Advanced Microeconomics WS 09 Prof.

Aleksander Berentsen
Solutions to Exercise Set 8 Assistant Daniel Müller

Solutions to exercise set 8: Static games with incomplete information

Exercise 1
Formulation as a static Bayesian game: G = {A1 , A2 ; T 1 , T 2 ; p1 , p2 ; u1 , u2 }

Both players have the same possible actions ”Contribution”(B) or ”No contribution”(N): Ai =
{B, N}. Both players can have high costs (H) or low costs (L). The type space therefore con-
sists of two types for both players: T i = {H, L}. The beliefs concerning the probabilities of the
possible types of the other player are the same for both players and independent of the players
own type: p1 = p2 = p. The payoffs ui are given in the exercise question, where player i’s costs
ci (ti ) are dependent on his/her type. A pure strategy si for player i assigns an action ai ∈ Ai to
each of his/her possible types ti ∈ T i : T i → Ai .

In this exercise we should now show that si (H) = N and si (L) = B are an optimal response
to the other players strategy s j , where s j (H) = N and s j (L) = B also hold for s j . Player is
expected utility, if she has high costs, is calculated as follows:

Eui (B, s j | ti = H) = (4 − 3) p + (4 − 3) (1 − p) = 1

Eui (N, s j | ti = H) = 0p + 4 (1 − p) = 4 (1 − p)
In order for si (H) = N, it must hold that

Eui (B, s j | ti = H) ≤ Eui (N, s j | ti = H)

1 ≤ 4 (1 − p)
3
p ≤
4
If player i has low costs, her expected utility is

Eui (B, s j | ti = L) = (4 − 1) p + (4 − 1) (1 − p) = 3

Eui (N, s j | ti = L) = 0p + 4 (1 − p) = 4 (1 − p)
In order for si (L) = B, it must hold that

Eui (B, s j | ti = L) ≥ Eui (N, s j | ti = L)

3 ≥ 4 (1 − p)
1
p ≥
4

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Advanced Microeconomics WS 09 Prof. Aleksander Berentsen
Solutions to Exercise Set 8 Assistant Daniel Müller

Exercise 2 (Cournot duopoly with demand uncertainty)

a) Firm 1 observes whether demand is high or low. It can thus take on one of two possible
types and chooses a strategy that assigns a different action to the two possible types; i.e.,
both supply quantities q1 (aH ) and q1 (aL ). Firm 1 solves the following problem if demand
is high:
q∗1 (aH ) = arg max aH − q1 − q∗2 − c q1


q1

FOC

−q1 + aH − q1 − q∗2 − c = 0
aH − q∗2 − c
q∗1 (aH ) =
2
Similarly, if demand is low, firm 1 chooses
aL − q∗2 − c
q∗1 (aL ) =
2
Firm 2 maximizes its expected profit given its beliefs p(aH ) = θ and p(aL ) = 1 − θ:

q∗2 = arg max θ aH − q∗1 (aH ) − q2 − c q2 + (1 − θ) aL − q∗1 (aL ) − q2 − c q2

   
q2

FOC

−θq2 + θ aH − q∗1 (aH ) − q2 − c − (1 − θ) q2 + (1 − θ) aL − q∗1 (aL ) − q2 − c = 0

   

−2q2 + θ aH − q∗1 (aH ) − c + (1 − θ) aL − q∗1 (aL ) − c = 0

   

Insert firm 1s optimal responses:

 a H − q2 − c   a L − q2 − c 
−2q2 + θ aH − − c + (1 − θ) aL − −c = 0
2 2
3 aH − c aL − c
− q2 + θ + (1 − θ) = 0
2 2 2
θaH + (1 − θ) aL − c
= q∗2
3
For firm 1 it follows that:
aH − c θaH + (1 − θ) aL − c
q∗1 (aH ) = −
2 6
aH − c (1 − θ)
= + (aH − aL )
3 6

aL − c θaH + (1 − θ) aL − c
q∗1 (aL ) = −
2 6
aL − c θ
= − (aH − aL )
3 6

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Advanced Microeconomics WS 09 Prof. Aleksander Berentsen
Solutions to Exercise Set 8 Assistant Daniel Müller

b) We compare
aH − c (1 − θ)
q∗1 (aH ) = + (aH − aL )
3 6
aL − c θ a−c
q∗1 (aL ) = − (aH − aL ) with q∗1 = q∗2 = .
3 6 3
θa H + (1 − θ) aL − c
q∗2 =
3
Firm 2 behaves similar to how it would with complete information. The one difference
is that it assumes the expected value E(a) = θaH + (1 − θ) aL for the demand parameter
a because it is unable to observe actual demand. With low demand, firm 2 therefore
overestimates the market size. Firm 1 anticipates this and reduces its supply compared
to the optimal quantity under complete information which is represented by the first
summand. In the case of high demand, firm 2 undervalues actual demand and firm 1 is
thus able to supply more in this case than would be optimal under complete information.

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