EXERCISES SET 1

1. SIMULTANEOUS GAMES

1.1) Consider the following matrix game:

L C R

T 3,1 a,3 0,4

M 1,b 2,0 1,1

B c,2 4,1 2,d

a) Provide the range of values for (a, b, c, d) such that both players have a dominant
strategy. Now, provide the range of values for which the pair of strategies (B, L) is a
Nash equilibrium of the game. (Topics 3 and 4)

b) Let a = 5 and b = 2. For what values of (c, d) is this game solvable by iterated
elimination of strictly dominated strategies? (Topic 3)

1.2) Consider the following matrix game:

L M R

T a,b 2,1 1,2

B 1,2 c,0 0,3

a) Provide the range of values for (a, b, c) such that both players have a dominant
strategy. Explain carefully your answer. (Topic 3)

b) Provide the range of values for (a, b) for which the pair of strategies (T, R) is a Nash
equilibrium of the game. Explain carefully your answer. (Topic 4)

c) Let a = 2, b = 1. Solve this game using the method of successive elimination of

dominated strategies. Explain carefully your answer. (Topic 3)

d) Assume a > 0, b > 0 and c > 0. Now the game is played sequentially under perfect
information. Player 1 (row player) moves first. Draw the tree for this game and
provide the range of values of (a, b) for which (T, L) is the unique perfect equilibrium
path of the game, explaining your answer. (Topic 6)
1.3) Two equally matched athletes compete in the final of a tournament. They have the same
probability of winning. Both of them consider the possibility of taking performance-
enhancing drugs. If only one of them does doping, then he wins with probability one.
But, if both athletes do doping, equality is re-established. The utility from winning is
one and from losing is zero. The individual cost from taking drugs is 0,1. Draw the
payoff matrix for this game. Do they have dominated actions? Make a prediction for
this game. Discuss its efficiency. (Topic 3)

1.4) A firm has two divisions, each of which has its own manager. Managers of these
divisions are paid according to their effort in promoting productivity in their divisions,
which is judged by comparison with the other manager. If both managers exert high
effort, each earns 150. If both exert low effort, each earns 100. But if one of the two
managers shows high effort, while the other shows low effort, the high effort manager
is paid 150 plus a 50 bonus, while the second manager gets a reduced salary of 80.
Managers make their effort decisions independently and without knowledge of the other
manager´s choice. High effort has an individual cost of 60.

a) Draw the payoff matrix for this game. Make a prediction for this game. Discuss its
efficiency. (Topic 3)

1.5) Two firms (1 and 2) simultaneously choose their levels of advertising expenditure x1
and x2 among three possible values {0, 1, 3}. The firms´ profit functions are: (V – xi) if
xi > xj; (V/2 – xi) if xi = xj and (-xi) if xi < xj , for i ≠ j . Assume that V = 8.

a) Draw the payoff matrix for this simultaneous game. Calculate the players´ best
response functions. Solve this game using the method of successive elimination of
dominated strategies. Explain carefully your answer. (Topic 3)

b) Suppose that the cost of advertising rises. In particular, c(xi) = 4xi for i = 1,2. Find
the Nash equilibria. What would be your prediction for the game in this situation?
Explain carefully your answer. (Topic 4)

1.6) Suppose two players select from three different numbers: 2, 10 or 40. They make their
decisions simultaneously. The person whose choice is closest to half of the average of
both decisions is the winner. The loser pays to the other player the amount chosen by
the winner. In case of a tie, both players get a payoff of zero.

a) Draw the payoff matrix for this game and solve it using the method of successive
elimination of dominated strategies. (Topic 3)

b) Assume that both players are rational. If player 1 does not know that player 2 is
rational, what actions would be eliminated? Explain carefully your answer. (Topic 3)

1.7) Each of two people chooses how much resources to use in fighting the other. If each
person devotes xi to fighting, then the total amount produced is y = 6 – x1 – x2. Each xi
can take the values {0, 1, 2}. The player that devotes more resources to fighting obtains
the whole output, that is, for example if x1 > x2, then player 1 obtains a payoff of y and
player 2 gets a payoff of zero. If x1 = x2 then each player obtains half of the output y.
 a) Draw the payoff matrix for this game. Calculate the players´ best response functions.
Solve this game using the method of successive elimination of dominated strategies.
(Topic 3)

b) Suppose that the government taxes the fight and now each xi has a cost for player i
given by c(xi) = 3xi. Repeat the analysis of the previous section. Assume now that
both players are rational and know the payoffs of the game. However, neither player
1 nor player 2 know their opponent´s rationality. What would be your prediction for
the game in this situation? Explain carefully your answer. (Topic 3)

1.8) Two drivers, player 1 and player 2, are simultaneously approaching an intersection
from different directions. They may choose to stop (S) or continue (C) at the intersection.
If they both stop, they prevent a crash and each receives a payoff of 1. If they both
continue they crash and each receives a payoff of 0. If only player 2 stops, then player 1
gets a payoff of 2 whereas player 2 gets a payoff of 1 - c; where c reflects the dislike of
the player being the only one to stop. Conversely, if only player 1 stops, then she gets 1
- c and player 2 gets 2. Assume 0 < c < 1.

a) Draw the payoff matrix for this game. Calculate the players´ best response functions.
Do they have dominated actions? Find the Nash equilibria. Discuss its efficiency.
Repeat the analysis if c > 1. (Topic 4)

b) Suppose now that c = 0,5 and both players´ utility function is given by U i(xi, xj) = xi
-α max{xj –xi, 0} – β max{xi – xj, 0} where α = 1 and β = 0,8 and xi and xj are the
monetary payoffs obtained by players i and j, respectively. That is, both players show
inequity aversion. Repeat the analysis of the previous section. Discuss the problem
of equilibrium selection, defining and applying the concepts of efficiency and risk
dominance. (Topic 4)

1.9) Two workers jointly produce a good. The level of output depends on the non-verifiable
work effort made by each of the individuals. Effort can take two values, ei  {1, 2}. The
individual cost of effort is given by the functions c(ei) = 3ei. The total revenue generated
by the team is R = 4(e1 + e2), which is equally shared by the players. It is common
knowledge that player 1 has selfish preferences, but player 2 is an advantageous inequity
averse player. His utility function is U2 (x1, x2) = x2 - (0,6)max{x2 –x1,0}, where x1 and x2
are the monetary payoffs obtained by players 1 and 2, respectively.

a) Draw the payoff matrix for this game. Calculate the players´ best response functions.
Do they have dominated actions? Find the Nash equilibrium. Discuss its efficiency.
(Topic 4)

b) The firm prefers that both workers exert high effort. Suppose that he can design the
productive process in a sequential way, that is, one of the workers chooses first and
after observing this choice, the other worker makes his decision. What system would
choose the firm: simultaneous or sequential choices? And, in this last case, who
should move first? Explain carefully your answer. (Topic 4)
1.10) Each of two people chooses how much resources to use in fighting the other. If each
person devotes xi to fighting, then the total amount produced is y = 3 – x1 – x2. Each xi
can take the values {0, 2}. The player that devotes more resources to fighting obtains the
whole output, that is, for example if x1 > x2, then player 1 obtains a payoff of y and player
2 gets a payoff of zero. If x1 = x2 then each player obtains half of the output y.

a) Draw the payoff matrix for this game. Calculate the players´ best response functions.
Do they have dominated actions? Find the Nash equilibrium. Discuss its efficiency.
(Topic 4)

b) Suppose now that the utility functions are Ui(xi, xj) = xi - 2max{xj –xi, 0}, where xi
and xj are the monetary payoffs obtained by players i and j, respectively. That is, both
players show disadvantageous inequity aversion. Repeat the analysis of the previous
section. Discuss the problem of equilibrium selection, defining and applying the
concepts of efficiency and risk dominance. (Topic 4)

1.11) A car driver and a pedestrian can get involved in an accident. Each of them chooses
between taking care or not. Taking care has a cost of 10 euros. The damage for the
pedestrian in case of an accident is 100 euros. There are no damages for the car driver.
If just one of them does not take care, then there is an accident with probability one. But
even if both players take care there is still a probability of a 10% of having an accident.

a) Draw the payoff matrix for this simultaneous game. Calculate the players´ best
response functions. Do they have dominated actions? Find the Nash equilibria.
Discuss its efficiency. (Topic 4)

b) Suppose that in case of an accident the car driver has to pay all damages to the
pedestrian, independently of who took care or not. Represent and analyze this new
game. Suppose alternatively, that the car driver pays all damages only in case he did
not take care. Analyze this situation and compare the two rules of legal liability
defined in this section. Which one is better from the social (efficiency) point of view?

1.12) Two individuals witness a crime. Each person can either call the police (C) or not
call the police (NC) and attaches a value of v to the police being informed (by anybody)
but bears the cost of the call, c. Assume that v > c > 0. Therefore, each individual receives
a payoff of zero if nobody calls, v if somebody other than him calls, and (v – c) if he calls.

a) Draw the payoff matrix for this game. Calculate the players´ best response functions.
Do they have dominated actions? Find the Nash equilibria. Discuss its efficiency.

b) Suppose now that three individuals witness the crime. The payoffs are the same as in
the previous section. Does it exist a Nash equilibrium where all players call the
police? Does it exist a Nash equilibrium where two players call the police? Find the
Nash equilibria. Explain carefully your answer.

1.13) Each of two players has 100 euros. They send simultaneously to a common fund an
amount xi ϵ {0, 50, 100} where i = 1, 2. The fund returns each one an amount: 2.min{x1,
x2}. That is, the utility function of each player is given by: Ui = 100 – xi + 2.min{x1, x2}.
 a) Draw the payoff matrix for this game. Calculate the players´ best response functions.
Do they have dominated actions? Find the Nash equilibria. Discuss its efficiency.
(Topic 4)

b) Suppose now that the game is played by three players. The payoffs are the same as in
the previous section. Find the Nash equilibria. Explain carefully your answer.

2. REPEATED GAMES

2.1) Two individuals have to decide simultaneously every period their contribution to a
public good in a repeated situation with infinite horizon. Individual contributions xi, can
only adopt two values: 0 or 10, where i = 1,2. The payoff function of each player, given
a pair of contributions, is: Ui = 10 – xi + ai.(x1 + x2), where a1 = 0,6 and a2 = 0,8 is the
marginal individual return of the public good for players 1 and 2 respectively. Both
players have the same discount factor .

a) Draw the payoff matrix of the stage-game. Is it possible to obtain the efficient
outcome in every period as a Nash equilibrium of the repeated game in which both
players use the Tit-for-Tat strategy? And, is it possible with the Grim Strategy?

b) What does it happen if the return of the public good, a, increases? Is it easier or more
difficult to sustain cooperation? Provide some intuition about the results you obtain.
Assume that 1 > a > 0,5.

2.2) Two individuals have to decide simultaneously every period their contribution to a
public good in a repeated situation with infinite horizon. Individual contributions xi can
only adopt two values: 0 or 5, where i = 1,2. The payoff function of each player, given a
pair of contributions, is: Ui = 5 – xi + a(x1 + x2), where a = 0,8 is the marginal individual
return of the public good. Both players have the same discount factor .

a) Draw the payoff matrix of the stage-game. Suppose that both players use the Tit-for-
Tat strategy in the repeated game. Determine for which values of the discount factor
is possible to obtain the efficient outcome in every period as a Nash equilibrium of
the repeated game. Analyse also the case in which both players use the Grim Strategy.

b) Suppose that this public good game is played each period by a group of three players.
Each individual leaves only three periods. In each period, the group is composed by
individuals of all generations (that is, there is a player in his first period, another
player in her second period and a third player in his third and last period). Each
individual choses between 0 and 5 and his per-period payoff is given by the function
Ui = 5 – xi + a(x1 + x2 + x3), where a = (0,5). Assume for simplicity that players
maximize the sum of the per-period payoffs. Find a perfect Nash equilibrium of the
repeated game in which everybody, except the player in his last period in the group,
chooses to contribute 5. (Topic 6)
2.3) Two workers jointly produce a good every period in a repeated game with infinite
horizon. The level of output depends on the non-verifiable work effort made by each of
the individuals. Effort can take two values, ei  {1, 2}. The individual cost of effort is
given by the functions c(ei) = 4ei, if player i exerts an effort greater or equal than his
opponent and by c(ei) = 4ei – 2, if he exerts a smaller effort than his opponent. The total
revenue generated by the team is R = 6(e1 + e2), which is equally shared. Both players
have the same discount factor .

a) Draw the payoff matrix of the stage-game. Define the Tit-for-Tat strategy for the
repeated game. Is it possible to obtain the efficient outcome in every period as a Nash
equilibrium of the repeated game in which both players use the Tit-for-Tat strategy?
And is it possible with the Grim strategy?

b) Suppose now the same situation as above except that player 1 obtains a share a of
total revenue and player 2 a share 1 – a and the discount factor of both players is 
= 0,9. Find the values of a for which both players playing the Grim strategy
constitutes a Nash equilibrium of the repeated game.

2.4) The following stage game is played with infinite horizon. Both players share the same
discount factor .

A B

A 2,1 5,0

B 0,5 3,4

a) Define the Tit-for-Tat strategy for the repeated game. Is it possible to obtain the
efficient outcome in every period as a Nash equilibrium of the repeated game in which
both players use the Tit-for-Tat strategy? And is it possible with the Grim strategy?

b) Assume now that the discount factor for both players is  =0’8 and the payoff of
player 1 in the pair of actions (B,B) is given by a parameter x. Find the range of x for
which both players using the Grim strategy is a Nash equilibrium of the repeated
game.

2.5) Two workers jointly produce a good every period in a repeated game with infinite
horizon. The level of output depends on the non-verifiable work effort made by each of
the individuals. Effort can take two values, ei  {1, 2}. The individual cost of effort is
given by the functions c(ei) = 3ei , if player i exerts an effort greater or equal than his
opponent and by c(ei) = 3ei – 1, if he exerts a smaller effort than his opponent. The total
revenue generated by the team is R = 4(e1 + e2), which is equally shared. Both players
have the same discount factor .

a) Draw the payoff matrix of the stage-game. Define the Tit-for-Tat strategy for the
repeated game. Is it possible to obtain the efficient outcome in every period as a Nash
equilibrium of the repeated game in which both players use the Tit-for-Tat strategy?
And is it possible with the Grim strategy?
 b) Suppose now the same situation as above except that total revenue is given by R =
6(e1 + e2) and the individual cost for each player is given by c(e i) = aei, where a >
3. The discount factor of both players is  = 0,9. Find the range of values of a for
which both players playing the Grim strategy constitutes a Nash equilibrium of the
repeated game.

3. SEQUIENTIAL GAMES

3.1) Consider the following game (where C denotes cooperation and NC non- cooperation):

C NC

C 2,2 0,3

NC 3,0 1,1

Suppose that this game is played sequentially and with perfect information between a son
(player 1) and his mother (player 2). The son is selfish; his utility coincides with his material
payoffs (x1), shown in the matrix. But the mother is altruist; her utility is given by the sum
of both material payoffs, that is, u2 = x2 + x1. Assume that the son (player 1) moves first.
a) Draw the tree for this game and describe the players´ strategy sets. Find the perfect
Nash equilibrium of the game, explaining your answer. Show a non-perfect Nash
equilibrium of the game representing a threat and discuss its credibility.

b) Suppose now that there is a change in the order of moves and the mother moves first.
Does the outcome of the game change?

c) Describe and explain, with the same order of moves of the previous section (a), any
credible strategic move of the mother that might induce the son´s cooperation.

3.2) Consider the following extensive form game:

 a) Assume that x = 1,5 and find the set of pure strategy Nash equilibria and subgame
perfect equilibria.

b) Find the range of x for which (R, u) is the unique subgame perfect equilibrium path.
Find the range of x for which L is a Nash equilibrium path.

3.3) Two people play a game in which they choose and divide a prize. Player 1 chooses how
to divide the prize: he can choose either an equal division or a split, where he gets 90%
and his opponent gets 10%. Player 2 decides how large the total prize should be: she can
choose either 100 or 10. Assume that this game is played sequentially under perfect
information. In particular, player 1 moves first choosing one of his two actions and, after
observing this choice, player 2 makes her decision.

a) Draw the tree for this game and describe the players´ strategy sets. Find the perfect
Nash equilibrium of the game, explaining your answer. Show a non-perfect Nash
equilibrium of the game representing a threat and discuss its credibility.

b) Player 2 can now choose between these alternatives: to change the order of moves in
the game, moving herself first or, alternatively, with the same order of moves of the
previous section, to write down a public contract with a third party (let´s say a N.G.O.
for example) committing to pay 10 to the third party in case player 2 chooses a prize
100 in the game with player 1. Draw the tree and find the perfect equilibrium for both
alternatives and explain if player 2 should choose any of them.

3.4) Two players have to make a decision about the construction of a swimming pool (a pure
public good for them). Its cost is 20 units (thousands of euros). It is common knowledge
that each player values the swimming pool in 30 units. The players move sequentially in
a previously established order: player 1 chooses whether to contribute or not and, after
observing player 1´s choice, player 2 makes her decision. If both players choose to
contribute, then they share equally the cost. If only one player chooses to contribute, he
pays all the cost. Finally, only if both players decide not to contribute, the swimming
pool is not constructed.

a) Draw the tree for this game and describe the players´ strategy sets. Find the perfect
Nash equilibrium of the game, explaining your answer. Show a non-perfect Nash
equilibrium of the game in which player 1 pays all the cost and discuss its credibility.
Find the set of Nash equilibria.

b) Player 2 publicly announces a contract with a delegate (d), that stipulates that the
game will be played by player d, instead of player 2 and that they will share equally
the net gains obtained in the game. It is common knowledge among all players that
the delegate is inequity averse with utility function Ud(x1, xd) = xd - 2max{x1 –xd, 0},
where x1 and xd are the monetary payoffs obtained by players 1 and d, respectively.
Find the perfect equilibrium and provide some intuition about the results you obtain.

c) Suppose now that in this situation a new option appears for player 1. He can choose
between an outside option (for instance a private swimming pool) which yields him
a final payoff of 15 units or playing the above game with player 2. In the first option,
player 2 does not make any choice and gets a payoff of zero. Should player 2 contract
the delegate? Find the perfect equilibrium in this situation, explaining carefully your
answer.
3.5) The parliament of Trumpland can pass a budget with only a social expenditure item
(action S), or just a military expenditure item (action M) or with both items (action S +
M). The country's president may sign the bill (i.e. accept the budget approved by the
parliament) or may veto it. In the latter case, it would extend the previous budget.
Therefore, there are four possible final outcomes: S budget, M budget, S + M budget
and the previous budget (P). The preferences of the parliament (player J1) and the
president (player J2) ordered from best (4) to worst (1) are shown in the following table

J1 J2

S 4 1

M 2 4

S+M 3 3

P 1 2

a) Draw the tree for this game and describe the players´ strategy sets. Find the perfect
Nash equilibrium of the game, explaining your answer. Show a Nash equilibrium of
the game in which the outcome is the M budget and discuss its credibility.

b) Suppose now that a constitutional change is proposed whereby the president could
veto either the entire budget as above or specific items of the budget (a line-item
veto). What would be the consequences of this change? Explain your answer by
analyzing the new sequential game. If you were president, would you be interested in
promoting this change?

3.6) Two players have to make a decision about the construction of a swimming pool (a pure
public good for them). Its cost is 40 units (thousand euros). It is common knowledge that
player A values the swimming pool in 30 units and player B in 60 units. The players
move sequentially in a previously established order: the player who moves first
announces whether he is willing to contribute with 40, 20 or 0 units. Then, unless this
player has announced 40, the player who moves second declares if she is willing to pay
the difference until 40. If she pays the difference, the swimming pool is constructed with
each player paying the announced amount. If she rejects to pay the difference, then the
swimming pool is not constructed.

a) Draw the tree for this game when player A moves first and describe the players´
strategy sets. Find the perfect Nash equilibrium of the game, explaining your answer.
Is there a Nash equilibrium of the game in which player A pays all the swimming
pool? Find the set of Nash equilibria.

b) Suppose now that player B moves first. Draw the tree for this game and find the
perfect equilibrium. What would be the maximal amount player B is willing to pay
for the right to move first? How much is player A willing to pay to prevent it?
3.7) Two players have to make a decision about the construction of a swimming pool (a pure
public good for them). Its cost is 40 units (thousands of euros). It is common knowledge
that player A values the swimming pool in 60 units and player B in 50 units. Both players
choose simultaneously whether to contribute or not. If both players choose to contribute,
then they share equally the cost. If only one player chooses to contribute, he pays all the
cost. Finally, only if both players decide not to contribute, the swimming pool is not
constructed.

a) Draw the payoff matrix for this game. Calculate the players´ best response functions.
Do they have dominated actions? Find the Nash equilibria. Discuss its efficiency.

b) Now the game is played sequentially under perfect information with player A moving
first. Before the game is played, player B can choose between two alternatives. He
can write down a public contract with a third party (let´s say a N.G.O. for example)
committing to pay 15 to the third party in case the swimming pool is constructed.
Alternatively, player B can publicly announce a contract with a delegate (D), that
stipulates that the game will be played by player D, instead of player B and that they
will share equally the net gains obtained in the game. It is common knowledge among
all players that the delegate is inequity averse with utility function Ud(xA, xd) = xd -
2max{xA –xd, 0}, where xA and xd are the monetary payoffs obtained by players A
and D, respectively. Draw the tree and find the perfect equilibrium for both
alternatives and explain if player B should choose any (or none) of them.

3.8) A team of three workers jointly produce a good every period in a repeated situation
with infinite horizon. The level of output depends on the non-verifiable work effort
made by each of the individuals. Effort can take two values, ei  {1, 2}. The total revenue
is R = 9(e1 + e2 + e3). The individual cost of effort is given by the functions c(ei) = 4ei.
Total revenue is equally shared. Each worker works only three periods. In each period,
the team is composed by workers of all generations, that is, there is a player in his first
period (effort e1), another player in her second period (effort e2) and a third player in
his third and last period (effort e3). Assume for simplicity that all players have the same
discount factor  = 0,9. Find a perfect Nash equilibrium of the repeated game in which
everybody, except the player in his last working period, chooses the high level of effort.
What would happen if there is a player with  = 0,4? Explain your answer.

3.9) A seller can produce, at a cost of 60 euros, a good that a buyer values at 100 euros.
Between them they will negotiate the sale price in a two-stage negotiation game. In the
first, the seller proposes a price that, if accepted, implies the sale at that price and the
end of the game. If the proposal is rejected, it will be the buyer's turn to propose a price.
If it is accepted by the seller, the good will be sold at that price and the game will end. If
it is rejected there are no more proposals or possibility of sale. Let p be the price at which
the good has been sold, the seller's utility will be p - 60 and the buyer's 100 - p. In case
there is no agreement, the utility is zero for both. The seller's discount rate is 1 = 1/4
and the buyer's 2 = 1/5. We will assume that, in case of indifference, the players accept
the proposal.

a) Draw the tree for this game and describe the players´ strategy sets, as well as their
actions in each of these sets.

b) Find the perfect Nash equilibrium of the game

 c) What agreement is reached, with what payments and in what period?

3.10) A company negotiates with a union the salary for its workers. The firm's profit
function is E= (10 - w)2 where w is the salary. The aim of the union is to maximize S
= 10w - w2- 5. The rules of negotiation are as follows. The company makes an offer that
the union can accept or reject. In case of acceptance, the negotiation ends. In case of
rejection, the union presents a counter-offer that the company can accept or reject. If
the counter offer is rejected, there is no production and both parties gain zero. If an offer
is accepted, both parties will have their benefits according to the agreement reached.
The discount factor for both players is 0.8.

a) Show the extensive form of this game. State the strategies of the two players and their
information sets.

b) What salary will N union offer if the game reaches the second stage? What are the
benefits of each in this case?

c) Find the unique subgame perfect Nash equilibrium of this bargaining game. What
salary will be agreed? What are the benefits? When will the agreement take place?

3.11) Ignacio and his sister, Amelia, have to decide on their financial options. Consider the
following time sequence: First, Ignacio has to share a budget of 1,000 euros with Amelia.
Second, if Amelia accepts such a share, Amelia's share will be put into a mutual fund
that with a 40% chance increases to 100% but with a 60% chance she gets half the
amount. In addition, Ignacio will get 20% more of his share of the investment funds. If
Amelia then declines, they both get 500 euros.

a) Draw the tree for this game. Find the perfect Nash equilibrium of the game,
explaining your answer

b) Suppose that Amelia is risk averse UA=X1/2 and Ignacio is risk neutral. He computes
the subgame perfect equilibrium.

4. UNCERTAINTY

4.1) Find the mixed equilibrium.

Head Croix

Head 1,-1 -1,1

Croix -1,1 1,-1

4.2) In the Figure game of Meeting in New York, find all equilibria for a; b> 0:
Empire States Grand Central

Empire States a,a 0,0

Grand Central 0,0 b,b

4.3) In the movie 'Rebel Without a Cause', James Dean participates in the 'chicken game'
with another teenager: Each drives a car at full speed towards a cliff; the first one to
jump out of his car is a 'chicken'. Suppose you both prefer to be the last to jump, but
also to jump first rather than not jump, in order to avoid falling. In this case, we can
represent the game strategically as (note: That both of them jump 'the last' is interpreted
as that neither jump; that both of them jump 'the first' means that they both jump at
the same time):
Jump last Jump first

Jump last 0,0 3,1

Jump first 1,3 2,2

a) Find all equilibria in pure and mixed strategies. What is the intuitive interpretation
of mixed equilibrium?

4.4) In 1944, the allied high command planned the landing on the continent, which would
finally take place on June 6. Among many other things, it was key to decide where to
land the bulk of the troops. We are going to model this problem as a game. Let us
suppose that there are two options (Normandy or Brittany) and that both the Allies and
the Germans must decide simultaneously in which of these two places they position their
troops. The Germans lose if both armies position their troops in different places, and
win otherwise. For the allies it is the other way around. On the other hand, the Allies
prefer to win in Normandy (which is closer to Paris and the German border) than in
Brittany. The following payout matrix seeks to summarize the above (the allies are the
player Row, and his payout is the left one in each cell):

a) Find the equilibrium (or equilibria) in mixed strategies of this game (call r the
probability that the Allies will land in Britain, and s the probability that the Germans
will station the bulk of their troops in Britain).

4.5) You have reached the final of a TV game show. The host offers you a choice between
two options. In the first one, you obtain 64.000 euros in cash. In the second one, you have
to choose one box out of three boxes. In one of the boxes there are 100.000 euros, in
another box 81.000 euros, and in the third one only 1.000 euros

a) What is the expected value of choosing a box?

b) If you are risk neutral, what would be your decision?

c) If your utility function is U= M1/2, what would be your decision?

 d) With the above utility function, how much money should the host offer you in order
to be indifferent between taking the money or choosing a box?

4.6) An individual with an initial wealth of 100 euros, faces a loss of 36 with probability 0,5.
This person has a utility function given by U(M) = M1/2, where M is the final wealth. An
insurance company offers him complete insurance (compensation C = 36) at a fair
premium P = 18

a) What is the expected value of not buying this insurance contract? And the expected
value of buying it? Will this individual buy this contract? Explain carefully your
answer. What would be the individual´s decision if his utility function were U(M) =
M 2?

b) What is the certainty equivalent of not buying any insurance? Suppose now that the
company offers complete insurance at a premium P = 20. Will the individual accept
this offer or will he prefer no insurance? What is the maximal insurance premium
that the individual is willing to pay for complete insurance?

4.7) Ana has a utility function given by U = M1/2, where M is her final income. If she becomes
a professor, she will make M = 81 with probability 1. If she becomes a lawyer, she will
make M = 900 if she becomes a partner in a stock-exchange firm, but only M = 25 if she
fails to make partner. The probability of becoming a partner is 0,1

a) What is the expected value of the latter option? What would be Ana´s choice?
Suppose that there are cuts in the salary of a professor. What is the critical value of
the salary such that for smaller values, Ana prefers to become a lawyer?

b) Consider again the situation where the salary of a professor is 81. Ana can now take
a Master in Law with a cost of 8 that will increase her probability of becoming a
partner to 0,2. Would Ana take the Master?

4.8) Ana has a utility function given by U = M1/2, where M is her final income. She has to
make a choice between a safe action that yields a payoff of M = 100 with probability 1
or a risky action that yields with equal probability a payoff M of 330, 90 or zero

a) What is the expected value of both actions? What would be Ana´s choice? What is
the critical value of M in the safe action such that for smaller values, Ana prefers to
choose the risky action?

b) Bruno, a risk neutral individual, offers Ana a contract where Ana agrees to take the
risky action and yields her returns to Bruno in exchange for a fixed wage. What would
be the minimal wage accepted by Ana? What would be the maximal wage offered by
Bruno? Compute Bruno´s profits if they sign such a contract. Discuss the results
explaining the efficiency and advantages of risk-sharing.

4.9) A risk neutral employer wants to hire a risk averse worker who has a utility function
U=R1/2. The worker will only accept a contract that yields him at least a utility of 10
units. The task developed by the worker has a probability of success of ½, yielding to the
employer profits of 10.000 euros and a probability of failure of ½, yielding zero profits
to the employer
 a) Analyze which of the two following policies yields higher expected profits to the
employer: to offer a fixed wage, that is, independent of the final profits, or to offer a
wage contingent to the final profits, that is, a positive wage in case of success and a
wage of zero in case of failure. Explain your answer.

b) Assume now that the above profits derived from the task can only be obtained if the
worker exerts high effort. The worker can also choose low effort which is less costly
but yields zero profits for the employer with certainty. Analyze if the results obtained
in the previous section are still valid when effort is not verifiable (cannot be included
in the contract).

4.10) Ana, who was injured by a defective product, makes a decision whether to sue the
manufacturer. Her utility function is given by U(M) = 1 – (1/M), where M is total wealth.
Therefore, Ana is a risk averse person. Her total wealth if she does not sue is 14. If she
sues, she would win with probability (0,5), in which case she would receive a damage
award of 10. If she loses, she will receive nothing in damages. The cost of a lawyer
required to file a suit is a fee of 4.

a) What is the expected value of the suit? What will be Ana´s choice? What is the
certainty equivalent of the suit?

b) Suppose that the lawyer is risk neutral. Can he offer Ana a fee schedule whose
expected value is exactly 4 and under which the lawyer assumes all the risk by
completely insuring Ana? Ana is completely insured if her final wealth is the same
irrespective of the suit´s outcome. Let w1 be the lawyer´s fee if Ana sues and wins
and w2 the fee if Ana sues and loses. Calculate and describe such a fee schedule.
(Hint: notice that w2 can be negative.)

5. PRIVATE INFORMATION
5.1) Consider a used-car market in which all sellers know the value of the cars they want to
sell, but the buyers only know the distribution of the car values. In particular, it is
common knowledge that one third of the cars in the market are high-quality cars (3.000
euros) and the rest are low-quality cars (1.000 euros), where the quality is the seller´s
provision cost. The reservation price or valuation of a buyer is 1,2 times the quality of
a high-quality car and 1,1 times the quality of a low-quality car. Buyers and sellers are
pair-wise matched and play the following sequential game: the seller announces a price
which the buyer either accepts or rejects.

a) Find the perfect Bayesian equilibrium (checking the different possibilities of

separating or pooling equilibria). Discuss its efficiency. What is the equilibrium if the
proportion of high-quality cars changes to (5/6)?

b) Suppose that the sellers can offer a one-year warranty (any other warranty is
forbidden). If the cost of the warranty for the seller of a high-quality car is x euros
and the corresponding cost for a low-quality car is 5x, what is the range of values of
x for which the warranty is a credible signal of high quality? If the proportion of high-
quality cars is (5/6), will the warranty be offered in this market?
5.2) A single monopoly firm produces a good, the quality of which is known to the firm but
not to the consumers. Quality can be either high (H) or low (L). The consumers´
reservation price for high quality is 160 and for low quality is 0. The firm´s provision
cost for H is 100 and for L is 50. Consumers assign an a priori probability of 0,3 to high
quality. There are 2000 potential consumers. There are two periods and consumers can
buy one unit of the good in each period. If the consumer buys the good in the first period,
then he perfectly learns the good´s quality.

a) If the firm can spend money in advertising before the market opens, what amount A
of advertising expenditure is a credible signal of high quality?

b) Assume now that the firm tries to signal high quality by setting a low price in the first
period. Find a separating equilibrium in which low prices in the first period are a
signal of high quality. What policy would prefer the firm (advertisement or promotion
prices)? And what is better for the consumers?

5.3) Football teams in the Spanish League are considering to sign Brazilian players for next
season. Spanish clubs have collected reports and know that all Brazilian players are
good, but can be “party lovers” or committed to the club. Brazilian clubs know what is
the true type of the player they want to sell. It is common knowledge that a Brazilian
player is a party lover type with probability 2/3 and a committed type with probability
1/3. Any Brazilian club would be willing to sell a party-lover player by 1 million euros
and a committed player by 3 million. Spanish clubs would be willing to pay at most 1.1
million euros for a party-lover and 3.6 million for a committed player. Buyers and sellers
are matched and play the following sequential game: the seller announces a price which
the buyer either accepts or rejects.

a) Find the perfect Bayesian equilibrium, checking the different possibilities of

separating or pooling equilibria. Discuss what type of players will be sold in the
market and the efficiency of the solution. Calculate the equilibrium if the proportion
of committed players changes to (5/6).

b) Suppose that, in order to signal that a player is a committed type, the Brazilian club
can offer guarantees to the Spanish club, making the player move to Spain with his
family. The cost of moving with the family for a committed player is x and 5x for a
“party lover” player. What is the range of values of x for which this warranty is a
credible signal of high quality (commitment)? If the proportion of committed players
is 5/6, will Brazilian clubs offer the warranty in this case?

5.4) Consider a used-car market in which all sellers know the value of the cars they want to
sell, but the buyers only know the distribution of the car values. In particular, it is
common knowledge that a proportion (1/4) of the cars in the market are high-quality
cars (400 euros) and the rest are low-quality cars (100 euros), where the quality is the
seller´s provision cost. The reservation price or valuation of a buyer is 600 euros for a
high-quality car and 200 for a low-quality car. Buyers and sellers are pair-wise matched
and play the following sequential game: the seller announces a price which the buyer
either accepts or rejects

a) Find the perfect Bayesian equilibria (checking the different possibilities of separating
or pooling equilibria). Discuss its efficiency.
 b) Repeat the analysis if the valuation of a buyer of a low-quality car were 50 euros.

c) Suppose the buyer´s valuations of section a). Now the sellers can offer a number (only
integers) of years of warranty. The cost per year for the seller of a warranty of a high-
quality car is 60 euros and the corresponding cost for a low-quality car is 250. How
many years of warranty are a credible signal of high quality? If the proportion of
high-quality cars is (3/4), will warranties be offered in this market?

5.5) There are two types of worker: L-types with low productivity 80 and H-types with high
productivity 100; each worker knows her own type. Two firms compete for the services
of the workers, but they cannot observe a worker´s type. Suppose that there are three
times as many L-types as H-types and that worker´s outside opportunities are valued
zero

a) What is the market equilibrium outcome?

b) Suppose the workers can acquire an education, observable by the firms. This would
cost 22 for an L-type and only 12 for an H-type. Characterize a separating
equilibrium.

c) How would the analysis change if education costs were changed to 18 for an L-type?

6. COURNOT

6.1) Consider two companies that compete in a market. They must decide how much to
produce and can only choose between 2, 4 and 6 units. The price of the product depends
on the total quantity produced, according to the following function: P (qi + qj) = 22 - (qi
+ qj), where qi is the quantity produced by firm i and qj is the quantity produced by firm
j. Firms face a unit cost of production equal to 9. Firm I's profit can then be written as:
πi (qi + qj) = P (qi + qj)qi + 9qi. And firm J's profit can then be written as: πj (qi + qj) = P (qi
+ qj)qj + 9qj

a) Complete the following table

qi qj P(qi + qj) πi (qi + qj) πj (qi + qj)

2 2
2 4
2 6
4 2
4 4
4 6
6 2
6 4
6 6

b) Assume that the two firms make their decisions simultaneously. Write the payoff
matrix

c) Identify the Nash Equilibrium (in pure strategies)

6.2) Two firms compete in a market producing the same good. Each firm can produce 2, 4,
or 6 units of the good. The profits of the companies according to the quantities produced
are the following

Q1 Q2 Ut1 Ut2
2 2 14 14
2 4 10 20
2 6 6 18
4 2 20 10
4 4 12 12
4 6 4 6
6 2 18 6
6 4 6 4
6 6 -6 -6

a) Write the payoff matrix

b) Identify the Nash Equilibria. Explain

6.3) Two countries share a river. They can install between 1 and 3 industrial plants on each
shore. Due to river pollution problems, the utility that each country obtains per installed
plant depends negatively on how many plants are installed on both banks: v = 16 – 3Q
= 16 – 3(q1 + q2), where q1 is the number of plants that are installed in country 1 and q2
is the number of plants that are installed in country 2. The total utility that country 1
obtains is: Π1 (q1,q2) = q1v. The total utility that country 2 obtains is: Π2 (q1,q2) = q2v.

a) Write the payoff matrix

b) Find the Nash Equilibrium (or equilibria)

c) Determine the socially optimal number of plants (this is the number of plants that
countries should install if they could agree). Compare the socially optimal outcome
and Nash equilibrium.

6.4) Three ranchers share a grazing field. Each can bring up to three animals to the shared
grazing field. The value reached by each animal depends on the total number of grazing
animals, according to the following formula: v(G) = 8 – G, where G = g1 + g2 + g3 and g1
to g3 are the quantities of animals carried by farmers 1 to 3. The total profits of each
rancher are: πi = giv(G).

a) Find the Nash Equilibrium. Justify your answer

b) Suppose now that the ranchers can agree on the number of cattle to carry and split the
profits evenly. What would be the number of cattle they should agree to take to the
grazing field? Justify your answer

c) If ranchers could not agree on the number of cattle to graze, would there be an
overexploitation of natural resources in this example? Justify your answer