ECON 100 Tutorial: Week 9
www.lancaster.ac.uk/postgrad/alia10/
a.ali11@lancaster.ac.uk
office hours: 3:45PM to 4:45PM tuesday LUMS C85
Question 1(a)
Define a dominant strategy equilibrium
– One strategy dominates another strategy when it yields a
higher payoff regardless of the strategy of the other player
or players
– A dominant strategy is one which dominates all other
strategies for a particular player. (i.e. your best response
function is the same regardless of what the other person
does)
– A dominant strategy equilibrium, if it exists, is the
combination of strategies and payoffs if each player plays
a dominant strategy.
• This has weak and strong forms
• A strategy weakly dominates another strategy when it yields
payoffs which are as high or higher than the other regardless of
the strategies of the other player.
Question 1(a)
• Example (player 1 is blue):
Question 1(b)
Define a Nash equilibrium
– A best response function
• A function which returns the strategy with the highest
payoff given the action of the other player
– A mutual best response
• When all players play best response strategies
– A Nash Equilibrium is a situation where economic
actors each choose their best strategy given the
strategies that all other actors have chosen (so in
short, Nash Equilibrium is a mutual best response)
– In other words, a Nash equilibrium is a set of
strategies, one for each player, such that no player has
incentive to change his or her strategy given what the
other players are doing.
Question 1(b) Example: Lecture 20 slide 4:
Isoprofit Curves and RFs (2)
Assume the strategic variable is output (this is a Cournot
competitition game):
q2
q2
RF1
RF1
q2
0
RF2
q1‘
q1
q1’’
q1
0
RF is a best response function. So each firm’s strategy in this case their best
response function.
The Nash equilibrium is where both firms play their RF quantity (where the to
best response functions cross each other).
q1
Question 1(b)
• Example (player 1 is blue):
Question 1(c)
Define a subgame perfect Nash equilibrium
• A game is represented in extensive form if it is shown as a
sequence of decisions (often in a tree diagram)
• A node in an extensive form game has perfect information if all
players know which decision was made in all nodes which
precede that node
• A subgame is a set of nodes (decisions for some player) and
payoffs that follow a perfect information node
• A subgame perfect Nash equilibrium is a NE such that players’
strategies constitute a NE in every subgame of the original
game.
– It may be found by backward induction. First, one determines the
optimal strategy of the player who makes the last move of the game.
Then, the optimal action of the next-to-last moving player is
determined taking the last player's action as given. The process
continues in this way backwards in time until all players' actions have
been determined.
– Thus it is a refinement of NE, and NE may exist which are not
subgame perfect
Question 1(c)
• Example
Question 1(ii)
Distinguish carefully between the three concepts
above.
• I think the example in the previous slide does a
good job of distinguishing and illustrating these
three concepts.
• In the previous example, there is no dominant
strategy equilibrium.
• Is there a NE which is not subgame perfect?
– [(g),(ns,s)] is a NE which is subgame perfect
– [(ng),(s,s)] is a NE which is not subgame perfect
Question 2(a)
Using diagrams where appropriate, explain what is
meant by Quantity reaction functions.
• If the strategies are quantities, a quantity reaction
function is a best response function where the
choice of quantity for one player is the best
response to the choice of quantity for the other
Question 1(b) Example:
Lecture 20 slide 4:
Isoprofit Curves and RFs (2)
Assume the strategic variable is output:
q2
q2
RF1
RF1
q2
0
RF2
q1‘
q1
q1’’
q1
0
q1
RF is a best response function. The Nash
equilibrium is where bother firms play their RF
quantity.
Question 2(b)
Using diagrams where appropriate, explain what is
meant by Cournot competition.
Assumptions:
• N players - firm 1, firm 2, … firm n
• Firms choose output strategies simultaneously
• Zero conjectural variations
• Both firms have complete information
• The firms produce a homogeneous good
• The firms face the same costs
The previous example is a 2 player Cournot
competition problem
Question 2(c)
Using diagrams where appropriate, explain what is
meant by Bertrand competition.
Lecture 20 slide 7 & 8 discuss Bertrand competition
Assumptions:
• N players - firm 1, firm 2, … firm n
• Firms choose price strategies simultaneously
• Zero conjectural variations
• Both firms have complete information
• The firms produce a homogeneous good
• The firms face the same costs
Question 2(c)
Assume MC constant, MC = AC.
The 45° line represents where
firm1’s price = firm2’s price.
Let’s first consider Player 1’s
best response function.
• If P2 chooses price less than
MC, P1 will still choose price
= MC (=AR).
• If P2 choses P>MC, P1 can
choose P just a bit lower and
capture the entire market
(but still above MC).
• If P2 chooses P>monopoly
price, P1 chooses
P=monopoly price, since P1
will capture entire market
and this P maximizes profit.
Question 2(c)
• Player 2’s
BR is similar
• Equilibrium
is P = MC,
and both
players split
the market.
Note: the important thing to remember is that in a Bertrand competition problem, P = MC.
Question 2(c)
Lecture 20 slide 8 presents a similar picture of Bertrand Competition
Assumptions:
• 2 players - firm 1, firm 2
• Firms choose price strategies simultaneously
Extension:
• Zero conjectural variations
N firm oligopoly
• Both firms have complete information
• The firms produce a homogeneous good
• The firms face the same costs
p2
RF1
Bertrand-Nash
equilibrium
RF2
Firm 1:
 D p1  if p1  p2 
 1

D1  p1 , p2    D p1  if p1  p2 
2

0 if p1  p2

 p1  p2  mc
mc
p1
Question 3
Develop a two player normal form game (this can
be, but does not have to be Economics related –
use your imagination). Select the strategy choices of
the players and present the resulting payoffs in a
normal form game payoff matrix. Identify any
dominant strategies of the players, and identify any
Nash equilibria. Be prepared to show your game
and the equilibrium outcomes to your class.
Question 4
Develop a two player extensive form game (this can
be, but does not have to be Economics related –
use your imagination. It can but does not need to
be related to the game created in Question 3).
Decide the number of periods, indicate the strategy
choices of the players and the resulting payoffs.
Identify the Nash equilibria of each subgame and
the subgame perfect Nash equilibrium. Be prepared
to show your game and the equilibrium outcomes
to your class.
Question 5
Suppose your only wealth is in an asset which is
worth 144 with probability 2/3 and worth 225 with
probability 1/3. Your utility function is U=Wealth
What is your expected utility? Suppose you could
insure against this risk – what is the maximum
insurance premium (P*) that you would be
prepared to pay to eliminate this risk?
Question 5
Suppose your only wealth is in an asset which is worth
144 with probability 2/3 and worth 225 with
probability 1/3.
From Ian’s slides, we know how to find expected value:
𝐸𝑉 = Σ 𝜋𝑖 𝑉𝑖 = 𝜋1 𝑉1 + 𝜋2 𝑉2
So the expected worth of this asset is:
EW = 144 * probability asset is worth 144
+ 225 * probability asset is worth 225
EW = (144 x 2/3) + (225 x 1/3)
EW = 96 + 75
EW = 171
Question 5
Your utility function is U=Wealth. What is your
expected utility?
From Ian’s slides, we know how to find Expected Utility:
𝐸𝑈 = Σ 𝜋𝑖 𝑈(𝑉𝑖 ) = 𝜋1 𝑈(𝑉1 ) + 𝜋2 𝑈(𝑉2 )
We can apply that here:
EU = the probability the asset is worth 144 * utility of 144
+ the probability the asset is worth 225 * utility of 225
EU = (2/3)(U(144)) + (1/3) (U(225))
EU = (2/3)( (144)) + (1/3)( (225))
EU = (2/3)(12) + (1/3)(15)
EU = 8 + 5
EU = 13
Question 5
Suppose you could insure against this risk – what is the maximum insurance
premium (P*) that you would be prepared to pay to eliminate this risk?
We know that the Expected Utility of our risky asset is EU = 13.
However, the utility of a risk-free asset with the same expected worth as
our asset is greater:
U(EW) = U(171) = 171 = 13.077
Which is greater than EU = 13
The insurance premium is the price (P*) we would pay to hold a risk-free
asset which always returns a value whose utility is the expected utility of
the risky asset (EU = 13).
To find this, we will set U(EW – P*) = EU and solve for P*:
U(EW-P*) = EU
U(171-P*) = 13
(171-P*) = 13
171 – P* = 169
P* = 2