University of Brighton

Brighton Business School

BA (Hons) ?????????????
EC364: Game Theory in Finance & Business
Final Year

Second Semester 2006 April 2006

Answer any three out of questions 1 to 6 and all parts of question 7

Time allowed: 3 hours
All questions carry equal (25) marks

Block A: Choose any three from questions 1 to 6

1. Explain the time inconsistency problem in monetary policy using the Barro-Gordon
model (1983).
(a) Show that this model analyses a non-cooperative game between a government
(as monetary authority) and the public which has a Nash equilibrium. (9 marks)
(b) Under what conditions has this Nash equilibrium an inflationary bias? (9 marks)
(c) Discuss the implications of time inconsistency for the design of monetary policy
institutions.
(7 marks)
2. The St. Petersburg paradox played an important role in the development of game
theory (and utility theory in general).
(a) Describe the game and explain the nature of the paradox?

(12 marks)

(b) Sketch the idea of Daniel Bernoullis solution to the paradox and explain its
importance for the development of game theory.
(8 marks)
(c) Can you imagine other solutions of the paradox?

(5 marks)

3. Consider two firms A and B in an oligopolistic market. Both produce the same
product and sell it at the same price. Total costs for A are given by C A ( x A ) x A and
by CB ( xB ) xB for B, where xi is the output of firm i A,B and 0 is a
positive constant. The market demand is given by p 10 x , where p is the market
price and x is the joint output of both firms. Both firms maximise their individual
profits. What is the equilibrium output for the two firms? What is the equilibrium
price?
(a) Solve this problem by applying the Cournots reaction functions.

(13 marks)

(b) Using a diagram showing the respective reaction functions, explain in what
sense this is an equilibrium.
(5 marks)
(c) Explore the impact of on the solution.
(7 marks)
4. Consider the following variant of the entry deterrence game: A monopolist A is
challenged by a newcomer B who wants to enter the market. If that happens, A can
either start a price war or tolerate the entry of B. Before B moves, however, A can
invest in sunk costs (e.g. advertising) which cannot be recalled afterwards. These
costs, say an amount C, reduce As payoff in each state of the world except for a
price war where the strategic advantage acquired results in lower losses for A. The
extensive form of the game is (As payoff is given first):

A1
B1

Tolerate

Enter

Invest

40-C | 40
-5 | -10

Fight

100-C | 0

Stay out

A
Dont invest
B2

Stay out
Fight

-10 | -10

Tolerate

40 | 40

Enter
A2

100 | 0

Using backward induction, determine the range in which the sunk costs C must lie in
order to make it worthwhile for A to invest and at the same time makes As threat to
fight in case of an entry credible.
(25 marks)
5. Consider the following game in strategic form: Two players, A with five strategies
and B with four strategies; both players move simultaneously or anyway without
being able to observe the others move. Payoffs are given in the matrix below.
Player B

Player A

B1

B2

B3

B4

A1

0|0

6|6

2|2

3|0

A2

6|6

8|8

0|2

1|3

A3

2|2

2|0

1|1

0|3

A4

10 | 5

9|2

8|6

6|4

A5

8|3

10 | 2

9|5

4|4

Solve this game using:

(a) Nashs equilibrium concept;

(10 marks)

(b) Maximin approach for both players;

(10 marks)

(c) Comment on the results.

(5 marks)

6. In Robert Axelrods (1984) famous computer tournaments he posed a conventional

prisoners dilemma which was iterated very often (virtual infinitely) between the
same two players (strategies). Of all strategies suggested by experts in game theory
from all over the world, the one proposed by Anatol Rapoport (University of
Toronto) proved to be the most successful over all. Rapoports strategy was named
Tit-for-Tat (this for that).

(a) Explain the strategy and its functioning.

(12 marks)

(b) Explore the reasons for its success.

(8 marks)

(c) Comment on the importance of this experiment.

(5 marks)

Block B: Answer all parts of question 7

7. Define and explain briefly the following concepts of game theory:
a) Move of nature.

(2 marks)

b) Nash equilibrium.

(5 marks)

c) Reaction function.

(3 marks)

d) Backward induction.

(3 marks)

e) Rational expectations.

(2 marks)

f) Credible commitment.

(5 marks)

g) Cooperative and non-cooperative games.

(2 marks)

h) Strategic (normal) and extensive forms of games.

(3 marks)