ECON-SHU 216 Problem Set 3

Fall 2019

Due Nov 7th (Th) in class

Problem 1. SPNE
There are two players in this game, the CEO of a company and a division manager. In
the first stage, the CEO could choose whether to adopt a new technology. If he chooses to
not adopt the technology, the two players get (1, 1). If he chooses to adopt the technology,
then the second stage of the game begins. The CEO designs a new task for a division
manager. The new task can be either high level (H) or low level (L). Then the manager
chooses to invest in good training (G) or bad training (B) without knowing the level of the
new task. The payoffs from the interaction in the second stage are given by the following
matrix:
Manager
G B
H 5, 4 −5, 2
CEO
L 2, −2 0, 0

(a) Present this game in a tree.

(b) Present this game in a matrix.

(c) Find all pure strategy Nash equilibria, if they exist.

(d) Find all SPNE in this game.

Problem 2. Bargaining
A firm owner and a worker are bargaining over a pie of 50 (the profit of the firm, which
is decided between the owner and the worker). The owner’s discount factor is δo = 0.5,
and the worker’s discount factor is δw = 0.2. The bargaining is composed of 3 rounds. The
procedure of the bargaining is as follows:

• In the first round, worker proposes wage w1 , and the owner decides whether to accept
the offer.

• If no agreement is reached in the first round, the game proceeds to the second round.
Owner proposes a wage w2 , and worker decides whether to accept the offer.

• If no agreement is reached in the second round, the game proceeds to the third round.
Worker proposes a wage w3 , and the owner decides whether to accept the offer.

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 • If no agreement is reached in the third round, the game ends and both parties get 0.

What does Backward Induction suggest about:

(a) Worker’s offer in the third round?

(b) Owner’s offer in the second round?

(c) Worker’s offer in the first round?

(d) the outcome of the game?

(Note: in this problem, the two parties have different discount factors. So we will not
use the shrinking pie model. Instead, the pie remains at 50 throughout the three rounds.)

Problem 3. Repeated Games

Ann has a beach house where she goes only for vacation. For the rest of the year, she
could choose to hire Bob to clean and maintain the house. Bob has two options when Ann
is away. He could choose to do his job and earn the payment from Ann, or he could list the
house on Airbnb to earn extra (illegal) rent. Such a stage game can be represented by the
tree below.
Ann

N ot Hire Hire

Bob
(0, 0)
Dishonest Honest

(−2, 5) (2, 2)

(a) Find all pure strategy Nash equilibria of the stage game.

(b) Find all pure strategy subgame perfect Nash equilibria of the stage game.

(c) Now let’s assume that Ann could renew the contract with Bob every year, with con-
tinuation probability δ. Consider the following Grim Trigger strategies of Ann and
Bob:
Grim Trigger of Ann (GTA): Play H in t = 1. For any t ≥ 2, if the past history is
“(H, H) for all stages”, play H; otherwise, play N .
Grim Trigger of Bob (GTB): Play H in t = 1. For any t ≥ 2, if the past history is
“(H, H) for all stages”, play H; otherwise, play D.
Give the conditions for δ such that (GTA, GTB) can be supported as a SPNE. (There
is no need to give the complete proof that it is an SPNE.)

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(d) Now consider a different type of strategies: limited punishment. The idea is that if
the anyone deviates from the specified strategies, the two players will play (N, D) for k
periods, and then go back to (H, H). Below is an example of 3 periods of punishment.
Limited Punishment (3 periods) of Ann (LPA-3): Play H in t = 1. In t = 2, if the
past history is “(H, H)”, play H; otherwise, play N . In t = 3, if the past history is
“{(H, H), (H, H)}”, play H; otherwise, play N . For any t ≥ 4, if the history in the last
stages is “(H, H)” or if the history in the last 3 stages is “{(N, D), (N, D), (N, D)}”,
play H; otherwise, play N .
Limited Punishment (3 periods) of Bob (LPB-3): Play H in t = 1. In t = 2, if the
past history is “(H, H)”, play H; otherwise, play D. In t = 3, if the past history is
“{(H, H), (H, H)}”, play H; otherwise, play D. For any t ≥ 4, if the history in the last
stages is “(H, H)” or if the history in the last 3 stages is “{(N, D), (N, D), (N, D)}”,
play H; otherwise, play D.
Basically, if no deviation occurs in the last period, they continue to cooperate. Other-
wise, they start 3 periods of punishment and then go back to cooperation.
Give the conditions for δ such that (LPA-3, LPB-3) can be supported as a SPNE.

(e) Show that given that Ann is playing LPA-3, and given that the δ condition you got in
part (d) is satisfied, Bob doesn’t have a profitable one-stage deviation after any history.
(For simplicity, only consider the periods after t ≥ 4.)