February 21, 2023

Foundations of Public Policy Homework Assignment #2

Part I. Finding a Nash Equilibrium

Question 1.
Two firms each decide how many widgets to produce. Firm 1 produces s1 widgets and Firm 2
produces s2 widgets. The price per widget is 100 − s1 − s2 . The cost of producing s widget is s2 .
Hence, Firm 1’s profits are
(100 − s1 − s2 ) × s1 − s21
and Firm 2’s profits are
(100 − s1 − s2 ) × s2 − s22
Firms’ utilities are equal to their profits.
(a) What is Firm 1’s best response if Firm 2 produces 100 or more widgets [1 point]?
(b) Use calculus to derive each firm’s best response correspondence, assuming the other firm
produces fewer than 100 widgets [1 point].
(c) Draw the best response correspondences and identify the Nash equilibrium graphically [1
point].
(d) Now solve for the Nash equilibrium [2 points]. Do this in three steps:
• Substitute Firm 2’s best response correspondence (assuming Firm 1 produces fewer than
100 widgets) into Firm 1’s best response correspondence to find out Firm 1’s equilibrium
number of widgets.
• Substitute this back into Firm 2’s best response correspondence to find Firm 2’s equi-
librium number of widgets
• Confirm that these are in fact less than 100.
(e) Argue that there is not an equilibrium where either firm produces 100 or more widgets [1
point].

Question 2.
Find the Nash equilibrium of the following normal-form game: S1 = [0, 1], S2 = [0, 1], u1 (s1 , s2 ) =
3s1 − 2s1 s2 − 2s21 , and u2 (s1 , s2 ) = s2 + 2s1 s2 − 2s22 . (The solution is interior, so you can use
calculus.) [5 points]

Question 3.
Consider a game in which, simultaneously, player 1 selects any real number x and player 2 selects
any real number y. The payoffs are given by:

u1 (x, y) = 2x − x2 + 2xy
u2 (x, y) = 10y − 2xy − y 2 .

(a) Calculate and graph each player’s best response function as a function of the opposing player’s
pure strategy [3 points].
(b) Find and report the Nash equilibria of the game [2 points].

1
Question 4.
Heather and David (players 1 and 2) are partners in a handmade postcard business. They each put
costly effort into the business, which then determines their profits. However, unless they each exert
at least 1 unit of effort, there are no revenues at all. In particular, each player i chooses an effort
level ei ≥ 0. Player i’s payoff is
(
−ei if ej < 1
ui (ei , ej ) = 2 1 2
ei (ej − 1) + ei − 2 ei if ej ≥ 1

where j denotes the other player.

(a) Prove that (0, 0) is a Nash equilibrium [1 point].
(b) Graph the players’ best responses as a function of each other’s strategies [3 points].

(c) Find all the other Nash equilibria [2 points].