Problem Set 7.
Ben Polak Econ 159a/MGT522a
Three questions due Nov 7, 2005 (plus one optional question).
1. \Not Survivor". [This question was on the 2001 nal exam.] Six former 159a students
Ann, Bob, Carl, Dora, Ed, and Fran are the contestants in a new \real TV" show. They are
placed on an island. The rules of the game are as follows. Ann goes rst. She is given a bag
that everyone knows contains six gold coins. Ann makes a proposal of how to allocate the six
coins among the six contestants including herself. The contestants (including Ann) then vote
`yes' or `no' on the proposal. If the proposal gets more than half the votes then the coins are
allocated according to the proposal and everyone leaves the island. If the proposal gets half or
fewer than half the votes then Ann has to leave the island empty-handed and she is out of the
game.
In this case, the bag of six gold coins passes to Bob. He gets to make a proposal of how to
allocate the coins among the remaining contestants (i.e., including Bob but excluding Ann) and
the remaining contestants (i.e., including Bob but excluding Ann) then vote. As before, if the
proposal gets more than half the votes then the coins are allocated according to the proposal
and everyone leaves the island. If the proposal gets half or fewer than half the votes then Bob
has to leave the island empty-handed and is out of the game. In this case, the bag of six gold
coins passes to Carl. And so on, with the same voting rules, with each failed proposal leading
to expulsion of the proposer, and with the role of proposer being passed on alphabetically.
The following assumptions matter. The coins are indivisible, there is no other money on
the island, and side contracts to make payments o the island are not allowed. There are no
abstentions; each surviving voter must vote yes or no: whenever a voter is indi erent, she or he
votes no. The players only care about the gold (and this is common knowledge). For example,
leaving empty handed because your proposal fails is the same as leaving empty-handed because a
successful proposal gives you no coins. Finally: it is common knowledge that all the contestants
were well trained in Game Theory at Yale.
What proposal should Ann make and why?
2. A Hold-Up Problem. [This question introduces you to an important kind of problem in
sequential strategic settings.] Suppose that Amtrack is choosing whether or not to build a new
high-speed railroad on the east coast. Building the railroad will involve an initial up-front sunk
cost k. To keep the accounting simple assume that the railway, if built, will run for exactly one
year, and that it will generate (new) revenues of $130; 000; 000. Operating the railroad for that
year would cost $10; 000; 000 in fuel, plus some labor costs. The labor costs depend on the wage.
The railroad would need to employ 1000 workers all of whom would be unionized. The current
going wage for union rail labor on the east coast is $50; 000. That is, without the new railroad,
these workers would earn $50; 000.
(a) Very brie y de ne what is meant by a sunk cost, and what is meant by the `sunk-cost
fallacy'. [Go look it up if you do not know.]
(b) Assuming that the labor can be hired at this going wage, for what values of k should
Amtrack build the new railroad? (Assume that Amtrack aims to maximize pro ts without
discounting).
(c) Suppose that, if the railroad is built, after it is built the rail union can make a `take it
or leave it' wage demand w to Amtrack to apply just for labor on the new line. The railroad's
only choice is to accept to pay the wage demand, w, or close the new line down. What demand
will the union make? Given this, if you were Amtrack, for what values of k would you build the
new line? Why is your answer di erent from that in part (b)?
Now suppose that the wage demand made after the railroad is built is not a `take it or leave
it' demand but rather part of negotiation. Suppose that, fearing strikes in the transport sector,
the government has instituted compulsory arbitration in wage disputes. The arbitrator always
follows a two-step approach. First, she disquali es any wage o ers lower than the current going
wage (that is, such that employees would rather walk away than accept the o er), and also any
wage demand that would cause the employer to shut down (that is, such that the employee
would rather walk away than accept the demand). Provided the o ers and demands survive this
test, she then \splits the di erence".
(d) What wage demands and wage o ers will be presented to the arbitrator after the railroad
is built. Given this, if you were Amtrack, for what values of k would you build the new line?
Why is your answer di erent from that in parts (b) and (c)?
(e) Issues like this are sometimes called `hold-up' problems. One way to avoid the problem
here (under-investment) is to give all the ex post bargaining power to the would-be ex ante
investor. (Here this is the employer but in other settings it might be an employee who must
decide how much to invest in skills that are speci c to a given rm.) Brie y list some other
ways we see people try to get around hold-up problems.
3. A Patent Race (Dutta) [This question looks at a patent race under very di erent assump-
tions to the `duel' we played in class.] Two rms, A and B, are each considering trying to
develop a new widget. Whichever rm is rst to develop the new widget wins a patent worth
$20 million plus a penny. Developing a new widget involves several `steps'. The rms alternate
moves, with A moving rst, until one of them wins the patent. All moves are observed. In each
turn, a rm can choose whether to take 0, 1, or 2 development `steps'. Taking 0 steps in a turn
costs that rm $0. Taking 1 step in a turn costs $4 million. And taking 2 steps in a turn costs
$11 million. For simplicity, assume a zero discount rate. Initially, each rm is 4 steps away from
completing development.
(a) Describe and explain carefully what will happen in this patent race and why. [Hint: it
may help to read Dutta ch 12 (but notice I changed the numbers).]
(b) Very brie y explain what is the economic rationale for granting `intellectual property
2
rights' such as patents. What are some disadvantages for society of granting such rights?
4. [Optional]. The Rectangular Array of Stones. Recall the game we played in class in
which, initially, there is an N M rectangle of stones. There are two players who take turns.
The player whose turn it is to move must select a stone and remove that stone and that lie
above or/and to the right of it. The loser is the person who takes the last stone. For all N and
M , show what is the solution of the game: that is, can player 1 force a win or can player 2 force
a loss. Try for as concise an argument as possible.
