ECO 2102 - Take Home Assignment 3

Remark: The assignment is due by 16.00 on Sunday, March 12. Please

be precise when answering the questions. Show the details of your work but
avoid verbosity. Attempt all questions. Together the questions amount to
110 points. But the maximum you can score on the assignment is 100 points.

1. (20 points) Three firms are considering whether to enter a new market
150
or not. The revenue for each firm that enters is n
, where n is the
number of firms that enter. The cost of entering is 50.

(a) Find the set of pure strategy Nash equilibria of this game.
(b) Is there a symmetric non-degenerate mixed strategy Nash equi-
librium of this game in which all three firms enter with the same
probability.

2. (20 point) Consider two firms that play a Cournot competition game
with demand P = 100 − Q and cost function of each firm given by
c(qi ) = 10qi . Suppose that before the two firms play the Cournot game,
firm 1 can invest in cost reduction. If it does invest, then its cost of
production will drop and its cost function will be c(qi ) = 5qi . The
cost of investment is F > 0. Firm 2 does not have this investment
opportunity.
Find the value of F ∗ such that for all F ≤ F ∗ , the (unique) Nash
equilibrium that survives the backward induction test involves firm 1
investing.

3. (20 points) Consider a continuum of potential buyers of a good who are

uniformly distributed on the interval [0, 1]. There are two firms, 1 and 2,
who both produce this good. These firms are located at each end of the
interval—firm 1 at 0 and firm 2 at the 1. Each firm i = 1, 2 decides what

1
 price pi to set for the good (pi can be any non-negative real number).
If a buyer buys the good, she does so from the firm which gives her
the highest value, with both price and distance entering her valuation.
Specifically, if a buyer buys the good from firm i, she receives a value of
v − pi − di , where v is her intrinsic valuation of the good; and di is the
distance between the buyer and firm i and represents her transportation
costs of buying from firm i. Thus a buyer positioned at a ∈ [0, 1]:

• buys from firm 1 if v − p1 − d1 > v − p2 − d2 ; and if buying is better

than not buying which gives a payoff of 0, i.e., v − p1 − d1 > 0.
• buys from firm 2 if v − p2 − d2 > v − p1 − d1 and v − p2 − d2 > 0
• does not buy if v − p1 − d1 < 0 and v − p2 − d2 < 0

Note that for the buyer positioned at a, the distances to the two firms
are d1 = a and d2 = 1 − a. Finally, assume that the cost of production
for both firms is zero and the objective of each firm is to maximize its
profits.
Model this strategic environment as a normal form game and answer
the following questions.

(a) Assume that v = 2. Find a pure strategy Nash equilibrium of the

game. Is the equilibrium you found unique?
(b) Is the Nash equilibrium you identified in the question above still
so if v = 1? Justify your answer.

4. (10 points) Consider the extensive game represented by the game tree
in Figure 1. Sketch the tree in your answer, label all its non-terminal
nodes and answer the questions below.

(a) Write down all the information sets of players 1 and 2.

(b) Write down the set of all strategies of players 1 and 2. Make
sure that there is no ambiguity in your specification of players’
strategies.

2
 Figure 1

A B

2 2

E F E F

1 1
1,2 2,0

C D C D
2 2
1,3 2,4
G H G H

2,-1 3,0 1,2 0,0

5. (20 points) Consider the following problem that we talked about during
lectures. There is a desirable good, the number of units of which is
determined stochastically—either 1 or 2 units are available with prob-
ability 0.5 each. Individual 1 knows how many units are available but
2 does not. Individual 1 can propose to give individual 2 either 0 or
1 unit of the good. Then individual 2, after seeing 1’s proposal, either
accepts or rejects the proposal. In the event of rejection, both individ-
uals receive zero units. Each person cares only about the number of
objects she obtains, i.e., her utility function is given by u(x) = x, where
x denotes the number of units of the good received.
Model this strategic environment as an extensive form game and answer
the following questions.

(a) Specify the normal form representation of this extensive form game.
Please do so by specifying the normal form using a matrix repre-
sentation. In particular, clearly explain what players’ strategy sets
are and how you derive their payoff functions.
(b) Find the set of all pure strategy Nash equilibrium of this game.

3
6. (20 points) Three firms, 1, 2 and 3, have to decide how much quantity
of a homogenous product to produce in a market with demand function
P = 100 − Q. The firms choose their quantities dynamically as follows.
First, firm 1 moves and decides how much quantity to produce. Then,
firm 2, after having observed firm 1’s production decision, decides how
much to produce. Finally, firm 3, after having observed both firm 1’s and
2’s production decisions, decides how much to produce. Each firm’s cost
of production is given by c(q) = q 2 and their objective is to maximize
profit.
Model this strategic environment as an extensive form game and answer
the following questions.

(a) Clearly specify the strategy sets of the 3 players.

(b) Determine a Nash equilibrium of this game that survives the back-
ward induction test. Is the equilibrium you identified the only such
equilibrium?
(c) Provide an example of a Nash equilibrium that does not survive
the backward induction test. Clearly establish that it is indeed a
Nash equilibrium and why it fails the backward induction test.