BITS PILANI, K.K.

BIRLA GOA CAMPUS

MID-SEMESTER EXAMINATION Semester I 2019-20
COURSE NO. BITS F314 COURSE TITLE: Game Theory and its Application
Date: 30/09/2019 Time: 90 min Total Marks: 30

Attempt any five questions

Q1. Consider two competing firms in a declining industry that cannot support both firms profitably. Each firm has
three possible choices as it must decide whether or not to exit the industry immediately, at the end of this quarter, or
at the end of the next quarter. If a firm chooses to exit then its payoff is 0 from that point onward. Every quarter that
both firms operate yields each a loss equal to -1, and each quarter that a firm operates alone yields a payoff of 2. The
payoff for each firm is the sum of its quarterly payoffs.

a. Complete the pay-off matrix of this game.

Player 2
E T N
E 0,0 0,2 0,4
Player 1 T 2,0
N 4,0
E: immediate exit; T: exit at the end of this quarter; N: exit at the end of next quarter.

b. Are there any strictly dominated strategies? Does the strategy  i  ( i ( E ),  i (T ),  i ( N ))  ( 1 ,0, 1 ) weakly
2 2
dominates T?
c. Find the pure strategy Nash equilibria. Find the unique mixed strategy Nash equilibrium. (Hint: you can use
your answer to (b) to make things easier). [1+1+4=6 marks]

Q2. Amy and Bill simultaneously write a bid on a piece of paper. The bid can only be either 2 or 3. A referee then
looks at the bids, announce the amount of the lowest bid (without revealing who submitted it) and invites Amy to
either pass or double her initial bid.
The outcome is determined by comparing Amy‟s final bid to Bill‟s bid: if one is greater than the other then the
higher bidder gets the object and pays his/her own bid; if they are equal then Bill gets the object and pays his bid.
For eg. If Amy bids $3, Bill bids $2, and Amy plays „pass‟, then „Amy wins and pays $3‟. Similarly, if Amy bids
$2, Bill bids $3 and Amy doubles her initial bid, „Amy wins and pays $4‟.

a. Draw an extensive form game that represents this situation (write the payoffs at the terminal node). How
many strategies does Amy have?
b. Find the subgame-perfect equilibrium of the game assuming the following about the player‟s preferences:
Both Amy and Bill are selfish and greedy, and are interested in their own net gain. Amy values the object at
$5 and Bill at $4. [3+3=6 marks]

Q3. Consider the variant of Bertrand‟s duopoly game in which first firm 1 chooses a price (first stage), then firm 2
chooses a price (second stage). Assume that each firm is restricted to choose a price that is an integral number of
cents, that each firm‟s unit cost is constant, equal to c (an integral number of cents), and that the monopoly profit is
positive. The payoff function of firm i=1,2 (i  j ) is given by:
( pi  c) D( p) if pi  p j

1
 i ( pi , x j )   ( pi  c) D( p) if pi  p j
2
0 if pi  p j
[6 marks]
Where D(p) is the market demand.
Show that the outcome of the sub-game perfect equilibrium is that both firms choose p  c  1.
Q4. Suppose three firms compete in a market for a single product with industry inverse demand curve P  a Q .
All three firms have constant marginal cost „m‟. Firm 1 is a leader and selects output level q1 . Firms 2 and 3 are
followers and select q2 and q3 after q1 . Note, q2 and q3 are chosen simultaneously. Total output is
Q  q1  q2  q3 . Find the sub-game perfect Nash equilibrium solution. [6 marks]

Q5. A citizen (player 1) must choose whether or not to file taxes honestly or whether to cheat. The tax man (player
2) decides how much effort to invest in auditing and can choose a  [0,1] and the cost to the tax man of investing
at 'a' level is c(a)  100 a 2 . If the citizen is honest then he receives the benchmark payoff of 0 , and the tax man
pays the auditing costs without any benefit from the audit, yielding him a payoff of (100 a ) . If the citizen cheats
2

then his payoff depends on whether he is caught. If he is caught then his payoff is (100 ) and the tax man‟s payoff
is 100  100 a . If he is not caught then his payoff is 50 while the tax man‟s payoff is (100 a ) . If the citizen
2 2

cheats and the tax man chooses to audit at level 'a' then the citizen is caught with probability 'a' and is not caught
with probability (1  a) .
a. If the tax man believes that the citizen is cheating for sure, what is his best response level of 'a' .
b. If the tax man believes that the citizen is honest for sure, what is his best response level of 'a' .
c. If the tax man believes that the citizen is honest with probability P what is his best response level of 'a' as
a function of P.
d. Is there a pure strategy Nash equilibrium of this game? Why or why not?
e. Is there a mixed strategy Nash equilibrium of this game? Why or why not?
[1+1+1+2+1=6 marks]

Q6. Read the following excerpt from The Economist and analyze the statement written in bold. Clearly mention the
theoretical model you have used for analysis. Justify the sub-game perfect Nash equilibrium path in your model
(Word limit: 100 words).

President Barack Obama promised that he would reduce the role that nuclear weapons played in America‟s national
security strategy. His successor has done the opposite. In a review of nuclear policy published in February 2018,
Donald Trump seemed to expand the circumstances in which America might use nuclear weapons first, to include
cyber-attacks on the networks that transmit presidential orders to silos, submarines and bombers. He also ordered the
manufacture of new low-yield warheads (these are equivalent to about half a Hiroshima), which critics fear are more
likely to be used. And he has issued hair-raising threats against North Korea, alarming those who worry about his
impulsiveness. All this is fuelling a debate about nuclear risks. Elizabeth Warren, a Democratic presidential
contender, wants to start with American nuclear doctrine. Every president since Harry Truman has reserved the right
to use nuclear weapons in a conflict even if an enemy has not unleashed them first. In January Ms Warren
introduced a Senate bill that would mandate a policy of what wonks call No First Use (NFU). Such pledges are
common: China and India committed themselves to versions of NFU decades ago, as did the Soviet Union. …

Proponents of NFU argue that launching nuclear weapons first in a conflict is neither necessary nor wise. It is not
necessary because America‟s regular armed forces are strong enough to defeat enemies without recourse to weapons
of mass destruction. It is not wise because an adversary that fears an American bolt from the blue is more likely to
put its own arsenal on hair-trigger alert, increasing the risk of unauthorised or accidental launch. An adversary might
also be tempted to pre-empt America by going even faster, a dangerous dynamic that Thomas Schelling, an
economist and nuclear theorist, called the “reciprocal fear of surprise attack”.

“Game theory can be used to provide one mathematical justification for the argument that nuclear buildup
makes the world a more peaceful place”. [6 marks]

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