ECON 440/640 Problem Set 2 Answers

Problem 2.3
Stage 2. Player 1 accepts player 2s offer if S2 1 s. Offering that minimum accepted offer leads to payoffs (1 s, 1 1 s) and making a lower offer leads to (1 s, 2 (1 s)). Hence progressing to stage 2 leads to payoffs (1 s, 1 1 s).

Stage 1. Player 2 accepts player 1s offer if 1 S1 2 (1 1 s) or S1 < 1 2 (1 1 s). If player 1 makes the minimum acceptable offer, the players payoffs are (1 2 (1 1 s), 2 (1 1 s)). If she makes a lower offer, player 1s payoff is 1 s.

Innite repetition. Following the books argument, s is dened by s = 1 2 (1 s)s(1 + 2 1) = 1 2 s = 1 2 . 1 + 2 1

Worker

Invest

Not Invest

Firm

Firm

Promote

Not Promote

Promote

Not Promote

Wd - C Yds - Wd

We - C Yes - We

Wd Yd0 - Wd

We Ye0 - We

Figure 1: Game Tree for Problem 2.5

Problem 2.5
Period 2. because The rm will not promote the worker without investment on the workers part (0, E ) = YE 0 WE > YD0 WD = (0, D) as long as WD WE , since YD0 < YE 0 . The rm will promote the worker if the worker invests as long as (S, E ) = YDS WD <YES WE = (S, D) YDS YES >WD WE .

(1)

Period 1.

Assuming (1) holds, the worker will invest if WD C > WE , or WD WE > C .

Wage setting. Lower wages are good for the rm, so it makes sense to consider two possibilities 1. WD = WE = 0 = the workers reservation utiity, and 2. WD = C , WE = 0, the minimum wages that induce investment. Equilibrium prots under option i are (0, E ) = YE 0 and under the second option are (S, D) = YSD C . By assumption investment is efcient (YSD YE 0 > c, so the rm makes the second set of offers.

Problem 2.13
Collusion. Colluding rms will charge the same price pC > c. Each rms prot from the arrangement is a pC = D ( p C c) = (pC c) 2 The prot-maximizing price level is pC = (a + c)/2. Hence the current and discounted future value of this arrangement is ( a c) 2 (a c)2 (a c)2 (a c)2 + + 2 + = . 4 4 4 4(1 )

Deviation. A rm can deviate and charge pD = pC , providing a one-time payoff of (a c)2 /2. Comparing this payoff to the value of maintaining the collusive agreement, collusion is supportable if (a c)2 (a c)2 > 4(1 ) 2 2 > 4(1 ) 1 > . 2

Problem 2.14
As in the previous problem, pH = aH + c 2 aL + c pL = . 2

Colluding in period t leads to expected prots in t + 1 to of discounted value V = = (aH c)2 (aL c)2 (aL c)2 (aH c)2 + (1 ) + (1 ) + 2 + ... 4 4 4 4 (aL c)2 (aH c)2 + (1 ) . 1 4 4

The incentives for each rm to deviate are going to be greatest when a = aH and the benets of cheating are large. The payoff to defecting and pricing at pH is (aH c)2 /2. Firms are only better off colluding if (aH + c)2 (aH + c)2 (aH + c)2 (aL + c)2 < + + (1 ) 2 4 1 4 4 2 2 2 (aH + c) (aH + c) (aL + c) (1 ) < + (1 ) 4 4 4 (aH + c)2 < ( + 1)(aH + c)2 + (1 )(aL + c)2

so (if Ri prots from collusion when a = ai ) = (aH c)2 ( + 1)(aH c)2 + (1 )(aL c)2 RH . = RH + RL + (RH RL ) 3

As a rudimentary check of whether this answer is correct, note that when = 1, = 0.5 as it should. Reducing pH will reduce the incentive to deviate, so when 0.5 < < , setting some intermediate price between pL and pH will allow credible collusion. Let p( ) be the maximum price that can be charged in aH periods if collusion is going to be successful. Let R( ) prots(p( )) = (aH p( ))(p( ) c)/4. Then p( ) is dened by the equation 2R( ) = R( ) + Solving for R( ), p2 R( ) = R( ) + (1 ) L 4 2 p (1 )R( ) = R( ) + (1 ) L 4 2 p (1 )R( ) = (1 ) L 4 (1 ) p2 L . R( ) = 1 4 1 Substituting in the denition of R( ), (aH p( ))(p( ) c) = 4 p( )2 + p( )(aH c) aH c = (1 ) 1 (1 ) 1 p2 L 4 p2 L 1 R( ) + (1 ) p2 L . 4

and solving the quadratic equation gives p( ).

Problem 2.17
Let et {0, c} be the tth workers effort choice and wt be the wage the rm pays to that worker. Consider the following strategies: wt = e1 = c et = 0 if et1 = c and wt1 < c c otherwise 4 0 if et = 0 c if et = c

Conditional on the rm following this wage-setting strategy, workers who put in effort get c + c > 0 so et = c is optimal. For the rm, offering wt = c gives 1 1 ( y c)

and paying 0 gives y . Hence the rm will prefer to not deviate if 1 1 (y c) > y y c > (1 )y y > c c > . y

Problem 3.3
When bi = bL , i (pi ) is i (pi ) = (a pi bL E [pj ])pi so di = a bL pj 2pi dpi a bL E [pj ] . p i = pL = 2 Likewise when bi = bH ,
p i = pH =

a bH E [ p j ] . 2

The expected price the other rm sets is

E [pj ] = E [p] = p H + (1 )pL

so E [p] = a bL E [ p ] + (1 ) 2 a E [p] = . 2 bL (1 )bH a bH E [p] 2

It is possible to use E [p] to solve for p H and pL , but as far as I can tell, doing so does not lead to anything interesting.

Problem 3.6
The problem asks you to show that in there are n bidders, then the strategy of bidding bi = (n 1)vi /n is a symmetric BNE. Given that everyone plays this strategy, the probability of bi being the winning bid is Pr(bi > max{bj |j = i}) = Pr(bi > b1 ) Pr(bi > b2 ) . . . = Pr(bi > (n 1)v1 /n) Pr(bi > (n 1)v2 /n) . . . = Pr(v1 < nbi /(n 1)) Pr(v2 < nbi /(n 1)) . . . = nbi n1
n1

The rst step follows because for bi to be the maximum bid, it must be greater than each other bid. Using this result, we can rewrite i as i = Pr(bi > max{bj |j = i})(vi bi ) nbi (vi bi ) = n1 n1 nn1 bi vi nn1 bn i = (n 1)n1 and use the rst order condition to nd b i (vi ):
2 n1 i (n 1)nn1 bn vi nn bi i = =0 bi (n 1)n1 n1

so (n 1)vi nbi = 0 (n 1)vi b . i (vi ) = n