The following table depicts a non- cooperative game between an investor in a firm’s shares and the firm’s auditor.

The investor has two strategies: invest or not invest. The auditor can choose to work for the investor by ensuring that the firm’s financial statements are free of opportunistic earnings management, or to work for the manager by allowing opportunistic earnings management, which may mislead the investor but benefit the manager.
The number pairs in the table represent the utility payoff to the investor and auditor, respectively, for each strategy combination. The rationale for these payoffs is as follows: Invest, work for investor:
The investor receives high- quality information ( generating utility of 5), but the auditor incurs high audit costs ( generating utility of 4) due to time spent arguing with the manager and possible loss of audit engagement.
Invest, work for manager:
The investor receives low- quality information (utility of 2), but the auditor’s costs are lower (utility of 6).
Do not invest, work for investor:
The investor buys lower- yielding securities (utility of 3). The firm’s cost of capital rises due to lower demand for its shares. As a result, its earnings fall. Auditor incurs high audit costs, and absorbs lower audit fee due to lower firm earnings (utility of 1).
Do not invest, work for manager: The investor buys lower- yielding securities. The auditor’s audit costs are lower due to less arguing with manager but audit fee is still low due to lower firm earnings (utility of 3).

a. Identify the Nash equilibrium of this game and explain why this is the predicted out-come of the game.
b. Identify the cooperative solution. Explain why it is unlikely to be attained in a single play of this game.
c. Outline three possible ways that the cooperative solution may beattained.

  • CreatedSeptember 09, 2014
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