ECON*6010: Microeconomic Theory II Ren Kirkegaard, Winter 2012

Assignment 2
Due Date: February 9, 2012, in class. Late assignments will not be accepted.
Assignments must be typed in LaTeX. 25 marks will be deducted if you fail to do so.
Question 1: Recall the Intuitive Criterion: Let J(c
1
) denote the set of types such
that
n

1
(o) max
a
2
2BR(;a
1
)
n
1
(c
1
. c
2
. o). (1)
If for some c
1
there exists a o
0
2 such that
n

1
(o
0
) < min
a
2
2BR(nJ(a
1
);a
1
)
n
1
(c
1
. c
2
. o
0
) (2)
then the equilibrium fails the intuitive criterion (and we should throw it out).
1.1 How do you respond to the following argument or criticism: As we move from
(1) to (2), the receiver updates his beliefs and concludes it is reasonable to believe
that o 2 nJ(c
1
). Why do we then not return to stage one and ask whether there
are other types for which
n

1
(o) max
a
2
2BR(nJ(a
1
);a
1
)
n
1
(c
1
. c
2
. o). (3)
and then throw out such types as well before moving to (2)? [Hint: this is a trick-
question...]
1.2 Let 1 be a set of Perfect Bayesian Equilibria (PBE), and let 1
I
1 denote
the set of PBE that survive the intuitive criterion. Consider two equilibria, c
I
2 1
I
and c, where c 2 1 but c , 2 1
I
. Do you agree that the sender is at least as well o
in equilibrium c
I
as in equilibrium c regardless of his type? Prove and explain your
answer.
1
Question 2: Ann has as item she wants to oer for sale to Bob. Anns own-use
value of the item is o 0. Thus, if Ann oers Bob a price of j and he accepts it with
probability , Anns expected payo is l(j. . o) = j + o(1 ). Bobs willingness
to pay is characterized in part by his type, , which is his private information.
Assume is distributed according to some continuously dierentiable distribution
function 1, with support [0. 1]. The density, ,, is strictly positive, and the hazard
rate is monotonic. However, Bobs willingness to pay is also inuenced by o, which
measures the quality of Anns item. Specically, the item is worth + o to Bob.
Both Ann and Bob are risk neutral.
2.1 Assuming o is common knowledge, derive Anns utility maximizing oer to Bob,
j

(o). How does the oer price and the probability of sale depend on o?
Assume for the remainder of the question that o is unknown to Bob (it is Anns
private information). Assume o takes one of two values, o
H
and o
L
, with o
H
o
L
0.
The probability that o = o
H
is ` 2 (0. 1).
2.2 Explain why the price Ann oers may serve to signal her type. Can you identify
the price oered by Ann if o = o
L
in a separating equilibrium? Explain your answer.
Use a gure to illustrate the range of separating equilibria. Howdoes Anns oer price
if o = o
H
compare to the price she would have oered under complete information?
Very carefully explain the economic intuition.
2.3 Describe the least-cost separating equilibrium in as much detail as possible.
Provide a full characterization for the case where 1 is the uniform distribution.
Assume now that Ann, before making an oer to Bob, can make publicly observable
investments in quality, improving o by a factor c 1 (thus increasing quality to
a total of co), where the costs of such improvements are given by c(c), which is
continuous, strictly increasing and strictly convex, with c(1) = 0.
2.4 Describe how Ann would determine the optimal value of c, c

(o), if o was com-

mon knowledge, and how it would depend on o. Assuming o is private information,
do you agree that if o
H
is suciently large compared to o
L
, a separating equilibrium
that supports the common-knowledge investment and pricing decisions could be sup-
ported? Explain your answer. In cases where this is not possible, do you agree that
in a least-cost separating equilibrium (if one exists), Ann would signal (if o = o
H
)
by choosing a (c. j) pair such that c 6= c

(o
H
) but j = j

(co
H
) (that is, she would
signal by distorting her investment)? Explain your answer.
2
Question 3: An incumbent rm, rm 1, faces the threat of competition from
a potential entrant, rm 1. However, the potential entrant does not know the
incumbents constant marginal cost, which may be either high, c
H
, or low, c
L
,
c
H
c
L
0. The timing is as follows: In period 1, the incumbent is a monop-
olist and sets some price, j, which may depend on his type (his costs). At the
end of period 1, the potential entrant observes j and decides whether to enter the
market at some xed cost. If he decides to enter, then he observes the incum-
bents cost at the beginning of period 2. Then, the active rms simultaneously
set prices (the incumbent remains a monopolist if the potential entrant did not en-
ter). If the incumbent is a monopolist, his prot at price j is :(j. c) = (j c)1(j)
when c is his marginal cost and where 1 is the demand function. Assume :(j. c)
is strictly concave in j and let j

k
= max
p
:(j. c
k
), / = H. 1. In case of a duopoly,
let 1
i
k
denote rm is prot if the incumbent has cost c
k
, i = 1. 1, / = H. 1
(this may include entry costs for rm 1). Assume that 1
E
H
0 1
E
L
and that
:(j

L
. c
L
) 1
I
L
: (j

H
. c
H
) 1
I
H
0. Let o 2 (0. 1) denote the incumbents
discount factor. Finally, assume : (j

H
. c
H
) + o1
I
H
< : (j

L
. c
H
) + o: (j

H
. c
H
).
3.1 Assume, for this question only, that c is common knowledge. How does the
monopoly price in period 1 depend on c? If c is not common knowledge, which
type has an incentive to signal to the entrant? Explain your answer. Do you think
such signaling is achieved by pricing above or below the complete information price?
Carefully explain your answer.
3.2 In the remainder of the question we search for separating equilibria. Let j
k
denote the incumbents price in period 1 if his type is /, / = H. 1, in some separating
equilibrium. Can you uniquely determine j
H
? Explain your answer. Write down a
condition that ensures type c
H
will not charge j
L
in period 1. Consider now type
c
L
, who in equilibrium is supposed to charge j
L
. If he considers charging a dierent
price, what would be the best deviation in period 1 [be careful]? Explain your answer.
Write down a condition that ensures type c
L
will not deviate from j
L
in period 1.
Specify beliefs to support the separating equilibrium.
3.3 Use a gure to illustrate the range of separating equilibria. Explain your gure.
Is your gure consistent with your answer to part 3.1? Use the intuitive criterion to
select a unique separating equilibrium. Explain your answer.
3.4 Is social welfare higher or lower when c is the incumbents private information
(and focusing on separating equilibria)? Explain your answer.
3