CHAPTER 8

STRATEGY AND GAME THEORY

These problems cover a variety of different concepts introduced in the chapter. They
range in difficulty from the simplest exercise of finding the Nash equilibrium in a two-
by-two matrix to characterizing equilibrium when players have continuous actions and
payoffs with general functional forms. Practice with problems may be the primary way
for students to master the material on game theory.
Comments on Problems
8.1 Provides practice in finding pure- and mixed-strategy Nash equilibria using a
simple payoff matrix. The three-by-three payoff matrix makes the problem
slightly harder than the simplest case of a two-by-two matrix. Although this
problem points the student where to look for the mixed-strategy equilibrium, in
other cases there may be many possibilities that need to be checked for mixed-
strategy equilibria. In a game represented by a three-by-three matrix, each
player has four combinations of two or more actions, and so there are 16
possible types of mixed-strategy equilibria to check. Software, called Gambit,
has been developed that can solve for all the Nash equilibria of games the user
specifies in extensive or normal form. Gambit is freely available on the Internet.
It is easy to use, almost functioning as a game-theory calculator. One useful
classroom exercise would be have students solve some of the problems on a
game-theory problem set using Gambit, either alone or in teams.
McKelvey, R.D.; A.M. McLennan; and T. L. Turocy (2007) Gambit: Software
Tools for Game Theory, Version 0.2007.01.30.
http://econweb.tamu.edu/gambit
8.2 A slight generalization of payoffs in the Battle of the Sexes provides students
with further practice in computing mixed-strategy Nash equilibria.
8.3 Provides practice in converting the payoff matrix for a simultaneous game into
one for a sequential game. Illustrates the application of subgame-perfect
equilibrium in the simple case of the famous Chicken game.
8.4 The problem provides practice in computing the Nash equilibrium in a game
with continuous actions (similar to the Tragedy of the Commons in this chapter
and in Chapter 15 with the Cournot game, except in this problem the best-
54
Chapter 8: Strategy and Game Theory
response functions are upward-sloping). Players best responses are computed
using calculus, and the resulting equations are then solved simultaneously.
8.5 Asks students to solve for the mixed-strategy Nash equilibrium with a general
number of players
n
. The punchline to the problem that the blond is less
likely to be approached as the number of males increases is a paradoxical result
characteristic of such games. The problem is based on a scene in the Academy
Award winning movie, A Beautiful Mind, about the life of John Nash, in which
the Nash character discovers his equilibrium concept (the one scene in the movie
that involves any game theory). If the classroom facilities allow, it is
worthwhile to show students this scene (Scene 5: Governing Dynamics) when
covering this problem.
8.6 Illustrates the folk theorem for finitely repeated games, similar to Example 8.7.
8.7 A simultaneous game of incomplete information providing practice in finding
the Bayesian-Nash equilibrium. Similar to the Tragedy of the Commons in
Example 8.9.
8.8 Asks students to solve for a hybrid perfect Bayesian equilibrium. Students may
find the application interesting given the growth in popularity of poker on
television, in particular Texas Hold Em (to which the name Blind Texan in
the problem is meant to be a tongue-in-cheek reference). In typical intermediate
microeconomics courses, instructors will have only a short time to cover
signaling games, and in such courses it would be perfectly reasonable to omit
this problem, focusing exclusively on the simpler computations associated with
separating and pooling equilibria. Two reasons to delve into hybrid equilibria if
there is sufficient time, say in an advanced course with an extensive game theory
component are a) games like Blind Texan do not have separating and pooling
equilibria, only a hybrid one and b) the full power of Bayes Rule in a signaling
game is only apparent with a hybrid equilibrium since the application of the rule
with separating and pooling equilibria is fairly trivial.
Analytical Problems
8.9 Dominant strategies. Result can essentially be shown in a one-line proof
linking the definitions of dominant strategy and Nash equilibrium. For
instructors who prefer this style of problem, 8.10 provides another possible good
choice. Other sources of proof type problems are generated by considering
two-by-two games. For example, students can be asked to prove directly that a
two-by-two game with no pure-strategy Nash equilibrium must have a mixed-
strategy Nash equilibrium or that the two-by-two game must have an odd
number of Nash equilibria generically (that is, if the game only has an even
55
Chapter 8: Strategy and Game Theory
number of Nash equilibria, a tiny change in the payoff will generate another
one).
8.10 Rotten Kid Theorem. Perhaps the most challenging problem in the chapter
since it works with general functional forms, so requires the application of the
implicit function theorem rather than the computation of explicit deriviatives.
Shows how subgame-perfect equilibrium concept can be used to derive one of
Nobel-prize winner Gary Beckers famous results. The parent-child application
may hold interest for students.
8.11 Alternatives to Grim Strategy. Provides further practice with the discounting
calculations associated with infinitely repeated games. Demonstrates the value
of harsh punishments in sustaining cooperation by examining the difficulty in
sustaining cooperation with less than grim-strategy punishments.
8.12 Refinements of perfect Bayesian equilibrium. Part (a) is standard. Given it is
the simplest problem on signaling games, all instructors who cover the topic
should consider including it in the problem set. Part (b) goes beyond the
material in the chapter in exploring the intuitive criterion, a refinement of perfect
Bayesian equilibrium, which restricts posterior beliefs to be reasonable.
Solutions
8.1
a.
) , ( F C
.
b. Let

and 1 be the probabilities that player 1 plays A and B ,

respectively. Player 2s expected payoff from playing D then is
) 1 ( 8 6 +

and from playing E is
) 1 ( 6 8 +
. For player 2 to be indifferent between D
and E and thus willing to randomize, these two expressions must be equal,
implying
2 / 1
*

. Similar calculations show that player 2 randomizes with
equal probability between D and E .
c. Players each earn 4 in the pure-strategy equilibrium. Player 2 earns
7 ) 2 / 1 ( 8 ) 2 / 1 ( 6 ) 1 ( 8 6
* *
+ +
in the mixed-strategy equilibrium; similar
calculations show player 1 earns 6 in this equilibrium.

56
Chapter 8: Strategy and Game Theory
d.

8.2 Let

and 1 be the wifes probabilities, respectively, of playing ballet and

boxing. The husbands expected payoff from ballet then is
+ ) 1 )( 0 ( ) )( 1 (
and from boxing is
K K K + ) 1 )( ( ) )( 0 (
. For
the husband to be indifferent, and thus willing to randomize, these two
expressions must be equal, implying
) 1 /(
*
K K +
. Similar calculations show
the husband plays boxing with probability
) 1 /( K K +
and ballet with the
complementary probability. Substituting 2 K allows us to recover the mixed-
strategy equilibrium found in Example 8.5.

2
1
A
B
C
D
E
F
7, 6
5, 8
7, 6

2
D
E
F
5, 8
7, 6
1, 1

2
D
E
F
0, 0
1, 1
4, 4
57
Chapter 8: Strategy and Game Theory
8.3 The question should refer to teens 1 and 2 throughout rather than teens A and B.
a.

b. (Dont veer, veer) and (veer, dont veer).
c. Let

and 1 be teen 1s probabilities, respectively, of veering and not.

Player 2s expected payoff from veering then is
+ + 1 ) 1 )( 1 ( ) )( 2 (
and
from not veering is
3 ) 1 )( 0 ( ) )( 3 ( +
. For teen 2 to be indifferent, and thus
willing to randomize, these two expressions must be equal, implying
2 / 1
*

.
Symmetrically, teen 2 randomizes with equal probabilities over the two actions.

2
1
Veer
Veer
Dont
veer
Dont
veer
2, 2
1, 3

2
Veer
Dont
veer
3, 1
0, 0
58
Chapter 8: Strategy and Game Theory


d. Teen 2 has four contingent strategies: always veer, take the same action as teen
1, do the opposite of teen 1, never veer. The normal and extensive forms for the
game are as follows.
Teen 2
(Veer | Veer
Veer | Dont)
(Veer | Veer
Dont | Dont)
(Dont | Veer
Veer | Dont)
(Dont | Veer
Dont | Dont)
T
e
e
n

1
Veer 2, 2 2, 2 1, 3 1, 3
Dont 3, 1 0, 0 3, 1 0, 0
0
Teen 1s
probability
of veering
Teen 2s
probability
of veering
1/2
1
1/2
1
BR
2
BR
1

E
1
E
2
Mixed-strategy
equilibrium
59
Chapter 8: Strategy and Game Theory

d. There are three Nash equilibria: 1 veers and 2 never veers, 1 doesnt veer and
2 always does, and 1 doesnt veer and 2 does the opposite of 1.
e. The game has three subgames: the game itself and the subgames starting from
the node at which teen 2 moves. The Nash equilibrium following 1s having
veered is for 2 not to and following 1s having not veered for 2 to veer. Thus 2s
strategy must be to do the opposite of 1 in a subgame-perfect equilibrium. Teen 1
thus would choose not to veer. The Nash equilibrium in which 2 always veers is
unreasonable because 2 would prefer not to veer if he sees 1 has first; the Nash
equilibrium in which 2 never veers is unreasonable because 2 would prefer to veer
if he sees 1 has not.
8.4 a. Homeowner 1s objective function is
1 2 1 1
4 ) 2 / 10 ( l l l l + . Taking the first-
order condition with respect to
1
l and rearranging yields the best-response
function 4 / 3
2 1
l l + . Symmetrically, homeowner 2s best-response function is
4 / 3
1 2
l l + . Solving simultaneously yields
4
*
2
*
1
l l
.

2
1
Veer
Veer
Dont
veer
Dont
veer
2, 2
1, 3

2
Veer
Dont
veer
3, 1
0, 0
60
Chapter 8: Strategy and Game Theory
b.

c. The change is indicated by the shift, following the arrow, in homeowner 1s
best response function. In the new Nash equilibrium, 1 mows a lot less and 2
mows a little less.
8.5 a. If all play blond, then one would prefer to deviate to brunette to obtain a
positive payoff. If all play brunette, then one would prefer to deviate to blond for
the higher payoff of
a
rather than b .
b. Playing brunette provides the male with a certain payoff of b . Playing blond
provides a payoff of
a
with probability
1
) 1 (

n
p
(the probability no other
player approaches the blond). Equating the two payoffs yields
) 1 /( 1 *
) / ( 1


n
a b p
.
c. The probability the blond is approached by at least one male equals 1 minus
the probability no males approach her:
) 1 /( *
) / ( 1 ) 1 ( 1


n n n
a b p
. This
expression is decreasing in
n
because the exponent
) 1 /( n n
is decreasing in
n

and the base of the exponent, a b / , is a fraction.
8.6 a. Player 1s minmax value is 0, achieved if 2 plays the pure strategy B. Player 2
can cause more harm to 1 by playing the mixed strategy of B with probability
9/10 and C with probability 1/10. Then 1s highest expected payoff is -1/10.
0
3
3

l
1
l
2
4
4
BR
1
(l
2
)
Initial Nash
equilibrium
BR
2
(l
1
)

61
Chapter 8: Strategy and Game Theory
b. Each player can play the strategy of beginning with A in the first period. If no
one deviated from A, C is played; otherwise B is played. Players earn a total of 18
each in equilibrium with these strategies (10 in the first period and 8 in the
second). The strategies are subgame perfect. In the second period, a Nash
equilibrium is always played, either (B, B) or (C, C). There is no incentive to
deviate in the first period: the first-period gain from deviation of 5 is less than the
second-period loss from moving to the less-preferred Nash equilibrium of 8.
c. The outer polygon is the feasible set; payoffs in the shaded region are
additionally above the minmax levels and thus are achievable in the limit.

8.7 a. The best-response function is
4 / 5 . 3
2
l l
LC
+
for the low-cost type of player
1,
4 / 5 . 2
2
l l
HC
+
for the high-cost type, and 4 / 3
1 2
l l + for player 2,
where
1
l is the average for player 1. Solving these equations yields 5 . 4
*

LC
l ,
5 . 3
*

HC
l , and
4
*
2
l
.
b. Player 2 best responds to the average best response across the two types of
player 1, given by the dashed line between the two best responses, and resulting in
a choice of landscaping level given by the dotted horizontal line. The two types
0
u
1
5 10
-5 -10
5
10
-5
-10
u
2
62
Chapter 8: Strategy and Game Theory
of player 1 best respond to the equilibrium landscaping effort of player 2,
resulting in the outcome labeled HC if player 1 is the high-cost type and LC if
player 1 is the low-cost type.

c. The low-cost type of player 1 earns 20.25 in the Bayesian-Nash equilibrium
and 20.55 in the full-information game, so would prefer to signal its type if it
could. Similar calculations show that the high-cost player would like to hide
its type.
8.8 a.
l
1
l
2
BR
HC
(l
2
)
BR
2
(l
1
)
BR
LC
(l
2
)
LC
HC
63
Chapter 8: Strategy and Game Theory

b. In a hybrid equilibrium, at least some type of some player plays a mixed
strategy. If player 1 sees the low card, she prefers the pure strategy of staying.
So it must be that player 1 randomizes after seeing a high card. (Verify that if
player 1 plays a pure strategy of either folding or staying, player 2s best
response is also a pure strategy, so the equilibrium would not be a hybrid one.)
For brevity, we will say that player 1 is the high type if she sees a high card
drawn and a low type if she sees a low card drawn. Let

and 1 be the
probabilities that the high type stays and folds, respectively. In order for the
high type to be willing to randomize, it must be that player 2 randomizes as
well. (Verify that this is the case.) Let

and
1
be the probabilities that
the high type stays and folds, respectively.

must be such that the high type is indifferent between staying and folding
for her to be willing to randomize. Staying provides the high type with an
expected payoff of
) 50 )( 1 ( ) 100 ( +
, and folding provides her with a
payoff of -50. Equating these two expressions and solving yields
3 / 2
*

.
In order for player 2 to be willing to randomize, he must be indifferent
between staying and folding. His expected payoff from staying is

1
Pr(H)
= 6/13
Stay
Fold

2
-50, 50
n
1
n
2
Fold
Stay
Pr(L)
= 7/13
-50, 50
Stay
Stay
Fold
Fold
100, -100
50, -50
50, -50
-100, 100
64
Chapter 8: Strategy and Game Theory
) 100 )]( | Pr( 1 [ ) 100 )( | Pr( + stay H stay H
where
) | Pr( stay H
is the posterior probability that player 1 is the high type
conditional on her staying. Player 2s payoff from folding is -50. Equating
the two expected payoffs yields
4 / 1 ) | Pr( stay H
.
) | Pr( stay H
must also
satisfy Bayes rule:
.
7 6
6
) 13 / 7 )( 1 ( ) 13 / 6 (
) 13 / 6 (
) Pr( ) | Pr( ) Pr( ) | Pr(
) Pr( ) | Pr(
) | Pr(
+

L L stay H H stay
H H stay
stay H
Equating this last expression with
4 / 1 ) | Pr( stay H
and solving yields
18 / 7
*

.
To summarize, in the hybrid equilibrium, the low type always stays, the high
type mixes between staying and folding with probabilities 7/18 and 11/18, and
player 2 randomizes between staying and folding with probabilities 2/3 and
1/3. Player 2s posterior beliefs are that player 1 is the high type with
certainty if she folds; if she stays she is the high type with probability 1/4 and
the low type with probability 3/4.
c. The low types expected payoff is (100)(2/3) + (50)(1/3) = 83.3. The high
types expected payoff is -50 (she is indifferent between staying and folding in
equilibrium, and earns -50 from folding). Given the prior probabilities of
being a high and low type, player 1s expected payoff from the game (prior to
learning her type) is (83.3)(7/13) + (-50)(6/13) = 21.8. Player 2s expected
payoff is -50 (he is indifferent between staying and folding in equilibrium and
earns -50 from folding). The game is clearly tilted toward player 1.
Analytical Problems:
8.9 Dominant strategies
For any strategy profile besides the dominant-strategy equilibrium, each player
would have an incentive to deviate to its dominant strategy, ruling out the profile
as a Nash equilibrium.
65
Chapter 8: Strategy and Game Theory
8.10 Rotten Kid Theorem
In the second stage, the parent chooses L to maximize
) ) ( ( ) ) ( (
1 1 2 2
L r Y U L r Y U + +
yielding first-order condition
0 ) ) ( ( ) ) ( (
1 1 2 2
+ + L r Y U L r Y U .
Even though the preceding equation cannot be solved explicitly for
) (
*
r L
, we can
still use the implicit function rule to find the derivative
1 2
1 1 2 2
*
) ( ) (
U U
r Y U r Y U
dr
dL
+

.
In the first state, the child maximizes
)) ( ) ( (
*
1 1
r L r Y U
, yielding first-order
condition
. 0
)] ( ) ( [
)] ( ) ( ) )( ( [
) (
2 1
1 2
2 1
1 1 2 2 1 2 1
1 2
1
*
1 1

,
_

+ +

,
_

1
1
]
1

+
r Y r Y
U U
U U
r Y U r Y U U U r Y
U U
U
dr
dL
r Y U

This equation implies 0 ) ( ) (

2 1
+ r Y r Y , the first-order condition for maximizing
their joint incomes.
8.11 Alternatives to Grim Strategy
66
Chapter 8: Strategy and Game Theory
a. Cooperating gives a stream of per-period payoffs of 2, for a present discounted
value of
) 1 /( 2
. If players use tit-for-tat strategies, the present discounted
value from deviating to fink at the start of the game is

,
_

+ +

1
2
1 3
2
.
The deviator earns 3 in the first period, followed by a period in which both fink
and earn 1, followed by a return to cooperating in the third period and thereafter.
For the displayed payoff not to exceed
) 1 /( 2
, 1 , that is, players must be
infinitely patient.
If players use two periods of punishment, the present discounted value from
deviating is

,
_

+ + +

1
2
1 1 3
3 2
.
For the displayed payoff not to exceed
) 1 /( 2
, we see, upon multiplying
through by 1 and simplifying, the required condition is
0 1 2
3

.
Factoring,
) 1 )( 1 ( 1 2
2 3
+
. Hence, the required condition can be
written
0 1
2
+
. Using the quadratic formula to obtain the roots of this
quadratic, we have 62 . 0 .
b. The required condition is that the present discounted value of the payoffs from
cooperating,
) 1 /( 2
, exceed that from deviating,
) 1 /( 2 ) 1 /( ) 1 ( 3
11 10
+ +
. Simplifying,
0 1 2
11

. As the
graph below shows, the expression
1 2
11

crosses the x-axis very slightly to
the left of 0.5. Using numerical methods or a more precise graph, it can be shown
that the condition is 50025 . 0 . The resulting condition is very close to the
condition for cooperation with infinitely many periods of punishment ( 2 / 1 ).
67
-0.03
-0.02
-0.01
0
0.01
0.02
0.03
0.49 0.495 0.5 0.505 0.51
Chapter 8: Strategy and Game Theory


8.12 Refinements of perfect Bayesian equilibrium
a. The key condition is for the firm to be willing to offer a job to an uneducated
worker. (Regarding the other player, the worker, all worker types obtain the
highest payoffs possible, since they are hired and dont have to expend the cost of
education.) The firms expected payoff from J is
) )]( | Pr( 1 [ ) )( | Pr( w NE H w NE H +
and from NJ is 0. The displayed expression exceeds 0 if
/ ) | Pr( w NE H
.
According to Bayes rule, along the equilibrium path, posterior beliefs are the
same as prior beliefs in a pooling equilibrium. Therefore,
) Pr( ) | Pr( H NE H
.
The required condition for the specified pooling equilibrium thus is
/ ) Pr( w H
.
All out-of-equilibrium beliefs and strategies are consistent with this pooling
equilibrium. If
/ ) | Pr( w E H
, then the firm would choose J conditional on
observing E. On the other hand, if
/ ) | Pr( w E H
, then the firm would choose
NJ conditional on observing E.
b. For the firm to prefer not to offer a job to an uneducated worker, calculations
similar to those in part (a) (but with the inequalities reversed) imply
/ ) Pr( w H
. A high skilled worker would deviate to E unless the firm
chooses NJ conditional on E. The firm prefers NJ to J conditional on E when
the out-of-equilibrium posterior beliefs satisfy
/ ) | Pr( w E H
or
equivalently
/ 1 ) | Pr( w E L
. Suppose
L H
c w c < < . Then it would be
unreasonable to think that type L would ever deviate to E. Regardless of what
strategy the firm plays, type Ls payoff would be negative from E and non-
negative from NE. (By contrast, type H may have an incentive to deviate: he
or she earns a positive payoff if the firm plays J conditional on E.) The Cho-
Kreps intuitive criterion restricts the out-of-equilibrium posterior belief
0 ) | Pr( E L
. Since
0 ) | Pr( E L
is inconsistent with the required condition
68
Chapter 8: Strategy and Game Theory
/ 1 ) | Pr( w E L
, the Cho-Kreps intuitive criterion rules out the pooling
equilibrium specified in part (b), leaving only the one specified in part (a).
69