Name (Print):

University Carlos III de Madrid

Exercise Points Score
Master in Economics
Master in Industrial Economics and Markets 1 35

Final Exam. Game Theory. 01/13/2023. 2 45

Time Limit: 120 Minutes. 3 35

4 40

Total: 155

1. Consider the following game in extensive form

1.1

A B

1.2 2.1

C D E F

2.2 1.3 1.4

G H G H I J K L

(6, 10) (3, 8) (3, 0) (9, 2) (1, 3) (0, 4) (6, 3) (3, 3)

(a) (5 points) What are the sub-games of the above game? It is enough to write the node at
which each sub-game starts.
Solution: There are five sub-games that start at the nodes 1.1, 1.2 2.1, 1.3 and 1.4.

(b) (10 points) Write the normal form of the sub-game that starts at at node 1.2. Find the
Nash equilibria (in pure and mixed strategies) of this sub-game.
Solution: The normal form of the sub-game that starts at at node 1.2 is,

G H
C 6, 10 3, 8
D 3, 0 9, 2

There are two NE in pure strategies: (C, G) with payoffs (6, 10) and (D, H) with payoffs
(9, 2). In addition, there is mixed strategy NE
   
1 1 2 1
C+ D , G+ H
2 2 3 3
Final Exam. Game Theory Page 2 of 8 01/13/2023

with payoffs
u1 = u2 = 5

(c) (20 points) Write the subgame perfect Nash equilibria of the whole game
Solution: The SPNE of the sub-game that starts at at node 2.1 are of the form σ2 =
xE + (1 − x)F , 0 ≤ x ≤ 1 with payoffs u1 = x + 6(1 − x) = 6 − 5x and u2 = 3. We use
the notation (1.2, 2.1, 1.3, 1.4). All the SPNE are of the form

(∗, xE + (1 − x)F, I, K)

a. Let us look for SPN in which in the subgame that starts at 1.2 the NE (C, G) is played.
1.1

A B

(6, 10) (6 − 5x, 3)

We obtain the SPNE

(A, xE + (1 − x)F, I, K) , 0 < x ≤ 1, u1 = 6, u2 = 10

and
(yA + (1 − y)B, F, I, K) , 0 ≤ y ≤ 1, u1 = 6, u2 = 10 + 3(1 − y)
b. Let us look for SPN in which in the subgame that starts at 1.2 the NE (D, H) is played.
1.1

A B

(9, 2) (6 − 5x, 3)

We obtain the SPNE

(A, xE + (1 − x)F, I, K) , 0 ≤ x ≤ 1 u1 = 9, u2 = 2
1
+ 12 D , 2
+ 13 H




c. Let us look for SPN in which in the subgame that starts at 1.2 the NE 2C 3G
is played.
1.1

A B

(5, 5) (6 − 5x, 3)

We obtain the SPNE

6
(A, xE + (1 − x)F, I, K) , <x<1 u1 = 5, u2 = 5
25
Final Exam. Game Theory Page 3 of 8 01/13/2023

6
(B, xE + (1 − x)F, I, K) , 0 ≤ x < u1 = 6 − 5x, u2 = 3
25
and
 
6 19
yA + (1 − y)B, E + F, I, K , 0 ≤ y ≤ 1, u1 = 5, u2 = 5y + 3(1 − y)
25 25

2. Two firms produce an externality on each other, that is the production of firm i = 1, 2 affects
negatively the profits of firm j ̸= i. Assume that, if each day, firm 1 produces q1 and firm 2
produces q2 , the profits of the firms are

u1 = (24 − q2 )q1 − q12

u2 = (24 − q1 )q2 − q22

Both firms decide simultaneous and independently the quantities q1 and q2 .

(a) (10 points) Compute the best reply of each firm if they interact only one day. Compute
the NE (q1∗ , q2∗ ) and the profits of the firms in the NE.
Solution: The best reply functions of the firms are
24 − q2 24 − q1
BR1 (q2 ) = max{0, }, BR2 (q1 ) = max{0, }
2 2
The NE is the solution to q1 = BR1 (q2 ), q2 = BR2 (q1 ). That is,
24 − q2 24 − q1
q1 = max{0, }, q2 = max{0, }
2 2
We obtain q1 = q2 = 8. The profits are u1 = u2 = 64.

(b) (10 points) Suppose firms interact only one day and can credibly agree on a production
plan (q̄1 , q̄2 ) that maximizes the joint profit, with q̄1 = q̄2 . What would that agreement
be. What would be the profits achieved by the firms?
Solution: The companies maximize

max u1 + u2
q1 ,q2

The first order conditions are

−2q1 − 2q2 + 24 = 0, −2q1 − 2q2 + 24 = 0

and we obtain q2 = 12 − q1 . Assuming q1 = q2 , we obtain q̄1 = q̄2 = 6. The profits would

be ū1 = ū2 = 72.

(c) (5 points) Suppose firms cannot commit to a production plan. Why the result of the
previous part is not reasonable?
Solution: Because BRi (6) = 9 ̸= 6. Note also that u1 (9, 6) = u2 (6, 9) = 81 > 72.
Final Exam. Game Theory Page 4 of 8 01/13/2023

(d) (20 points) Suppose now that firms interact an infinite number of days and that each day
each firm decides simultaneous and independently a new production plan for the day. Is
there a SPNE in which, in the equilibrium path, the production plan (q̄1 , q̄2 ) is carried out
every day.
Solution: Consider the trigger strategy:
• At t = 1 play (6, 6).
• If t > 1 play (6, 6) if (6, 6) was played at previous periods. Play (8, 8) otherwise.
We show that the trigger strategy is a NE of the whole game. With the trigger strategy the
payoffs of the players are
72
ut == 72 + 72δ + 72δ 2 + · · · + 72δ k =
1−δ
If one player deviates at period 1, her payoff would be at most
64δ
ut = 81 + 64δ + 64δ 2 + · · · + 64δ k = 81 +
1−δ
So, the trigger strategy is a NE of the whole game iff
72 64δ
≥ 81 +
1−δ 1−δ
9 9
that is if δ ≥ 17 . Now the standard argument shows that for δ ≥ 17 , the trigger strategy is
also a NE of every sub-game.

3. Consider the situation in which player 2 knows which game is played (a or b below). However,
player 1 only knows that table a is played with probability 12 and table b is played with
probability 12 .
Player 2 Player 2
C D C D
A 3 ,7 1, 1 A 5 ,1 1, 3
Player 1 Player 1
B 2, 1 4,3 B 4, 5 2, 1
a b
(a) (5 points) Describe the situation as a Bayesian game.
Solution: There are two players N = {1, 2}. There are two types of player 2: T2 =
{a, b}. There is one type of player 1: T1 = {t}. The sets of strategies are S2 =
{CC, CD, DC, DD}, S1 = {A, B}. The beliefs of the players are

p2 (t1 = t|t2 = a) = p2 (t1 = t|t2 = b) = 1

p1 (t2 = a|t1 = t) = p1 t2 = c| t1 = t = 1/2

The payoffs are given by the above tables.

(b) (10 points) Find the Bayesian–Nash equilibria in pure strategies and the payoffs of the
players.
Solution: The associated normal form game is
Final Exam. Game Theory Page 5 of 8 01/13/2023

CC CD DC DD
A (4, 4) (2, 5) (3, 1) (1, 2)
B (3, 3) (2, 1) (4, 4) (3, 2)
and we see that there are two BNE in pure strategies (A, CD) with payoffs (2, 5) and
(B, DC) with payoffs (4, 4).

(c) (20 points) Find the Bayesian–Nash equilibria in mixed strategies and the payoffs of the
players.
Solution: Let us look for a BNE of the form

(xA + (1 − x)B, (yC + (1 − y)D, zC + (1 − z)D))

Let

s1 = xA + (1 − x)B
sa = yC + (1 − y)D
sb = zC + (1 − z)D

We have that
1 1
u1 (A; sa , sb ) = (3y + 1 − y) + (5z + 1 − z) = 1 + y + 2z
2 2
1 1
u1 (B; sa , sb ) = (2y + 4(1 − y)) + (4z + 2(1 − z)) = 3 − y + z
2 2
ua (s1 , C) = 7x + 1 − x = 1 + 6x
ua (s1 , D) = x + 3(1 − x) = 3 − 2x
ub (s1 , C) = x + 5(1 − x) = 5 − 4x
ub (s1 , D) = 3x + 1 − x = 1 + 2x

Suppose first that player 2a is using a completely mixed strategy. Then ua (s1 , C) =
ua (s1 , D). Hence, 1 + 6x = 3 − 2x and we conclude that x = 14 . For this value of x
we have that ub (s1 , C) = (5 − 4x)|x= 1 = 4 and ub (s1 , D) = (1 + 2x)|x= 1 = 32 , so z = 1.
4 4
We check if there is a BNE of the form
 
1 3
A + B; (yC + (1 − y)D, C)
4 4

Player 1 must be indifferent between A and B. Hence, 1 + y + 2z = 3 − y + z. Since z = 1,

we obtain that y = 21 . And we have checked that
  
1 3 1 1
A + B; C + D, C
4 4 2 2

is BNE in mixed strategies with payoffs u1 = 72 , ua = 52 , ub = 4.

Suppose now that player 2b is using a completely mixed strategy. Then ub (s1 , C) =
ub (s1 , D). Hence, 5 − 4x = 1 + 2x and we conclude that x = 32 . For this value of x
we have that ua (s1 , C) = (1 + 6x)|x= 2 = 5 and ua (s1 , D) = (3 − 2x)|x= 2 = 53 , so y = 1.
3 3
Final Exam. Game Theory Page 6 of 8 01/13/2023

We check if there is a BNE of the form

 
2 1
A + B; (C, zC + (1 − z)D)
3 3

Player 1 must be indifferent between A and B. Hence, 1 + y + 2z = 3 − y + z. Since y = 1,

we obtain that z = 0. And we have checked that
 
2 1
A + B; (C, D)
3 3

is the other BNE in mixed strategies with payoffs u1 = 2, ua = 53 , ub = 37 .

4. Consider a market with one good and two firms. The firms decide prices p1 and p2 simultaneous
and independently. Given those prices, the amount sold by each company is
p2
x1 (p1 , p2 ) = 54 − p1 +
2
p1
x2 (p1 , p2 ) = 54 − p2 +
2
Firm 2 has constant marginal cost c2 = 6. Firm 2 does not know the cost of firm 1. Firm 2
thinks that with probability 21 firm 1 has constant marginal cost cl = 4 and with probability 12
firm 1 has constant marginal cost ch = 8. Firm 1 knows its costs and the costs of firm 2. This
situation is common knowledge for both firms.
(a) (10 points) Write the payoffs of the firms.
Solution: There are two players N = {1, 2}. There are two types of player 2: T2 =
{cl , ch }, where cl = 4 and ch = 8. There is one type of player 1: T1 = {c}. The sets of
strategies are S2 = {CC, CD, DC, DD}, S1 = {A, B}. The beliefs of the players are

p2 (t1 = c|t2 = cl ) = p2 (t1 = c|t2 = cl ) = 1

p1 (t2 = cl |t1 = t) = p1 t2 = c| t1 = t = 1/2

The payoffs are

p1
uh (ph , p1 ) = (54 − ph + )(ph − ch )
1
p1
ul (pl , p1 ) = (54 − 1pl + )(pl − cl )
 1 
1 ph  1  pl 
u1 = (p1 − 6) 54 − p1 + + 54 − p1 +
2 1 2 1
Final Exam. Game Theory Page 7 of 8 01/13/2023

(b) (20 points) Compute the best reply of each firm. You must compute the best reply of
each type of the firms.
Solution: Agent 1, type ch , maximizes maxph uh = (54 − ph + p22 )(ph − ch ). The first
order condition is
p2
− 2ph + 62 = 0.
2
Note that the second derivative with respect to ph is

∂ 2 uh
= −2 < 0
∂p2h

Hence, the first order condition corresponds to a maximum of uh . The best reply of agent 1,
type ch , is
p2 + 124
BRh (p2 ) =
4
Likewise, agent 1, type cl , maximizes maxpl ul = (pl − 4) p22 − pl + 54 . The first order

condition is
p2
− 2pl + 58 = 0.
2
Note that the second derivative with respect to pl is

∂ 2 ul
= −2 < 0
∂p2l

Hence, the first order condition corresponds to a maximum of ul . The best reply of agent 1,
type cl , is
p2 + 116
BRl (p2 ) =
4
Finally, agent 2 maximizes
  
1 ph  1  pl 
max(p2 − 6) 54 − p2 + + 54 − p2 +
p2 2 2 2 2

The first order condition is

1 ph  1  pl 
54 − p2 + + 54 − p2 + − p2 + 6 = 0
2 2 2 2
The best reply of agent 2 is
1
BR2 (ph , pl ) = (ph + pl + 240)
8

(c) (10 points) Compute the Bayes–Nash equillibrium, the quantities sold in this equilibrium
and the profits of each firm.
Solution: The NE is the solution to
p2 + 124 p2 + 116 1
ph = pl = p2 = (ph + pl + 240)
4 4 8
We obtain
Final Exam. Game Theory Page 8 of 8 01/13/2023

p∗h = 41 p∗l = 39 p∗2 = 40

the utilities of the agents are

u∗h = 1089 u∗l = 1225 u∗2 = 1156

and the quantities sold are

x∗h = 33 x∗l = 35 x∗2 = 34