SAMPLE EXAM 3

Exam is closed book. The points add up to 100. Good luck!

1. (10 points) For a principal-agent problem give definitions of production efficiency

and risk efficiency.

2. (10 points) Give definitions of positive externality and negative externality.

3. (10 points) Describe what is a lemons market. Give some examples of lemons
markets.

4. (10 points) Find Nash Equilibria of the following game:

A B C
N 3,2 2,1 1,5
W 1,1 0,2 3,3
S 4,5 0,6 2,4
E 1,4 1,5 3,6

5. The economy consists of two firms called 1 and 2 and two goods called G1 and
G2 . Firm i (i = 1, 2) produces only good Gi . The goods are complements, so the
inverse demands for goods G1 and G2 are given by

P1 (q1 , q2 ) = a − q1 + kq2
P2 (q1 , q2 ) = a − q2 + kq1

where q1 and q2 are the amounts of goods G1 and G2 produced by firms 1 and 2
and 1 ≤ k < 1.1 is a constant. The marginal costs for both firms are c.

a) (10 points) Suppose that firms simultaneously choose quantities. Find a

Nash Equilibrium.
b) (10 points) Now suppose that first firm 1 chooses its quantity, then firm
2 observes the choice of firm 1 and also chooses quantity. Use backward
induction to find equilibrium outcome (if you get a messy formula with
parameters a, k and c do not spend time simplifying, leave it as is).

1
6. Consider a Static Game of Incomplete Information (Player 1 chooses rows A
or B; Player 2 has two types “Low” and “High”, each type chooses between
columns C and D):
Low High
C D C D

A 0, 0 7, -2 A 7, 7 5, 0

B -2, 7 5, 5 B 0, 5 -2, -2

a) (10 points) Suppose that player 1 believes that type “Low” of player 2 hap-
pens with probability p. For any p find all Bayesian Nash Equilibria.
b) (10 points) For each p specify which equilibria are pooling and which are
separating.

7. Consider an abstract bargaining game in which two players bargain over the
amount of pollution that will be produced, say from 0 to 1. The bargaining
process consists of four steps: 1) Player 1 (P1) makes an offer x to Player 2 (P2)
about how much pollution he wants; 2) P2 accepts x or rejects the offer. In case
of acceptance game ends and P1’s offer is realized; 3) In case of rejection P2 can
make a counteroffer y; 4) P1 accepts or rejects the counteroffer. If P1 accepts, the
counteroffer is realized, however since bargaining takes time the payoffs of both
players are reduced according to the discounting factor 0 < δ < 1. If P1 rejects,
the status quo outcome (δs, 0) is realized (here 1 > s > 0 is some number). The
bargaining game looks like this (top payoffs are of P1 and bottom are of P2):
1

1 δs
P2 ect 0
Rej
ect
y P1
P1 Rej Ac
x P2 cep
Ac t
cep 0
t δ(1-y)
0 δy
1-x
x

a) (20 points) Solve the game by backward induction and find which offers
are made in equilibrium in all nodes of the game.