University Carlos III of Madrid Departament of Economics

Game Theory: Problem set 1. Solutions.

Problem 1: For each one of the following normal form games find

(a) The pure-strategy Nash equilibria and their payoffs;

(b) The mixed-strategy Nash equilibria and their payoffs;
(c) Are there any equilibria in dominant strategies? If yes, which ones?

C D
(a) A −50, −50 100, 0
B 0, 100 0, 0
Solution: The best responses of the players are

C D
A −50, −50 100, 0
B 0, 100 0, 0

There are two NE in pure strategies: (A, D) and (B, C). We look for a NE in mixed strategies of the
form

σ1 = xA + (1 − x)B
σ2 = yC + (1 − y)D

The expected utilities of the players are

u1 (A, σ2 ) = −50y + 100(1 − y) = 100 − 150y

u1 (B, σ2 ) = 0 × y + 0 × (1 − y) = 0

and

u2 (σ1 , C) = 50x + 100(1 − x) = 100 − 150x

u2 (σ1 , D) = 0 × x + 0 × (1 − x) = 0

Equating the utilities of the players

100 − 150y = 0, 100 − 150x = 0

we obtain x = y = 32 . Thus, there is an additional NE in mixed strategies,

2 1
σ1 = A+ B
3 3
2 1
σ2 = C+ D
3 3

C D
(b) A −1, 2 1, −2
B 1, −2 −1, 2
Solution: The best responses of the players are

C D
A −1, 2 1, −2
B 1, −2 −1, 2

1
 There are no NE in pure strategies. We look for a NE in mixed strategies of the form
σ1 = xA + (1 − x)B
σ2 = yC + (1 − y)D
The expected utilities of the players are
u1 (A, σ2 ) = −y + (1 − y) = 1 − 2y
u1 (B, σ2 ) = y − (1 − y) = 2y − 1

and
u2 (σ1 , C) = 2x − 2(1 − x) = 4x − 2
u2 (σ1 , D) = −2x + 2(1 − x) = 2 − 4x
Equating the utilities of the players
1 − 2y = 2y − 1, 4x − 2 = 2 − 4x
we obtain x = y = 21 . Thus, there is an additional NE in mixed strategies,
1 1
σ1 = A+ B
2 2
1 1
σ2 = C+ D
2 2

C D
(c) A −10, −10 0, −20
B −20, 0 10, 10
Solution: The best responses of the players are

C D
A −10, −10 0, −20
B −20, 0 10, 10

There are two NE in pure strategies: (A, C) and (B, D). We look for a NE in mixed strategies of the
form
σ1 = xA + (1 − x)B
σ2 = yC + (1 − y)D
The expected utilities of the players are
u1 (A, σ2 ) = −10y + 0 × (1 − y) = −10y
u1 (B, σ2 ) = −20y + 10(1 − y) = 10 − 30y

and
u2 (σ1 , C) = −10x + 0 × (1 − x) = −10x
u2 (σ1 , D) = −20x + 10(1 − x) = 10 − 30x
Equating the utilities of the players
−10y = 10 − 30y, −10x = 10 − 30x
we obtain x = y = 21 . Thus, there is an additional NE in mixed strategies,
1 1
σ1 = A+ B
2 2
1 1
σ2 = C+ D
2 2

2
 C D
(d) A 3, 3 0, 0
B 0, 0 1, 1
Solution: We look for a NE of the form

σ1 = xA + (1 − x)B
σ2 = yC + (1 − y)D

The expected utilities of the players are

u1 (σ1 , σ2 ) = 1 − x − y + 4xy = 1 − y + x(4y − 1)

u2 (σ1 , σ2 ) = 1 − x − y + 4xy = 1 − x + y(4x − 1)

We see that 
1
1
 if y > 4
1
BR1 (y) = [0, 1] if y = 4
1

0 if y <

4

and 
1
1
 if x > 4
1
BR2 (x) = [0, 1] if x = 4
1

0 if x <

4

Graphically,

BR2 (x)
1

BR1 (y)

1/4

1/4 1 x

And we obtain three NE

(a) (A, C) with payoffs u1 = u2 = 3.
(b) (B, D) with payoffs u1 = u2 = 1.
(c) 14 A + 34 B, 41 C + 34 D with payoffs u1 = u2 = 43 .

C D
(e) A 4, −8 −2, −7
B 1, −5 −1, −6
Solution: We look for a NE of the form

σ1 = xA + (1 − x)B
σ2 = yC + (1 − y)D

3
 The expected utilities of the players are

u1 (σ1 , σ2 ) = −1 − x + 2y + 4xy = −1 + 2y + x(4y − 1)

u2 (σ1 , σ2 ) = −6 − x + y − 2xy = −6 − x + y(1 − 2x)

We see that 
1
1
 if y > 4
1
BR1 (y) = [0, 1] if y = 4
1

0 if y <

4

and 
1
1
 if x < 2
1
BR2 (x) = [0, 1] if x = 2
1

0 if x >

2

Graphically,

BR2 (x)
1

BR1 (y)

1/4

1/2 1 x

And we obtain a unique NE

 
1 1 1 3
(A, C), (B, D), A + B, C + D
2 2 4 4

with payoffs
1 13
u1 = − , u2 = −
2 2

C D
(f) A 2, 5 8, −1
B 4, −8 −2, −3
Solution: We look for a NE of the form

σ1 = xA + (1 − x)B
σ2 = yC + (1 − y)D

The expected utilities of the players are

u1 (σ1 , σ2 ) = −2 + 10x + 6y − 12xy = −2 + 6y + x(10 − 12y)

u2 (σ1 , σ2 ) = −3 + 2x − 5y + 11xy = −3 + 2x + y(11x − 5)

4
 We see that 
5
1
 if y < 6
5
BR1 (y) = [0, 1] if y = 6
5

0 if y >

6

and 
5
1
 if x > 11
5
BR2 (x) = [0, 1] if x = 11
5

0 if x <

1

Graphically,

BR2 (x)
1
5
6

BR1 (y)

5 x
11 1

And we obtain a unique NE

 
5 6 5 1
(A, C), (B, D), A + B, C + D
11 11 6 6

with payoffs
23
u1 = 3 u2 = −
11

C D
(g) A 10, 10 −2, −7
B 1, −5 1, 1
Solution: We look for a NE of the form

σ1 = xA + (1 − x)B
σ2 = yC + (1 − y)D

The expected utilities of the players are

u1 (σ1 , σ2 ) = 1 − 3x + 12xy = 1 + x(12y − 3)

u2 (σ1 , σ2 ) = 1 − 8x − 6y + 23xy = 1 − 8x + y(23x − 6)

We see that 
1
0
 if y < 4
1
BR1 (y) = [0, 1] if y = 4
1

1 if y >

4

5
 and 
6
1
 if x > 23
6
BR2 (x) = [0, 1] if x = 23
6

0 if x <

23

Graphically,

BR2 (x)
1

BR1 (y)
1
4

6 x
23 1

And we obtain three NE

(a) (A, C) with payoffs u1 = u2 = 10.
(b) (B, D) with payoffs u1 = u2 = 1.
6
A + 17 1 3 25


(c) 23 23 B, 4 C + 4 D with payoffs u1 = 1, u2 = − 23 .

Problem 2: For the normal form games below determine

(a) the strategies that survive the iterated elimination of strictly dominated strategies.
(b) the pure strategy Nash equilibria of the game.
(c) the mixed strategy Nash equilibria of the game.

X Y Z
(a) A 20, 10 10, 20 1, 1
B 10, 20 20, 10 1, 1
C 1, 1 1, 1 0, 0
Solution: Note that C is dominated by A for player 1. Hence, we obtain the game

X Y Z
A 20, 10 10, 20 1, 1
B 10, 20 20, 10 1, 1

Now that Z is dominated by X for player 2. Hence, we obtain the game

X Y
A 20, 10 10, 20
B 10, 20 20, 10

The rationalizable strategies are {A, B} × {X, Y }. The best replies of the players are

6
 X Y
A 20, 10 10, 20
B 10, 20 20, 10

We see that there are no NE in pure strategies. Let us look for a NE in mixed strategies of the form

σ1 = xA + (1 − x)B
σ2 = yX + (1 − y)Y

The expected utilities of player 1 when he chooses pure actions are

u1 (A, σ2 ) = 20y + 10(1 − y) = 10 + 10y

u1 (B, σ2 ) = 10y + 20(1 − y) = 20 − 10y

We must have that 10 + 10y = 20 − 10y. That is y = 21 .

The expected utilities of player 2 when he chooses pure actions are

u2 (σ1 , X) = 10x + 20(1 − x) = 20 − 10x

u2 (σ1 , Y ) = 20x + 10(1 − x) = 10 − 20x

Equating 20 − 10x = 10 − 20x, we obtain x = 12 . We conclude that there is a NE in mixed strategies,

1 1
σ1 = A+ B
2 2
1 1
σ2 = X+ Y
2 2

D E F
(b) A 2, 0 1, 1 4, 2
B 3, 4 1, 2 2, 3
C 1, 3 0, 2 3, 0
Solution: Note that C is dominated by A for player 1,

D E F
A 2, 0 1, 1 4, 2
B 3, 4 1, 2 2, 3

And now E is dominated by F for player 2,

D F
A 2, 0 4, 2
B 3, 4 2, 3

The rationalizable strategies are {A, B} × {D, F }. The best responses are

D F
A 2, 0 4, 2
B 3, 4 2, 3

and we obtain that the NE in pure strategies are (B, D) and (A, F ).

We look now for a NE in mixed strategies of the form

σ1 = xA + (1 − x)B
σ2 = yD + (1 − x)F

The expected utilities of player 1 when he chooses pure actions are

u1 (A, σ2 ) = 2y + 4(1 − y) = 4 − 2y
u1 (B, σ2 ) = 3y + 2(1 − y) = 2 + y

7
 We must have that player 1 is indifferent between A, B. That is 4 − 2y = 2 + y. Therefore, y = 2/3.
The expected utilities of player 2 when he chooses pure actions are

u2 (σ1 , D) = 0x + 4(1 − x) = 4 − 4x
u2 (σ1 , F ) = 2x + 3(1 − x) = 3 − x

We must have that player 2 is indifferent between D and F . That is, 4 − 4x = 3 − x. Therefore,
x = 1/3. We obtain the NE  
1 2 2 1
A + B, D + F
3 3 3 3
with expected payoffs u1 = u2 = 38 .

D E F
(c) A 2, 2 1, 1 4, 3
B 1, 4 0, 5 3, 3
C 3, 3 −2, 2 3, 0
Solution: Note that B is dominated by A for player 1,

D E F
A 2, 2 1, 1 4, 3
C 3, 3 −2, 2 3, 0

And now E is dominated by D for player 2,

D F
A 2, 2 4, 3
C 3, 3 3, 0

The rationalizable strategies are {A, C} × {D, F }. The best responses are

D F
A 2, 2 4, 3
C 3, 3 3, 0

and we obtain that the NE in pure strategies are (C, D) and (A, F ).

We look now for a NE in mixed strategies of the form

σ1 = xA + (1 − x)C
σ2 = yD + (1 − x)F

The expected utilities of player 1 when he chooses pure actions are

u1 (A, σ2 ) = 2y + 4(1 − y) = 4 − 2y
u1 (C, σ2 ) = 3y + 3(1 − y) = 3

We must have that player 1 is indifferent between A and C. That is 4 − 2y = 3. Therefore, y = 21 .

The expected utilities of player 2 when he chooses pure actions are

u2 (σ1 , D) = 2x + 3(1 − x) = 3 − x
u2 (σ1 , F ) = 3x + 0(1 − x) = 3x

We must have that player 2 is indifferent between D and F . That is, 3 − x = 3x. Therefore, x = 43 .
We obtain the NE  
3 1 1 1
A + B, D + F
4 4 2 2
with expected payoffs u1 = 3, u2 = 94 .

8
 D E F
(d) A 4, −1 3, 4 2, 0
B 1, 4 −3, 5 −3, −3
C 3, 3 2, −2 8, −3
Solution: Note that B is dominated by A for player 1,

D E F
A 4, −1 3, 4 2, 0
C 3, 3 2, −2 8, −3

and F is dominated by E for player 2,

D E
A 4, −1 3, 4
C 3, 3 2, −2

Now, C is dominated by A for player 1,

D E
A 4, −1 3, 4

And D is dominated by E for player 2. The set of rationalizable strategies is {A} × {E}. The unique
NE is (A, E).

D E F
(e) A 2, −1 2, −1 4, −2
B 2, −1 −2, −1 3, −2
C 1, 3 −2, 2 3, 4
Solution: Note that C is dominated by A for player 1,

D E F
A 2, −1 2, −1 4, −2
B 2, −1 −2, −1 3, −2

and F is dominated by D for player 2,

D E
A 2, −1 2, −1
B 2, −1 −2, −1

The best responses of the players are

D E
A 2, −1 2, −1
B 2, −1 −2, −1

We have three NE in pure strategies: (A, D), (A, E) and (B, D). We look now for a NE in mixed
strategies of the form

σ1 = xA + (1 − x)B
σ2 = yD + (1 − y)E

The expected utilities of player 1 when he chooses pure actions are

u1 (A, σ2 ) = 2y + 2(1 − y) = 2
u1 (B, σ2 ) = 2y − 2(1 − y) = −2 + 4y

9
 Now, for 0 ≤ y < 1 we have that u1 (A, σ2 ) > −2 + 4y. Hence, in a mixed NE, player 1 will not
choose strategy B with positive probability unless y = 1. The expected utilities of player 2 when he
chooses pure actions are

u2 (σ1 , D) = −x − (1 − x) = −1
u2 (σ1 , E) = −x + −(1 − x) = −1

for any 0 ≤ x ≤ 1. Player 2 is indifferent among all his strategies. We obtain infinitely many NE of
the form,

σ1 = xA + (1 − x)B, 0≤x≤1
σ2 = D

with payoffs u1 = 2, u2 = −1. And we also obtain infinitely many NE of the form,

σ1 = A
σ2 = yD + (1 − y)E, 0≤y≤1

with payoffs u1 = 2, u2 = −1.

A B C D
(f) X 1, 4 2, 2 4, 1 2, 0
Y 0, 0 1, 3 2, 5 0, 0
Z 0, 1 5, 0 8, 1 3, 3
Solution: Note that Y is dominated by X for player 1,

A B C D
X 1, 4 2, 2 4, 1 2, 0
Z 0, 1 5, 0 8, 1 3, 3

Now, B is dominated by A for player 2,

A C D
X 1, 4 4, 1 2, 0
Z 0, 1 8, 1 3, 3

For the moment, we consider the strategies S1 {X, Y }, S2 = {A, C, D}. The best responses of the
player are

A C D
X 1, 4 4, 1 2, 0
Z 0, 1 8, 1 3, 3

We obtain two pure strategy NE: (X, A) and (Z, D). We look now for a NE in mixed strategies of
the form

σ1 = pX + (1 − p)Z
σ2 = xA + yC + (1 − x − y)D

The expected utilities of player 2 when he chooses pure actions are

u2 (σ1 , A) = 4p + (1 − p) = 1 + 3p
u2 (σ1 , C) = p + (1 − p) = 1
u2 (σ1 , D) = 0p + 3(1 − p) = 3 − 3p

We represent this three functions graphically,

10
 3 u2 (σ1 , A) = 1

u2 (σ1 , D) = 3 − 3p

1
u2 (σ1 , C) = 1

1 p
3 1

We see in this picture, that player 2 does not want to consider strategy C. In fact, consider now the
mixed strategy
1 1
σ2 = A + D
2 2
for player 2. Note that

u2 (X, σ2 ) = 2 > 1 = u2 (X, C)

u2 (Z, σ2 ) = 2 > 1 = u2 (Z, C)

That is, strategy C is (strictly) dominated the the mixed strategy σ2 . We may eliminate strategy C.
The rationalizable strategies are {X, Y } × {A, D}. The best responses of the player are

A D
X 1, 4 2, 0
Z 0, 1 3, 3

We obtain two pure strategy NE: (X, A) and (Z, D). We look now for a NE in mixed strategies of
the form

σ1 = pX + (1 − p)Z
σ2 = xA + (1 − x)D

The expected utilities of player 2 when he chooses pure actions are

u2 (σ1 , A) = 4p + (1 − p) = 1 + 3p
u2 (σ1 , D) = 0p + 3(1 − p) = 3 − 3p

We represent this three functions graphically,

11
 u2

3 u2 (σ1 , A) = 1 + 3p

u2 (σ1 , D) = 3 − 3p

3 1
3 1 p

We see that
0 ≤ p < 13

D (x = y = 0) if
BR2 (σ1 ) = {A, D} (x ∈ [0, 1]y = 0) if p = 31
1
A (x = 1) if 3 <p≤1


The expected utilities of player 1 when he chooses pure actions and y = 0 are

u1 (X, σ2 ) = x + 2(1 − x) = 2 − x
u1 (Z, σ2 ) = 0x + 3(1 − x) = 3 − 3x

Hence,
0 ≤ x < 21

Z  (p = 0) if
BR1 (σ2 ) = {X, Z} (p ∈ [0, 1]) if x = 21
X (p = 1) if 12 < x ≤ 1


Graphically,

BR2 (p)
1

1 BR1 (x)
2

1
1 p
3

And we obtain three NE

(a) x = y = 0; p = 0. That is, (Z, D), with payoffs u1 = u2 = 3.

12
 (b) x = 1, y = 0; p = 1. That is, (A, X), with payoffs u1 = 1, u2 = 4.
(c) x = 12 , y = 0; p = 31 . That is,
1 2
σ1 = X+ Z
3 3
1 1
σ2 = A+ D
2 2
with payoffs u1 = 23 , u2 = 2.

Problem 3: For the normal form game

X Y Z
A 10, 30 0, 20 20, 30
B 15, 35 10, 40 10, 40
C 25, 25 5, 25 5, 25

determine all the Nash equilibria of the game.

Solution: There are no (strictly) dominated strategies. The best replies of the players are

X Y Z
A 10, 30 0, 20 20, 30
B 15, 35 10, 40 10, 40
C 25, 25 5, 25 5, 25

We obtain three NE in pure strategies, (A, Z), (B, Y )and (C, X). We look now for a NE in mixed
strategies of the form

σ1 = xA + yB + (1 − x − y)C
σ2 = tX + sY + (1 − t − s)Z

The expected utilities of player 1 when he chooses pure actions are

u1 (A, σ2 ) = 10t + 20(1 − t − s) = 20 − 10t − 20s

u1 (B, σ2 ) = 15t + 10s + 10(1 − t − s) = 10 + 5t
u1 (C, σ2 ) = 25t + 5s + 5(1 − t − s) = 5 + 20t

The expected utilities of player 2 when he chooses pure actions are

u2 (σ1 , X) = 30x + 35y + 25(1 − x − y) = 25 + 5x + 10y

u2 (σ1 , Y ) = 20x + 40y + 25(1 − x − y) = 25 − 5x + 15y
u2 (σ1 , Z) = 30x + 40y + 25(1 − x − y) = 25 + 5x + 15y

Thus, the expected payoffs of the players under these strategies are,

u1 (σ1 , σ2 ) = 5 + 20t + 15x − 20sx − 30tx + 5y − 15ty

u2 (σ1 , σ2 ) = 25 + 5x − 10sx + 15y − 5ty

Method 1. We must have that both players are indifferent between the strategies used with (strictly)
positive probability.

Case 1: Suppose, there is a NE in mixed strategies in which player 1 is indifferent between strategies A,
B and C. We must have that
20 − 10t − 20s = 10 + 5t = 5 + 20t

13
So, t = 31 , s = 14 with expected utility u1 (A, σ2 ) = u1 (B, σ2 ) = u1 (C, σ2 ) = 35
3 . In this NE player 2 is
indifferent between strategies X, Y and Z. And we must have that

25 + 5x + 10y = 25 − 5x + 15y = 25 + 5x + 15y

But, this implies that x = y = 0. Hence, we conclude that there is no NE in which player 1 is indifferent
between strategies A, B and C. And we find the following NE

σ1 = C
1 1 5
σ2 = X+ Y + Z
3 4 12
with payoffs u1 = 35 3 , u2 = 25. Note for those values of t and s for which u1 (C, σ2 ) ≥ u1 (A, σ2 ) and
u1 (C, σ2 ) ≥ u1 (B, σ2 ) we also have that

σ1 = C
σ2 = tX + sY + (1 − t − s)Z

constitute a NE. That is, for those values of t, s ∈ [0, 1] such that t + s ≤ 1 and

20 − 10t − 20s ≤ 5 + 20t, 10 + 5t ≤ 5 + 20t,

the strategies σ1 and σ2 above constitute a NE. The above inequalities are equivalent to
1
t≥ , 3 ≤ 6t + 4s
3
and these are solved below in Case 1 of method 2. We obtain the following NE.

s1 = C
1 1 3 3
σ2 = tX + sY + (1 − t − s)Z, ≤t≤ , − t≤s≤1−t
3 2 4 2
and

s1 = C
1
σ2 = tX + sY + (1 − t − s)Z, ≤ t ≤ 1, 0≤s≤1−t
2
with payoffs u1 = 5 + 20t and u2 = 25.

Note that there are infinitely many NE of the form

Case 2:

s1 = B
1
σ2 = sY + (1 − s)Z, <s≤1
2
with payoffs u1 = 10, u2 = 40.

Case 3:

s1 = A
1
σ2 = tX + (1 − t)Z, 0≤t≤
2
with payoffs u1 = 20 − 10t, u2 = 30.

14
Case 4: Let us look for a NE in mixed strategies in which player 1 uses the two strategies A and C
with strictly positive probability. That is y = 0, 0 < x < 1. In this equilibrium, the expected utilities of
player 2 when he chooses pure actions are

u2 (σ1 , X) = 25 + 5x
u2 (σ1 , Y ) = 25 − 5x
u2 (σ1 , Z) = 25 + 5x

Since, u2 (σ1 , Y ) < u2 (σ1 , X) = u2 (σ1 , Z) for 0 < x < 1, the only possibility is that player 2 is using
strategies X and Z. That is, s = 0. The expected utilities of player 1 when he chooses pure actions are

u1 (A, σ2 ) = 20 − 10t
u1 (C, σ2 ) = 5 + 20t

And we must have 20 − 10t = 5 + 20t, That is t = 21 . That is, there are infinitely many NE of the form

σ1 = xA + (1 − x)C, 0≤x≤1
1 1
σ2 = X+ Z
2 2
The (expected) utilities of the players are

u1 (σ1 , σ2 ) = 15, u2 (σ1 , σ2 ) = 25 + 5x

Case 5: Let us look for a NE in mixed strategies in which player 1 uses the two strategies A and B with
strictly positive probability. That is y = 1 − x, 0 < x < 1. In this equilibrium, the expected utilities of
player 2 when he chooses pure actions are

u2 (σ1 , X) = 35 − 5x
u2 (σ1 , Y ) = 40 − 20x
u2 (σ1 , Z) = 40 − 10x

Note that u2 (σ1 , Y ) < u2 (σ1 , Z) for 0 < x < 1. Hence, player 2 will not use strategy Y . For player 2 to
be indifferent between X and Y we must have that 35 − 5x = 40 − 10x. That is, x = 1. Hence, there is no
NE in mixed strategies in which player 1 uses the two strategies A and B with strictly positive probability.

Let us look for a NE in mixed strategies in which player 1 uses the two strategies B and C with strictly
positive probability. That is x = 0, 0 < y < 1. In this equilibrium, the expected utilities of player 2 when
he chooses pure actions are

u2 (σ1 , X) = 25 + 10y
u2 (σ1 , Y ) = 25 + 15y
u2 (σ1 , Z) = 25 + 15y

Since, u2 (σ1 , X) < u2 (σ1 , Y ) = u2 (σ1 , Z) for 0 < y ≤ 1, the only possibility is that player 2 is using
strategies Y and Z. That is, t = 0. The expected utilities of player 1 when he chooses pure actions are

u1 (B, σ2 ) = 10
u1 (C, σ2 ) = 5

Since, u1 (B, σ2 ) > u1 (C, σ2 ), it is not possible that player 1 uses the strategies B and C. We conclude
that there is no NE in mixed strategies in which player 1 uses the two strategies B and C with strictly
positive probability.

15
Method 2. We use that (σ1∗ , σ2∗ ) is a NE iff σ1∗ ∈ BR1 (σ2 ) and σ2 ∈ BR2 (σ1∗ ). We use the notation
BR1 (s, t) = BR1 (σ2 ), BR2 (x, y) = BR2 (σ1 ). Player 1 chooses x, y ∈ [0, 1] with x + y ≤ 1. Player 2
chooses s, t ∈ [0, 1] with t + s ≤ 1. Recall that

u1 (x, y; s, t) = 5 + 20t + 15x − 20sx − 30tx + 5y − 15ty

u2 (x, y; s, t) = 25 + 5x + 15y − 5ty − 10sx

Case 1: Let us look for a NE in which x = y = 0. The utility of player 2 is

u2 (0, 0; s, t) = 25

And player 2 is indifferent among any of his strategies. The utility of player 1 may be written as

u1 (x, y; s, t) = 5 + 20t + 15x − 20sx − 30tx + 5y − 15ty

= 5 + 20t + 5x(3 − 4s − 6t) + 5y(1 − 3t)

The action x = y = 0 is a best response for player 1 only if 3 − 4s − 6t ≤ 0 and 1 − 3t ≤ 0. Graphically,

3/4

s+t=1

3 − 4s − 6t = 0

1/3 1/2 1 t

The green area represents the values of s, t for which we have 3 − 4s − 6t ≤ 0 and 1 − 3t ≤ 0. This region
may be described as
1 1 3 3 1
A = {(s, t) ∈ R2 : ≤t≤ , − t ≤ s ≤ 1 − t} ∪ {(s, t) ∈ R2 : ≤ t ≤ 1, 0 ≤ s ≤ 1 − t}
3 2 4 2 2
Thus, we find infinitely many NE of the form

s1 = C
σ2 = tX + sY + (1 − t − s)Z, t, s ∈ A

The utilities of the players are

u1 = 5 + 20t u2 = 25

Let us look for a NE in which x = 0, y > 0. The utility of player 2 is

u2 (0, y; s, t) = 25 + 15y − 5ty

Since, y > 0, player 2 chooses t = 0. The utility of the player 1 is

u1 (x, y; s, 0) = 5 + 15x − 20sx + 5y = 5 + x(15 − 20s) + 5y

16
We see that if s ≥ 34 , then player 1 chooses x = 0, y = 1. If s < 3
4 , then we may assume x + y = 1 and

u1 (x, 1 − x; s, 0) = 10 + x(10 − 20s)

and we see that player 1 chooses

• x = 0, y = 1, if s > 21 ;
• x = 1, y = 0, if s < 12 ;
• x ∈ [0, 1], y = 1 − x, if s = 12 .

That is, 
1
x = 0, y = 1
 if s> 2
1
BR1 (t = 0, s) = x = 1, y = 0 if s< 2
1

x ∈ [0, 1], y = 1 − x if s=

2

Case 2: Now we check wether

1
x = 0, y = 1, t = 0, s ≥
2
is NE. If player 1 chooses x = 0, y = 1, the utility of player 2 is

u2 (0, 1; s, t) = 40 − 5t
1
so his best response is to choose t = 0 and any s. If Player 2 chooses t = 0, s ≥ 2 we have already seen
that player 1 chooses y = 1. Hence, we have infinitely many NE of the form

s1 = B
1
σ2 = sY + (1 − s)Z, ≤s≤1
2
The utilities of the players are
u1 = 10 u2 = 40

Let us look for a NE in which x > 0, y = 0. The utility of player 2 is

u2 (x, 0; s, t) = 25 + 5x − 10sx

Since, x > 0, player 2 chooses s = 0. The utility of the player 1 is

u1 (x, y; 0, t) = 5 + 20t + 15x − 30tx + 5y − 15ty = 5 + 20t + x(15 − 30t) + 5y(1 − 3t)

Note that,

1
(i) For t > 2 the coefficients of x and y are negative and player 1 chooses x = y = 0.
1
(ii) If t = 2 we have  
1 5y
u1 x, y; , 0 = 15 −
2 2
so player 1 chooses y = 0, any x ∈ [0, 1].
(iii) For 13 < t < 12 the coefficient of y is negative and the coefficient of x is positive. Hence, player 1
chooses x = 1, y = 0.
1
(iv) For t = 3 the coefficient of y is 0 and the coefficient of x is positive. Hence, player 1 chooses x = 1,
y = 0.
1
(v) For t < 3 the coefficients of y and x are both positive. We may assume y = 1 − x and

u1 (x, 1 − x; t, 0) = 10 + 5t + 10x − 15tx = 10 + 5t + x(10 − 15t)

Hence, player 1 chooses x = 1, y = 0.

17
That is, 
x = y = 0
 if t > 21
BR1 (t, s = 0) = y = 0, x ∈ [0, 1] if t = 21
1

x=1 if 0≤t<

2

Case 3: Now we check wether

1
x = 1, y = 0, s = 0, t ≤
2
is a NE. If player 1 chooses x = 1, y = 0, the utility of player 2 is

u2 (1, 0; s, t) = 30 − 10s

So, player 2 chooses s = 0 and any t ∈ [0, 1]. We have infinitely many NE of the form

s1 = A
1
σ2 = tX + (1 − t)Z, 0≤t≤
2
The utilities of the players are
u1 = 20 − 10t u2 = 30

Case 4: We check if there is a NE with

1
y = 0, x ∈ (0, 1], s = 0, t =
2
The utility of player 1 is  
1 5y
u1 x, y; 0, = 15 −
2 2
So, player 1 chooses y = 0 and any x ∈ [0, 1]. For y = 0 the utility of player 2 is

u2 (x, 0; s, t) = 25 + 5x − 10sx

so player 2 chooses s = 0 and any t ∈ [0, 1]. Therfore, there are infinitely many NE of the form

σ1 = xA + (1 − x)C, 0≤x≤1
1 1
σ2 = X+ Z
2 2
The (expected) utilities of the players are

u1 (σ1 , σ2 ) = 15, u2 (σ1 , σ2 ) = 25 + 5x

Case 5: Let us look for a NE in which x > 0, y > 0. In this case, player 2 chooses t = s = 0. The
utility of player 1 is
u1 (x, y; 0, 0) = 5 + 15x + 5y
we may assume y = 1 − x ,
u1 (x, 1 − x; 0, 0) = 10 + 10x
and player 1 chooses x = 1, y = 0. There is no such NE.
Problem 4: Consider a game in which there is a prize worth $30. There are three contestants, A, B,
and C. Each can buy a ticket worth $15 or $30, or not buy a ticket at all. They make these choices
simultaneously and independently. Once the ticket purchase decisions have been made, the prize is
awarded. If no one bought the ticket, the prize is not awarded. Otherwise, the ticket is awarded to the
buyer of the higher cost ticket if there is only one such player, or split equally between two or three
players if there are ties among the highest cost ticket buyers.

18
 1. Write the normal form of the game. (Hint: Draw a box for each of player C?s possible strategies.)
2. Identify the Nash equilibria in pure strategies of this game.

Solution: Player C chooses one of the following 3 matrices

Player B
0 15 30
(a) Player C chooses 0: 0 0, 0, 0 0, 15, 0 0, 0, 0
Player A 15 15, 0, 0 0, 0, 0 −15, 0, 0
30 0, 0, 0 0, −15, 0 −15, −15, 0

Player B
0 15 30
(b) Player C chooses 15: 0 0, 0, 15 0, 0, 0 0, 0, −15
Player A 15 0, 0, 0 −5, −5, −5 −15, 0, −15
30 0, 0, −15 0, −15, −15 −15, −15, −15

Player B
0 15 30
(c) Player C chooses 30: 0 0, 0, 0 0, −15, 0 0, −15, −15
Player A 15 −15, 0, 0 −15, −15, 0 −15, −15, −15
30 −15, 0, −15 −15, −15, −15 −20, −20, −20

The best responses of the players are

Player B
0 15 30
(a) Player C chooses 0: 0 0, 0, 0 0, 15, 0 0, 0, 0
Player A 15 15, 0, 0 0, 0, 0 −15, 0, 0
30 0, 0, 0 0, −15, 0 −15, −15, 0

Player B
0 15 30
(b) Player C chooses 15: 0 0, 0, 15 0, 0, 0 0, 0, −15
Player A 15 0, 0, 0 −5, −5, −5 −15, 0, −15
30 0, 0, −15 0, −15, −15 −15, −15, −15

Player B
0 15 30
(c) Player C chooses 30: 0 0, 0, 0 0, −15, 0 0, −15, −15
Player A 15 −15, 0, 0 −15, −15, 0 −15, −15, −15
30 −15, 0, −15 −15, −15, −15 −20, −20, −20

We see that there are 6 NE in pure strategies of to types:

Type 1: One player plays 0 and the other two play 15.
Type 2: One player plays 15 and the other two play 0.

Problem 5: Two firms, 1 and 2, produce heterogeneous products. If the two firms set prices p1 and p2 ,
respectively, the quantities demanded of the products of the two firms will be,
  
p1 + p2
x1 (p1 , p2 ) = max 0, 180 − p1 − p1 −
2
  
p1 + p2
x2 (p1 , p2 ) = max 0, 180 − p2 − p2 −
2

19
The above demand functions describe a situation in which the products are not perfectly homogeneous.
For instance, the demand for good 1, even if decreasing in the price set by firm 2, is positive also when
p1 > p2 (which is not the case when the good are homogeneous), or, in a different way, the demand for
good 1 will be lower than 180 − p1 when the price of good 1 is higher than the mean of the prices (and
therefore higher than p2 ) and higher than that when the price of good 1 is lower than the mean of the
prices (and therefore lower than p2 ). Assume that the firms have constant marginal costs MC1 = 20
and MC2 = 20. Assume also that the characteristics of the market are such that the firms have to set
simultaneously the prices.

(a) Write down firms’ profits, π1 (p1 , p2 ) and π2 (p1 , p2 ), as functions of the prices they set.
(b) Find firm 1’s best response to a price set by firm 2, BR1 (p2 ).
(c) Find firm 2’s best response to a price set by firm 1, BR2 (p1 ).

(d) Find the Nash equilibrium (p∗1 , p∗2 ).

(e) Determine equilibrium profits, π1 (p1 ,∗ p∗2 ) and π2 (p∗1 , p∗2 ).
(f) Are equilibrium profits zero? Why?
(g) Draw the best response function and the Nash equilibrium in the p2 − p1 plane (p2 on the horizontal
axis and p1 on the vertical axis).

Solution:

(a) We assume prices are such that the quantities demanded are positive. The profits of the firms are

3p2
  
p1 + p2 p1 p2
π1 (p1 , p2 ) = 180 − p1 − p1 − (p1 − 20) = − 1 + + 210p1 − 10p2 − 3600
2 2 2
3p2
  
p1 + p2 p1 p2
π2 (p1 , p2 ) = 180 − p2 − p2 − (p2 − 20) = − 10p1 − 2 + 210p2 − 3600
2 2 2

(b) Firm 1’s best response to a price set by firm 2 is

p2 + 420
BR1 (p2 ) =
6

(c) Fiirm 2’s best response to a price set by firm 1 is

p1 + 420
BR2 (p1 ) =
6

(d) The Nash equilibrium (p∗1 , p∗2 ) is the solution of the following system of equations
p2 + 420
p1 =
6
p1 + 420
p2 =
6
The solution is p∗1 = p∗2 = 84.
(e) The equilibrium profits are π1 (p∗1 , p∗2 ) = π2 (p∗1 , p∗2 ) = 6144.
(f ) The equilibrium profits aren’t zero because products are heterogeneous.

(g) Graphically, the best response function and the Nash equilibrium are

20
 p1

BR2 (p1 )
84
BR1 (p2 )
70

70 84 p2

Problem 6: Two firms, 1 and 2, produce heterogeneous products. If the two firms set prices p1 and p2 ,
respectively, the quantities demanded of the products of the two firms will be:
 
p1 + p2
x1 (p1 , p2 ) = 140 − p1 − p1 −
2
 
p1 + p2
x2 (p1 , p2 ) = 140 − p2 − p2 −
2

Suppose the two firms have constant marginal costs MC1 = 40 and MC2 = 40 and that they have to set
their prices simultaneously.

(a) What is the Nash equilibrium ? What are the Nash equilibrium profits for firms 1 and 2?
(b) Are the profits in equilibrium equal to 0? Why or why not?

Solution:

(a) We assume prices are such that the quantities demanded are positive. The profits of the firms are

3p2
  
p1 + p2 p1 p2
π1 (p1 , p2 ) = 140 − p1 − p1 − (p1 − 40) = − 1 + + 200p1 − 20p2 − 5600
2 2 2
3p2
  
p1 + p2 p1 p2
π2 (p1 , p2 ) = 140 − p2 − p2 − (p2 − 40) = − 20p1 − 2 + 200p2 − 5600
2 2 2

Firm 1’s best response to a price set by firm 2 is

p2 + 420
BR1 (p2 ) =
6

Fiirm 2’s best response to a price set by firm 1 is

p1 + 400
BR2 (p1 ) =
6

The Nash equilibrium (p∗1 , p∗2 ) is the solution of the following system of equations
p2 + 420
p1 = .
6
p1 + 400
p2 =
6
The solution is p∗1 = p∗2 = 80. The equilibrium profits are π1 (p∗1 , p∗2 ) = π2 (p∗1 , p∗2 ) = 2400.

21
(b) The equilibrium profits aren’t zero because products are heterogeneous.

Problem 7: Assume that two firms, 1 and 2, produce heterogeneous products and the quantities de-
manded by the market, when these firms fix prices p1 and p2 , are, respectively:

x1 (p1 , p2 ) = 200 − p1 + p2 /3
x2 (p1 , p2 ) = 200 − p2 + p1 /3

These demand functions describe a situation in which products are not perfectly homogenous. Suppose
that both firms have constant marginal costs MC= 50 and MC2 = 50 and that the features of the market
are such that both firms have to set prices simultaneously.

(a) Find the Nash equilibrium (p∗1 , p∗2 ).

(b) Determine equilibrium profits, π1 (p∗1 , p∗2 ) and π2 (p∗1 , p∗2 ). Are equilibrium profits zero? Why?
(c) Suppose now that firm 1 and 2 could make an agreement on how to make their products different so
that the demand functions become,

x1 (p1 , p2 ) = 200 − p1 + p2 /2
x2 (p1 , p2 ) = 200 − p2 + p1 /2

Do you think that it pays for the firms to agree on these new differentiated products?

Solution: Let us consider the following market demand functions

x1 (p1 , p2 ) = 200 − p1 + bp2

x2 (p1 , p2 ) = 200 − p2 + bp1

with 0 ≤ b < 2. We assume prices are such that the quantities demanded are positive. Now, the profits
of the firms are

π1 (p1 , p2 ) = (200 − p1 + bp2 ) (p1 − 50) = bp1 p2 − 50bp2 − p21 + 250p1 − 10000
π2 (p1 , p2 ) = (200 − p2 + bp1 ) (p2 − 50) = bp1 p2 − 50bp1 − p22 + 250p2 − 10000

Firm 1’s best response to a price set by firm 2 is

1
BR1 (p2 ) = (bp2 + 250)
2

Fiirm 2’s best response to a price set by firm 1 is

1
BR2 (p1 ) = (bp1 + 250)
2

The Nash equilibrium (p∗1 , p∗2 ) is the solution of the following system of equations
1
p1 = (bp2 + 250)
2
1
p2 = (bp1 + 250)
2
The solution is
250
p∗1 = p∗2 =
2−b

The equilibrium profits are

2500(b + 3)2
π1 (p∗1 , p∗2 ) = π2 (p∗1 , p∗2 ) =
(2 − b)2

22
Note that the funcion
2500(b + 3)2
f (b) =
(2 − b)2
is increasing in b. Its graph is the following.

1 × 106

800 000

600 000

400 000

200 000

0.5 1.0 1.5 2.0

(a) Taking
1
b=
3
we obtain that the Nash equilibrium (p1 , p2 ) is is p1 = p∗2 = 150.
∗ ∗ ∗

(b) Taking
1
b=
3
the equilibrium profits are π1 (p∗1 , p∗2 ) = π2 (p∗1 , p∗2 ) = 10000. The equilibrium profits aren’t zero because
products are heterogeneous.

(c) Suppose now that firm 1 and 2 could make an agreement on how to make their products different so
that the demand functions become,

x( p1 , p2 ) = 200 − p1 + p2 /2
x2 (p1 , p2 ) = 200 − p1 + p1 /2

Now, taking
1
b=
2
The Nash equilibrium is p∗1 = p∗2 = 460 ∗ ∗ ∗ ∗
3 . And the equilibrium profits are π1 (p1 , p2 ) = π2 (p1 , p2 ) =
96100
9 ≈ 10677.61. Hence, the firms would benefit from product differentiation.

Problem 8: Firms 1 and 2 compete in a market with a homogeneous product. Firms have to decide
how much to produce and put up for sale. Let q1 and q2 denote the quantities produced and put up for
sale by firm 1 and 2, respectively. The clearing market price of the homogeneous product on sale depends
on quantities produced according to the following inverse demand function: P (Q) = max{0, 10 − Q},
where Q = q1 + q2 is the total number of units of the product in the market. Total production costs are
c1 (q1 ) = q12 and c2 (q2 ) = q22 . This is the Cournot model of oligopoly competition that you will study in
the course of Industrial Organization.

(a) Describe the situation as a normal form game.

23
(b) Find the Nash equilibrium.

Solution:

(a) The set of players is N = {1, 2}, the sets of strategies are S1 = S2 = [0, ∞) and the payoffs are

π1 (q1 , q2 ) = (10 − q1 − q2 ) q1 − q12

π2 (q1 , q2 ) = (10 − q1 − q2 ) q2 − q22

(b) The profits of the firms are

π1 (q1 , q2 ) = (10 − q1 − q2 ) q1 − q12 = q1 (−q1 − q2 + 10) − q12

π2 (q1 , q2 ) = (10 − q1 − q2 ) q2 − q22 = q2 (−q1 − q2 + 10) − q22

Firm 1’s best response to a price set by firm 2 is

10 − q2
BR1 (q2 ) =
4
Firm 2’s best response to a price set by firm 1 is
10 − q1
BR2 (q1 ) =
4

The Nash equilibrium (q1∗ , q2∗ ) is the solution of the following system of equations
10 − q2
q1 =
4
10 − q1
q2 =
4
The solution is q1∗ = q2∗ = 2. The Equilibrium profits are π1∗ = π2∗ = 8.

Problem 9: Two Airlines, Fly and Connect, sell a round trip in economic class between two cities for
$400. Each one of the Airlines serves half the market and it thinks that if it lowers its fare by a 10%
and the competitor does not change its fare, its demand would rise by a 40% (which means that its price
elasticity is −4). Of this increase, 20% represents clients of the other company who change attracted by
lower fares, and the remaining 20% represent new clients attracted by lower fares. If both companies
lower their price by 10% both are going to increase by a 20 their respective demands due to new clients
(price elasticity is −2). The unitary cost for carrying each passenger is $200 for each of the Airlines.
Assume that they have to simultaneously decide whether to lower the prices by 10% or not.

(a) Represent the normal form of the game and find the Nash equilibrium.
Solution: Let 2N be the total number of customers. Note that the customers each company gets

Connect
$ 400 $ 360
Fly $ 400 N, N N (1 − 0.2), N (1 + 0.4)
$ 360 N (1 + 0.4), N (1 − 0.2) N (1 + 0.2), N (1 + 0.2)
Number of passengers

So the total profits are

Connect
$ 400 $ 360
Fly $ 400 N (400 − 200), N (400 − 200) N (1 − 0.2)(400 − 200), N (1 + 0.4)(360 − 200)
$ 360 N (1 + 0.4)(360 − 200), N (1 − 0.2)(400 − 200) N (1 + 0.2)(360 − 200), N (1 + 0.2)(360 − 200)
Number of passengers

24
 That is,

Connect
$ 400 $ 360
Fly $ 400 200N, 200N 160N, 224N
$ 360 224N, 160N 192N, 192N
Normalized profits

By normalizing N = 1, we see that the normal form of the game is the following

Connect
$ 400 $ 360
Fly $ 400 200, 200 160, 224
$ 360 224, 160 192, 192
Normalized profits

The NE is ($360, $360) with payoffs u1 = u2 = 192.

(b) Assume now that the two Airlines agree to have their total revenues accrue into a common pool
which is then shared equally, while each airline pays its own costs. As before, the Airlines have to
decide whether or not lowering their fares by 10%. Represent the game in its normal form and find
the Nash equilibrium.
Solution: Let 2N be the total number of customers. Note that the customers each company gets

Connect
$ 400 $ 360
Fly $ 400 N, N 0.8N, 1.4N
$ 360 1.4N, 0.8N 1.2N, 1.2N
Number of passengers

So, the total revenue for each company is

Connect
$ 400 $ 360
Fly $ 400 400N, 400N 0.8 × 400N, 1.4 × 360N
$ 360 1.4 × 360N, 0.8 × 400N 1.2 × 360N, 1.2 × 360N
total revenue

That is,

Connect
$ 400 $ 360
Fly $ 400 400N, 400N 320N, 504N
$ 360 504N, 320N 432N, 432N
total revenue

Total revenue for both companies are

Connect
$ 400 $ 360
Fly $ 400 800N 824N
$ 360 824N 864N
total revenue

And the profits are (since they share the revenue),

25
 Connect
$ 400 $ 360
Fly $ 400 400N − 200N, 400N − 200N 412N − 200 × 0.8 × N, 412N − 200 × 1.4 × N
$ 360 412N − 200 × 1.4 × N, 412N − 200 × 0.8 × N 432 − 200 × 1.2 × N, 432 − 200 × 1.2 × N
Profits

That is,

Connect
$ 400 $ 360
Fly $ 400 200N, 200N 252N, 132N
$ 360 132N, 252N 192N, 192N
profits

By normalizing N = 1, we see that the normal form of the game is the following

Connect
$ 400 $ 360
Fly $ 400 200, 200 252, 132
$ 360 132, 252 192, 192
Normalized profits

The NE (in dominant strategies) is ($400, $400) with payoffs u1 = u2 = 200.

(c) Do you believe that companies are going to act as in (b). Why?
Solution: Yes. The common pool reduce the incentives to lower prices and lead to high equilibrium
prices.

Problem 10: Two theaters are located on the same street. They advertise and, by so doing, attract
customers to the area so that each of the two theaters’ advertising is beneficial to both. Let x1 be the
advertising level of theater 1 and x2 be the advertising level of theater 2 (for instance, x1 could denote
the number of potential customers reached by theater 1’s advertising). The profit functions for theaters 1
and 2 are respectively:

π1 (x1 , x2 ) = (30 + x2 )x1 − 2x21

π2 (x1 , x2 ) = (30 + x1 )x2 − 2x22

(a) What are the Nash equilibrium advertising levels of the two theaters?

(b) What are their equilibrium profits?

(c) Could the theaters increase total profits if they could commit to given advertising levels? What
advertising levels would they choose?

Problem 11: For most new films, the demand for movie theaters is highest in the first few days after
opening, then taper off. Accordingly, studios must time new releases very carefully. Two key factors
affecting potential demand are the season and the timing of other releases. Suppose that both Suprafilm
and National are producing major action movies. The two studios simultaneously must choose between
release in November or December. If both films open on November, each will sell 200,000 tickets. If one
opens on November and the other in December, then the early release will sell 350,000 tickets, while the
later release will sell 220,000. If both open in December, each will sell 300,000 tickets.

(a) Construct a game in normal form to illustrate the situation.

26
(b) Identify the Nash equilibrium or equilibria.

Problem 12: Two executives, A and B, have to submit a proposal to a firm’s board about the price
of the firm’s product. There are four possible prices: 100, 110, 120 or 130 euros. The board is made
up of 13 members and conversations prior to the meeting have led four members to prefer the price of
100, two members to prefer the price of 110, one member prefers 120, and six members prefer the price
of 130. Both executives have to submit their proposals simultaneously. Once the proposals are received,
each member of the board will vote for one of the executives as the next CEO. Each member will vote for
the executive whose price proposal is closer to his own ideal price. If both executives propose the same
price, members vote with probability 1/2 for each. If one member has to decide between two equidistant
prices (from his ideal price), he will vote for each executive with probability 1/2. The executive with
more votes will be the next CEO.

(a) Design a table with the (expected) votes each executive would get depending on both proposals for
prices. (Suggestion: Place executive A’s proposed prices in rows and B’s prices in columns) Suppose
that both executives only care about being chosen as CEO and that they do not have any other
preference regarding a particular price.
(b) Find the normal form of this game.

(c) Find the pure strategy Nash equilibria.

(d) Comment on the result.

Problem 13: Two firms, H and S, produce complementary hardware and software products. This
means that if one firm dedicates more resources to investment, it increases not only the demand of its
own product but also the demand of the product of the other firm. Letting xH and xS denote the
investment expenditures of H and S, respectively, their profits are

x2H
πH (xH , xS ) = (30 − xS )xH + 40xS −
2
x2S
πS (xH , xS ) = (30 − xH )xS + 40xH −
2

(a) If firms H and S simultaneously decide their investment expenditures, what are the equilibrium
investment expenditures?

(b) What are the equilibrium profits?

(c) Suppose now that firm H can make a take-it-or-leave-it offer to buy firm S from its owners. What is
the lowest amount that the owners of firm S would be willing to accept?
(d) Suppose that the owners of firm S accept the offer, and that the new firm will decide both xH and
xS . What are the optimal investment expenditures for the new firm? What profit will it obtain?
(e) Suppose that firm H makes the lowest offer that would be accepted by the owners of firm S, that
they accept such offer and that the new firm will then set the optimal investment expenditure levels
that you have found in part (d). Would the profits of firm H (net of the price paid to buy firm S)
increase? If so, by how much?

Problem 14: The three members of the board of directors of a corporation, A, B, and C, have to
vote on whether to raise their salaries. Assume that each director prefers a raise over no raise; however,
each also knows that voting for a pay raise may reduce the probability of being reappointed at the end of
his/her term. Thus, the best possible outcome for an individual director is to vote against a pay raise that
still wins majority approval, and the worst possible outcome is to vote for a pay rise that fails. Not all
directors agree on how to rank the other two outcomes. For directors B and C, the second-best outcome

27
 Outcomes Director A’s rankings Director B’s and C’s rankings
Best, 3 points Raise passes, vote against Raise passes, vote against
Second best, Raise fails, vote against points Raise passes, vote for
Third best, 1 point Raise passes, vote for Raise fails, vote against
Worst, 0 points 1 point Raise fails, vote for Raise fails, vote for

is to have a raise proposal pass with their vote being in favor. For director A, however, the second-best
outcome is for a raise proposal to fail, with his vote being against. The payoff ranking below (where large
numbers represent more favorable outcomes) summarizes this situation. (You should assume that each
director knows the rankings of all three directors.) Assume that the directors vote simultaneously.

(a) Write the normal form of this game (Suggestion: Let A be the row player, B be the column player
and C be the matrix player.)
(b) Find the Nash equilibria of this game.
(c) Explain (in words) the results of part (b).

Problem 15: The board of directors of a company is composed of 9 directors. The board of directors
has to make a decision about the CEO and there are three possible choices

A: Fire the CEO .

B: Keep the CEO but not give him a pay raise.
C: Keep the CEO and give him a pay raise.

Directors have different opinions about the appropriate course of actions. Some would want to fire the
CEO and get a new CEO on board. Some believe that the CEO should not be fired, but that there is
no need to give him a pay raise. Some finally believe that the CEO should be kept, but that only a pay
raise will make sure that he will not be snatched away by the competition.
The ordering of preferences is the following:

• Four directors (the ‘archenemies’) prefer A to B to C

• Three directors (the ‘enthusiasts’) prefer C to B to A
• Two directors (the ‘moderate’) prefer B to C to A

The board of directors has agreed to the following voting procedure. Each director may vote for one of
the three choices. Then, the choice with the least number of votes is dropped, and the directors vote on
the remaining two. Whichever choice receives the most votes in round two is the winner.

(a) What would happen if each director voted according to his true preferences?
(b) Consider now the case in which the directors are aware of the strategic implications of their actions.
How would you vote if you were an archenemy? [Hint 1: Do not try to draw the extensive form
because it is very complicated and it will not help you much. Hint 2: Ask yourself: 1) What are the
possible outcomes of the first vote? 2) For each of these possible outcomes, how would directors vote
in the second vote? 3) Given the answers to the previous questions, how do you think each type of
director will vote in the first vote?]

Problem 16: Two bidders, A and B, participate in an auction to buy a plot of land. Each of the two
bidders can only bid one of three possible prices, low, medium and high. The plot will be sold to the
highest bidder and in case of a tie a coin will be tossed to determine the winner.
The value of obtaining the plot net of the price to be paid is the following:

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 Price Net value
High 10
Medium 30
Low nt 40

(a) Write down the normal form of the game.

(b) Find the pure strategy Nash equilibria.

Consider now the possibility of modifying the rules of the auction so that in case of a tie the winner is A
with probability 1.

(c) Write down the normal form of the game.

(c) Find the pure strategy Nash equilibria.

(c) If you wanted to sell the plot and therefore wanted to maximize the expected sale price, which of the
two auction formats would you prefer? Explain your answer.

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