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Exercise 23

James has a cup of café latte every morning. His utility from having a good cup of
latte is 20 utils and his utility from having a bad cup of latte is –10 utils.
James visits a new town and he will stay there for two mornings. He finds a café that
sells café latte. He wonders if he should give it a try.
His prior belief is that with probability 0.25 this café has ‘High’ standard and with
probability 0.75 this café has ‘Low’ standard.
If the café has high standard, it will serve good latte and bad latte with probabilities
0.9 and 0.1, respectively.
If the café has low standard, it will serve good latte and bad latte with probabilities
0.1 and 0.9, respectively.
He has another option of going to Costa Coffee to get an okay latte, the utility of
which is 0 utils to him.
Analyse what James will do on the first and second mornings,
(i) when he is a myopic optimiser; and
(ii) when he is a dynamic optimiser.

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Answer to Exercise 23 (i) Good 0.25x0.9=0.225
1st period latte
Myopic optimiser 0.9

High Prob. of
standard ‘Good latte’
0.3
0.25 0.1 Bad
0.25x0.1=0.025
latte + 20 utils

Good 0.75x0.1=0.075
0.75 0.1 latte Prob. of
Low
‘Bad latte’
standard
0.7
0.9
– 10 utils
Bad
latte 0.25x0.9=0.675
Myopic optimiser:
Try: 0.3 x (20) + 0.7 x (– 10) = – 1 utils
Not try (Go to Costa): 0 utils  Not give it a try

P(High|Good) = P(High & Good)/P(Good) = 0.225/0.3 = 0.75


P(High|Bad ) = P(High & Bad )/P(Bad) = 0.025/0.7 = 0.036 6
Case 1: 1st time Answer to Exercise 23 (ii)
was good. P(G|H) P(H and G) =
20 2nd period
=0.9 0.75x0.9=0.675
P(H) P(G)= Go:
=0.75 P(B|H) P(H and B)= 0.7 0.7 x (20)
=0.1 –10 0.75x0.1=0.075 + 0.3 x (– 10)
P(G|L) 20 P(L and G)= = 11 utils
P(L) =0.1 0.25x0.1=0. 025 P(B)=
=0.25 0.3 Not go: 0 utils
P(L and B)=
P(B|L) –10 0.25x0.9=0.225 Go!
=0.9

Case 2: 1st time


was bad. P(G|H) P(H and G) =
20
=0.9 0.036x0.9=0.032
Go:
P(H) P(G)= 0.128 x (20)
=0.036 P(B|H) P(H and B)= 0.128 + 0.872 x (– 10)
=0.1 –10 0.036x0.1=0.004 = – 6.14 utils
P(G|L) 20 P(L and G)=
P(L) =0.1 0.964x0.1=0. 096 P(B)= Not go: 0 utils
=0.964 0.872
P(B|L)
P(L and B)=  Not go!
–10 0.964x0.9=0.868 7
=0.9
Answer to Exercise 23 (ii) cont. Good 0.25x0.9=0.225
1st period latte
Dynamic optimiser 0.9

High Prob. of
standard ‘Good latte’
0.3
0.25 0.1 Bad
0.25x0.1=0.025
latte + 20 utils
& 11 utils
next period
Good 0.75x0.1=0.075
0.75 0.1 latte Prob. of
Low
‘Bad latte’
standard
0.7
0.9
– 10 utils
Bad
latte 0.25x0.9=0.675 & 0 utils
next period
Dynamic optimiser:
Try: 0.3 x (20 + 11 utils) + 0.7 x (– 10 + 0 utils) = 2.3 utils
Not try: 0 + max{0, –1} = 0 utils
 Give it a try!!
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Exercise 24
James often feels weak and dizzy so getting some vitamin C from one bottle of apple juice
every morning is his daily practice. One day, James wakes up in the morning and finds two
bottles of apple juice on the kitchen table. It seems that he forgot to put them in the
refrigerator after he came back from shopping last evening. He immediately puts them in the
fridge but perhaps it is too late. Last night was particularly warm so there is a 30% chance that
the bottles of apple juice have gone bad (B). With probability 70%, they are still drinkable (D).
(The two bottles have the same state.) If James drinks bad apple juice, he will feel sick (S) with
probability 0.7 and he will feel fine (F) with probability 0.3. If the juice is drinkable and he
drinks it, he will feel sick with probability 0.1 and will feel fine with probability 0.9. His utility
from drinking juice and feeling sick is −30. His utility from drinking juice and feeling fine is 10.
His utility from not drinking is 0.

(a) What is the probability that James will feel sick after he drinks the first bottle of apple juice?
(b) Given that he feels sick after drinking the first bottle of juice, what is the probability that
the juice is bad?
(c) Given that he feels fine after drinking the first bottle of juice, what is the probability that
the juice is bad?
(d) Should James drink the second bottle of juice? Explain.
(e) Should James drink the first bottle of juice? Explain for (i) when James is a myopic optimiser
and (ii) when James is a dynamic optimiser. 9
Exercise 24 Answer Get sick 0.3x0.7=0.21
1st period 0.7

Prob. of
Bad getting sick
0.28
0.3 0.3
Feel 0.3x0.3=0.09
fine – 30 utils

Get sick 0.7x0.1=0.07


0.7 0.1
Prob. of
Drinkable feeling fine
0.72
0.9
10 utils
Feel
fine 0.7x0.9=0.63

(a) Figure shows the probability tree that James faces in the first period. As the tree shows,
he feels sick with probability 0.28.
(b) By Bayes’ rule, it is P(B|S) = P(B&S)/P(S) = 0.21/0.28 = 0.75.
(c) By Bayes’ rule, it is P(B|F) = P(B&F)/P(F) = 0.09/0.72 = 0.125.
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Exercise 24 Answer continued

(d) The answer depends on what happens in the first period. Figure 2 shows the probability
trees that James faces in the second period. As the tree shows, if he feels sick after
drinking the first bottle of juice, the probability that he will feel sick after drinking the
second bottle of juice is 0.55. Therefore, his expected utility from drinking the second
bottle is 0.55 × (−30) + 0.45 × (10) = −12 < 0. So he had better not drink the second
bottle. On the other hand, if he feels fine after drinking the first bottle of juice, the
probability that he will feel sick after drinking the second bottle of juice is 0.175.
Therefore, his expected utility from drinking the second bottle is 0.175×(−30)+0.825×(10)
= 3 > 0. So he should choose to drink the second bottle.

(e)
(i) As we saw in part (a), the probability of him feeling sick the first time he drinks the juice
is 0.28. If he is a myopic optimiser, he computes 0.28 × (−30) + 0.72 × (10) = −1.2 < 0, so
he should not drink the first bottle of juice.
(ii) If he is a dynamic optimiser, he maximises in the first period the total sum of the present
and future utilities. Hence he computes 0.28 × (−30 + 0) + 0.72 × (10 + 3) = 0.96 > 0, and
he tries the first bottle.

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Case 1: 1st time
got sick. P(S|B) –30 P(B and S) = 2nd period
=0.7 0.75x0.7=0.525
P(B) P(S)=
=0.75 P(F|B) P(B and F)= 0.55
=0.3 10 0.75x0.3=0.225
P(S|D) –30 P(D and S)=
P(D) =0.1 0.25x0.1=0. 025 P(F)=
=0.25 0.45
P(D and F)=
P(F|D) 10 0.25x0.9=0.225
=0.9 Exercise 24 Answer
continued
Case 1: 1st time
felt fine. P(S|B) –30 P(B and S) = Figure 2
=0.7 0.125x0.7=0.0875
P(B) P(S)=
=0.125 P(F|B) P(B and F)= 0.175
=0.3 10 0.125x0.3=0.0375
P(S|D) –30 P(D and S)=
P(D) =0.1 0.875x0.1=0. 0875 P(F)=
=0.875 0.825
P(D and F)=
P(F|D) 10 0.875x0.9=0.7875 12
=0.9
Exercise 25

Proportion 25% 25% 25% 25%


Quality θ £5K £6K £8K £10K
Reservation
£4.0K £4.8K £6.4K £8.0K
value for owners

There is a large number of car owners whose car quality is distributed as above.

Suppose that car owners’ reservation value of a car with θ is 0.8θ, so if the price is at
least as high as 0.8θ, the owner of that car wants to sell it.

There are many car buyers. They offer price θ for a car with quality θ. In addition,
the buyers are risk-neutral so if they do not observe the car quality, the price they
offer is equal to the expected quality of that car.

The car quality is private information of its owner. To buyers, all cars look the same.
Owners observe the buyers’ offer and decide whether to sell or not.

Explain what happens in this environment. What price do buyers offer in the end?
Who will exit the market and who will stay in the market? 13
Exercise 25

Proportion 25% 25% 25% 25%


Quality θ £5K £6K £8K £10K
Reservation
£4.0K £4.8K £6.4K £8.0K
value for owners

First, buyers offer


0.25 x 5K + 0.25 x 6K + 0.25 x 8K + 0.25 x 10K = £7.25K.  Type θ=10K exits!!

Now the distribution of θ=5K, 6K, 8K is (1/3, 1/3, 1/3).


So, buyers offer
0.333 x 5K + 0.333 x 6K + 0.333 x 8K = £6.333.  Type θ=8K exits!!

Now the distribution of θ=5K, 6K is (0.5, 0.5).


So, buyers offer
0.5 x 5K + 0.5 x 6K = £5.5K.  Type θ=5K and 6K stay in the market.

So, in the equilibrium, buyers offer £5.5K, types θ=10K and 8K exit the market and
types θ=6K and 5K stay in the market.
14
Exercise 30 You are a monopolistic firm that provides flight service from Exeter to Paris.
• There are 1K passengers every month who buy at most one ticket. Among them, 0.1K are
extravagant (‘High type’) and 0.9K are parsimonious (‘Low type’). Types are hidden.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
– Type H: uH = q – p/2
– Type L: uL = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q2.
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative
utility. If there are two kinds, they choose whichever is better.
Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?

A. Only (.5, .5).


B. Only (.2, .1).
C. (.5, .5) & (.2, .1).
D. (.5, .6) & (.2, .1).
E. (.5, .7) & (.2, .1).
F. (.5, .8) & (.2, .1).
G. Only (.5, .8)
15
Answer to Exer30 You are a monopolistic firm that provides flight service from Exeter to Paris.
• There are 1K passengers every month who buy at most one ticket. Among them, 0.1K are
extravagant (‘High type’) and 0.9K are parsimonious (‘Low type’). Types are hidden.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
– Type H: uH = q – p/2
– Type L: uL = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q2.
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative
utility. If there are two kinds, they choose whichever is better.
Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?
uH from uH from uL from uL from
the 1st the 2nd the 1st the 2nd
choice choice choice choice The firm’s total profits (£)
A Only (.5, .5) 0.25 ---- -0.50 ---- .1K(0.5-0.52)K=0.025M
B Only (.2, .1) 0.15 ---- 0 ---- 1K(0.1-0.22)K = 0.060M
C (.5, .5) & (.2, .1) 0.25 0.15 -0.50 0 .1K(0.5-0.52)K+.9K(0.1-0.22)K=0.079M
D (.5, .6) & (.2, .1) 0.20 0.15 -0.70 0 .1K(0.6-0.52)K+.9K(0.1-0.22)K=0.089M
E (.5, .7) & (.2, .1) 0.15 0.15 -0.90 0 .1K(0.7-0.52)K+.9K(0.1-0.22)K=0.099M
F (.5, .8) & (.2, .1) 0.10 0.15 -1.10 0 .1K(0.1-0.22)K+.9K(0.1-0.22)K=0.060M
G Only (.5, .8) 0.10 ---- -1.10 ---- .1K(0.8-0.52)K=0.055M 16
Exercise 31 Suppose that the monopolistic airline company in the last exercise solves the profit
maximisation problem by using Excel Solver.


Initially, cells B2:B5 are set to zero. But the values of these cells will be changed by the solver.
Here, (qH, pH) and (qL, pL) are the ticket plans designed for high and low types, respectively.
Cells B6:B10 have some equations, which are
B6: High type’s utility from choosing plan H
B7: High type’s utility from choosing plan L
B8: Low type’s utility from choosing plan L
B9: Low type’s utility from choosing plan H
B10: The flight company’s total profits

Q1: Write down the expressions for B6:B10, starting with “= ”.


Q2: Fill in the constraints part in the solver window. (You can omit $ signs.) 17
Exercise 31 Suppose that the monopolistic airline company in the last exercise solves the profit
maximisation problem by using Excel Solver.


Initially, cells B2:B5 are set to zero. But the values of these cells will be changed by the solver.
Here, (qH, pH) and (qL, pL) are the ticket plans designed for high and low types, respectively.
Cells B6:B10 have some equations, which are
B6: High type’s utility from choosing plan H = B3 – B2/2
B7: High type’s utility from choosing plan L = B5 – B4/2
B8: Low type’s utility from choosing plan L = B5 – 2*B4
B9: Low type’s utility from choosing plan H = B3 – 2*B2
B10: The flight company’s total profits
= 0.1*(B2 – B3^2) + 0.9*(B4 – B5^2) B6 ≥ B7
B6 ≥ 0
Q1: Write down the expressions for B6:B10, starting with “= ”. B8 ≥ B9
Q2: Fill in the constraints part in the solver window. (You can omit $ signs.) B8 ≥ 0 18
Exercise 32 You are a monopolistic firm that provides train service from Exeter to London.
• There are 1K passengers every month who buy at most one ticket. Among them, 0.4K are
extravagant (‘High type’) and 0.6K are parsimonious (‘Low type’). Types are hidden.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
– Type H: uH = q – p/2
– Type L: uL = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q2.
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative
utility. If there are two kinds, they choose whichever is better.
Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?

A. Only (.5, .5).


B. Only (.2, .1).
C. (.5, .5) & (.2, .1).
D. (.5, .6) & (.2, .1).
E. (.5, .7) & (.2, .1).
F. (.5, .8) & (.2, .1).
G. Only (.5, .8)
19
Answer to Exer32 You are a monopolistic firm that provides train service from Exeter to London.
• There are 1K passengers every month who buy at most one ticket. Among them, 0.4K are
extravagant (‘High type’) and 0.6K are parsimonious (‘Low type’). Types are hidden.
• Buyers’ utility is determined by the quality (q) of the service and its price (p).
– Type H: uH = q – p/2
– Type L: uL = q – 2p
• For each sale, the firm’s profit (V) is given by V = p – q2.
• The firm offers (q, p). It can offer two kinds of (q, p) if it wants to. (“economy & 1st class”)
• Buyers’ utility from not buying a ticket is 0. Buyers buy a ticket if it does not give negative
utility. If there are two kinds, they choose whichever is better.
Let the units of p and V be K£. If the firm offers the following (q,p), how much profits can it get?
uH from uH from uL from uL from
the 1st the 2nd the 1st the 2nd
choice choice choice choice The firm’s total profits (£)
A Only (.5, .5) 0.25 ---- -0.50 ---- .4K(0.5-0.52)K=0.1M
B Only (.2, .1) 0.15 ---- 0 ---- 1K(0.1-0.22)K = 0.060M
C (.5, .5) & (.2, .1) 0.25 0.15 -0.50 0 .4K(0.5-0.52)K+.6K(0.1-0.22)K=0.136M
D (.5, .6) & (.2, .1) 0.20 0.15 -0.70 0 .4K(0.6-0.52)K+.6K(0.1-0.22)K=0.176M
E (.5, .7) & (.2, .1) 0.15 0.15 -0.90 0 .4K(0.7-0.52)K+.6K(0.1-0.22)K=0.216M
F (.5, .8) & (.2, .1) 0.10 0.15 -1.10 0 .4K(0.1-0.22)K+.6K(0.1-0.22)K=0.060M
G Only (.5, .8) 0.10 ---- -1.10 ---- .4K(0.8-0.52)K=0.220M 20
Prelim: Pareto -efficiency
Exercise 33
(1) The following is the preference orders of four students about restaurants for today’s
dinner. Note that “>” means “is preferred to” and “=” means “is as good as”.
Kerem: Chinese>Indian>Italian>French
Ayse: Chinese>Italian>French>Indian
Ethem: Indian>French=Italian>Chinese
Esra: Italian>Chinese>French=Indian
Select all the Pareto-optimal choices.

(2) The following are the preference orderings of a group of three persons. Select the correct
statement below.
Rupert: football>golf>tennis>rugby> skiing>cricket>basketball
Hedwig: golf>football>tennis>skiing>cricket>basketball>rugby
Maria: skiing>golf>tennis>cricket> basketball>rugby>football

A. Football Pareto-dominates rugby.


B. Skiing Pareto-dominates golf.
C. Football Pareto-dominates golf.
D. Tennis is a Pareto-optimal choice.
E. Golf is a Pareto-optimal choice.
Prelim: Pareto -efficiency
Exercise 33
(1) Answer: Italian Pareto-dominates French. So French is not Pareto-optimal choice. Italian
does not Pareto-dominate Chinese or Indian due to Kerem.
French does not Pareto-dominate Chinese or Italian due to Ayse and it does not Pareto-
dominate Indian due to Ethem.
Chinese does not Pareto dominate Indian or French or Italian due to Ethem.
Indian does not Pareto-dominate Italian or Chinese or French due to Ayse.
Therefore, Pareto-optimal choices are Italian, Chinese and Indian.

(2) Answer is E.
A: Maria likes rugby better than football so football does not Pareto-dominate rugby.
B: Rupert and Hedwig like golf better than skiing so skiing does not Pareto-dominate golf.
C: Hedwig and Maria like golf better than football so football does not Pareto-dominate golf.
D: Tennis is Pareto-dominated by golf so it is not Pareto-optimal.
Prelim: Commitment
Exercise 34 Explain the following situations as an SPE of a two-stage dynamic game.
First, formulate a two-stage game by specifying players, actions and payoffs. Then
find the SPE of that game. In your answer, draw a game tree.
(i) A woodblock (woodcut) artist says “I will make only
100 copies of this woodblock print and sell each for
£1000.” The art collectors are willing to pay £1000 only
if he makes only 100 copies and not any more copies.
However, they suspect that the artist may make
thousands of copies later so they won’t pay £1000.
(ii) Nobita is a lazy boy who does not like studying. He
used to study for exams simply because he was scared
of his mother. Doraemon is a new friend of Nobita and
can use magic. He wants Nobita to study so he says
“Even if you don’t study and get in trouble, I won’t
help you.” But Nobita shirks his studies knowing that
Doraemon cannot help using his magic to help Nobita
whenever he is in trouble.
(iii) In the past, in Japan, it was hard for patients and their
family to sue doctors and hospitals if there is any
malpractice. The legal environment has been changed
so they can take legal actions if they want to. Since
then many hospitals have been refusing to accept ill
women who are expecting a baby as patients. 23
Exercise 34 Explain the following situations as an SPE of a two-stage dynamic game.
First, formulate a two-stage game by specifying players, actions and payoffs. Then
find the SPE of that game. In your answer, draw a game tree.
(i) A woodblock (woodcut) artist says “I will make only Not buy (1,0)
Collector
100 copies of this woodblock print and sell each for Not print
£1000.” The art collectors are willing to pay £1000 only Buy more
(2,1)
if he makes only 100 copies and not any more copies.
However, they suspect that the artist may make Artist
Print (0,2)
thousands of copies later so they won’t pay £1000. more
(ii) Nobita is a lazy boy who does not like studying. He
used to study for exams simply because he was scared Study (1,2)
of his mother. Doraemon is a new friend of Nobita and Nobita Use
can use magic. He wants Nobita to study so he says Shirk magic (2,1)
“Even if you don’t study and get in trouble, I won’t Not use
help you.” But Nobita shirks his studies knowing that Doraemon magic
Doraemon cannot help using his magic to help Nobita (0,0)
whenever he is in trouble.
(iii) In the past, in Japan, it was hard for patients and their refuse (1,0)
family to sue doctors and hospitals if there is any Hospital
malpractice. The legal environment has been changed Not sue (2,1)
accept
so they can take legal actions if they want to. Since
then many hospitals have been refusing to accept ill Patient Sue
women who are expecting a baby as patients. (0,2) 24