BE

510 Business Economics 1 - Autumn 2021

Problem Set 7

1. Consider two rival profit-maximizing firms who choose output levels 𝑞! and 𝑞" from a
continuous interval. The market price is 𝑝 = 90 − 𝑞! − 𝑞" . There are no costs of production.
Determine the Nash equilibrium of this game.

2. Two players are invited to each submit a non-negative number (independently). Whoever
chooses the lower number receives that number as an amount in Euros; the other player
receives nothing. For example, if one player submits a 15 and the other a 20 then the first
player receives €15 and the second player receives €0. If there is a tie for the lowest number
the money is shared (e.g. €7.50 for each if both submit 15).
(a) Perform a pure-strategy Nash equilibrium analysis of this game. (For simplicity, assume
that the possible numbers and payments include arbitrary fractions of cents.)
(b) Are any numbers in this game dominated?

3. A group of 𝑛 firms in an office building are all connected to the same underground internet
broadband cable. Fast access to the internet is important to the firms but the connection speed
is inversely related to the total usage of bandwidth. Denote the amount of bandwidth used by
each firm 𝑖 as 𝑥# . Suppose a firm’s value from internet access is 𝑣# (𝑥# ) = 𝑥# -1 − ∑%$&! 𝑥$ 0 if
∑ 𝑥$ ≤ 1 and zero otherwise.

(a) Under the assumption that each firm independently seeks to maximize this value
determine the pure-strategy Nash equilibrium of the resulting game.
(b) Find an action profile such that all firms are better off than in the Nash equilibrium.

4. Consider a setting with two firms where each firm chooses its own output to supply the
market. Firm 1 chooses output 𝑥 and firm 2 chooses output 𝑦. Firm 1’s and firm 2’s demand
and cost functions are such that their per-unit profits turn out to be:
210𝑥
𝜏! (𝑥) = 600 − 2(𝑥 + 𝑦) and 𝜏" (𝑦) = 600 − 3𝑦 −
𝑦
(For example, if firm 1 produces 𝑥 = 40 and firm 2 𝑦 = 120 units then firm 1 will earn 𝜏! = €280 per unit and
firm 2 will earn 𝜏" = €170 per unit. Firm 1’s total profit is 𝜋! = €11,200 and firm 2’s profit is 𝜋" = €20,400.)
Furthermore, firm 2 has the opportunity to leave this market altogether (𝑦 = 0) and, by doing
so, earn a total of €10,000 from other business opportunities.
Each firm strives to choose the output level (𝑥 or 𝑦) that maximizes its total profit. Solve this
game by Iterated Elimination of Strictly Dominated Strategies. Explain in detail which outputs
are (and are not) dominated in each step.

Problem Set 7 - Solutions BE 510 Business Economics 1 - Autumn 2021

Problem Set 7 - Solutions

No guarantees for correctness. If you find errors in the proposed solutions, please let us know.

1. Consider two rival profit-maximizing firms who choose output levels 𝑞! and 𝑞" from a
continuous interval. The market price is 𝑝 = 90 − 𝑞! − 𝑞" . There are no costs of production.
Determine the Nash equilibrium of this game.
The firms’ profit functions are 𝜋# (𝑞# ) = -90 − 𝑞# − 𝑞$ 0𝑞# . The first-order conditions are
𝜋#' (𝑥# ) = 90 − 2𝑞# − 𝑞$ = 0. From this we obtain two best response functions,
1 1
𝑞! (𝑞" ) = 45 − 𝑞" and 𝑞" (𝑞! ) = 45 − 𝑞! .
2 2
We have a Nash equilibrium (mutual best responses) when both these equations hold
simultaneously. Using equation 1 in equation 2 we get
1 1
𝑞" = 45 − @45 − 𝑞" A
2 2
and hence 𝑞"∗ = 30. From firm 1’s best response function we then also obtain 𝑞!∗ = 30.

2. Two players are invited to each submit a non-negative number (independently). Whoever
chooses the lower number receives that number as an amount in Euros; the other player
receives nothing. For example, if one player submits a 15 and the other a 20 then the first
player receives €15 and the second player receives €0. If there is a tie for the lowest number
the money is shared (e.g. €7.50 for each if both submit 15).
(a) Perform a pure-strategy Nash equilibrium analysis of this game. (For simplicity, assume
that the possible numbers and payments include arbitrary fractions of cents.)
The pure-strategy equilibrium of this game is easy to find. Consider a pair of numbers, 𝑥!
and 𝑥" , chosen by player 1 and player 2. For a Nash equilibrium we need that 𝑥! is a best
response to 𝑥" and vice versa. Given that 𝑥" > 0 player 1’s best response is an 𝑥! that is
marginally lower than 𝑥" : The payoff from this strategy is 𝑥" − 𝜀 in Euros and for any
sufficiently small 𝜀 this exceeds the payoff from matching player 2’s choice (0.5𝑥" ), and it
obviously also exceeds the zero payoff from choosing a number greater than 𝑥" .
Since the same can be said about player 2’s best response to player 1’s number, there is
no pair of positive numbers which satisfies the conditions of a Nash equilibrium. The only
remaining possibility is that both players choose the number 0. And indeed, given that
the other player submits a zero, choosing zero as well is a best response because you
would earn zero whatever number you submit in this case. Hence, (0, 0) is the unique
pure-strategy Nash equilibrium of this game.

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Problem Set 7 - Solutions BE 510 Business Economics 1 - Autumn 2021

(b) Are any numbers in this game dominated?

No positive number is dominated by any other number. For example, if you submit 7 you
earn €7 whenever the other player happens to choose a number greater than 7. If instead
you submit some other number this can turn out to improve your payoff or worsen it,
depending on what the other player does. For example, submitting a 6 instead of a 7
improves your payoff if the other player happens to choose some number in between 6
and 7, but it makes you worse off if the other player happens to choose some number
greater than 7. Similarly, submitting an 8 instead of a 7 improves your payoff if the other
player happens to choose some number greater than 8, but it makes you worse off if the
other player happens to choose some number in between 7 and 8.
Only one choice is (weakly) dominated: 0, the Nash equilibrium strategy. If the other
player chooses 0, choosing 0 yourself is just as good or bad as any other number (as they
all yield a zero payoff), but in all other cases there are positive numbers that yield positive
payoffs. For example, 100 dominates 0 because in all cases where the other player
chooses 100 or more, choosing 100 yourself gives you a positive payoff (either €50 or
€100) whereas choosing 0 always gives you €0. The worst that could happen to you when
you choose 100 is that you earn €0 if the other player chooses some lower number. But
this is not worse than the €0 that you would get in any case when you submit 0.

3. A group of 𝑛 firms in an office building are all connected to the same underground internet
broadband cable. Fast access to the internet is important to the firms but the connection speed
is inversely related to the total usage of bandwidth. Denote the amount of bandwidth used by
each firm 𝑖 as 𝑥# . Suppose a firm’s value from internet access is 𝑣# (𝑥# ) = 𝑥# -1 − ∑%$&! 𝑥$ 0 if
∑ 𝑥$ ≤ 1 and zero otherwise.

(a) Under the assumption that each firm independently seeks to maximize this value
determine the pure-strategy Nash equilibrium of the resulting game.
Some remarks: Before we determine the equilibrium notice a few properties of 𝑣# (𝑥# ).
First of all, we can see immediately that the more the others are using the internet the lower the payoff for
the individual firm. The idea is that when others use up a lot of the bandwidth the connection speed declines
and reduces the benefit for the individual firm.
Second, 𝑣# (𝑥# ) is a hill-shaped function. That is, starting at 𝑣# (0) = 0 this function first increases up to some
maximum and then decreases to zero again. This means that there is an optimal level of internet usage for
the individual firm.
Third, the location of the maximum depends on the sum of the 𝑥$ , 𝑗 ≠ 𝑖. In other words, each firm’s optimal
level of internet usage depends on how much the other firms use the internet. We can see this when we
maximize the payoff functions.
To find the Nash equilibrium we use the trick that was introduced in the lecture. We
define
%

𝑋 ≔ G 𝑥$
$&!

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Problem Set 7 - Solutions BE 510 Business Economics 1 - Autumn 2021

such that we can rewrite 𝑣# (𝑥# ) as 𝑣# (𝑥# ) = 𝑥# (1 − 𝑋). Then, the first-order conditions are
𝑣#' (𝑥# ) = 1 − 𝑋 − 𝑥# = 0 ⇔ 𝑥# = 1 − 𝑋.
Thus, we now have 𝑛 equations:
𝑥! = 1 − 𝑋,
𝑥" = 1 − 𝑋,
…
𝑥% = 1 − 𝑋.
If we sum up these equations (all left hand sides and all right hand sides) we get
%

G 𝑥# = 𝑛(1 − 𝑋)
#&!

or, equivalently, 𝑋 = 𝑛(1 − 𝑋), which we can solve for 𝑋:

𝑛
𝑋∗ =
𝑛 + 1.
This gives us
1
𝑥#∗ = 1 − 𝑋 ∗ =
𝑛+1
Note that this procedure does not assume symmetry anywhere. Thus, while the Nash
equilibrium turns out to be symmetric (every firm chooses the same level of 𝑥), we have
not imposed symmetry on the solution.

(b) Find an action profile such that all firms are better off than in the Nash equilibrium.
We can do so by maximizing the total value that is generated. This does not guarantee a
Pareto improvement but might be a good place to start looking for one. The total value is:
% %

G 𝑣# (𝑥# ) = 𝑥! (1 − 𝑋) + 𝑥" (1 − 𝑋) + ⋯ + 𝑥% (1 − 𝑋) = (1 − 𝑋) G 𝑥# = 𝑋 − 𝑋 " .

#&! #&!

The first-order condition for the maximization problem is

𝜕 ∑%#&! 𝑣# (𝑥# )
= 1 − 2𝑋 = 0
𝜕𝑥$

yielding 𝑋L = 0.5. There are many different ways of arriving at a sum 𝑋 = 0.5. If all firms
use the internet to the same extent, we have
1
𝑥M# =
2𝑛.
Let’s compare the value per firm under the Nash equilibrium,

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Problem Set 7 - Solutions BE 510 Business Economics 1 - Autumn 2021

1 1 𝑛 1
𝑣#Nash @ A= N1 − O=
𝑛+1 𝑛+1 𝑛+1 (𝑛 + 1)" ,
with the value per firm under the efficient solution,
1 1 𝑛 1
𝑣#eff @ A = N1 − O =
2𝑛 2𝑛 2𝑛 4𝑛.
The latter is greater than the former if (𝑛 − 1)" > 0, which is the case for any 𝑛 ≥ 2. That
means that there really is a Pareto improvement: Everyone can be made better off. Just
some numerical examples:

𝑛 = 4: 𝑣#eff ≈ 1.6𝑣#Nash

𝑛 = 20: 𝑣#eff ≈ 5.5𝑣#Nash

Thus, the difference in payoffs can be quite substantial.
Some additional remarks: This problem is known as the tragedy of the commons. It describes situations
where the interaction between several users of some resource leads to overexploitation of the resource, a
bad outcome for everyone involved. A classic example is overfishing. One solution is to introduce rules or
laws to limit usage of the resource.

4. Consider a setting with two firms where each firm chooses its own output to supply the
market. Firm 1 chooses output 𝑥 and firm 2 chooses output 𝑦. Firm 1’s and firm 2’s demand
and cost functions are such that their per-unit profits turn out to be:
210𝑥
𝜏! (𝑥) = 600 − 2(𝑥 + 𝑦) and 𝜏" (𝑦) = 600 − 3𝑦 −
𝑦
(For example, if firm 1 produces 𝑥 = 40 and firm 2 𝑦 = 120 units then firm 1 will earn 𝜏! = €280 per unit and
firm 2 will earn 𝜏" = €170 per unit. Firm 1’s total profit is 𝜋! = €11,200 and firm 2’s profit is 𝜋" = €20,400.)
Furthermore, firm 2 has the opportunity to leave this market altogether (𝑦 = 0) and, by doing
so, earn a total of €10,000 from other business opportunities.
Each firm strives to choose the output level (𝑥 or 𝑦) that maximizes its total profit. Solve this
game by Iterated Elimination of Strictly Dominated Strategies. Explain in detail which outputs
are (and are not) dominated in each step.
The profit functions are
𝜋! (𝑥) = 𝑥𝜏! (𝑥) = -600 − 2(𝑥 + 𝑦)0𝑥

𝜋" (𝑦) = 𝑦𝜏" (𝑦) = 600𝑦 − 3𝑦 " − 210𝑥

Consider firm 2 first. Maximizing 𝜋" (𝑦) yields 𝑦 ∗ = 100. This optimal choice is independent
of the value of 𝑥 and therefore 𝒚∗ = 𝟏𝟎𝟎 strictly dominates any other value 𝒚 > 𝟎.

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Problem Set 7 - Solutions BE 510 Business Economics 1 - Autumn 2021

Firm 2’s profit at 𝑦 ∗ = 100 is 𝜋" (100) = 30,000 − 210𝑥. The only other alternative is 𝑦 = 0
which we know yields a payoff of 10,000. Hence, there is no dominance relationship
between 𝒚 = 𝟏𝟎𝟎 and 𝒚 = 𝟎 since 𝑦 = 100 can be better or worse than 𝑦 = 0 depending on
the value of 𝑥: If 𝑥 > ~95 leaving the market is better than choosing 100.
Now consider firm 1. Firm 1’s best response function is
1
𝑥(𝑦) = 150 − 𝑦 for any 𝑦 ∈ [0, 300].
2
This shows that many different values of 𝑥 can be a best response. Depending on what firm 1
expects firm 2 to do, firm 1 might find it optimal to choose any 𝑥 in between 0 and 150.
However, this also means that choosing an output level above 150 is never a best response!
But are outputs above 150 strictly dominated? Yes, they are. For any given level of 𝑦 the profit
function of firm 1 has the shape of a (two-dimensional) hill and this hill has a peak at 𝑥 =
150 − 0.5𝑦. If the value of 𝑦 changes, the hill is just moving to the left or to the right (it’s also
moving up or down but that’s not important for the optimal choice). Thus, if 𝑥 is sufficiently
large then a further increase in 𝑥 will always reduce the profit for firm 1, and so choosing any
𝑥 > 150 is definitely strictly worse than choosing 𝑥 = 150 for any value of 𝑦. Hence, any 𝒙 >
𝟏𝟓𝟎 is strictly dominated by 𝒙 = 𝟏𝟓𝟎.
Taking into account firm 2’s remaining, non-dominated, options (𝑦 = 0 and 𝑦 = 100) it is also
clear that choosing any 𝒙 < 𝟏𝟎𝟎 is strictly dominated by 𝒙 = 𝟏𝟎𝟎 (𝑥 = 100 is the best
response to firm 2 choosing 𝑦 = 100. Thus, the non-dominated numbers for firm 1 are 𝒙 ∈
[𝟏𝟎𝟎, 𝟏𝟓𝟎]. Any output level within this interval can be better or worse than either 𝑥 = 100
or 𝑥 = 150.
If we consider that firm 1 will only ever choose non-dominated numbers, it is therefore clear
that 𝑥 > 95 and therefore leaving the market (𝒚 = 𝟎) is the optimal choice for firm 2 (𝒚 =
𝟏𝟎𝟎 is now dominated). Given 𝑦 = 0 it is dominant for firm 1 to choose 𝒙 = 𝟏𝟓𝟎 and all
other x-values are strictly dominated.