Nash Equilibrium

Theory and Denitions Basic Examples Nash Equilibrium and Modeling Examples Conclusion
Econ 414 Lecture: Nash Equilibrium

Je Borowitz
Summer I 2010
Je Borowitz
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Je Borowitz
Summer I 2010
Je Borowitz
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Theory and Denitions Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium Basic Examples The Driving Game Battle of the Sexes A 3x3 Game Nash Equilibrium and Modeling Examples Cournot Competition Bertrand Bertrand vs. Cournot Conclusion
Je Borowitz Econ 414 Lecture: Nash Equilibrium 3 / 52
Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium
Outline
1
Motivation: The Driving Game

Alice and Bob can each choose whether to drive on the left or right side of the road. Bob L R L 0,0 -10,-10 Alice R -10,-10 0,0 For both Alice and Bob, both L and R are rationalizable Therefore, the concept of Dominant Strategy Equilibrium tells us nothing at all A better concept is the Nash Equilibrium
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Motivation for Another Solution Concept
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Solution Concepts for the Driving Game
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Pure Strategies
Pure strategies are as opposed to mixed strategies which will be covered later
Denition (Pure Strategy)

If a player has a strategy set S = (s1 , s2 , . . . , sn ), a pure strategy is an element of the set S . That is, s1 , s2 , . . . are all pure strategies. Both C and RS are pure strategies in the Prisoners Dilemma.
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Best Response
Denition (Best Response)
Player i s best response to the other players strategies BRi (si ) is the set of strategies out of Si that maximize i s payo when the other players play si . Formally, BRi (si ) = {si : ui (si , si ) ui (si , si )} In the Driving game, Alices best response function is: BRA (sB ) = L, sB = L R , sB = R
There can be more than one strategy that satises the denition of best response, so generally BRi (si ) is a correspondence
Nash Equilibrium
Denition (Nash Equilibrium)

, s , . . . , s ) is a Nash Equilibrium if for every A set of strategies S = (s1 n 2 i 1, 2, . . . , n, si BRi (s i)
In a Nash Equilibrium, every players strategy is optimal, given every other players strategy in the equilibrium In a Nash Equilibrium, no player has an incentive to deviate.
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Nash Equilibrium and Whispering
Consider a game where everyone is rational A referee whispers a Nash Equilibrium in everybodys ear Everyone knows this: its common knowledge
Denition (Nash Equilibrium: Whispering)

A Nash Equilibrium is a strategy for each player such that when the referee whispers everyone their equilibrium strategy, everyone will agree that what the referee whispered was (weakly) the best strategy.
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How to Find the Nash Equilibria
1 2
Find each players best response BRi (Si ) Impose that for every i : si = BRi (Si )
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How to Find the Nash Equilibria
1 2
Find each players best response BRi (Si ) Impose that for every i : si = BRi (Si )
Thats it! Ill show some examples of exactly what this means.
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Question
Consider the strategy prole (C , C ) in the standard Prisoners Dilemma: Bob C RS C 3, 3 0, 4 Alice RS 4, 0 1, 1 This strategy prole is:
1 2 3 4
A Dominant Strategy Equilibrium A Nash Equilibrium Both Neither
Question
Consider the strategy prole (C , C ) in the standard Prisoners Dilemma: Bob C RS C 3, 3 0, 4 Alice RS 4, 0 1, 1 This strategy prole is:
1 2 3 4
A Dominant Strategy Equilibrium A Nash Equilibrium Both Neither
Both: a strategy in a DSE for a player is a best response for any opponent strategies, which includes the equilibrium strategies
Question
Which Equilibria does the following game have? Bob A Alice B

1 2 3 4
C 6, 4 1, 1
D 1, 1 2, 2
Dominant Strategy Equilibria Nash Equilibria Both Neither
Question
Which Equilibria does the following game have? Bob A Alice B

1 2 3 4
C 6, 4 1, 1
D 1, 1 2, 2
Dominant Strategy Equilibria Nash Equilibria Both Neither
Nash Equilibria: Neither strategy dominates for either player, so there is no DSE. The Nash Equilibria are (A, C ) and (B , D )
Nash Equilibria Versus Dominant Strategy Equilibria
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The Driving Game Battle of the Sexes A 3x3 Game
Outline
1
The Driving Game
Bob Alice L R L 0,0 -10,-10 R -10,-10 0,0
Find best responses by underlining the payo that each players best response yields If single box has both numbers underlined, it is a Nash Equilibrium
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Question
Bob L Alice R L 0,0 -10,-10 R -10,-10 0,0
What is Alices best response if Bob is driving on the right hand side (playing R )?
1 2
Play L Play R
Question
Bob L Alice R L 0,0 -10,-10 R -10,-10 0,0
What is Alices best response if Bob is driving on the right hand side (playing R )?
1 2
Play L Play R
Play R
The Driving Game: Solution
Bob L Alice R L 0, 0 -10,-10 R -10,-10 0, 0
Both LL and RR are Nash Equilibria. This is a much better concept: both equilibria make sense and are observed in the real world!
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Battle of the Sexes

Alice and Bob want to meet up (before cell phones) They can either go to the football game (F ) or the opera (O ). Bob prefers seeing football and Alice prefers the opera, but both would rather meet than not. Bob Alice F O F 1, 3 0, 0 O 0, 0 3, 1
What are the Nash Equilbria?
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Battle of the Sexes
Bob F Alice O Both FF and OO are equilibria. This makes sense: if Bob knew that Alice was going to the Opera, he would rather go to it than the football game. F 1, 3 0, 0 O 0, 0 3, 1
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A Larger Game
Consider the game: A D 1, 0 Alice E 2, 3 F 0, 1 Apply the underlining technique Bob B 2, 2 1, 0 0,2 C 1,2 1,1 3,0
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A Larger Game
D Alice E F
A 1, 0 2, 3 0, 1
Bob B 2, 2 1, 0 0, 2
C 1, 2 1, 1 3, 0
Note that only one utility is underlined for 1 in each row and for 2 in each column, unless the two underlined utilities are the same Nash Equilibria are ((E , A), (D , B ))
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Another 3x3 Game
Consider the following game: A D 0, 8 Alice E 3, 4 F 2, 5 What are the Nash Equilibria? Bob B 1, 1 2, 8 3, 5 C 5, 6 1, 3 8, 9
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Solution
Using underlining: Bob A B 0, 8 1, 1 3, 4 2, 8 2, 5 3, 5 Equilibrium is C 5, 6 1, 3 8, 9 (F , C )
D Alice E F The only pure strategy Nash
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Cournot Competition Bertrand Bertrand vs. Cournot
Outline
1
Cournot Competition
Consider two rms who produce identical products and sell to the same market. The market has an inverse demand curve given by: P (q1 , q2 ) = a b (q1 + q2 ) Each rm has constant marginal cost c . Firm i s prot function is given by i (q1 , q2 ) = P (q1 , q2 ) qi c qi Each rm takes the others quantity output as given.
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Cournot Competition: Solution

Step 1 is to nd the best response function (maximizing prots) Taking Firm 2s action q2 as given, rm 1 solves: max 1 (q1 , q2 ) = max (a b (q1 + q2 )) q1 c q1
q1 q1 = BR (q ) Firm 1 chooses q1 as a best response to a given q2 : q1 1 2
Here,
q1 = BR1 (q2 ) =
a c bq2 2b a c bq1 2b
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And similarly:
q2 = BR2 (q1 ) =
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Cournot Competition
Step 2 is applying the fact that in the Nash Equilibrium, every players strategy is a best response to the opponents , q ) such that: Note that the Nash Equilibrium here is given by (q1 2
q1 =BR1 (q2 ) q2 =BR2 (q1 )
Solving these two equations, we nd: ac q0 q1 = 3b 3 ac q2 = 3b And the equilibrium payo for both rms is
= P (q1 , q2 )q1 cq1 =
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1 (a c )2 0 9b 9
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Cournot: Analysis
What if there was only one rm in the market? Just set the opponents quantity to 0 in the best response function q1 = q0 ac = 2b 2
The total quantity for two rms is 2q0 /3 Prots are also higher for one rm! 1 = (a c )2 0 0 = >2 4b 4 9
So one rm is able to restrict production and raise prots compared to two rms! More on this in the homework. . .
Cournot: An Alternative Approach

Remember the best response function for rm 1: BR1 (q2 ) =
ac bq2 2b
Since 1 would never choose q1 > q0 /2, 2 doesnt have to worry about producing any more than BR2 (q0 /2), and 1 can take this into account A similar argument can be made for 2. Since the only way 1 would play any strategy less than BR1 (q0 /2) is if 2 played something above q0 /2, and we already know 2 will play something below q0 /2, we know that 1 will play something within [BR1 (q0 /2), q0 /2]. Etc. . . Continuing with this logic, we are left with just the point where the two functions cross, as seen on the board
Cournot Best Responses

BR (q )
1 2
BR (q )
2 1
(ac)/b
(ac)/2b (ac)/3b
(ac)/3b (ac)/2b
(ac)/b
Discussion of Approaches
The Nash Equilibrium of a Cournot game is also a DSE Which concept is more compeling here?
Here, DSE requires an innite number of iterated eliminations NE requires
1 2
Each player plays a best response to the others choice Players somehow know that they will play NE (BRi can take many values)
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Bertrand Competition
Two rms can produce goods at constant marginal cost c (no xed costs). Firms set price pi below a maximum bound p Demand for Firm i s goods is: , pi > p i 0 (a bpi )/2 , pi = pi qi (p1 , p2 ) = a bpi , pi < p i If the prices are equal, the market is shared equally. Prots for rm i are i = (pi c )qi
In words: all customers buy from the rm with the lowest price.
Question
Remember that demand for rm i s goods 0 qi (p1 , p2 ) = (a bpi )/2 a bpi

1 2 3 4
is: , pi > p i , pi = p i , pi < p i
What is rm 1s best response if rm 2 charges p2 = c + 3?

p1 p1 p1 p1 =c =0 = c + 2.999 . . . =c +2
Question
Remember that demand for rm i s goods 0 qi (p1 , p2 ) = (a bpi )/2 a bpi

1 2 3 4
is: , pi > p i , pi = p i , pi < p i
What is rm 1s best response if rm 2 charges p2 = c + 3?

p1 p1 p1 p1 =c =0 = c + 2.999 . . . =c +2
3 is best Its best to charge the highest price possible, as long as p1 < p2
Bertrand Competition: Solution

Since the payo functions are not continuous, instead of using equations lets use the denition of a Nash Equilibrium and rule out some possible Nash Equilibria. Pick a potential NE and see if it works.
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Since the payo functions are not continuous, instead of using equations lets use the denition of a Nash Equilibrium and rule out some possible Nash Equilibria. Pick a potential NE and see if it works. Consider i playing pi < c
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Since the payo functions are not continuous, instead of using equations lets use the denition of a Nash Equilibrium and rule out some possible Nash Equilibria. Pick a potential NE and see if it works. Consider i playing pi < c
There are basically two cases here - pi pj and pi > pj Prots are negative if pi pj and 0 if pi > pj Therefore, i would want to deviate from her NE strategy to play pi = c and always receive 0 prots
So pi < c cant be part of a Nash Equilibrium!
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Now consider pi > c
For this to be a NE, j should be playing its best response: a price just under pi : pi However, if pj = pi , then i would want to deviate and choose a price just below pj
Intuitively, if one rm knows what the other rm will do, it will try to barely undercut. But if the other rm knows that it will try to barely undercut the rst, etc. So no prices p > c can support an equilibrium.
= p = c , which are a NE Therefore, the only prices left are p1 2
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Bertrand Analysis
= p = c , prots are zero for both rms Note that at p1 2
Having just one competitor has made prots go from the monopoly level to zero! Modeling issue: discontinuity of demand is unrealistic
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Dierentiated Bertrand
One problem with the Bertrand model is that it requires goods to be perfect substitutes: this is pretty strong Consider a version where the goods are now partial substitutes Demand is given by qi (p1 , p2 ) =a pi + bpj This makes sense for partial substitutes:
The demand for rm i is decreasing in i s own price The demand for rm i is increasing in the competitors price
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Players can choose any price 0 pi Prots are given by 1 (p1 , p2 ) =q1 (p1 , p2 )[p1 c ] = (a p1 + bp2 )(p1 c ) 2 (p1 , p2 ) =q2 (p1 , p2 )[p2 c ] = (a p2 + bp1 )(p2 c ) Firm 1s best response is given by: 1 (p1 , p2 ) =0 = (a p1 + bp2 ) p1 c p1 a + bp2 + c BR p1 (p2 ) = 2
Firm 2s best response is similar, so the best responses are:
BR p1 (p2 ) =(a + bp2 + c )/2 BR p2 (p1 ) =(a + bp1 + c )/2
Imposing that both rms best respond to each other, the condition for rm 1 gives:
+ c )/2 + c a + b (a + bp1 2 a + c p1 = 2b p1 =
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, we get: Plugging in p1
a + b (a + c )/(2 b ) + c 2 a + c p2 = 2b
p2 =
The Nash Equilibrium is therefore: a+c a+c , 2b 2b
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, we get: Plugging in p1
a + b (a + c )/(2 b ) + c 2 a + c p2 = 2b
p2 =
The Nash Equilibrium is therefore: a+c a+c , 2b 2b A problem: what if p2 = 1000?

Remember, demand for 1 is: q1 = a p1 + bp2 Demand for rm 1 is super high this isnt realistic
Model Predictions
Bertrand (undierentiated) predicts = 0 while Cournot predicts >0 Bertrand has price competition while Cournot has quantity competition Which is right?
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Model Predictions
Bertrand (undierentiated) predicts = 0 while Cournot predicts >0 Bertrand has price competition while Cournot has quantity competition Which is right? Obviously it depends on the situation - its better to ask when each applies
Cournot and Opec Bertrand and Pricewatch.com - elasticity of 40!
Most of the time, Bertrand is probably too stringent for the outcomes we see If you like this sort of problem this is more or less what Econ 460 is about
Outline
1
Equilibrium Concepts in General
Require assumptions Will select some outcomes of a game as solutions Have a tradeo between assumptions and solutions that it chooses
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Nash Equilibrium as an Equilibrium Concept

Assumptions about what the players know
Both players know the game Both players prefer higher payos Both players know the last two points (common knowledge) Both players have expectations that the other player will play their Nash Equilibrium strategy
Which solutions does it select? Those where:

Each player is playing a best response to the other players strategy Those where no player can protably deviate
Tradeos between assumptions and predictions

We make the additional assumptions that players will know which equilibrium to play, and that players will choose their best response to the other players equilibrium strategy We get fewer solutions, and more specic predictions (e.g. driving game)
Techniques for Finding Nash Equilibrium
Big picture: have each player choose a strategy that is a best response to the other players strategies in Equilibrium Specic techniques:
Underlining: used in box games, underline each players best responses, and when they match up there is a NE Calculating Best Response Functions: used in games with continuous strategies (like Cournot), you use calculus to set derivative of prot function equal to zero for all players at once Thinking: used in games with special structure (like Bertrand): think through what patterns a best response has, and see what can be NE
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The End

Nash Equilibrium

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Nash Equilibrium

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Theory and Denitions Basic Examples Nash Equilibrium and Modeling Examples Conclusion

Econ 414 Lecture: Nash Equilibrium

Econ 414 Lecture: Nash Equilibrium

Econ 414 Lecture: Nash Equilibrium

Econ 414 Lecture: Nash Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium

Motivation: The Driving Game

Econ 414 Lecture: Nash Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium

Motivation for Another Solution Concept

Econ 414 Lecture: Nash Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium

Solution Concepts for the Driving Game

Econ 414 Lecture: Nash Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium

Denition (Pure Strategy)

Econ 414 Lecture: Nash Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium

Denition (Nash Equilibrium)

Econ 414 Lecture: Nash Equilibrium

Motivation Denitions Nash Equilibrium and Dominant Strategy Equilibrium