1. (10 points) Consider the following 3x3 game (the actions are given fanciful names-- this is just for technical practice, so don't read realism into it).
(a) Name any dominated strategies.
(b) Name any Nash equilibria.
Firm 2
Innovate Copy
Hesitate
High 1, 5 3,7 2,2
Firm 1 Medium 2,4 2,6 12,2
Low 3, 7 0,4 0,2
ANSWER: (a) For Firm 2, Hesitate is dominated.(b). (High,Copy) is Nash. So is (Low, Innovate)
2. (15 points) Albert is a young M.B.A. with an idea for a new breakfast cereal, peppermint corn flakes, that he is considering introducing at a cost of 100 thousand dollars. Price competition will not be important in this market, and the industry profit will, after the initial shakedown period in which the 100,000 dollars is spent, have a present value of either 300,000 or 900,000 dollars. He assesses each of these as having equal probability.
What Albert is is most worried about is that the industry leader, Behemoth, will enter with a competing brand once they see that there is a market for Pep Flakes, as he plans to call his product. He knows that if Behemoth enters, Behemoth will drive him out of business and take the entire profit, since Behemoth has much better marketing channels. His one comfort is that it will cost Behemoth 400,000 dollars to enter.
(a) Draw a game tree to represent this situation.
(b) What should Albert do, and what is his expected profit?
ANSWER. (a) I set this up as Behemoth knowing the size of the market before it enters (having observed Albert's success). Thus, Albert chooses Enter or Don't Enter, then Nature chooses Big or Small with probability .5 on each node, then Behemoth chooses Enter or Don't, with appropriate payoffs at the end of the tree. It is also reasonable to have Behemoth not know the market size. Then Nature moves at the end rather than in the middle.
(b) Albert should enter, for an expected profit of -100+ .5 (0) + .5(300) =50. Note that his expected profit is not just .5 times his expected profit if Behemoth enters plus .5 times his expected profit if Behemoth does not enter, because Behemoth does not enter randomly, but only when the market is most profitable.
If you assume that Behemoth does not observe the size of the market before making its decision, then Behemoth faces an expected payoff of -400+ .5(900) + .5(300) = +200 from entering, and will do so. Therefore, Albert should not enter, and his expected payoff is zero.
3. (15 points) The Wall Street Journal article excerpted below, ``Cash Flow: `Pay to Play' Is Banned'', May 13, 1998, discusses campaign finance and municipal bond underwriting. (a) Explain why the oligopoly game we played in class is like the Prisoner's Dilemma. (b) Explain why the underwriting firms in New York are in a game like the Prisoner's Dilemma. (c) Why was Rule G-37 put in place?
ANSWER. (a) As in the Prisoner's Dilemma, the players would do best as a group if each of them chose a dominated strategy-- to produce output of 40, in the oligopoly-- instead of producing more. But if any one firm were to produce more than 40, it would earn higher profits than the other firms, so long as the price remains above 20. Thus, in the oligopoly game everyone ends up worse off than if they could agree to all produce 40 and stick to that agreement. (b) Certainly before rule G-37, and apparently even now, underwriters were caught in a pay-to-play bind. If all of them contributed to politicians, none of them had any special advantage in getting the contract, so only the politicians would be better off than if none of them contributed. If all are contributing, tho, any one firm that deviates by not contributing loses, because it definitely does not get the contract. And if none are contributing, any one firm could contribute and definitely get the contract. So all are tempted to contribute, ultimately to none of their benefits, a prisoner's dilemma.
(c) Rule G-37 says that underwriters are forbidden to contribute directly to politicians. (That underwriters are forbidden to try to influence politicians in this way is the rule, not the explanation for the rule.) The reason for the rule is to solve the Prisoner's Dilemma and save the underwriters the expense of campaign contributions. They can still try to contribute to politicians indirectly, but this is harder to do, so total spending most likely has decreased.
Whatever the policy merits of the state takeover, there is no question it is a good deal for the underwriters. They stand to collect about $40 million in fees.
The contenders for this lucrative business were put "through a competitive process," then selected on the basis of their skill and experience, says the state agency that is handling the deal. That seems a reasonable contention; the winning underwriters are, after all, highly experienced firms.
Still, they are more than that. The firms that walked away with the biggest chunks of the issue also all have extensive links to political figures in a position to influence the selection of underwriters. And all have made substantial political contributions that found their way to powerful New York politicians, despite the supposed demise of the ethically questionable political/muni-bond nexus known as "pay to play."
In attacking that system four years ago, the Securities and Exchange Commission put in place a rule barring from muni-bond underwriting any firm that gives to state or local officials in position to influence underwriter selection. It also sharply limits giving by firms' employees. Rule G-37, as it is called, was promulgated by an industry self-regulatory group called the Municipal Securities Rulemaking Board.
But judging by the mammoth Lilco underwriting, the game didn't end, it just got more complicated. Muni-bond underwriters are barred from direct giving to a great many state and local campaigns now. But they have their ways.
Bond firms and employees of the firms ship money off to a variety of legal destinations: state-party "housekeeping accounts," bond-act committees, federal political-action committees and nationalparty kitties that ostensibly finance federal candidacies. At the same time, the underwriting firms burnish their welcome by hiring politically connected law firms, lobbyists and consultants, who sometimes proceed to make campaign contributions of their own to muni-bond decision makers.
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The board that selected the underwriters has 15 members (there is one vacancy). New York Gov. George Pataki names nine of the members, including the chairman. Three more are named by a close Pataki ally, the Republican leader of the state senate, with the other three picked by the Democratic leader of the state assembly.
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State and federal campaign-contribution records show that all four of the firms chosen to lead the Lilco underwriting have contributed to various political committees and funds that exist to get Messrs. Pataki and D'Amato re-elected or to further causes they are promoting. Both are up for re-election this year.
Bear Stearns is one of Sen. D'Amato's very biggest boosters on Wall Street. In 1996, Bear Stearns and its chief executive, James Cayne, chipped in a total of $50,000 to promote a state environmental-bond act, ads for which prominently and favorably featured Sen. D'Amato as an environmentally concerned senator. In 1997, Bear Stearns officials exceeded their counterparts at other firms in total contributions to the senator, giving $42,750.
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In 1996, Bear Stearns made some of the largest corporate donations to the National Republican Senatorial Committee, at a time when Sen. D'Amato was its chairman. Bear Stearns gave $150,000 to the committee's building fund.
Bear Stearns hadn't given to the committee in the two years before the Senate banking chairman took it over. After he left, the firm cut its giving to the committee in half.
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Gov. Pataki's spokeswoman says his campaign committee "abides by the letter of the law," and all contributions "are fully disclosed and fully documented." Nonetheless, at the time, his solicitation came to the attention of the Municipal Securities Rulemaking Board. The board was gradually realizing that Wall Street had figured out ways around Rule G-37. It had identified common tactics, including contributing to public officials' favorite charities and sponsoring quasipolitical conferences attended by governors and other state officials.
Rule G-37 includes a clause barring firms from making indirect contributions when they can't contribute directly, but proving such violations is difficult. Essentially, regulators have to prove that munibond executives intended to funnel their donations to state and local officials, a task that is nearly impossible.
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Mr. Taylor says there is no way to close every loophole in the contribution restrictions. "Politicians have an insatiable appetite for money," he says, adding: "It's a shakedown."
But one participant in the bond market suggests that it is naive to be surprised by firms' efforts to build ties to the influential. "People don't do arm's-length relationships with everything they do," says Michael Shamosh, a fixed-income strategist at Tucker Anthony Inc. in New York City. "It's not possible to do business without influence. Influence is always there and available, and it's used in government and business. You can't legislate away relationships."