University of Hong Kong

ECON6036 Game Theory and Applications

Review Problems II

1 Bayesian game
1. Two people are involved in a dispute. Person 1 does not know whether
person 2 is strong or weak; she assigns probability to person 2s being
strong. Person 2 is fully informed. Each person can either fight or yield.
Each person get the payo of 0 if she yields (regardless of the other persons
action) and a payo of 1 if she fights and her opponent yields; if both
people fight, then their payos are (-1,1) if person 2 is strong and (1,-1)
if person 2 is weak. Formulate this situation as a Bayesian game and find
its Nash equilibria if < 1/2 and if > 1/2.
2. Whether candidate 1 or candidate 2 is elected depends on the votes of
two citizens. The economy may be in one of two states, A and B. The
citizens agree that candidate 1 is best if the state is A and candidate 2 is
best if the state is B. Each citizen gets a payo of 1 if the best candidate
for the state wins (obtains more votes than the other candidate), a payo
of 0 if the other candidate wins, and payo of 1/2 if the candidates tie;
both citizens are expected value maximizers. Citizen 1 is informed of the
state, whereas citizen 2 believes it is A with probability 0.9 and B with
probability 0.1. Each citizen may either vote for candidate 1, vote for
candidate 2, or not vote.
(a) Formulate this situation as a Bayesian game. (Construct the table
of payos for each state.)
(b) Show that the game has exactly two pure Nash equilibria, in one of
which citizen 2 does not vote and in the other of which she votes for
1.
(c) Show that an action of one of the players in the second equilibrium
is weakly dominated.
(d) Why is swing voters curse an appropriate name for the determi-
nant of citizen 2s decision in the first equilibrium?
3. (Double auction) A single seller and a single buyer may trade 0 or 1
unit of a good. The seller (player 1) has cost c, and the buyer (player
2) has valuation v, where v and c both are private information and are
uniformly distributed in [0, 1]. The seller and the buyer simultaneously
and independently choose bids b1 , b2 [0, 1] . If b1 b2 , the two parties
trade at price t = (b1 + b2 )/2. If b1 > b2 , the parties do not trade. The
sellers payo is thus u1 = (b1 + b2 )/2 c if b1 b2 , and 0 if b1 > b2 ; the
buyers payo is u2 = v (b1 + b2 )/2 if b1 b2 , and 0 if b1 > b2 . Suppose
each players strategy is a strictly increasing, linear function of his type.
Solve for the equilibrium.

1
2 Bayesian Extensive Game
1. Consider N villagers i = 1, ..., N, each of whom is privately informed of
the cost he must incur if he goes hunting. This cost, denoted ci , is a priori
uniformly distributed on [0, 1 + ], where is some positive number, and
the ci are independently distributed across villagers. If all hunt together,
they will catch a deer, which yields a value 1 to each of them. On the
other hand, if some villager decides to stay at home, the other will not be
able to catch the stag and will have a payo of zero. All villagers are risk
neutral. Except for the costs of hunting, all components of the model are
commonly known.

(a) Find all Nash equilibria of this game.

(b) Now consider a modified game as follows. In the first stage each
villager announces yes or no to all the others, and announcing
itself is costless (hence we are considering a cheap talk game). In the
second stage each of them decides whether to go hunting. Show that
in this modified game there exists an equilibrium in which in the first
stage each villager announces yes if and only if his private cost ci
is lower than 1. Completely describe this equilibrium.

2. (Is reputation always good?) Start a one-shot model of an agent and a

principal. Think of them as a car mechanic and car owner. The car owner
does not know which type of repair is needed: either to have the engine
replaced, or just to have a tune-up. But he knows that they are of equal
probability. The payo to the car owner is u if the right repair is taken
and is w otherwise, where w > u > 0. The car mechanic has expert
knowledge so that he knows exactly which kind of repair is needed once
the car is seen. But there are two types of car mechanicshe can be either
good or bad. If the car mechanic is a good one, his payo is exactly the
same as the car owner. When the right repair is made, his payo is u;
when the wrong repair is made, his payo is w. In case the car is not
given to the mechanic for repair, both partiess payos are zero. If the
car mechanic is a bad one, he is one who always replace engine. (Hence,
a bad mechanic is like a machine always doing the same thing.) The prior
probability that the car mechanic is bad with probability .

(a) Will the car owner bring his car to the car mechanic if = 0? Will
he do so > 0 but suciently close to zero?
(b) Now consider an infinite horizon model with one infinite-lived car
mechanic and a sequence of car owners who arrive and live one pe-
riod only. Let the prior probability that the car mechanic is bad be
probability 0 > 0. The type of the car mechanic remains unchanged
over time. We assume that decisions to bring cars to the mechanic
and repair decisions are observable and are used for future car owners
to updating their belief about the type of the car owner. (Whether a

2
 repair turns out to be good or bad is not observable, however). Show
that in any perfect Bayesian equilibrium, no car owner will ever bring
his car to car mechanic. Show that, however, if 0 = 0, there exists a
perfect Bayesian equilibrium in which car owners always bring their
cars to the mechanic. (This type of result is called "discontinuity at
zero.")
3. (Auctions) The following are standard assumptions in so called "Private
Value Auctions": (i) One object for sale; (ii) N symmetric bidders, i =
1, ..., N ; (iii) Bidder is maximum willing to pay (his valuation) is denoted
by Xi , which is independently and identically distributed on some interval
[0, ] according to distribution function F with associated density function
f ; (iv) Bidder i knows his realized valuation xi but not others; (v) no
liquidity or budget constraint; (vi) All compenents of the model other
than the realized values are commonly known among all bidders. Now we
turn to first price auction, in which each bidder i submits a sealed bid of
bi , and given these bids, the payos are

xi bi if bi > maxj6=i bj
i =
0 if bi < maxj6=i bj
We also assume that if there is a tie, so that bi = maxj6=i bj , the object goes
to each winning bidder with equal probability. We want to characterize
the equilibrium in which each bidder follows the symmetric, increasing
and dierentiable equilibrium strategy I = .
(a) Suppose bidders j 6= i follow I = . Suppose bidder 1s value
is x and bids b. Bidder 1 wins whenever his bid is highest, i.e.,
whenever maxi6=1 (Xi ) < b. Since is increasing, maxi6=1 (Xi ) =
(maxi6=1 (Xi )) = (Y1 ), where Y1 is the highest of N 1 values.
Bidder 1 wins whenever (Y1 ) < b or Y1 < 1 (b). Bidder 1s
expected payo is
G 1 (b) (x b) ,
where G(.) = [F (.)]N1 . Maximizing this with respect to b yields the
first order condition,

g 1 (b)
0
1 (x b) G 1 (b) = 0
(b)
where g = G0 is the density of Y1 . Find .
(b) Suppose values are uniformly distributed on [0,1]. Find .

3 Cooperative Game Theory

1. The convex hull of a finite set of points is the smallest convex set that
contains the points. Depict graphically the corresponding convex hull for
each of the following cases.

3
 (a) (0, 0), (1, 0), and (0, 2).
(b) (0, 0), (0, 1),and (1, 0)
(c) (0, 0), (1, 0), (1/2, 1/2), and (0, 1/2).

2. Consider a bargaining between Gary and Francis on the division of an ice

cream. Garys utility level is x2 if his fraction of ice cream is x, while

Franciss utility level is y if his fraction is y. If they dont come to
an agreement, each will receive zero fraction of the ice cream. What
is the feasible set of utility pairs [randomization permitted]? What is the
disagreement point? Find the Nash bargaining solution (in terms of utility
levels). What contract(s) can support this solution?

3. Consider a function g(x1 , x2 ) = x1 + x2 . For the bargaining solution
that assigns to each bargaining problem hS, di the (unique) maximizer of
g(s1 d1 , s2 d2 ) over {s S : s d}. This function can be shown to
satisfy PAR, IIA, and SYM [proof not requested]. However it violates INV.
Illustrate this violation by the following problem hS, di where d = (0, 0)
and S is the convex hull of the points (0, 0), (1, 0), and (0, 2).
4. For any bargaining problem hS, di, the solution f assigns to it the utility
pair
arg max (s1 d1 ) (s2 d2 )1 .
(d1 ,d2 )(s1 ,s2 )S

This family of solution {f }(0,1),6=0.5 is known as the family of asym-

metric Nash solutions. Every solution f satisfies INV, IIA, and PAR
[proof not requested], but violates SYM. Use the following bargaining
problem to illustrate the violation. d = (0, 0) and S is the convex hull of
(0, 0), (1, 0), and (0, 1).
5. For any bargaining problem hS, di, let si be the maximum utility Player
i gets in {s S : s d} , for i = 1, 2. Consider the solution f KS (S, d)
that assigns to hS, di the maximal member of S on the line joining d and
(s1 , s2 ). This bargaining solution is known as Kalai-Smorodinsky solution.
Show that the solution satisfies both SYM and PAR. [It also satisfies INV,
but proof is not requested.] Use the following bargaining problem (and
related bargaining problems) to illustrate that it violates IIA. d = (0, 0)
and S is the convex hull of (0, 0), (1, 0), (1/2, 1/2), and (0, 1/2).
6. Consider the solution f d defined by f d (S, d) = d. Show that this solution
satisfies INV, SYM, and IIA, but violates PAR.

4
 7. Verify whether the following characteristic function is superadditive, and
whether the game is convex. There are three players: 1,2,3. v () = 0,
v ({1}) = v ({2}) = v ({3}) = 0, v ({1, 2}) = v ({1, 3}) = 6, v ({2, 3}) = 3,
v ({1, 2, 3}) = 10.
8. There are two characteristic functions: v (as described in question 4)
and u, where u () = 0, u ({1}) = u ({2}) = 4, u ({3}) = 0, u ({1, 2}) =
4, u ({1, 3}) = 6, u ({2, 3}) = 12, u ({1, 2, 3}) = 20. Let w = v + u be a
characteristic function being the sum of v and u. Write down u completely.
9. Recall example 3 (with four players) we used in class to motivate the
concept of Shapley value. Write down the characteristic function, and
calculate the cost allocation to the four players according to Shapley value.
10. In the case of two sellers with unequal reserve prices, 100 for S1 , and 150
for S2 , and one buyer B with a willingness to pay of 300, show that in a
core allocation, the respective surpluses x1 , x2 and y must satisfy x1 50,
x2 = 0, and y 150. Verify that this outcome means that S1 sells his
house for a price between 100 and 150.
11. There are four sellers and three buyers. Each seller has one unit to sell
and a reserve price (i.e., minimum willingness to sell) of 100. Each buyer
wishes to buy one unit. One is willing to pay up to 400; each of the other
two, up to 300. Find the market equilibrium (i.e., the outcome at which
both sellers and buyers are price taking) by drawing a figure. Find the
core by setting up and solving all the no-blocking inequalities.
12. An airport runway is going to be used by four types of planes: small
corporate jets and commercial jets of the narrow-body, wide-body, and
jumbo varieties. A corporate jet needs a runway 2,000 feet long, a narrow-
body 6,000 feet, a wide-body 8,000 feet, and a jumbo 10,000 feet. The
cost of constructing a runway is proportional to its length. Considering
each type of aircraft as a player, use Shapley value to allocate the costs
of constructing the 10,000-foot runway among the four types. Is this a
reasonable way to allocate the costs?
13. Greatest lower bound and least upper bound. If S is a set of real
numbers, we say that b is an upper bound for S if for each x S we have
x b. A number c is called a least upper bound, or supremum, for S if it is
an upper bound for S and if c b for each upper bound b of S. We write
c = sup S. Similarly, the concept of greatest lower bound, or infimum,
written as inf S is defined. Note that the supremum and infimum to a set
of real number are unique as long as they exist. Find out the sup S, inf S,
max S, and min S to each of the following cases.

(a) S = {6.4, 1997, 2}

(b) S = {1, 1/2, ..., 1/n, ...}
(c) S = [0, 1)

5
 (d) S = {0, 1, 2, ..., n, ...}

14. Shapley value. Calculate the Shapley value to a 2 person game with the
characteristic function v(.): v() = 0, v(1) > 0, v(2) > 0, and v(1, 2) >
v(1) + v(2).
15. Suppose the old owner of an asset is going to retire and he wants to sell it
at the highest price. The asset will yield a surplus of 100 if it is operated
by two agents, called them 1 and 2; it will yield a surplus of zero otherwise.
There is a third person who does not play any role in the production is
also interested in gaining the asset. Suppose an (open ascending) auction
is held so that one of the three who is willing to pay the highest will gain
it; suppose also that the three bid non-cooperatively. If the third agent
becomes the owner, he will have to cooperate with agents 1 and 2. We
assume that they equally split the surplus. Then each will expect a gain
of 33 13 out of production. Then their payo profile is (33 13 , 33 13 , 33 13 p3 )
where p3 is the price agent 3 paid in the auction. If agent 1 becomes the
owner, he will have to cooperate with agent 2, while agent 3 is excluded.
Assume they equally split the dierence; then each will get a gain of 50.
Their payo profile is (50p1 , 50, 0). (The case where agent 2 is the owner
is symmetric).

(a) Find each agents maximum willingness to pay. Who is the winner
in the bidding?
(b) Suppose subsequent to the determination of ownership, agents 1 and
2 are allowed to choose, independently and simultaneously, an in-
vestment in his human capital. The cost of investment to the agent
is 5 but increases the surplus by 12. We assume the bargaining so-
lution that the surplus is equally split among the involved parties.
Show that (i) the first best is for each agent (1 and 2) to make the
investment, (ii) under agent 3s ownership, neither 1 nor 2 will make
an investment; (iii) under agent 1s (or agent 2s) investment, both 1
and 2 will make an investment; (iv) in the auction, agent 3 will win
and become the owner of the asset.
(c) (Optional) Suppose agents 1 and 2 collude in the bidding, i.e., they
act as if a single bidder in the bidding (but they are still non-
cooperative in the ex post bargaining). Redo the whole exercise.

4 Knowledge
1. A building has its oce doors painted in red for odd floors and in yellow
for even floors. Each floor is also marked with a floor number in the lobby.
Suppose = {1, ...., 13}. Hence a state of the world is the floor one is
in. Consider an alien decision maker knows all of above except that he
does not read. Write down his information function. Is it partitional?

6
 Consider an event E = {9, 10, 11, 12}=the set of floors in which economics
department has oces in. Under what states the decision maker knows
E?
2. Let = [0, 1) and assume that the decision-maker observes only the first
four digits of the decimal expansion of a number. Then for each
the set P () is the set of all states 0 such that the first four digits of
0 are the same as those of . Is this information function is partitional?
3. A decision-maker is told an integer n but remembers only that the number
is either n 1, n, or n + 1. Model the decision-makers knowledge by an
information function and determine if the function is partitional.
4. Let = { 1 , 2 , 3 , 4 , 5 }, let P1 and P2 be the partitional information
functions of individuals 1 and 2, and let K1 and K2 be the associated
knowledge functions. Let the partitions induced by the information func-
tions be

P1 = {{ 1 } , { 2 , 3 , 4 } , { 5 }}
P2 = {{ 1 , 2 , 3 } , { 4 } , { 5 }} .

(a) Find all events that are common knowledge between 1 and 2 in state
5 . Show your argument.
(b) Repeat (a) in state 1 .

5. Let = { 1 , 2 , 3 , 4 } and each state has equal prior probability, and

let the payo under the five states is -10, -5, 5, 10 respectively. Let P1 and
P2 be the partitional information functions of individuals 1 and 2 such
that P1 = {{ 1 } , { 2 , 3 , 4 }} and P2 = {{ 1 , 2 , 3 } , { 4 }}. Let K1
and K2 be the associated knowledge functions

(a) What is the event that 1 thinks the expected payo is > 0?
(b) What is the event that 2 thinks the expected payo is < 0?
(c) What is the event that 1 thinks that 2 thinks the expected payo
is <0?
(d) What is the event that 2 thinks that 1 thinks the expected payo
is >0?
(e) Consider an event E = { 1 , 2 }. What is the event 1 assigns a
probability greater than or equal to 0.6 to E? What is the event 2
assigns a probability greater than or equal to 0.6 to E?