Financial Game Theory

Midterm Exam
Spring 2022

1. Suppose firm A and firm B repeatedly face the following situation, and the
interest rate is 40%:
Firm B

Low High

Low 0, 0 50, -40

Firm A
High -40, 50 10, 10

The firms agree to charge a high price each period, provided neither firm has
cheated on this agreement in the past (i.e., they use the “grim strategy”).

a. What are firm A’s profits if it cheats on the collusive agreement?

b. What are firm A’s profits if it does not cheat on the collusive agreement?
c. Does an equilibrium exist where the firms charge the high price each
period?

2. Suppose that it’s the year of 1830, and George and Mary fight a duel. Each has a
pistol loaded with one bullet. They start 10 steps apart and walk toward each
other at the same pace, 1 step at a time. After each step, either may fire his/her
gun. When one shoots, the probability of scoring a hit depends on the distance.
After k steps the probability is k/5, and so it rises from 0.2 after the first step to 1
after 5 steps, at which point they are right up against one another. If one player
fires and misses while the other has yet to fire, the walk must continue even
though the bulletless one now faces certain death. Each gets a payoff of -1 if he
himself/she herself is killed and 1 if the other is killed. If neither or both are
killed, each gets 0.

This is a game with five sequential steps and simultaneous moves (shoot or not
shoot) at each step. Find the subgame-perfect equilibrium of this game, that is, at
what step George should shoot, and at what step Mary should shoot.

3. The following table illustrates the money payoffs associated with a two-person
simultaneous move game:

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 Colin

Left Right

Up 1, 16 4, 6
Rowena
Down 2, 20 3, 40

a. Find the mixed-strategy Nash equilibrium for this game.

b. What are the payer’s expected payoffs in the equilibrium?

4. In each of the following games, identify the subgame perfect equilibrium

outcome of each game.

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1

2
As usual for sequential-move games, we begin at the end. Suppose both players have walked 5
steps and are right next to each other, but neither has yet fired. The payoffs are shown below,
and it is easy to see that Shoot is the dominant strategy at this step for each player; the resulting
payoffs are (0, 0).
Mary
Shoot Not
Shoot 0, 0 1, –1
George
Not –1, 1 0, 0

Knowing the equilibrium at the 5-step subgame, we use rollback to consider the payoffs after
each player has walked 4 steps:

Mary
Shoot Not
Shoot 0, 0 0.6, –0.6
George
Not –0.6, 0.6 0, 0

Payoffs above are derived as follows: (i) Top right cell: If George shoots and Mary does not,
then George hits with probability 0.8 and gets 1, and misses with probability 0.2, in which case
Mary has a sure shot after 5 moves, so George gets –1. George’s expected payoff is 0.8  1 +
0.2  (–1) = 0.6. Mary’s expected payoff is 0.8  (–1) + 0.2  1 = –0.6. Bottom left cell
calculations are similar. (ii) Top left cell: If both shoot, Mary gets 0.8  0.8  0 + 0.8  0.2  1
+ 0.2  0.8  (–1) + 0.2  0.2  0 = 0. (iii) Bottom right cell: If neither shoots on step 4, the
game goes to step 5, where we know the equilibrium payoff is (0, 0). Thus, we make use of the
analysis of step 5 performed above. Now analyzing the payoff table for step 4, we see Shoot is
the dominant strategy for both, and the resulting payoff is (0, 0).

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 For step 3, the duelists are six steps apart and the probability of hitting if you shoot is 0.6.
Similar calculations as those for step 4 (for instance, in top right and bottom left cells, use
0.6  1 + 0.4  (–1) = 0.2) lead to the following payoff table:

Mary

Shoot Not
Shoot 0, 0 0.2, –0.2
George
Not –0.2, 0.2 0, 0

Again, Shoot is dominant for each player and yields the payoffs (0, 0).

Next move back to step 2, with the pair 8 paces apart and the probability of hitting down
to 0.4. The payoff table is now

Mary

Shoot Not
Shoot 0, 0 –0.2, 0.2
George
Not 0.2, –0.2 0, 0

Things have changed: Not shoot is now the dominant strategy for both. The resulting
equilibrium payoff is still (0, 0).

Finally, at step 1, with the pair in their starting positions and the probability of hitting only
0.2, the payoff matrix is as shown below.

Mary

Shoot Not
Shoot 0, 0 –0.6, 0.6
George
Not 0.6, –0.6 0, 0

Not shoot is again the dominant strategy with payoffs of (0, 0).

Actual play of the game will result in both players shooting on step 3.

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(a) There is no pure-strategy Nash equilibrium here, hence the search for an equilibrium in

mixed strategies. Rowena’s p-mix (probability p on Up) must keep Colin indifferent and so

must satisfy 16p + 20(1 – p) = 6p + 40(1 – p); this yields p = 2/3 = 0.67 and (1 – p) = 0.33.
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Similarly, Colin’s q-mix (probability q on Left) must keep Rowena indifferent and so must

satisfy q + 4 (1 – q) = 2q + 3(1 – q); the correct q here is 0.5.

(b) Rowena’s expected payoff is 2.5. Colin’s expected payoff = 17.33.