2019

Sem 1

ECON90034

ASSIGNMENT 3
Bingran Li 798564

THE UNIVERSITY OF MELBOURNE

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 Problem 1. Game Theory

a) No, Blue Bank and Green Bank are not expected to play these strategies.
(M, PPP) is not a Nash Equilibrium because both players can do better by changing their
strategies. Blue Bank can change its plan from Medium to High and will get payoff of 4 rather
than 3. Green Bank can change its plan from Passive to Active when Blue Bank chooses High
plan and will get payoff of 5 rather than 3.
It is neither a subgame perfect Nash Equilibrium because SPNE has more restrictions than
NE.

All subgame perfect Nash Equilibria:

By using backward induction, Green bank will choose Active when Blue Bank chooses High
plan, Passive when Blue Bank chooses Medium plan and no difference between Active and
indifferent between Passive and Active when Blue Bank chooses Low plan.

Assume Green bank will choose Passive, Blue Bank can predict the strategy of Green Bank,
so it will choose High plan since it will provide a payoff of 5 rather than Medium plan with
payoff of 3 or Low plan with a payoff of 1.

Assume Green bank will choose Active, Blue Bank can predict the strategy of Green Bank, so
it will choose Low plan since it will provide a payoff of 7 rather than Medium plan with
payoff of 3 or high plan with a payoff of 5.

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 According to the game tree above, there are two SPNE. Blue Bank chooses {High plan},
Green Bank chooses: {Active} if Blue Bank chooses 'High plan'; {Passive} if Blue Bank chooses
'Medium plan'; and {Passive} if Blue Bank chooses ‘Low plan'.
Blue Bank chooses {Low plan}, Green Bank chooses: {Active} if Blue Bank chooses 'High plan';
{Passive} if Blue Bank chooses 'Medium plan'; and {Active} if Blue Bank chooses ‘Low plan'.
The two SPNE in shorthand could be written as (H, APP) and (L,APA).

b) Payoff matrix:

B/G Active Passive

High 5,5* *4,3
Medium 6,2 3,3*
Low *7,2* 1,2*

We could see that: both players have no dominant strategies. The NE is where the best
responses intersect, which is (7, 2). In this case, Blue Bank chooses {Low plan}, Green Bank
chooses {Active}. The NE in shorthand could be written as (L, A).

c) The assumption is Blue Bank and Green Bank have seven weeks to make choices. Each bank
uses backward induction to determine what choice to make each week. If we start with the
final week, the choice that the two banks will make in the seventh week will be the same as
the answer in b), ie: Blue Bank chooses {Low plan}, Green Bank chooses {Active}, with a
payoff (7, 2). This is because in the final week, it is just like a one shot game as in b) so both
players will play a Nash equilibrium strategy regardless of what happened in the earlier
weeks.
Because there is only one Nash equilibrium here, there is only one subgame perfect Nash
equilibrium in each round of the game. Knowing this and knowing the result in the final
week, there is no reason for both players to punish or promise reward in the game’s second
to seventh round. This will apply back to the first week therefore the whole finitely repeated
game.
As a result, Blue Bank will choose {Low plan} and Green Bank will choose {Active}
continuously from the first to seventh round.

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 Problem 2. Hidden action: Moral Hazard.

a) If the effort is observable, then the owner doesn’t need to provide incentives for the manager to
work hard. The owner shall pay the manager a constant wage so that the manager is indifferent
between accepting the contract and the reservation utility.
To implement low effort level for Joon, choose constant wage:
√𝑤 − 𝑐(𝑙𝑜𝑤 𝑒𝑓𝑓𝑜𝑟𝑡) = 𝑈 ̅

√𝑤 − 0 = 7

𝑤300 = 𝑤60 = 49

To implement high effort level for Joon, choose constant wage:

√𝑤 − 𝑐(ℎ𝑖𝑔ℎ 𝑒𝑓𝑓𝑜𝑟𝑡) = 𝑈 ̅

√𝑤 − 3 = 7

𝑤300 = 𝑤60 = 100

The optimal effort shall maximize the expected profit of the owner:

𝐸𝜋(𝑒𝐿 ) = 300 × 0.3 + 60 × 0.7 − 49 = 83

𝐸𝜋(𝑒𝐻 ) = 300 × 0.6 + 60 × 0.4 − 100 = 104

Therefore the owner will offer the high effort level contract to Joon.

Constraints:

Individual rationality (IR): The owner needs to make sure that the manager will agree on the

contract and get at least reservation utility. ie:

̅𝑖
𝑝𝑖 √𝑤300 + (1 − 𝑝𝑖 )√𝑤60 − 𝑐(𝑒𝑖 ) ≥ 𝑈

This shall be hold as an equality because it is not necessary for the owner to pay more than the

reservation utility to get the contract.

Constant wage: 𝑤300 = 𝑤60. This is because the owner is risk natural but the manager is risk

averse and expects constant wages. If different wages are set, the owner has to pay more on

average to compensate the extra risk the manager bears.

b) To implement low effort level for Abi, choose constant wage:

√𝑤 − 𝑐(𝑙𝑜𝑤 𝑒𝑓𝑓𝑜𝑟𝑡) = 𝑈 ̅

√𝑤 − 1 = 5

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 𝑤300 = 𝑤60 = 36

To implement high effort level for Joon, choose constant wage:

√𝑤 − 𝑐(ℎ𝑖𝑔ℎ 𝑒𝑓𝑓𝑜𝑟𝑡) = 𝑈 ̅

√𝑤 − 5 = 5

𝑤300 = 𝑤60 = 100

The optimal effort shall maximize the expected profit of the owner:

𝐸𝜋(𝑒𝐿 ) = 300 × 0.3 + 60 × 0.7 − 36 = 96

𝐸𝜋(𝑒𝐻 ) = 300 × 0.6 + 60 × 0.4 − 100 = 104

Therefore the owner will offer the high effort level contract to Abi.

c) The owner is indifferent to hire between Joon and Abi because the expected profit owner could

receive by contracting with Joon and Abi are the same (104).

d) Under moral hazard, there is individual rationality (IR) constraint and the incentive compatibility

(IC) constraint. IR ensures the owner to get the contract but do not overpay the manager. ie: EU

̅ . IC ensures the owner to provide just enough incentives so the manager is indifferent
(e=H) = U

between high and low effort. ie: EU(e=H) = EU (e=L).

To implement the high effort level for Joon:

̅
IR: EU (e=H) = U

0.6√𝑤300 + 0.4√𝑤60 − 3 = 7

IC: EU(e=H) = EU (e=L)

0.6√𝑤300 + 0.4√𝑤60 − 3 = 0.3√𝑤300 + 0.7√𝑤60 − 0

Simplify to obtain:

3√𝑤300 + 2√𝑤60 = 50

√𝑤300 − √𝑤60 = 10

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 Therefore, √𝑤300 = 14, √𝑤60 = 4. 𝑤300 = 196. 𝑤60 = 16.

To implement the high level effort the owner should offer the contract 𝑤300 = 196. 𝑤60 = 16.

This means the base salary is 16 and the bonus is 196 - 16 = 180 when firm’s revenue is 300.

To implement the low effort level for Joon:

The owner should offer a constant wage because there is no need to provide incentives for the

manager to choose low effort level. Therefore, the answer is the same as in a): 𝑤300 = 𝑤60 =

49.

The optimal effort shall maximize the expected profit of the owner:

𝐸𝜋(𝑒𝐿 ) = 300 × 0.3 + 60 × 0.7 − 49 = 83

𝐸𝜋(𝑒𝐻 ) = (300 − 196) × 0.6 + (60 − 16) × 0.4 = 80

Therefore the owner will offer the low effort level contract to Joon.

e) To implement the high effort level for Abi:

̅
IR: EU (e=H) = U

0.6√𝑤300 + 0.4√𝑤60 − 5 = 5

IC: EU(e=H) = EU (e=L)

0.6√𝑤300 + 0.4√𝑤60 − 5 = 0.3√𝑤300 + 0.7√𝑤60 − 1

Simplify to obtain:

3√𝑤300 + 2√𝑤60 = 50

3√𝑤300 − 3√𝑤60 = 40

Therefore, √𝑤300 = 15.33, √𝑤60 = 2. 𝑤300 = 235.11. 𝑤60 = 4.

To implement the high level effort the owner should offer the contract 𝑤300 = 235.11. 𝑤60 = 4.

This means the base salary is 4 and the bonus is 235.11 - 4 = 231.11 when firm’s revenue is 300.

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 To implement the low effort level for Abi:

The owner should offer a constant wage because there is no need to provide incentives for the

manager to choose low effort level. Therefore, the answer is the same as in b): 𝑤300 = 𝑤60 =

36.

The optimal effort shall maximize the expected profit of the owner:

𝐸𝜋(𝑒𝐿 ) = 300 × 0.3 + 60 × 0.7 − 36 = 96

𝐸𝜋(𝑒𝐻 ) = (300 − 235.11) × 0.6 + (60 − 4) × 0.4 = 61.33

Therefore the owner will offer the low effort level contract to Abi.

f) The owner should hire Abi because the expected profit after hiring Abi (96) is higher than hiring

Joon (83).

g) There is a welfare loss due to the moral hazard. When effort is observable, the expected profit of

the owner is 104 rather than 96 under moral hazard.

This is because when the manager’s action is unobservable, to incentive the manager, the owner

has to compensate manager a bonus for taking risk. The owner should pay the manager higher

wage on average (From 100 to 0.6*235.11+0.4*4= 142.67). The cost of providing incentives to

both managers increase too much that it is no longer optimal for the owner to implement the

high effort but to implement the low effort by offering Abi the contract with a constant wage at

36. This reduces the expected revenue from 0.6*300+0.4*60=204 to 0.3*300+0.7*60=132. In

total, the expected profit decreases from 104 to 96.

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