgame-perfect equilibria of this game.
ANSWER: The stage game has a unique Nash equilibrium, in which m = 0 and
the customer does not buy. Therefore, this finitely repeated game has a unique
subgame-perfect equilibrium, in which the stage equilibrium is repeated.
(b) Now assume that this is repeated infinitely many times and each player tries to
maximize the discounted sum of his or her stage payoffs, where discount rate is
δ ∈ (0, 1). What is the range of prices p for which there exists a subgame perfect
equilibrium such that, everyday, the milkman chooses m = 1, and the customer
buys on the path of equilibrium play?
ANSWER: The milkman can guarantee himself 0 by always choosing m = 0.
Hence, his continuation value at any history must be at least 0. Hence, in the
worst equilibrium, if he deviates customer should not buy milk forever, giving the
milkman exactly 0 as the continuation value. Hence, the SPE we are looking for
is the milkman always chooses m=1 and the customer buys until anyone deviates,
and the milkman chooses m=0 and the customer does not buy thereafter. If the
milkman does not deviate, his continuation value will be
p−c
V = .
1−δ
The best deviation for him (at any history on the path of equilibrium play) is to
choose m = 0 (and not being able to sell thereafter). In that case, he will get
Vd = p + δ0 = p.
In order this to be an equilibrium, we must have V ≥ Vd ; i.e.,
p−c
≥ p,
1−δ

2
 i.e.,
c
p≥ .
δ
In order that the customer buy on the equilibrium path, we must also have p ≤ v.
Therefore,
c
v≥p≥ .
δ
3. For the game in question 2.a, assume that with probability 0.001, milkman strongly
believes that there is some entity who knows what the milkman does and will punish
him severely on the day 101 for each day the milkman dilutes the milk (by choosing
m < 1). Call this type irrational. Assume that this is common knowledge. For some
v > p > c, find a perfect Bayesian equilibrium of this game. [If you find it easier,
take the customers at different dates different, but assume that each customer knows
whatever the previous customers knew.]
ANSWER: [It is very difficult to give a rigorous answer to this question,
so you would get a big partial grade for an informal answer that shows
that you understand the reputation from an incomplete-information point
of view.] Irrational type always sets m = 1. Since he will be detected whenever he
sets m < 1 and the customer buys, the rational type will set either m = 1 or m = 0.
We are looking for an equilibrium in which early in the relation the rational milkman
will always set m = 1 and the customer will always buy, but near the end of the relation
the rational milkman will mix between m = 1 and m = 0, and the customer will mix
between buy and not buy.
In this equilibrium, if the milkman sets m < 1 or the customer does not buy at any
t, then the rational milkman sets m = 0 at each s > t. In that case, if in addition the
costumer buys at some dates in the period {t + 1, t + 2, . . . , s − 1} and if the milkman
chooses m = 1 at each of those days, then the costumer will assign probability 1 to
that the milkman is irrational and buy the milk at s; otherwise, he will not buy the
milk. On the path of such play, if the milkman sets m < 1 or the customer does not
buy at any t, then the rational milkman sets m = 0 and the costumer does not buy at
each s > t. In order this to be an equilibrium, the probability µt that the milkman is
irrational at such history must satisfy

µt (100 − t) (v − p) − (1 − µt ) p ≤ 0,

where the first term is the expected benefit from experimenting (if the milkman happens
to be irrational) and the second term is the cost (if he is rational). That is,
p
µt ≤ .
p + (100 − t) (v − p)

Now we determine what happens if the milkman has always been setting m = 1,
and the customer has been buying. In the last date, the rational type will set m = 0,
and the rational type will set m = 1; hence, the buyer will buy iff

µ100 (v − p) − (1 − µ100 ) p ≥ 0,

3
i.e.,
p
µ100 ≥ .
v
Since we want him to mix, we set
p
µ100 = .
v
We derive µt for previous dates using the Bayes’ rule and the indifference condition
necessary for the customer’s mixing. Let’s write αt for the probability that the rational
milkman sets m = 1 at t, and at = µt + (1 − µt ) αt for the total probability that m = 1
at date t. Since the customer will be indifferent between buying and not buying at
t + 1, his expected payoff at t + 1 will be 0. Hence, his expected payoff from buying at
t is
at (v − p) + (1 − at ) (−p) .
For indifference, this must be equal to zero, thus
p
at = .
v
On the other hand, by Bayes’ rule,
µt
µt+1 = .
at
Therefore,
p
µt = at µt+1 = µt+1 .
v
That is,
p
µ100 =
v
³ p ´2
µ99 =
v
³ p ´3
µ98 =
v
..
.

Note that p
p v
− µt
at = = µt + (1 − µt ) αt ⇒ αt = .
v 1 − µt
Assume that (p/v)100 < 0.001. Then, we will have a date t∗ such that
³ p ´101−t∗ ³ p ´100−t∗
< 0.001 < .
v v
At each date t > t∗ , we will have µt = (p/v)101−t and the players will mix so that
at = vp . At each date t < t∗ , the milkman will set m = 1 and the customer will buy.
At date t∗ , the rational milkman will mix so that
³ p ´100−t∗ µ∗ 0.001
= µt∗ +1 = t = ,
v at∗ at∗

4
hence
0.001
at∗ = ¡ p ¢100−t∗ .
v

Note that at∗ > p/v, hence the customer will certainly buy at t∗ .
Let’s write β t for the probability that the customer will buy at day t. In the day
99, if the rational milkman sets m = 1, he will get

U = β 99 (p − c) + β 99 β 100 p + (1 − β 99 ) (−c) ,

where the first term is the profit from selling at day 99, the second term is the profit
from day 100 (when he will set m = 0), and the last term is the loss if the customer
does not buy at day 99. If he sets m = 0, he will get β 99 p (from the sale at 99, and
will get zero thereafter). Hence, he will set m = 1 iff

β 99 (p − c) + β 99 β 100 p + (1 − β 99 ) (−c) ≥ β 99 p

i.e.,
c
β 99 β 100 ≥ .
p
We are looking for an indifference, hence we set
c
β 99 β 100 = .
p
Similarly, at day 98 the rational milkman will set m = 1 iff

β 98 (p − c) + β 98 β 99 p + (1 − β 98 ) (−c) ≥ β 98 p,

where the second term is due to the fact that at date 99 he will be indifferent between
choosing m = 0 and m = 1. For indifference, we set
c
β 98 β 99 = .
p
We will continue on like this as long as we need the milkman to mix. That is, we will
have
c
β t∗ β t∗ +1 = ,
p
c
β t∗ +1 β t∗ +2 = ,
p
..
.
c
β 98 β 99 = ,
p
c
β 99 β 100 = .
p

5
 As we noted before, β t∗ = 1. Hence, β t∗ +1 = pc . Hence, β t∗ +2 = 1, ... That is,

β t∗ = 1,
c
β t∗ +1 = ,
p
β t∗ +2 = 1,
c
β t∗ +3 = ,
p
..
.

Bonus: [10 points] Discuss what would happen if the irrational type were known to
dilute the milk by accident with some small but positive probability.

4. Find a perfect Bayesian equilibrium of the following game.

-1 1
1 du 1
el uel
beer quiche d
{.1} don
0 ’t 3
0 don tw
’t
0

1 0
0 ts
0
el
du

du
el

beer {.9} quiche

3 ’t don 2
1 don ’ t 1

ANSWER:

6
 -1 1
1 du 1
el uel
beer quiche d

0 n’ t {0} {.1} {1} d

on’ 3
0 do tw t
0

1 0
0 ts
0

el
du

du
el

{1}beer {.9} quiche {0}

3 ’t don 2
1 don ’ t 1

5. A risk-neutral entrepreneur has a project that requires $100,000 as an investment, and

will yield $300,000 with probability 1/2, $0 with probability 1/2. There are two types
of entrepreneurs: rich who has a wealth of $1,000,000, and poor who has $0. For some
reason, the wealthy entrepreneur cannot use his wealth as an investment towards this
project. There is also a bank that can lend money with interest rate π. That is, if
the entrepreneur borrows $100,000 to invest, after the project is completed he will pay
back $100, 000 (1 + π) – if he has that much money. If his wealth is less than this
amount at the end of the project, he will pay all he has. The order of the events is as
follows:

• First, bank posts π.

• Then, entrepreneur decides whether to borrow ($100,000) and invest.
• Then, uncertainty is resolved.

(a) Compute the subgame perfect equilibrium for the case when the wealth is common
knowledge.
ANSWER: The rich entrepreneur is always going to pay back the loan in full
amount, hence his expected payoff from investing (as a change from not investing)
is
(0.5)(300, 000) − 100, 000 (1 + π) .
Hence, he will invest iff this amount is non-negative, i.e.,

π ≤ 1/2.

Thus, the bank will set the interest rate at

π R = 1/2.

7
 The poor entrepreneur is going to pay back the loan only when the project suc-
ceeds. Hence, his expected payoff from investing is

(0.5)(300, 000 − 100, 000 (1 + π)).

He will invest iff this amount is non-negative, i.e.,

π ≤ 2.

Thus, the bank will set the interest rate at

π P = 2.

(b) Now assume that the bank does not know the wealth of the entrepreneur. The
probability that the entrepreneur is rich is 1/4. Compute the perfect Bayesian
equilibrium.
ANSWER: As in part (a), the rich type will invest iff π ≤ π R = .5, and the poor
type will invest iff π ≤ π P = 2. Now, if π ≤ πR , the bank’s payoff is
· ¸
1 3 1 1
U (π) = 100, 000 (1 + π) + 100, 000 (1 + π) + 0 − 100, 000
4 4 2 2
5
= 100, 000 (1 + π) − 100, 000
8
5
≤ 100, 000 (1 + π R ) − 100, 000
8
5 1
= 100, 000 (1 + 1/2) − 100, 000 = − 100, 000 < 0.
8 16
If π R < π ≤ π P , the bank’s payoff is
· ¸
3 1 1
U (π) = 100, 000 (1 + π) + 0 − 100, 000
4 2 2
3
= 100, 000 (π − 1) ,
8
which is maximized at πP , yielding 38 100, 000. If π > π P , U (π) = 0. Hence, the
bank will choose π = πP .

8
 14.12 Game Theory — Final
12/21/2001

Prof. Muhamet Yildiz

Instructions. This is an open book exam; you can use any written material. You have 2
hours 50 minutes. Each question is 20 points. Good luck!

1. Consider the following extensive form game.

1 A 2 α 1 a
(1,4)

D δ d

(1,1) (0,3) (2,2)

(a) Find the normal form representation of this game.

1\2 α δ
Aa 1,4 0,3
Ad 2,2 0,3
Da 1,1 1,1
Dd 1,1 1,1
(b) Find all rationalizable pure strategies.

1\2 α δ
Ad 2,2 0,3
Da 1,1 1,1
Dd 1,1 1,1

(c) Find all pure strategy Nash equilibria.

1\2 α δ
Ad 2,2 0,3
Da 1,1 1,1
Dd 1,1 1,1

(d) Which strategies are consistent with all of the following assumptions?
(i) 1 is rational.
(ii) 2 is sequentially rational.
(iii) at the node she moves, 2 knows (i).
(iv) 1 knows (ii) and (iii).

1
 ANSWER: By (i) 1 does not play Aa. Hence, by (iii), at the node she moves, 2
knows that 1 does not play Aa, hence he knows that 1 plays Ad. Then, by (ii), 2
must play δ. Therefore, by (i) and (iv), 1 must play Ad or Aa. The answer is 1
plays A, given chance 2 would play δ.

2. This question is about a game between a possible applicant (henceforth student) to

a Ph.D. program in Economics and the Admission Committee. Ex-ante, Admission
Committee believes that with probability .9 the student hates economics and with
probability .1 he loves economics. After Nature decides whether student loves or hates
economics with the above probabilities and reveals it to the student, the student decides
whether or not to apply to the Ph.D. program. If the student does not apply, both the
student and the committee get 0. If student applies, then the committee is to decide
whether to accept or reject the student. If the committee rejects, then committee gets
0, and student gets -1. If the committee accepts the student, the payoffs depend on
whether the student loves or hates economics. If the student loves economics, he will be
successful and the payoffs will be 20 for each player. If he hates economics, the payoffs
for both the committee and the student will be -10. Find a separating equilibrium and
a pooling equilibrium of this game.
ANSWER: A separating equilibrium:

(-10,-10)
Apply Accept
{0} Reject
Don’t (-1,0)
.9
Hate
(0,0) (20,20)
Love {1}
Apply Accept
.1
Reject
Don’t (-1,0)

(0,0)

A pooling equilibrium:

2
 (-10,-10)
Apply Accept
{.9} Reject
Don’t (-1,0)
.9
Hate
(0,0) (20,20)
Love {.1}
Apply Accept
.1
Reject
Don’t (-1,0)

(0,0)

3. Consider a bargaining problem where two risk-neutral players are trying to divide a
dollar they own, which they cannot use until they reach an agreement. The players
do not discount the future, but at the end of each rejection of an offer the bargaining
breaks down with probability 1 − δ ∈ (0, 1) and each player gets 0.

(a) Consider the following bargaining procedure. Player 1 makes an offer (x, 1 − x),
where x is player 1’s share. Then, player 2 decides whether or not to accept the
offer. If she accepts, they implement the offer, yielding division (x, 1 − x). If she
rejects the offer, then with probability 1 − δ, the bargaining breaks down an each
gets 0; with probability δ, player 1 makes another offer, which will be accepted or
rejected by player 2 as above. (If player 2 rejects the offer, bargaining will break
down with probability 1 − δ again.) If the offer is rejected and the bargaining
did not break down, now player 2 makes a counter offer, and player 1 accepts
or rejects this counter offer as above. If the offer is rejected, this time the game
will end, and each will get 0. Find the subgame-perfect Nash equilibrium of this
game. Compute the expected payoff of each player at the beginning of the game
in this equilibrium.
ANSWER: On the last day, 1 accepts any offer, so 2 offers (0,1). Hence, on the
previous day, 2 accepts an offer iff she gets at least δ. Hence, 1 offers (1 − δ, δ) –
accepted.
¡ Thus, in¢ the first day, 2 accepts an offer iff she gets
¡ at least¢ δ 2 . Hence,
1 offers 1 − δ 2 , δ 2 – accepted. The expected payoffs are 1 − δ 2 , δ 2 .

(b) Compute the subgame-perfect equilibrium of the game in which the procedure in
part (a) is repeated 2 times. (The probability of bargaining breakdown after each
rejection is 1 − δ, except for the end of the game.)
ANSWER: The last period as above. Let’s look at the first period.
¡ ¢On the last
2
day of the first period, 1 accepts an offer iff he gets at least δ 1 − δ , so 2 offers

3
 ¡ ¡ ¢ ¡ ¢¢
δ 1 − δ2 , 1 − ¡ δ 1 −¡ δ 2
. ¢¢
Hence, on the previous day, 2 accepts an offer iff she
2
gets at least δ 1 − δ 1 − δ . Hence, 1 offers
¡ ¡ ¡ ¢¢ ¡ ¡ ¢¢¢ ¡ ¡ ¢ ¡ ¡ ¢¢¢
1 − δ 1 − δ 1 − δ2 , δ 1 − δ 1 − δ2 = 1 − δ + δ2 1 − δ2 , δ 1 − δ 1 − δ2
–¡accepted.
¡ Thus,
¢¢ in the first day, 2 accepts an offer iff she gets at least
2 2
δ 1 − δ 1 − δ . Hence, 1 offers
¡ ¡ ¡ ¢¢ ¡ ¡ ¢¢¢ ¡ ¡ ¢ ¡ ¡ ¢¢¢
1 − δ2 1 − δ 1 − δ2 , δ 1 − δ 1 − δ2 = 1 − δ2 + δ3 1 − δ2 , δ2 1 − δ 1 − δ2
– accepted.
(c) Find the subgame-perfect equilibrium of the game in which this procedure is
repeated until they reach an agreement. Note that player 1 makes two offers,
then 2 makes one offer, then 1 makes two offers, and so on. You need to show
that the proposed strategy profile is in fact a subgame-perfect equilibrium. (The
probability of bargaining breakdown after each rejection is 1 − δ.)
[Hint: One way is to compute the SPE for the game in which the procedure
is repeated n times and let n → ∞. A somewhat easier way is to consider
an alternating offer bargaining procedure with some effective discount rates –
different for a different player.]
ANSWER: If you compare the calculations above with the calculations with the
alternating offer case with asymmetric discount rates, you should realize that
the first offer player 1 makes and the offer player 2 makes are identical to the
offers players 1 and 2 make, respectively, if the discount rates were δ1 = δ and
δ 2 = δ 2 . Intuitively, in his second offer player 1 makes player 2 indifferent between
accepting 1’s second offer and making an offer next day, and in his first offer he
makes her indifferent between accepting the offer and waiting for the second offer.
Therefore, 2 is indifferent between accepting 1’s first offer and waiting two days
two make an offer, as in the the alternating offer case when her discount rate
is δ 2 . Now conjecture that the subgame-perfect equilibrium would be as in the
alternating offer game with above discount rates. That is,
• in his first offer, player 1 offers
µ ¶ µ ¶ µ ¶
1 − δ2 1 − δ2 1 − δ 2 δ 2 (1 − δ 1 ) 1 − δ 2 δ2 (1 − δ)
,1 − ≡ , ≡ ,
1 − δ1δ2 1 − δ1δ2 1 − δ1 δ2 1 − δ1 δ2 1 − δ3 1 − δ3
µ ¶
1+δ δ2
≡ , ;
1 + δ + δ2 1 + δ + δ2
• in his secon offer, he will offer
µ ¶ µ ¶
δ (1 − δ 1 ) δ (1 − δ1 ) 1 + δ2 δ
1− , ≡ , ;
1 − δ1δ2 1 − δ1δ2 1 + δ + δ2 1 + δ + δ2
• player 2 will offer
µ ¶ µ ¶ µ ¶
1 − δ1 1 − δ1 δ 1 (1 − δ 2 ) 1 − δ 1 δ + δ2 1
1− , ≡ , ≡ , .
1 − δ1 δ2 1 − δ1 δ2 1 − δ1δ2 1 − δ1δ2 1 + δ + δ2 1 + δ + δ2

4
 Player 1’s first offer and player 2’s offer are by formula for alternating offer, player
1’s second offer is calculated by backward induction using the player 2’s offer in
the next period. Using single deviation property, you need to check that this is
an equilibrium.

4. We have an employer and a worker, who will work as a salesman. The worker may be
a good salesman or a bad one. In expectation, if he is a good salesman, he will make
$200,000 worth of sales, and if he is bad, he will make only $100,000. The employer
gets 10% of the sales as profit. The employer offers a wage w. Then, the worker accepts
or rejects the offer. If he accepts, he will be hired at wage w. If he rejects the offer,
he will not be hired. In that case, the employer will get 0, the worker will get his
outside option, which will pay $15,000 if he is good, $8,000 if he is bad. Assume that
all players are risk-neutral.

(a) Assume that the worker’s type is common knowledge, and compute the subgame-
perfect equilibrium.
ANSWER: A worker will accept a wage iff it is at least as high as his outside
option, and the employer will offer the outside option – as he still makes profit.
That is, 15,000 for the good worker 8,000 for the bad.

(b) Assume that the worker knows his type, but the employer does not. Employer
believes that the worker is good with probability 1/4. Find the perfect Bayesian
Nash equilibrium.
ANSWER: Again a worker will accepts an offer iff his wage at least as high as
his outside option. Hence if w ≥ 15, 000 the offer will be accepted by both types,
yielding

U (w) = (1/4) (.1) 200, 000 + (3/4) (.1) 100, 000 − w = 12, 500 − w < 0

as the profit for the employer. If 8, 000 ≤ w < 15, 000, then only the bad worker
will accept the offer, yielding

U (w) = (3/4) [(.1) 100, 000 − w] = (3/4) [10, 000 − w]

as profit. If w < 0, no worker will accept the offer, and the employer will get 0. In
that case, the employer will offer w = 8, 000, hiring the bad worker at his outside
option.

(c) Under the information structure in part (b), now consider the case that the em-
ployer offers a share s in the sales rather than the fixed wage w. Compute the
perfect Bayesian Nash equilibrium.
ANSWER: Again a worker will accept the share s iff his income is at least as high
as his outside option. That is, a bad worker will accept s iff

100, 000s ≥ 8, 000

5
 i.e.,
8, 000
s ≥ sB = = 8%.
100, 000
A good worker will accept s iff
15, 000
s ≥ sG = = 7.5%.
200, 000
In that case, if s < sG no one will accept the offer, and the employer will get 0; if
sG ≤ s < sB , the good worker will accept the offer and the employer will get

(1/4) (10% − s) 200, 000 = 50, 000 (10% − s) ,

and if s ≥ sB , each type will accept the offer and the employer will get

(10% − s) [(1/4) 200, 000 + (3/4) 100, 000] = 125, 000 (10% − s) .

Since 125, 000 (10% − sB ) = 2%125, 000 = 2, 500 is larger than 50, 000 (10% − sG ) =
2.5%50, 000 = 1, 250, he will offer s = sB , hiring both types.

5. As in question 4, We have an employer and a worker, who will work as a salesman.

Now the market might be good or bad. In expectation, if the market is good, the
worker will make $200,000 worth of sales, and if the market is bad, he will make only
$100,000 worth of sales. The employer gets 10% of the sales as profit. The employer
offers a wage w. Then, the worker accepts or rejects the offer. If he accepts, he will be
hired at wage w. If he rejects the offer, he will not be hired. In that case, the employer
will get 0, the worker will get his outside option, which will pay $12,000. Assume that
all players are risk-neutral.

(a) Assume that whether the market is good or bad is common knowledge, and com-
pute the subgame-perfect equilibrium.
ANSWER: A worker will accept a wage iff it is at least as high as his outside
option 12,000. If the market is good, the employer will offer the outside option
w = 12, 000, and make 20, 000 − 12, 000 = 8, 000 profit. If the market is bad, the
return 10,000 is lower than the worker’s outside option, and the worker will not
be hired.

(b) Assume that the employer knows whether the market is good or bad, but the
worker does not. The worker believes that the market is good with probability
1/4. Find the perfect Bayesian Nash equilibrium.
ANSWER: As in part (a). [We will have a separating equilibrium.]

(c) Under the information structure in part (b), now consider the case that the em-
ployer offers a share s in the sales rather than the fixed wage w. Compute a
perfect Bayesian Nash equilibrium.
ANSWER: Note that, since the return is 10% independent of whether the market
is good or bad, the employer will make positive profit iff s < 10%. Hence, except

6
for s = 10%, we must have a pooling equilibrium. Hence, at any s, the worker’s
income is
[(1/4) 200, 000 + (3/4) 100, 000] s = 125, 000s.
This will be at least as high as his outside option iff
12, 000
s ≥ s∗ = = 9.6% < 10%.
125, 000
Hence an equilibrium: the worker will accept an offer s iff s ≥ s∗ , and the employer
will offer s∗ . The worker’s beliefs at any offer s is that the market is good with
probability 1/4. [Note that this is an inefficient equilibrium. When the market is
bad, the gains from trade is less than the outside option.]
There are other inefficient equilibria where there is no trade (i.e., worker is
never hired). In any such equilibrium, worker take any high offer as a sign that the
market is bad, and does not accept an offer s unless s ≥ 12, 000/100, 000 = 12%,
and the employer offers less than 12%. When the market is good, in any such
pure strategy equilibrium, he must in fact be offering less than s∗ . (why?) For
instance, employer offers s = 0 independent of the market, and the worker accept
s iff s > 12%.

7
 14.12 Final Exam Grade Distribution
Average = 73.82 Std. Dev = 20.74
120

100

80
grade

60

40

20

0
1

11

13

15

17

19

21

23

25

27

29

31

33

35

37

39

41

43

45
rank
 Final Grade, Final Grade + Quiz

100

A+
90
88

A
80

76

70
A-
60

B+

52
50
B
45
B-
40

30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45

Series1 Series2
 Final Grade (.25M1+.25M2+.4F+.1PS)

100

A+
90
88

80 A
76

70
A-
60
B+
52
50 B

45
B-
40

C
30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45
rank
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5
 14.12 Game Theory – Midterm I
10/19/2000
Prof. Muhamet Yildiz
Instructions. This is an open book exam; you can use any written material. You have one hour and
20 minutes. Each question is 33 points. Good luck!
1. Consider the following game.
1\2 L M R
T 3,2 4,0 1,1
M 2,0 3,3 0,0
B 1,1 0,2 2,3
a. Iteratively eliminate all the strictly dominated strategies.
b. State the rationality/knowledge assumptions corresponding to each elimination.
c. What are the rationalizable strategies?
d. Find all the Nash equilibria. (Don’t forget the mixed-strategy equilibrium!)
2. Consider the following extensive form game.
X
1 (2,2)

T
B

2 2
L R L R
(3,1) (0,0) (5,0) (0,1)

a. Find the normal form representation of this game.

b. Find all pure strategy Nash equilibria.
c. Which of these equilibria are subgame perfect?
3. Consider two agents £1, 2¤ owning one dollar which they can use only after they divide it. Each
player’s utility of getting x dollar at t is - t x for -  Ÿ0, 1 . Given any n  0, consider the
following n-period symmetric, random bargaining model. Given any date t  £0, 1, T , n " 1¤,
we toss a fair coin; if it comes Head (which comes with probability 1/2), we select player 1; if it
comes Tail, we select player 2. The selected player makes an offer Ÿx, y   ¡0, 1¢ 2 such that
x  y t 1. Knowing what has been offered, the other player accepts or rejects the offer. If the
offer Ÿx, y  is accepted, the game ends, yielding payoff vector Ÿ- t x, - t y . If the offer is rejected,
we proceed to the next date, when the same procedure is repeated, except for t  n " 1, after
which the game ends, yielding (0,0). The coin tosses at different dates are stochastically
independent. And everything described up to here is common knowledge.
a. Compute the subgame perfect equilibrium for n  1. What is the value of playing this game
for a player? (That is, compute the expected utility of each player before the coin-toss,
given that they will play the subgame-perfect equilibrium.)
b. Compute the subgame perfect equilibrium for n  2. Compute the expected utility of each
 player before the first coin-toss, given that they will play the subgame-perfect equilibrium.
c. What is the subgame perfect equilibrium for n u 3.
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5
 14.12 Solutions for Question 7 (or 8)
Kenichi Amaya1
November 9, 2001
(a)
Let’s denote firm 2’s by c2 , i.e., c2 ∈ {cL , cH }. Let p1 and p2 be each firm’s
price (action). Then, each firm’s payoff functions can be written as

 p1 − c if p1 < p2
p1 −c
π1 (p1 , p2 ) = if p1 = p2 ,
 2
0 if p1 > p2

 p2 − c2 if p2 < p1
p2 −c2
π2 (p1 , p2 ; c2 ) = 2 if p2 = p1
0 if p2 > p1


(b)
A pure strategy profile {p∗1 , (p∗2L , p∗2H )} is a Bayesian Nash equilibrium if
p∗1 = argmaxp1 θπ1 (p1 , p∗2L ) + (1 − θ)π1 (p1 , p∗2H ),
p∗2L = argmaxp2 π2 (p∗1 , p2 ; cL ),
p∗2H = argmaxp2 π2 (p∗1 , p2 ; cH ),

(c)
If there exists a pure strategy Bayesia Nash equilibrium, it must be true that
p∗1 = min{p∗2L , p∗2H }.
To see this, if p∗1 < min{p∗2L , p∗2H }, firm 1 is always selling to the whole market.
If it increases the price slightly, it still sells the whole market. So it can increase
the payoff. If p∗2k < p∗1 , where k is either L or H, firm 2 is selling to the whole
market when its type is k. If it increases the price slightly, it still sells the whole
market. So it can increase the payoff.
Next, if there exists a pure strategy Bayesia Nash equilibrium, it must be
true that
p∗1 = min{p∗2L , p∗2H } = c.
To see this, if p∗1 < c, firm 1 is selling positive amount and losing money.
Therefore it’s better to charge a price higher than R and not to sell to get zero
profit. On the other hand, if p∗1 < c, firm 1 can increase it’s profit by slightly
reducing its price.
Finally, p∗1 = min{p∗2L , p∗2H } = c can not be an equilibrium because firm 2
of type L can increase its profit by choosing a price slightly smaller than c.
1 E52-303, kamaya@mit.edu, 253-3591

1
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5
 14.12 Game Theory
Fall 2000
Final Exam Solutions

December 14, 2001

1. (a) Given perfect competition among firms, wages will be w1 = 1,w2 = 2

and w3 = 3 for types t = 1, 2, 3 respectively. The incentive compatibility
constraints give us the conditions that the education levels must fulfill
in equilibrium: e∗2 ≥ 1 + e∗1 and e∗3 ≥ 2 + e∗1 for t = 1, e∗2 ≤ 2 + e∗1 and
e∗3 ≥ 2 + e∗2 for t = 2, and e∗3 ≤ 3 + e∗2 and e∗3 ≤ 6 + e∗1 for t = 3.
If we let, for example, e∗1 = 0, then e∗2 = 1 and e∗3 = 3. Beliefs are
µ(t = 1|e0 ) = 1, where e0 is in [0, inf), µ(t = 2|e = 1) = 1 and µ(t = 3|e =
3) = 1.
(b) Let w1 = 1 as before, since type 1 is separating. Given that types 2
and 3 are pooling, their wage is the expected marginal productivity or
1/2(2) + 1/2(3) = 5/2. Letting e∗1 = 0, the compatibility constraints
provide the conditions that the education levels must fulfill in equilibrium:
e∗ ≥ 3/2 and e∗ ≤ 3. For instance, we choose e∗ = 2. Beliefs are
µ(t = 1|e 6= e∗ ) = 1, µ(t = 2|e∗ ) = 1/2 and µ(t = 3|e∗ ) = 1/2.

2. (a) Let the separating equilibrium be one where top plays R, bottom plays L.
The beliefs are µ(top|R) = 1 and µ(bottom|R) = 1. Player 2, the receiver,
plays up in the information set on the right-hand side, and down, on the
information set on the left-hand side. Now it is easy to check that player
1’s types do not want to deviate: if top type plays L instead, she gets
0 as opposed to 3, while bottom type, if she plays R instead, gets 1 as
opposed to 2.
(b) Pooling on R: player 2 plays down when sees R since EU (up|R) =
0.4(1) + 0.6(0) = 0.4 < EU (down|R) = 0.4(0) + 0.6(1) = 0.6. Any
beliefs about types given L actually support this equilibrium.
(c) Mixed strategies equilibrium: Bottom mixes αR + (1 − α)L. Player 2
mixes 1/2up+1/2down when sees R. By applying Bayes’ rule and forcing
it to be equal to 1/2, because this is the value that would make the
bottom type want to mix, we have µ(top|R) = 0.4(1)/(0.4+0.6(α)) = 1/2.
In particular, for player 2, EU (up|R) = P (top|R) and EU (down|R) =
1 − P (top|R). Setting these two equal, because we need player 2 to mix

1
 after observing R in order for bottom type to want to mix, we obtain that
P (top|R) = 1/2. From the Bayes’ rule equation we solve for α above, such
that bottom type’s strategy is 2/3R + 1/3L. Top type always plays R.
Player 2 plays 1/2up + 1/2down when sees R and plays down when sees
L. Beliefs are µ(bottom|L) = 1 and µ(top|R) = 1/2.

3. Given no discounting, and the fact that the plaintiff gets to make the first offer,
the game ends in the first day, with the plaintiff making an offer w and the
defendant accepting the offer. In particular, taking into account the legal fees
both parties must pay until court day, and the amount the defendant must pay
then, which is certain and common knowledge, the plaintiff will offer 1, 110K
and the defendant will accept all offers less than or equal to this amount, and
reject all others.

4. One pooling equilibrium of this game would be for the firm to reject all offers
w0 > 5 and accept all others, for both types of workers to offer w0 = 5, and to
offer w1 = 5 in the following period if reached. Beliefs: µ(type = 0|w 6= 5) = 1.
Workers do not want to deviate because that would lead to a rejection and a
wage of 5 in the following period, which is what they can get now (so they are
indifferent).

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