In game theory, Nash equilibrium (named after John Forbes Nash, who proposed it) is a solution concept of a game involving

two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy unilaterally. If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payoffs constitute a Nash equilibrium. Stated simply, Amy and Bill are in Nash equilibrium if Amy is making the best decision she can, taking into account Bill's decision, and Bill is making the best decision he can, taking into account Amy's decision. Likewise, a group of players is in Nash equilibrium if each one is making the best decision that he or she can, taking into account the decisions of the others. However, Nash equilibrium does not necessarily mean the best cumulative payoff for all the players involved; in many cases all the players might improve their payoffs if they could somehow agree on strategies different from the Nash equilibrium (e.g., competing businesses forming a cartel in order to increase their profits). The Nash equilibrium concept is used to analyze the outcome of the strategic interaction of several decision makers. In other words, it is a way of predicting what will happen if several people or several institutions are making decisions at the same time, and if the outcome depends on the decisions of the others. The simple insight underlying John Nash's idea is that we cannot predict the result of the choices of multiple decision makers if we analyze those decisions in isolation. Instead, we must ask what each player would do, taking into account the decision-making of the others. Nash equilibrium has been used to analyze hostile situations like war and arms racesHYPERLINK \l "cite_note-0"[1] (see Prisoner's dilemma), and also how conflict may be mitigated by repeated interaction (see Tit-for-tat). It has also been used to study to what extent people with different preferences can cooperate (see Battle of the sexes), and whether they will take risks to achieve a cooperative outcome (see Stag hunt). It has been used to study the adoption of technical standards, and also the occurrence of bank runs and currency crises (see Coordination game). Other applications include traffic flow (see Wardrop's principle), how to organize auctions (see Auction theory), and even penalty kicks in soccer (see Matching pennies).[2]Coordination game Main article: Coordination game A sample coordination game showing relative payoff for player1 / player2 with each combination Player 2 adopts strategy A Player 1 adopts strategy A Player 1 adopts strategy B 4, 4 3, 1 Player 2 adopts strategy B 1, 3 3, 3

The coordination game is a classic (symmetric) two player, two strategy game, with an example payoff matrix shown to the right. The players should thus coordinate, both

you will apply best response analysis to such output decisions in both a simultaneous and sequential setting. For example. neither player has incentive to change strategy due to a reduction in the immediate payoff (from 3 to 1). If both firms agree on the chosen technology. An example of a coordination game is the setting where two technologies are available to two firms with compatible products. there is still a Nash equilibrium. when both choose to either drive on the left or on the right.e.100%) for player one. the coordination game can be defined with the following payoff matrix: The driving game Drive on the Left Drive on the Left Drive on the Right 100. Driving on a road. If we admit mixed strategies (where a pure strategy is chosen at random. to receive the highest payoff. producing identical products so that . 4. then there are three Nash equilibria for the same case: two we have seen from the pure-strategy form. firm 1 and firm 2. 0%) for player two respectively.. with payoffs 100 meaning no crash and 0 meaning a crash. 0 100. Cournot Competition An often-studied simultaneous game is the Cournot quantity-competition model of oligopoly. 100 Drive on the Right In this case there are two pure strategy Nash equilibria. is also a coordination game.adopting strategy A. Dixit and Skeath. firm output decisions (how much to produce) are often continuous variables. Consider two firms. 100 0. and (100%. we must find equilibria through cell-by-cell inspection or best response analysis. Both strategies are Nash equilibria of the game. Although each player is awarded less than optimal payoff. but also games with pure strategies that are continuous variables (See your text. few sales result. and they have to elect a strategy to become the market standard. 0 0. If the firms do not agree on the standard technology. For example. 0%) for player one. If both players chose strategy B though. high sales are expected for both firms. (0%. 100%) for player two. section 9). In this exercise. i. (100%. and having to choose either to drive on the left or to drive on the right of the road. where the probabilities are (0%. We add another where the probability for each Game Theory Applied to Oligopoly Competition When players do not have dominant or dominated strategies. This best response analysis applies not only to games for which we can draw game diagrams. chapter 4. subject to some fixed probability). Augustin Cournot developed one of the first models of competition between firms in 1835.

the choices of the two firms must. we can use calculus to deduce that firm 1's optimal quantity is given by profit maximizing value of q1 = 300 . it will reduce its own output. Otherwise. Suppose that firm 1 thinks that firm 2 will produce q2. If the firms must make their output decisions simultaneously. the resulting price is 400. So. each firm must be producing a best response to the choice of the other firm. a firm will always have incentive to change its output. Only one pair of outputs simultaneously solves both best reply equations. So the equilibrium profits for each firm are: 200*200 = 40..q2. In Cournot's model. the resulting industry price is whatever price is required to "clear the market" which is the price at which consumers are willing to buy the total production.q1 . for example. In order to be at equilibrium. the sole strategic choice of the firms is the amount they choose to produce. market demand is given by: P = 600 . so that q1=q2=100. In order for q1 to be an equilibrium output.q2 = 600-200-200 = 200. The solution turns out to be: q1 = q2 = 200. q1 and q2. we can calculate firm 2's best response to firm 1's choice of quantity: profit maximizing value of q2 = 300 .5q2 this profit-maximizing value of q1 is called firm 1's best response to firm 2. q1+q2. Then. That means that if firm 1 expects firm 2 to increase output. how much will each firm produce? In order to be at equilibrium.5q1 Now we know what each firm will produce given the output choice of the other firm. Once the firms select their quantities. firm 1 estimates that if it produces q1 units of output.they are forced to charge identical prices. its profit will be: Profit of firm 1 = P * q1 = (600-q1-q2)*q1 To maximize the above profit. if each firm produces 100 units. . simultaneously. In a similar manner. firm 1's best response is a decreasing function of q2.q1 .000. Suppose that the firms have no marginal costs of production. it must maximize firm 1's profit given firm 2's choice of q2. Substituting these choices of quantity into the demand equation gives P = 600 . be best responses to each other.. Consider the decision of firm 1. According to this equation.

we consider the effects of transforming this simultaneous game into a sequential one. we use rollback. In the next go first or second? Would you prefer to have to select your quantity first.q2. we cannot write down each strategy and look for equilibria in a game box. In order to find the equilibrium of this sequential game. what you will do? Obviously.q1 . since I can see what the first firm chose. isn't your competitor smart as well? Can't your competitor also calculate. However. there are no marginal costs. Firm 1 selects its quantity in period 1. . Again. Then. and firm 2 in period 2. pointed out that the results would be quite different if the two firms chose quantities sequentially. you would select the quantity that maximizes your profit given what the first firm chose. had to make yours? The intuitive answer is often "I would prefer to go second. Stackelberg Competition The Cournot model has often been criticized as unrealistic because it is rare that firms would select quantities simultaneously. Using the same demand curve from the previous section. Firm 1 will anticipate firm 2's response. and you. if you're so smart. The first firm. the first mover has the advantage. in his 1934 criticism of the Cournot model. Heinrich von Stackelberg. what will firm 1 do in the first period. without any ability to observe the choices of their competitors. or would you prefer if your competitor selected her quantity first. What will firm 2 do in the second period if firm 1 chose q1. a firm must be playing the best response to the choice of the other firm. and the intuition is as follows: What advantage would you gain by being second? You would observe what the first firm chose. then. which we calculated above: profit maximizing value of q2 = 300 . Consider a two-period model. Firm 1 is better off. In order to be at equilibrium.5q1 Now.This shows that finding the equilibrium of games in which we cannot write down a "game box" is also possible. the first firm can predict the reaction of the second firm. by choosing its quantity is maximizing its own profit. the same principle applies. P = 600 . who has more power? The second firm is simply reacting to the choice of firm 1. ahead of time." However. in fact). as we will see. A natural question is which position is better . and in the second period. except that one firm gets to act before the other. Start with the decision of firm 2. This is given by the best response of firm 2. taking this reaction into account. In the first period. Since each firm has many strategies (an infinite number. only upon observing this decision. considered the same model as Cournot competition. But. firm 2 observes the choice of firm 1 and then selects its own output. Then.. firm 1 selects its output.

5q1)q1 From which we may find that the profit-maximizing output for firm 1 is: q1 = 300 If firm 1 produces 300. firm 1 is able to commit to a quantity higher than the equilibrium of the simultaneous game. . By so doing. Substituting firm 2's best response into firm 1's profit: Profit of firm 1 = P * q1 = (600-q1-(300 .5q1))*q1 = (300-. firm 1 forces firm 2 to cut back on its own production. This commitment yields the first firm a market share of 2/3 compared to the 1/2 it had in the simultaneous move game. Also.q1 . firm 2 produces 150.q2 = 600-300-150 = 150 And the resulting profits are: Profit of firm 1 = 300*150 = 45. and the market price is: P = 600 . Moving first is an advantage! Summarizing: In a sequential model. firm 1 earns a greater profit than it did in the simultaneous (Cournot) game.000 Profit of firm 2 = 150*150 = 22..Firm 1 maximizes its profit given by: Profit of firm 1 = P * q1 = (600-q1-q2)*q1 But. firm 1 knows exactly what firm 2 will pick: its profit-maximizing value.500 So firm 1 earns a greater profit than firm 2.

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