18-09-2014

Instruction Course Week 3 Intermediate Microeconomics 2014-2015

Course Week 3 Game theory: Strategic Interaction II

Key topics
Game theory
- Players, payoffs, actions and strategies
- Subgame perfect Nash equilibrium
- Credible and noncredible threats
Oligopoly
- Stackelberg model
- Bertrand model
- Kinked demand curve
- Price leadership
- Dominant firm

Specific learning objectives

-

Use game theory to analyse business decisions

Learn to recognise the importance of credibility in making threats

Literature

Pindyck, R.S. and D.L. Rubinfeld 2012 ( 2013)), Microeconomics, 8th edition:
Chapter 12; section 12.2, pp. 463-464 and sections 12.4-12.5
Chapter 13; sections 13.5-13.7
Extensions to Pindyck & Rubinfeld, Chapter 13 (to be downloaded from Blackboard), Section 7
Articles (available online via UU-library (Omega)):
Gibbons, R., 1997, An Introduction to Applicable Game Theory, Journal of Economic Perspectives, 11,
pp. 127-149 (for this week pp. 133-137 only)
Camerer, C. & R.H. Thaler (1995), Ultimatums, Dictators and Manners, Journal of Economic
Perspectives, 9 (2), Spring, pp. 209-219.
Eckel, C. & P.J. Grossman (1996), Altruism in anonymous dicatator games, Games and Economic
Behavior, 16, pp. 181-191
McKelvey, R.D. & T.R. Palfrey (1992), An experimental study of the centipede games, Econometrica,
60, pp. 803-8036 (sections 1 through 3 only)
Instruction
Lecture

Reading guide

Detailed comments on Pindyck & Rubinfeld

Oligopoly
o P&R, 8th edition, pp. 463-464: A first mover advantage is defined to be the additional profit a player
can get by moving first, compared to the situation of simultaneous decisions.
o P&R, 8th edition, p. 479, line 1: Pc should read Pc .

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Instruction Course Week 3 Intermediate Microeconomics 2014-2015

Exercises Wednesday Tutorial

1) Two profit-maximising firms, A en B, have to make a decision how much they will produce of a certain
product. They can decide to supply an amount of either 25, 50 or 75 units. Binding contracts between A
and B are not possible. If the firms decide simultaneously, their profits are presented in the payoff
matrix below, which matrix is common knowledge.

QA=25
QA=50
QA=75

QB=25
74, 78
80, 60
74, 40

B
QB=50
60, 80
64, 64
50, 32

QB=75
40, 76
30, 48
0, 0

Suppose that the firms have to choose sequentially. Assume that firm A is the first that decides.
a) Present the extensive form of the game
b) What amounts will A and B each supply?
c) What profit will A and B each earn?
2) A strategic move limits ones flexibility and yet gives one an advantage. Why? How might a strategic
move give one an advantage in bargaining?

3) This exercise is a continuation of exercise 4 of the Wednesday tutorial of Course Week 2. We return to
two firms with the same constant average and marginal cost, AC = MC = 5, facing the market demand
curve Q1 + Q2 = 53 - P. Now we will use the Stackelberg model to analyse what will happen if one of
the firms makes its output decision ahead of the other one.
Suppose Firm 1 is the Stackelberg leader (i.e., makes its output decisions ahead of Firm 2).
a) Find the reaction curves that tell each firm how much to produce in terms of the output of its
competitor.
b) How much will each firm produce, and what will its profit be?
c) Is there a first mover advantage for Firm 1 (the first mover) and, if so, to what does it amount?
4)

Consider the following Entry Game. A monopolist, firm M, is confronted with a potential entrant, firm
E. The entrant has two decisions to make: First, whether to enter or not and, second, when it decides to
enter, whether to set a High price or a Low price. If the potential entrant enters, the incumbent has one
decision to make: whether to set a High price or a Low price. The price-setting game after entry is a
simultaneous-move game. Both firms strive for maximum profits. Binding contracts between the two
firms are not possible. All elements of the structure of the game are common knowledge. Profits for
each firm, given the different possible choices, are presented in the following payoff matrix:
High price

Firm E
(Potential
entrant)

Out, High price if enters

Out, Low price if enters
Enter, High price if enters
Enter, Low price if enters

0, 4
0, 4
6, 2
2, 4

Firm M (Incumbent)
Low price
0, 4
0, 4
4, 2
6, 2

a) Present the game in extensive form.

b) Infer from the game in strategic form whether there are any Nash equilibria in pure strategies and, if
so, which are they?

18-09-2014
Instruction Course Week 3 Intermediate Microeconomics 2014-2015

c) -

Is this game a game with complete or a game with incomplete information?

Is this game a game with perfect or a game with imperfect information?
Are there any subgames in this game and, if so, which are they?
Are there any proper subgames in this game and, if so, which are they?
Which of the Nash equilibria found in part b, if any, are subgame perfect?

4) Draw the normal-form matrix of each of the following extensive-form games.

5) Two players play the following alternative bidding shrinking pie bargaining game. Player A moves first,
and makes Player B an offer for the division of 100. (For example, Player A could suggest that she
takes 60 and Player B takes 40). Player B can accept or reject the offer. If he rejects, the amount of
money available drops to 90, and he then makes an offer for the division of this amount. If Player A
rejects this offer, the amount of money drops to 80, and Player A makes an offer for its division. If
Player B rejects this offer, the amount of money drops to 0. Both players are rational, fully informed,
risk neutral and want to maximise their payoffs. Money is their only motive. Bids are made in round
euros. Both players are risk neutral
a. What is the best offer to Player B that Player A can make in the first round?
b. Change the amounts of money available in the three periods in such a way, that Player B will end
up with a share that is larger than 50%.
6) Read the article by Camerer and Thaler.
a) Based on the predictions of standard game theory, how do you expect Proposers and Responders to
act in an Ultimatum Game?
b) How do Proposers and Responders act in the laboratory Ultimatum Game experiments Camerer and
Thaler describe?
c) How could the difference between game theoretic predictions and the findings in experiments be
explained?
d) Explain Rabins concept of a fairness equilibrium. Can the outcome of a Prisonerss Dilemma
game be Pareto optimal when taking into account the possible existence of a fairness equilibrium?

18-09-2014
Instruction Course Week 3 Intermediate Microeconomics 2014-2015

Exercises Friday Tutorial

1) Two computer firms, A and B, are planning to market network systems for office information
management. Each firm can develop either a fast, high-quality system (H), or a slower, low-quality
system (L). Market research indicates that the resulting profits to each firm for the alternative strategies
are given by the following payoff matrix for simultaneous decisions, which matrix is common
knowledge.
Firm B
Firm A

H
L

H
30, 30
40, 60

L
50, 35
20, 20

a) If both firms make their decisions at the same time and follow maximin (low-risk) strategies, what
will the outcome be?
b) Suppose both firms try to maximise profits, but Firm A has a head start in planning, and can commit
first. Now what will the outcome be? What will the outcome be if Firm B has a head start in
planning and can commit first?
c) Getting a head start costs money (you have to gear up a large engineering team). Now consider the
two-stage game in which first, each firm decides how much money to spend to speed up its
planning, and second, it announces which product (H or L) it will produce. Which firm will spend
more to speed up its planning? Given the assumption that this firm wants to exclude all uncertainty
with respect to outcomes, how much will it spend? Should the other firm spend anything to speed
up its planning? Explain.
2) Consider a three-period, alternating-offer bargaining game. Suppose that the discount factor for both
players is , where 0 < < 1. In this game, player 1 makes the first offer, in period 1. If player 2 rejects
this offer, then the game continues in period 2, where player 2 makes the offer and player 1 decides
whether to accept or reject it. If player 1 rejects this offer, then the game continues in period 3, where
player 1 makes the final offer and player 2 accepts or rejects. Compute the subgame perfect equilibrium
of this game.
3) In the extensive-form game that follows, how many strategies does player 2
have?

4) This exercise is a continuation of exercise 2 of Friday of Course Week 2. Now the game is played
sequentially.

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Instruction Course Week 3 Intermediate Microeconomics 2014-2015

Two duopolists produce similar but slightly differentiated products. They face similar demand curves:
Q1 = 40 P1 + (1/2)P2
Q2 = 40 P2 + (1/2)P1
Also: AC1 = MC1 = AC2 = MC2 = 20.
Both duopolists compete on price.
a) Suppose firm 1 is able to invest to move second, but firm 2 is not.
- What is the maximum amount of money firm 1 is willing to invest to move second?
- If firm 1 is able to move second, what will be the market shares of firm 1 and firm 2,
respectively?
b) Suppose the two firms collude and agree to share profits equally. What profit will each firm make?
5) Suppose a couple, Donna and Eric, is deciding on the division of household labour. Their options are to
each spend either zero, five or ten hours per week on household labour. The minimum of their jointly
spent time on household labour is five. Also, spending in total more than fifteen hours on household
labour makes no sense in terms of additional output. Both Donna and Eric strive for maximum payoffs
and are completely informed. Their payoff matrix is:

Donna

Hours = 0
Hours = 5
Hours = 10

Hours = 0
0, 0
8, 10
10, 18

Eric
Hours = 5
10, 8
13, 13
14,15

Hours = 10
18, 10
15, 14
0, 0

All payoffs are equal to the respective outputs of household production, taking into account increasing
and decreasing marginal product segments and co-ordination costs, and net of the relevant disutilities of
spending time on household labour.
a)
b)

Are there one or more Nash equilibria in pure strategies in this matrix? If so, which are they?
Suppose now that Donna and Eric do not only attach value to the payoffs mentioned above, but
also to what they consider to be a fair distribution of household labour. Their utility function is:
Ui = PiFi
with:
i = Donna, Eric
U = Utility
P = Payoff in terms of the payoff matrix above
F = Fairness, with:
Shares are equal F = 1
Shares are 1/3 versus 2/3 or 2/3 versus 1/3 F = 2/3
Shares are 0 versus 1 or 1 versus 0 F = 1/2
Construct the new payoff matrix, now in utility terms.
Are there one or more Nash equilibria in pure strategies in this matrix? If so, which are they?

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Instruction Course Week 3 Intermediate Microeconomics 2014-2015

6)

Read the article by Eckel and Grossman.

a) What is a Dictator Game?
b) According to the findings of Eckel and Grossman, is behaviour as found in laboratory experiments
consistent with the prediction of standard game theory? If not, how do Eckel and Grossman explain
the difference?
c) Why is a non-zero offer in a Dictator Game not always an indication of a concern for fairness by
the donor?
d) Is the Ultimatum Game, as described on page 185 of the article, a game with complete or with
incomplete information?
e) Why do Eckel and Grossman replace the anonymous receiver by a deserving charity in the
Dicator Game? Does this change the findings of the experiment?

7)

Read the article by McKelvey and Palfrey

a) What is the subgame perfect Nash equilibrium in the Centipede Game according to standard game
theory?
b) In Figure 1 op p. 806, how many strategies are there for each of the players? How many subgames
does this game contain? How many proper subgames?
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