University Carlos III of Madrid Departament of Economics

Game Theory: Problem set 2. Solutions.

Problem 1: Anna, Barbara and Clara are playing the following extensive form game,

Anna
a1 a2

Barbara (2, 2, 1)

b1 b2

(1, 3, −1) Carla

c1 c2

(0, −1, 3) (0, 4, 2)

(a) Write the game in its normal form.

Solution:

Anna

a1 a2

Carla Carla
c1 c2 c1 c2
Barbara b1 1, 3, −1 1, 3, −1 Barbara b1 2, 2, 1 2, 2, 1
b2 0, −1, 3 0, 4, 2 b2 2, 2, 1 2, 2, 1

(b) Find the pure strategy Nash equilibria of the game.

Solution: They are the following.
• (a2 , b1 , c3 ).
• (a2 , b1 , c4 ).
• (a2 , b2 , c3 ).
• (a2 , b2 , c4 ).
(c) Find the proper subgames of the game and write them in their normal forms.
Solution:
• The game that starts with Barbara,
Carla
c1 c2
Barbara b1 1, 3, −1 1, 3, −1
b2 0, −1, 3 0, 4, 2

• The game that starts with Carla,

Carla
c1 c2
0, −1, 3 0, 4, 2
(d) Find the Nash equilibria of such subgames.
Solution:

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 • The NE of the game that starts with Barbara is (b1 , c1 ).
• The NE of the game that starts with Barbara is (c1 ).
(e) Find the subgame perfect Nash equilibria of the game.
Solution: (a2 , b1 , c1 ).

Problem 2: A firm’s foundation has to choose whether to contribute to University A or to University

B. Each University is interested only in the contributions it receives. The foundation announces that
the contribution will be decided by the following mechanism. University A is proposed a contribution of
$10,000 for itself and $0 for University B. If University A accepts, the contribution is assigned. Otherwise
the Foundation increases the total contribution to $40,000 and asks University B whether it wants to
keep all the $40,000 for itself or whether it prefers that the contribution is equally shared between the
two Universities ($20,000 to A and $20,000 to B).

(a) Draw the extensive form of the game (i.e., the tree whose nodes represent when players play and
whose branches represent their decisions).
Solution:

A
a na

(10, 0) B

k s

(0, 40) (20, 20)

(b) Find the subgame perfect equilibrium of the game.

Solution: (a, k).
(c) Represent the game in its normal form (i.e., the matrix whose rows represent University A’s strategies
and whose columns represent University B’s strategies, and the cells containing players’ payoffs for
any possible combination of strategies).
Solution: SA = {a, na}, SB = {k, s}. The normal game for is the following.

B
k s
A a 10, 0 10, 0
na 0, 40 20, 20

(d) Find the pure-strategy Nash equilibria. Has one of the players a dominant or a dominated strategy?
Solution: The NE is (a, k). Strategy a is weakly dominated for player 2, but it is not strictly
dominated.

Problem 3: Macrosoft has developed a new video game and it wants to launch it on the market. In
particular the choice is between using an impacting advertising campaign or leaving the promotion to the
communication between buyers and potential buyers (‘word of mouth’). Macrosoft knows that the video
game will last only 2 years on the market (as in 2 years newer and better video games will be introduced).
It also knows that the sales do not depend on marketing strategy, but the temporal distribution of the
sales do. The advertising campaign produces high sales in the first year but lower in the second due to
market saturation. Using the word of mouth strategy, sales will be lower in the first year and higher in
the second year. The following table describes Macrosoft’s income depending on the strategy it adopts.

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 Advertising Word of mouth
Macrosoft first year income 900,000 200,000
Macrosoft second year income 100,000 800,000
Marketing cost 570,000 200,000

(a) Draw the decision tree that represents Macrosoft problem and derive Macrosoft optimal decision.
Solution:

Macrosoft

A W OM

43 = 90 + 10 − 43 80 = 20 + 80 − 20

The optimal decision is W OM .

Assume now that a competitor, Microcorp, observes Macrosoft’s strategy and can decide to develop a
copy of the videogame in a year starting from the beginning of the promotion campaign. If Microcorp
develops the copy, both firms share the market equally. The cost for Microcorp of developing the copy is
300.000.

(b) Draw the extensive form of the game(the ‘game tree’).

Solution:

Macrosoft

WOM A

Microcorp.1 Microcorp.2

D N D N
80
(20 + 2 − 20 = 40, 80
2 − 30 = 10) (80, 0) (90 + 10
2 − 57 = 38, 10
2 − 30 = −25) (43, 0)

where
• W OM = Word of mouth.
• A = Advertise.
• DN = Do not develop.
• N = Develop.
(c) Find the subgame perfect Nash equilibria of the game.
Solution: We will use the backwards induction procedure. We draw in red the best responses of
the players. In the he first step, Microcorp decides D at the node Microcorp.1 and N at the node
Microcorp.2.

Macrosoft

WOM A

Microcorp.1 Microcorp.2

D N D N

(40, 10) (80, 0) (38, −25) (43, 0)

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 Given this, Macrosoft’s best option is to choose A.

Macrosoft

WOM A

Microcorp.1 Microcorp.2

D N D N

(40, 10) (80, 0) (38, −25) (43, 0)

The SPNE is (A, DN ).

(d) What is Macrosoft’s strategy space?
Solution: SMacrosoft = {W OM, A}.
(e) What is Microcorp’s strategy space?
Solution: SMicrocorp = {DD, DN, N D, N N }.
(f) What is the normal form of the game?
Solution:

Microcorp
DD DN ND NN
Macrosoft W OM 40, 10 40, 10 80, 0 80, 0
A 38, −25 43, 0 38, −25 43, 0

(g) Find the pure strategy Nash equilibria.

Solution: The set of NE is (A, DN ) and (W OM, DD). The NE (W OM, DD) is based on a non-
credible threat.

Problem 4: Companies A and B are considering developing a new commercial aircraft. Suppose that
A is ahead in the development process and that B is considering whether to enter the competition. If B
stays out, it earns zero profit and A, being the monopolist, earns a profit of $1 billion. If B decides to
enter and develop the rival airplane, then A has to decide whether to accommodate B peaceably, or to
wage a price war. In the event of peaceful competition, each firm will make a profit of $300 million. If
there is a price war, each will lose $100 million.

(a) Draw the game tree (‘extensive form’) for this game.
Solution:

O I

(0, 1000) A

F A

(−100, −100) (300, 300)

(b) What is the subgame perfect Nash equilibrium?

Solution:

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 B

O I

(0, 1000) A

F A

(−100, −100) (300, 300)

The SPNE is (I, A). The payoffs are uA = ub = 300.

(c) How many strategies does each player have?
Solution: SA = {F, A}, SB = {I, O}.
(d) Write the normal form of the game.
Solution:

A
A F
B I 300, 300 −100, −100
O 0, 1000 0, 1000

(e) Find all Nash equilibria of this game.

Solution: Let us look for a NE of the form
σ1 = xI + (1 − x)O
σ2 = yA + (1 − y)F
We compute the expected utilities of the players
u1 (I, σ2 ) = 300y − 100(1 − y) = 400y − 100
u1 (O, σ2 ) = 0y + 0(1 − y) = 0
u2 (σ1 , A) = 300x + 1000(1 − x) = 1000 − 700x
u2 (σ1 , F ) = −100x + 1000(1 − x) = 1000 − 1100x

Note that
(a) 0 > 400y − 100 for 0 < y < 41 .
(b) 0 = 400y − 100 for y = 41 .
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(c) 0 < 400y − 100 for 4 < y ≤ 1.
Thus, we have that best reply of player 1 is

x = 0
 if 0 ≤ y < 14
BR1 (σ2 ) = [0, 1] if y = 41
1

x=1 if 4 <y ≤1


Note now that

(a) 1000 − 700x > 1000 − 1100x for x > 0.
(b) 1000 − 700x = 1000 − 1100x for x = 0.
Thus, we have that best reply of player 2 is
(
y=1 if 0<x≤1
BR2 (σ1 ) =
[0, 1] if x=0

Graphically,

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 y

BR2 (x)

BR1 (y)

1
4

1 x

We see that there are the following NE,

• (O, F ) with payoffs uA = 1000, uB = 0.
• (I, A) with payoffs uA = 300, uB = 300.
• (O, yA + (1 − y)F ) 0 ≤ y ≤ 14 , with payoffs uA = 1000, uB = 0.
Only the NE (I, A) is a SPNE. All the other NE are based on non-credible strategies.

Problem 5: Find the subgame perfect Nash equilibria of the following games.

(a)

A B

2.1 2.2
X1 Y1 X2 Y2

(10, 10) (150, 0) (0, 150) (100, 100)

Solution:

A B

2.1 2.2
X1 Y1 X2 Y2

(10, 10) (150, 0) (0, 150) (100, 100)

The SPNE is (A, (X1 , X2 )) with payoffs u1 = u2 = 10.

(b)

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 1.1
a1 a2

2.1 (2, 1)

b1 b2

(2, 4) 1.2
c1 c2

(6, 3) 2.2
d1 d2

(4, 8) 1.3
e1 e2

(10, 5) (9, 9)

Solution: One SPNE in pure strategies is ((a2 , c1 , e1 ), (b1 , d1 )). That is,

1.1
a1 a2

2.1 (2, 1)

b1 b2

(2, 4) 1.2
c1 c2

(6, 3) 2.2
d1 d2

(4, 8) 1.3
e1 e2

(10, 5) (9, 9)

with payoffs u1 = 2, u2 = 1.

The other SPNE in pure strategies is ((a1 , c1 , e1 ), (b1 , d1 )). That is,

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 1.1
a1 a2

2.1 (2, 1)

b1 b2

(2, 4) 1.2
c1 c2

(6, 3) 2.2
d1 d2

(4, 8) 1.3
e1 e2

(10, 5) (9, 9)

with payoffs u1 = 2, u2 = 4.

Problem 6: Suppose that two firms are negotiating an agreement. If the two parties reach an agreement
immediately, each will have a gain of 100. If the two parties don?t achieve an agreement immediately
they will have a second and last chance of achieving an agreement in a month. If the agreement is reached
in a month, firm A will have a gain of 40 and firm B will have a gain of 55. Negotiation works in the
following way: In the first period Firm A demands a payment of firm B in order to sign the agreement. If
firm B accepts, the agreement is reached, the payoff to firm A will be 100 plus the payment that firm B
has accepted to make. And the payoff to firm B will be 100 minus the payment it has accepted to make.
If firm B rejects the offer, it will make an offer to firm A in the second period with the offer consisting
again of a demand of a payment in order to sign the agreement.

(a) How much does firm A demand of firm B in the first period in the subgame perfect Nash equilibrium
of this game? (Hint: Solve the game by backward induction.)
Solution: The extension game form representation is the following.

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 A.1

d1

B.1

A R

(uA = 100 + d1 , uB = 100 − d1 ) B2

d2

A.2

A R

(uA = 40 − d2 , uB = 55 + d2 ) (0, 0)

We compute the SPNE. At node A.2, firm A accepts iff 40 − d2 ≥ 0. That is, firm A accepts iff
d2 ≤ 40. Given the best reply of firm A at node A.2, the best response of firm B at node B.2 is to
offer d2 = 40. Thus, we may assume that if we ever reach node B.2, firm B will offer d2 = 40 and
firm A accepts. The payoffs will be uA = 0, uB = 95. We replace this payoffs at node B.2

A.1

d1

B.1

A D

(uA = 100 + d1 , uB = 100 − d1 ) (uA = 0, uB = 95)

Now, player B at node B.1 accepts iff 100 − d1 ≥ 95. That is, at node B.1 player B accepts iff d1 ≤ 5.
The best response now for player A is to offer d1 = 5 at node A.1. The SPNE is the following.
• Node A.1: d1 = 5.
• Node B.1: accept iff d1 ≤ 5.

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 • Node B.2: d2 = 40.
• Node A.2: accept iff d2 ≤ 40.
The payoffs are uA = 105, uB = 95.
(b) Suppose now that firm B made the offer in the first period and firm A in the second period. How
much would firm B demand of firm A in the first period in the subgame perfect Nash equilibrium of
this game?
Solution: The roles of B and A are reversed now. The extension game form representation is the
following. The extension game form representation is the following.

B.1

d1

A.1

A R

(uA = 100 − d1 , uB = 100 + d1 ) A.2

d2

B.2

A R

(uA = 40 + d2 , uB = 55 − d2 ) (0, 0)

We compute the SPNE. At node B.2, firm B accepts iff 55 − d2 ≥ 0. That is firm B accepts iff
d2 ≤ 55. Given the best reply of firm B at node B.2, the best response of firm A at node A.2 is to
offer d2 = 55. Thus, we may assume that if we ever reach node A.2, firm A will offer d2 = 55 and
firm B accepts. The payoffs will be uA = 95, uB = 0. We replace this payoffs at node B.2

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 B.1

d1

A.1

A D

(uA = 100 − d1 , uB = 100 + d1 ) (uA = 95, uB = 0)

Now, player A at node A.1 accepts iff 100 − d1 ≥ 95. That, is at node A.1 player A accepts iff d1 ≤ 5.
The best response now for player B is to offer d1 = 5 at node B.1. The SPNE is the following.
• Node B.1: d1 = 5.
• Node A.1: accept iff d1 ≤ 5.
• Node A.2: d2 = 40.
• Node B.2: accept iff d2 ≤ 40.
The payoffs are uA = 95, uB = 105.
(c) If you worked for firm A would you rather have your firm be the first or the second to make the offer?
Solution: Player A prefers to move first.

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