Game Theory (S4415) : Answers To Problem Set 4: Prajit K. Dutta June 22, 2001

Game Theory (S4415): Answers to Problem Set 4
Prajit K. Dutta
June 22, 2001
Chapter 13
1.4 Write down the extensive form of the game above. How many subgames are there in this game? How many strategies does Coke have?
Answer:
Coke
Pepsi
-2,-1
-3,1
0,-3
A
Coke
1,2
O
T
0,1
A
0,0
Extensive form given by Figure 5. Single subgame - the entire game.

Coke's strategies are ET , EA, OT; and OA:
2.3 Finally, identify a part of the tree that is not a subgame because it
does not contain all the nodes in some information set although it contains
some.
Answer: The part of Figure 4 starting at node .
4.4 What must be the votes cast in the Senate by i) a Democrat, and ii)
a Republican if neither plays a dominated strategy?
1
Answer: The dominant strategy Nash equilibrium voting in the Senate

is truthful voting - both parties vote V ersion 2 over the status quo but only
Republicans vote for V ersion 1:
4.10 What is the subgame perfect equilibrium of this model? Does rm
2 enter the market?
Answer: After Firm 2 enters the market, there is only one possible Nash
equilibrium play - with prices (1; 1) and prots 52 ; 52 . If the costs to entering
the market are greater than 52 then rm 2 will not enter and otherwise it
will.
Chapter 15
2.1 Consider the innitely repeated Prisoners Dilemma. Show that the
strategy that plays (c; c) in every subgame - regardless of past behavior - is
a subgame perfect equilibrium.
Answer: Suppose that player 1 plays n instead at some stage. He loses
2 as a consequence in that stage. Furthermore, he does not inuence player
2 after that stage in any way; player 2 continues to play c thereafter. Hence,
there is no benet in the future to playing n in that stage. In other words,
each player might as well treat each stage as if it is a one-shot game. The
only Nash equilibrium in the stage therefore is to play (c; c):
3.1 Write down the extensive form of the game. Identify the subgames.
Answer: The tree is an innite unfolding of the Prisoners Dilemma (see
Figure 3, Chapter 17 in the text). There are an innite number of stages to
this repeated game. At each of these stages starts a number of subgames; the
number of subgames starting at stage 18 is equal to the number of dierent
ways that the rst 17 stages might have got played. Each of these subgames
must include all of the tree that follows after the start of this subgame.
3.4 Show that there is also a subgame perfect equilibrium in which the
price is always 2 dollars but which is sustained by a forgiving trigger. Be
explicit about the nature of the forgiving trigger.
Answer: The forgiving trigger strategy is as follows: start by pricing
at (2; 2) and continue doing so if each rm has priced in that fashion in the
past. The rst time that either rm posts a price other than 2, switch to
pricing at 1 for the next T periods. Stay at that price of 1 for the T periods
regardless of what your rival does during those periods. After T periods of
pricing at 1, switch back to 2, i.e., restart the whole procedure: start by
pricing at (2; 2) and continue doing so if each rm has priced in that fashion
in the past. The rst time that either rm posts a price other than 2, switch
to pricing at 1 for the next T periods....
Within a trigger - i.e., within the T periods, neither rm gains by posting
2
any price other than 1. That will only result in a zero prot in that stage
(whereas they make some positive prots at a price of 1) and will have no
eect on the length of the trigger.
In a non-trigger phase, the payos to undercutting a price of 2 is:
4
5 + 25 + 52 2 + 52 3 + ::: 52 T + T +1 1
T +1 4
= 5 + 52 1
T +
1
where I have used the fact that the monopoly prots at a price of 1 is 5
whereas at a price of 2 is 8 and the fact that + 2 + 3 + :::T = 1

T . On
the other hand, staying with a price of 2 yields a payo of
4
1
Comparing the two payos it is benecial to stay with the strategy if
or
4
5
4
>5+
+ T +1
1
2 1 T
1
4
5
(1 T +1 ) > 5 +
1
2 1 T
The last equation is satised when is close to 1 and T is large because
the left-hand side (by L'Hospital's rule - see text) goes to 4(T + 1) whereas
the right-hand side goes to 5 + 52 T (as goes to 1).
3.7 Provide an argument in support of your stated result (in the previous
question).
Answer: Mimic the remarks given at the end of the proof of the Folk
Theorem for the Prisoners Dilemma in the text.
Chapter 16
2.2 For the specication of demand and supply given by the previous
question, what is the collusive ask price? What about the collusive bid
price? Hence, what is the collusive spread? Do collusive market-makers sell
as much as they buy? (Continue to assume that the market-clearing price
is the value of the share.)
Answer: The market-makers prots are
(b a) (140 5a)
where I have used the fact that the quantity demanded will be equal to
quantity supplied. In fact that equality implies that
140 5a = 60 + 5b
3
i.e., b = 40 a. Substituting the prots become

(40 2a) (140 5a)
Marginal prots are zero if
20a = 480
or a = 24. Hence b = 16 and the spread is 8.
3.1 Show that an ask and a bid of 20 is a stage-game Nash equilibrium.
Answer: The market-clearing price of 20 is a Nash equilibrium; no dealer
would like to undercut this price since they will either buy above value or
sell above value (= 20) by doing so. Any prices above 20 for an ask or below
20 for a bid is ineective since it does not bring in any orders.
3.5 Consider, nally, the forgiving trigger strategy: trade at the collusive
quote unless some dealer undercuts. Thereafter trade at the market-clearing
price for T stages. After that revert to the collusive quotes. When is this
strategy an equilibrium?
40
Answer: Trading according to this strategy yields N(1)
. Deviating
yields 30 +
40 T +1
N(1) .
This strategy is an equilibrium if

40
(1 T +1 ) 30
N(1 )
4.2 Can you show that the same conclusion is true regardless of what
demand and supply function we consider?
Answer: Consider any supply and demand functions. Denote the collu
. Suppose that deviating against
sive prots as . Hence each dealer gets N
the collusive price yields a dealer a prot equal to N

(shared because there
is perfect order preferencing), where, by denition, < . Not deviating is
clearly better.
Chapter 17
2.1 Write down the payo matrix for good demand periods.
Answer: For these prices, the payo matrix is:
SAnV A
qH
qL
QH
130; 91 160; 80
QL
128; 112 152; 95
2.3 Suppose that good demand is expected to persist forever. For what
values of discount factors does a low production level become an equilibrium?
4
Answer: For SA the total discounted prots from producing (QL ; qL )

152
are 1
. On the other hand, the prots from expanding output to QH - and
then (QH ; qH ) thereafter - are:
160 +
130
1
Evidently withholding production is better if

152 +
130
152
> 160 +
1
1
44
> 16.
i.e., if 1
For the smaller producer V A the total discounted prots from producing
95
(QL ; qL ) are 1
. On the other hand, the prots from expanding output to
qH - and then (QH ; qH ) thereafter - are:
112 +
91
1

95 +
95
91
> 112 +
1
1
44
i.e., if 1
> 187. It is immediate that if V A will not cheat then neither
will SA.
3.2 How would your answer be any dierent if OPEC used the forgiving
trigger instead - and chose to overproduce for T periods only? Explain.
Answer: Starting in a good period, for the smaller producer V A the total
discounted prots from producing (QL ; qL ) in good periods and (QH ; qH ) in
bad periods are 95 + 95p+55(1p)
. On the other hand, the prots from
1
expanding output in that period to qH - and then (QH ; qH ) for T periods are:
91p + 55(1 p)
95p + 55(1 p) T +1
112 +
(1 T ) +
1
1
95 +
95p
91p
(1 T ) > 112 +
(1 T )
1
1
Check that if V A will not cheat then neither will SA in a good demand
period. (And that in bad demand periods neither player has an incentive to
cheat.
5

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Game Theory (S4415): Answers to Problem Set 4

Extensive form given by Figure 5. Single subgame - the entire game.

Answer: The dominant strategy Nash equilibrium voting in the Senate

whereas at a price of 2 is 8 and the fact that + 2 + 3 + :::T = 1

Comparing the two payos it is benecial to stay with the strategy if

i.e., b = 40 a. Substituting the prots become

This strategy is an equilibrium if

the collusive price yields a dealer a prot equal to N

Answer: For SA the total discounted prots from producing (QL ; qL )

Evidently withholding production is better if

Evidently withholding production is better if

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