Problem Set 4 – BIE Game Theory

Due on March 16, 11:59pm

Submission instructions:

• Submit your answers in a single PDF file.

• The title of the file should be of the form: “BIEMadrid_LastName_FirstName_Pset4.pdf”.

• Upload your PDF file directly on Blackboard.

• You can also give me a paper copy in class.

1
1. (Creating & Solving Extensive Form Games) Consider a two-player game in which
Player 1 chooses first A or B, Player 2 then chooses C or D, and Player 1 then moves a
second time and chooses E or F . The payoffs are as follows:

Players’ strategies Player 1 Payoff Player 2 Payoff

AE, C 12 10

AF, C 9 6

AE, D 7 9

AF, D 6 4

BE, C 14 2

BF, C 5 2

BE, D 9 14

BF, D 4 11

(a) (10 points) Draw the extensive form.

(b) (10 points) Find all of the SPE of this game using backward induction.

2. (Simultaneous vs. sequential moves) Consider the Hawk-Dove game with the follow-
ing payoff matrix:

Player 2
Dove H awk
Dove (3, 3) (1, 5)
Player 1
H awk (5, 1) (0, 0)

(a) (5 points) How many Nash equilibria in pure strategies are there? Specify them.
(b) (10 points) Now suppose this game is played sequentially, with player 1 moving
first and player 2 moving second. What is/are the subgame perfect equilibria?
(c) (5 points) Explain in words why you think the SPE in the sequential move game
differ from the NE in the simultaneous move game.

2
3. (Principal-agent problem) An absentee landlord owns a farm and hires a labourer to
p
work it. The output of the farm as a function of the effort level, e, of the worker is e.
The landlord can not directly observe the effort level supplied by the worker, but she
does get to write a contract ahead of time, specifying the share α of future output that
will be kept by the worker. After observing α, the worker gets to choose his effort level e.
p
Effort is costly to the worker. Given α and e, the landlord’s utility is v(α, e) = (1 − α) e
(the output less the worker’s share), and the worker’s utility (which could, in principle,
p
be negative) is u(α, e) = α e − e (her share of output minus her effort cost). Assume
that 0 ≤ α ≤ 1 and 0 ≤ e ≤ 1.

(a) (25 points) What is the worker’s optimal level of effort given the share α she gets
to keep? (hint: find the worker’s best-response function)
(b) (25 points) Knowing the worker’s optimal level of effort, what is the choice of α
of the landlord? (hint: remember the landlord maximises his objective function
given a constraint on the worker’s optimal effort)
(c) (10 points) Given the landlord’s choice of α, what is the induced effort of the
worker?