Commerce
295/FRE 295

Fall
2014

Assignment 2

Assigned: Nov. 10/11

Due: Nov. 24/27

Instructions:

1. This
assignment is due (in hardcopy form) by the beginning of your class on the date shown above. Assignments up to 24 hours late
will receive a 25% penalty. Assignments more than 24 hours late will not be
accepted. Late assignments can be given to Helen Ho in HA 266 or to Ines Bilec
in the Undergraduate office or can be given to your instructor.

2. Extensions
are possible only for genuine emergencies. Permission for the extension must be
in advance (i.e. at least 24 hours before the assignment is due) and must be
accompanied by appropriate documentation. See Ines Belic in the Undergraduate
Office.

3. Show your working for all questions.
Please be concise with your answers, and clearly identify the answer to the
specific question you are being asked. Please carry 2 non-zero digits to the
right of the decimal for answers that do not work out to whole numbers. Explain
your reasoning where asked to do so.

4. Please use the remaining pages (not this
page) as a template.You may type in your answers before printing out the
document or you may print out the document and print your answers neatly by
hand.
Your answers must be neat and easily readable. If not, marks will be
deducted or the answer will be ignored entirely. If in doubt, type your answer.
Please confine your answer to the
allowed space. Do question 7 before
printing out the template as question 7 requires you to cut and paste a
spreadsheet into the template.

5. Some of the
questions have lines on which you are to write the answer. Do not exceed this
space. Part of your task is to choose the right thing to say in a small space.

6. If you do not
follow these instructions you will not get full credit for your work.

7. Students
often like to work together in doing assignments. However, this is NOT a group
assignment. It is primarily an individual effort. The basic rule about joint
work is that it is acceptable to discuss questions with classmates but you must
do the actual write-up of the assignment on your own. You must not copy someone
else’s answer. Copied or plagiarized answers will be subject to appropriate
penalties.

8. You may use
pen or pencil but if you use pencil we cannot review situations where you think
there is a marking mistake (except addition errors).

9. The
assignment is challenging. Do not leave it to the last minute. When doing each
question it is a good idea to find and read the relevant sections of the
textbook first. Good Luck.

DATE:
______________

UBC Sauder School of Business

Commerce 295 / FRE 295

Fall 2014

Assignment 2

NAME: _______________________________________

STUDENT NUMBER:_______________________________________

SECTION
NUMBER: _______________________________________

PROFESSOR: _______________________________________

MARKS: Points

1
/10

2
/10

3
_______ /10

4 /10

5 /10

6 /10

7 _ /10

8 _______ /10

9 /10

10 /10

TOTAL _________ / 100

Each
question is worth 10 pts. Each part of each question is worth 5 pts. Show your
working.

1. (Game Theory I)Suppose Air Canada and
West Jet are deciding whether to offer a frequent flyer program (FFP). The annual profits of the two firms from each
combination of strategies they choose is given in the following payoff matrix.
The firms choose simultaneously.

a)Identify any dominant strategies. Determine the Nash equilibrium in
this game.(State the strategies and the payoffs.) Determine
the maximin solution. Is this an example of a Prisoner’s Dilemma? In answering
this question provide the relevant definitions and explain briefly how they
apply.

b) Here is an entry game.

Identity
any Nash equilibria in pure strategies. If firm 1 plays a mixed strategy of
entering with 90% probability, what is the best response of firm 2? Is this
combination of strategies a Nash equilibrium? Explain briefly. (Hint: when
considering whether a proposed solution is a Nash equilibrium ask whether
either firm regrets its choice – whether its best response is different from
what it actually chose.)

2. (Coordination Games). Consider the
following network scheduling payoff matrix for Shaw Cable and Telus.

a) Identify
any Nash equilibria in this game. Explain briefly.

b)Would pre-play communication or application of the Pareto criterion be
helpful in this game? Explain briefly.

3. (Repeated
Games)Apple and Microsoft must decide on a pricing strategy for their
tablet devices, the iPad and the Surface. Their respective marketing
departments have determined two potential prices, one high and one low. The
payoffs (in millions of dollars) are summarized in the table below.

Microsoft Surface

Apple iPad

a) What is the Nash equilibrium in the
one-shot (static) game? Now suppose that the companies repeat this game every
year with new versions of the tablets. Describe two different Nash equilibria
of this infinitely repeated game and explain why each is an equilibrium. Your
description of each equilibrium should be a pair of strategies (one for each
firm), and the equilibrium payoffs for each firm per round.

b) A start-up competitor has developed a
new technology that will make current tablet computers obsolete. There is no
uncertainty about the success of the new venture, but it will take an
additional 3 years to manufacture the required components. The founder of the
start-up makes a public announcement that the new device will go on sale in
three years. Do we expect Apple and Microsoft to make the most of the next
three years by colluding on high prices? Explain your answer using appropriate
terminology.

4. (Stackelberg
Oligopoly)Consider the competition between Honda and Toyota in the compact
car market. Each firm must commit to a production level at the beginning of the
year. The payoffs for three possible outputs of each firm (in millions of
dollars) are given in the table below. Suppose Honda preempts Toyota by
finishing plans on its latest upgrade early, and therefore makes a public
commitment on quantity before Toyota.

Toyota Corolla

Honda Civic

a) Draw the relevant extensive form
representation (game tree) for this strategic interaction. What is the sub-game
perfect Nash Equilibrium?

b) Suppose Honda must spend an additional
15 million dollars to be in the position to announce first, and otherwise the
two firms announce simultaneously. Is it profitable for Honda to expedite
planning? Now suppose that Toyota goes first unless Honda spends the $15
million to expedite planning, in which case Honda goes first. Would the 15
million dollar investment be worthwhile in this case? Explain.

5. Sequential Games

a) Consider the following game tree
describing strategic interaction between an incumbent monopolist and a
potential rival.

For what range of values of X and Y
will the incumbent deter entry by investing? Show your working.

b) A mining company is considering
starting operations in a foreign country known to be rich in mineral deposits
but with an unreliable government. Extracting the minerals will be very
profitable, but requires extensive and costly digging before anything can be
extracted from the ground. Explain briefly using appropriate terminology why
the company might be hesitant to start work on this potentially profitable
project. (No diagram is needed.)

__________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

6. Behavioral Economics

a. Consider a game with 10 players. Each
person submits an integer between 0 and 100. The winner of the game is the person
who submits a number closest to 60% of the average number submitted. The winner
gets a prize of $1000 and no one else gets anything. If two or more people tie
for the win they share the prize equally. Assuming that all players are fully
rational and that rationality is common knowledge, what is the Nash equilibrium? If you were playing this game with
randomly chosen first year UBC students, would you bid the Nash equilibrium
value?

The Nash equilibrium is
__________________________________________________________.

We know this is a
Nash equilibrium because
_____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

If I were trying
to win this game I would submit the value _________________________.

I think this
offers the best chance of success because _________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________.

b. State whether prospect theory, the reciprocity
norm, or neither can explain the following phenomena. Circle the correct
response and explain briefly.

Framing effects. Prospect Theory or Reciprocity
Norm or Neither.
______________________________________________________________________________________________________________________________________________________________

The Certainty Effect. Prospect Theory or
Reciprocity Norm or Neither.

______________________________________________________________________________________________________________________________________________________________

Overconfidence.Prospect Theory or
Reciprocity Norm or Neither.

______________________________________________________________________________________________________________________________________________________________

Behavior in Ultimatum Games. Prospect
Theory or Reciprocity Norm or Neither.

______________________________________________________________________________________________________________________________________________________________

Bounded Rationality. Prospect Theory or Reciprocity
Norm or Neither.

______________________________________________________________________________________________________________________________________________________________

7. (Uncertainty)A manager must choose one
of four advertising strategies, with the following characteristics. The manager
cares only about the expected value and variance of the projects.

a. Put this data into a spreadsheet, add three
columns with headings EV, VAR, and SD, and use the spreadsheet to calculate the
expected value, variance, and standard deviation. Paste the resulting
spreadsheet in the space below.

Which strategy would be chosen by a risk
preferring manager? a risk neutral manager? a risk averse manager?

A risk preferring
manager would choose _____ because _________________________________
______________________________________________________________________________________________________________________________________________________________

A risk neutral
manager would choose ________ because _________________________________
______________________________________________________________________________________________________________________________________________________________

For a risk averse
manager we can say ________________________________________________
_______________________________________________________________________________
_______________________________________________________________________________

b. Suppose utility is given by U = ?Y where
Y is the return. For Strategy B what is the expected utility and what is the
risk premium? Draw the associated diagram showing the risk premium. (Do not
worry about making the diagram precise. Just illustrate the general idea, but
include the relevant numbers on the axes.)

8. (Adverse
Selection)Consider the used car example described in Q&A 15.1, except
the numbers are different. Buyers value lemons at $5000 and good used cars at
$10,000. The reservation price of lemon owners is $4000 and the reservation
price of owners of good used cars is $7,500. Owners know the quality of the
cars but buyers do not. (Show your working.)

a. Suppose that 40% of the used cars are
good used cars and 60% are lemons. Describe the equilibrium.

b. Now suppose that 60% of the cars are
good used cars and 40% are lemons. Describe the equilibrium now.

9. (Agency) Priscilla hires Arnie to
manage her business; both of them are risk neutral. The following table shows Priscilla’s profits
(before paying Arnie) for two different levels of Arnie’s effort and two
different market situations. If Arnie provides
low effort, his cost of effort is zero but if he provides high effort his cost
is 10. Weak demand and strong demand are
equally likely. (Show your working.)

Weak Demand Strong Demand

Low Effort 20 40

High Effort 40 80

a)
If Priscilla offers a profit sharing contract in which Arnie gets 30% of the
profits, what effort level would Arnie provide? Calculate Priscilla’s expected
net profits (after paying to Arnie) under this contract.

b)
If Priscilla offers a bonus contract in which Arnie gets a base salary of 4 (no
matter whether demand is weak or strong) plus 80% of all profits exceeding 40,
what effort level would Arnie choose now? Which contract (profit sharing or
bonus) would Priscilla prefer? Which contract would Arnie prefer?

10.
(Economic Research)

Holloway, Lee and Shen (2014) study the
determinants of cross-border leveraged buyouts.

a) The authors present a stylized model of
the global competition among buyout firms.

i) What factors in the model determine the
number of acquisitions by buyout firm in each country?

ii) Can you think of any other factors that
likely play a role in the real world?

iii) Where do these other factors
implicitly enter the equation for the number of completed buyout deals by each
investor in each country?

b) The authors test the predictions of the
model using a sample of worldwide buyout deals.

i) Which two countries dominate as home
countries for buyout firms in the sample?

ii) How do the authors test the prediction
that transaction costs associated with remote ownership impact the number of
deals? How do they measure the theoretical cost mitigation ability?

______________________________________________________________________________________________________________________________________________________________

_____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

iii) Are results consistent with the
predictions of the model? How can you tell?

____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________