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ECON 90034: Economics of Finance - Blue and Green Banks Economics Assessment Answer
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Subject Code: ECON90034
Internal Code: 1AIJDE
b) (3 points) Now assume that Blue Bank and Green Bank play the game with the same actions (plans they developed) and payoffs as in a) but they make their choices simultaneously. What is the payoff matrix for this new game? What do you predict will happen in the game? Explain.
c) (3.5 points) Assume that simultaneous game from part b) is played seven times, i.e. Blue Bank and Green Bank play a repeated game with the stage game described in b). What do you predict will happen in the game, if banks play a subgame perfect Nash equilibrium? Explain.
Problem 2 Moral Hazard
The owner of a firm needs to hire a manager to be in charge of a project. The project can give rise to two different results, depending on the effort of the manager (high or low). The high effort results in revenue R1 ? 300 with probability 0. 6 and revenue R0 ? 60 with probability 0. 4. The low effort results in revenue R1 with probability 0. 3 and revenue R0 with probability 0. 7.
The owner is risk neutral and maximizes the expected profit.
There are two managers the owner can hire: Joon and Abi.
Each of them has a Bernoulli utility function u?w, ei? ? w ? c?ei?, where w is the wage, ei is the effort and c?ei? is the disutility of effort ei.
For Joon, the disutility of effort is equal to 3 for high effort, eH, and 0 for low effort, eL. His reservation utility is 7.
For Abi, the disutility of effort is equal to 5 for high effort, eH, and 1 for low effort, eL. Her reservation utility is 5.
Calculate wages and profits up to two decimal places (for example, you should round 3.576 to
3.58, round 3.572 to 3.57, round 3.575 to 3.58 but leave 7, 7.5 and 12. 55 as it is).
First, assume that effort is observable and can be included in the contract.
a) (1.5 points) If the owner wants to hire Joon, what contract (effort and wages) should he offer to him? Briefly explain what constraints will be satisfied and why.
b) (0.5 point) If the owner wants to hire Abi, what contract should he offer to her?
c) (0.5 points) Should the owner hire Joon or Abi?
Now assume that effort is not observable and cannot be included in the contract.
d) (3 points) If the owner wants to hire Joon, what contract (wages w1 and w0) should he offer to him? Briefly explain what constraints will be satisfied and why.
e) (2 points) If the owner wants to hire Abi, what contract should he offer to her?
f) (0.5 points) Should the owner hire Joon or Abi?
g) (2 points) Compare your answers to c) and f). Provide intuition for the result. Is there any welfare loss due to Moral Hazard?
Blue and Green Banks Economics Assessment Answer
TASK: Problem 1. Game Theory Blue and Green Banks are engaged in intense competition with each other. Blue Bank team came up with three plans of action which they named High, Medium and Low. The Green Bank team came up with two plans of their own, Active and Passive. a) (3.5 points) Consider the following strategy profile depicted on the game tree below: Blue Bank plays Medium plan and Green Bank’s strategy is Passive Passive Passive (that could be written as PPP). Would you expect Blue Bank and Green Bank to play these strategies? If yes, explain why; if not, explain why not. (Hint: Is the strategy profile (M, PPP) a Nash equilibrium? a subgame perfect Nash equilibrium?) Find all subgame perfect Nash Equilibria by using backward induction.
b) (3 points) Now assume that Blue Bank and Green Bank play the game with the same actions (plans they developed) and payoffs as in a) but they make their choices simultaneously. What is the payoff matrix for this new game? What do you predict will happen in the game? Explain.
c) (3.5 points) Assume that simultaneous game from part b) is played seven times, i.e. Blue Bank and Green Bank play a repeated game with the stage game described in b). What do you predict will happen in the game, if banks play a subgame perfect Nash equilibrium? Explain.
Problem 2 Moral Hazard
The owner of a firm needs to hire a manager to be in charge of a project. The project can give rise to two different results, depending on the effort of the manager (high or low). The high effort results in revenue R1 ? 300 with probability 0. 6 and revenue R0 ? 60 with probability 0. 4. The low effort results in revenue R1 with probability 0. 3 and revenue R0 with probability 0. 7.
The owner is risk neutral and maximizes the expected profit.
There are two managers the owner can hire: Joon and Abi.
Each of them has a Bernoulli utility function u?w, ei? ? w ? c?ei?, where w is the wage, ei is the effort and c?ei? is the disutility of effort ei.
For Joon, the disutility of effort is equal to 3 for high effort, eH, and 0 for low effort, eL. His reservation utility is 7.
For Abi, the disutility of effort is equal to 5 for high effort, eH, and 1 for low effort, eL. Her reservation utility is 5.
Calculate wages and profits up to two decimal places (for example, you should round 3.576 to
3.58, round 3.572 to 3.57, round 3.575 to 3.58 but leave 7, 7.5 and 12. 55 as it is).
First, assume that effort is observable and can be included in the contract.
a) (1.5 points) If the owner wants to hire Joon, what contract (effort and wages) should he offer to him? Briefly explain what constraints will be satisfied and why.
b) (0.5 point) If the owner wants to hire Abi, what contract should he offer to her?
c) (0.5 points) Should the owner hire Joon or Abi?
Now assume that effort is not observable and cannot be included in the contract.
d) (3 points) If the owner wants to hire Joon, what contract (wages w1 and w0) should he offer to him? Briefly explain what constraints will be satisfied and why.
e) (2 points) If the owner wants to hire Abi, what contract should he offer to her?
f) (0.5 points) Should the owner hire Joon or Abi?
g) (2 points) Compare your answers to c) and f). Provide intuition for the result. Is there any welfare loss due to Moral Hazard?
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