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MFM 5031 Financial Decision Theory

M.Sc. FINANCIAL MATHEMATICS


ASSIGNMENT III

1. Consider the Cournot duopoly game: There are two firms operating in a limited
market. Market production is: P (Q) = a − bQ, where Q = q1 + q2 for two firms.
Both companies will receive profits derived from a simultaneous decision made by
both on how much to produce, and also based on their cost functions: T Ci = ci qi .
It is given that a > c1 > c2 . Compute the Nash equilibrium.

2. Consider the Cournot duopoly game with the following payoff functions of firm i,

ui (q1 , q2 ) = (1 − αi )(profit of i) + αi (sales of i),

where 0 ≤ α ≤ 1. You may consider αi as a measure of firm i’s desire to capture


a high market share. Set a = 2, b = 1, c = 1, and find the Nash equilibria of this
game, and interpret your results when

(a) α1 = α2 > 0,
(b) α1 > α2 .

3. Suppose that two firms are competing in a market and their products are imperfect
substitutes for one another. The demand functions for the products of firms 1 and
2 are given respectively as

Q1 (p1 , p2 ) = 10 − αp1 + p2 ,
Q2 (p1 , p2 ) = 10 − αp2 + p1

where p1 and p2 are prices charged by firm 1 and firm 2, respectively. The firms can
charge any non-negative price, and we assume that α > 1 so that the ”own-price
effect” is larger than the ”cross-price effect”. For simplicity assume that the unit
costs of each firm is equal to zero, and each firm aims to maximize its own profits.
Formulate this situation as a strategic form game, and find its Nash equilibria. How
does the firms’ profits change as α gets larger?

4. Two people can perform a task if, and only if, they both work. The cost of effort
is 0 < c < 1, and if the task is performed their payoff is 1 each. This results in the
following bi-matrix representation, where W stands for working, and S stands for
shirking. Find all the Nash equilibria of this game (both pure and mixed strategy
equilibria). How does the mixed strategy equilibrium change as c increases?

M.Sc. in Financial Mathematics, Department of Mathematics 1


MFM 5031 Financial Decision Theory

W S
W 0,0 0,-c
D -c, 0 1-c,1-c

5. A child’s action a affects both her own private income c(a) and her parent’s income
p(a), for all values of a we have c(a) < p(a). The child is selfish, she cares only about
the amount of money she has. The parent cares both about how much money she
has and how much her child has. Specifically, her payoff is the smaller of the amount
of money she has and the amount of money her child has. The parent may transfer
money to her child. First the child takes an action, and after observing the action
the parent decides how much money to transfer to the child. Show that in a sub-
game perfect equilibrium of this game the child takes an action that maximizes the
sum of her private income and her parent’s income.

6. Consider the ultimatum bargaining game as introduced in the class with the follow-
ing modification. If the share of player i is xi and that of player j is xj , where j ̸= i,
then the payoff of player i is

xi − βxj ,

where β > 0. The parameter β can be interpreted as a measure of envy of player i


towards player j. Find the sub-game perfect equilibria of this game.

7. Consider the following bargaining game in which two players are trying to share a
cake of size 1. Player 1 offers x1 ∈ [0, 1] and player 2 either accepts (Y ) of rejects
(N ). If player 2 accepts player 1 receives a payoff of x1 and player 2 receives 1 − x1 .
If player 2 rejects, then player 2 moves again to offer x2 ∈ [0, 1] to which player 1
responds by either accepting (Y ) or rejecting (N ). If player 1 accepts player 1 and 2’s
payoffs are δ(1 − x2 ) and δx2 respectively, where δ ∈ (0, 1) is the common discount
factor for the players. If player 1 rejects the offer then an arbitrator terminates
the bargaining process and gives player 1 a share y and player 2 the rest which,
because of discounting, players value as δ 2 y and δ 2 (1 − y). Find the sub-game
perfect equilibria of this game.

8. Consider the following prisoners’ dilemma game.

C D
C 2, 2 0, 3
D 3, 0 1, 1

M.Sc. in Financial Mathematics, Department of Mathematics 2


MFM 5031 Financial Decision Theory

For what values of δ, if any, the following strategies constitute sub-game perfect
equilibria?

(a) Tit-For-Tat: Choose C in period 1 and then do whatever your opponent did
last period.
(b) Pavlov: Choose C in period 1. Choose C after any history in which the
outcome in the last period is either (C, C) or (D, D). Choose D after any
other history.

9. Now consider the following prisoners’ dilemma game and answer the same questions
in (8).

C D
C 4, 4 0, 6
D 6, 0 1, 1

10. Consider a Cournot duopoly model with inverse demand function


a − Q, Q ≤ a
P (Q) =
0, Q>a

where Q = Q1 + Q2 and cost functions Ci (Qi ) = cQi , i = 1, 2. The profit function


of firm i is given by

ui (Q1 , Q2 ) = Qi (P (Q1 + Q2 ) − c).

Consider the following grim-trigger strategy. Produce half the monopoly output
in the first period and as long as everybody has produced that amount so far.
Otherwise produce the Cournot output. Verify that this is a sub-game perfect
equilibrium.

M.Sc. in Financial Mathematics, Department of Mathematics 3