Case Western Reserve University

Department of Economics
ECON 329 - Game Theory
Spring 2015

Homework #5
Lectures 16, 17 & 18
Return in Class on Thursday 9th
Name:

Total points ____ out of 20.

1. Stackelberg Model of duopoly where firms have convex costs (8 points).
A product is produced by only two firms: firm 1 and firm 2. The timing of the game is as follows: firm 1
chooses a quantity 1 0, then firm 2 observes 1 and chooses a quantity 2 0. The payoff of each firm
depends on the market price and the cost of production . The market price is determined by the following
formula: () = , where is a constant number and = 1 + 2 is the aggregate quantity produced on
the market by both firms. The cost to firm of producing is ( ) = 2 . (Note: the only difference between
this problem and the standard problem is that instead of ( ) = we have ( ) = 2 ).
a) Find the best response function for firm 2 as a function of firm 1s quantity 1 . (2 points).

b) Find the best response function for firm 1, given that firm 1 knows the best response of firm 2. (2 points).

c) What is SPNE of this game? (2 points).

d) What is the outcome of SPNE of this game: equilibrium quantities for firm 1 and 2? (2 point).

2. Resolving conflicts by flipping a fair coin (10 points).

Consider a game of potential conflict between two players for a prize valued at v by both players. The game
takes place in two sequential stages, the conflict resolution stage and the conflict stage. In the conflict resolution
stage, players 1 and 2 simultaneously decide whether to resolve the conflict by flipping a fair coin (call this
strategy Flip) or to enter the conflict stage (call this strategy Conflict). If both players agree to Flip, then
the game ends with neither player advancing to the conflict stage. The prize is allocated to each player with
probability p1Flip = p2 Flip = 0.5, and players 1 and 2 receive the expected payoffs of E(1Flip) = E(2Flip) = v/2.
However, if either player refuses to Flip (i.e., one or both players choose Conflict), then both players
advance to the conflict stage. In the conflict stage, both players make irreversible effort expenditures e1 0 and
e2 0 to increase their probabilities of receiving the prize. Players have different conflict capabilities (strengths)
a1 > 0 and a2 > 0, so that the stronger player 1 (a1 > a2) can expend the same effort, yet have a higher chance of
winning the prize. Specifically, player 1s probability of winning is p1(e1,e2) = a1e1/(a1e1 + a2e2) and player 2s
probability of winning is p1(e1,e2) = a2e2/(a1e1 + a2e2). The expected payoff in a conflict for player 1 is
E(1Conflict) = p1(e1,e2)v - e1 = va1e1/(a1e1 + a2e2) - e1 and the expected payoff in a conflict for player 2 is
E(2Conflict) = p2(e1,e2)v - e2 = va2e2/(a1e1 + a2e2) - e2.
a) What is the Nash equilibrium of the conflict stage subgame? (2 points). (Hint: In the conflict stage both
players will maximize their respective payoffs, so just solve the following two First Order Conditions
E(1Conflict)/e1 = 0 and E(2Conflict)/e2 = 0 simultaneously, in order to get e1* and e2*).

b) What is the Nash equilibrium payoff in the conflict stage? (2 points). (Hint: Plug in the solution e1* and e2*
into E(1Conflict) and E(2Conflict) to get the Nash equilibrium payoffs).

c) Prove that the weaker player 2 will always choose Flip. (Hint: show that the payoff for player 2 in the case
of Conflict is always lower than in the case of Flip, i.e., E(2Conflict) < E(2Flip)) (2 points).

d) What are the needed restrictions on a1 and a2 for the stronger player 1 wanting to choose Flip. (Hint:
examine when the payoff for player 1 in the case of Conflict is lower than in the case of Flip i.e., E(1Conflict)
< E(1Flip)) (2 points).

e) Friedrich Nietzsche said "Justice originates among those who are approximately equally powerful (...) where
there is no clearly recognizable predominance and a fight would mean inconclusive mutual damage (...)."
Explain how your findings support this conjecture. (2 point).

3. Commitment problems in conflict resolution (2 points).

In the literature on conflict resolution there is a well-known problem, called a commitment problem: in the
absence of credible commitment, parties on the less favored side of any proposed resolution face incentives to
ignore the resolution. Such commitment problems arise both on a macro level between countries and competing
economies, as well as on a micro level between individuals. For example, a country that finds a UN resolution
counter to its interests could simply exit the organization and ignore the international community. When
examining the commitment problem using game theoretic analysis, all Subgame Perfect Nash Equilibria
(SPNE) lead to a conflict.
a) Do you think that making commitment costly would help resolving the commitment problem? (2 points).
Hint: To answer this question, please read the article Commitment Problems in Conflict Resolution which
was published in the Journal of Economic Behavior and Organization
http://www.sciencedirect.com/science/article/pii/S0167268115000281. If you are off campus, you may not have
a direct access to the journal, so here is the link to an open access version:
https://ideas.repec.org/p/chu/wpaper/13-11.html.