USSR

Mathematics Exploration
Business and Economics were the two subjects, which played an important role
in decision to enter the English school system. My school, Kent College, offered
both of these subjects at the same time as the opportunity to do the International
Baccalaureate.
Therefore I was looking for topic for my exploration, which combines both my
interest Economics and Mathematics.
In Economics we have currently just covered a section called Microeconomics
including the topic for Higher Levels Theory of the firm. In Theory of the firm
we dealt with different market structures and the decision making of the firms in
these market structures to arrive at a market price and output.
In the circumstances of one of these market structures named Oligopoly an
assumption has been made that states that the firms operating in this market
structure are interdependent. Meaning that the firms are dependent on the price
and output decision of the their fellow firms. This is result of the low amount of
firms the operating in this market structure (usually around 3-4), leading to a
high market share/power of each firm. For instance, if one firms increases its
price, interdependent means that the other firms in this industry are directly
affected by this decision, hence they show a reaction towards this decision.
To illustrate and solve such a situation to the best, mathematics has been applied
resulting in the formation of a concept called Game theory. Game theory is a
branch of mathematics and social science that tries to capture behaviour in
strategic situations Maley and Welker 2012. In my following exploration I will
not simply explore the Game theory, but applying the Game theory to situation
often found in Business bargaining. I will try to find the best outcome of
different bargaining situations by creating linear equations based on conditions
(nash-axioms) created by the noble winner John Forbes Nash. This will be
explained and illustrated by using examples and diagrams.

The bargain issue could be formally described as M payout-combinations which
can be achieved together by n amount of player. The different combinations can
lead to many different outcomes for each player.
In the Game Theory this becomes illustrated in a Pay-off Matrix.
As it is said that during the cold war, game theory was employed by the US and
the USSR to try to understand which strategies the opponent would use in
making decisions regarding their nuclear arsenals, I am going to show such a
pay-off matrix demonstrating the nuclear arsenals issue.

US

Nuclear
A
ttack
No Nuclear Attack

US destroyed
US destroyed
Nuclear Attack

USSR destroyed





USSR destroyed
US and USSR survive
No Nuclear Attack

As shown in the pay-out matrix there 4 payout combinations (m=4) with two
players (n=2).

Now in my following special example I am going to add a specific outcome
combination called conflict-combination, comes into force if the players are not
able to find an agreement for a payout-combination. Furthermore in a the
bargain issue it is assumed that there is at least one payout-combination with
which the players can achieve a higher outcome than with conflict-combination.

To illustrate this better, a real life situation is created:

Two firms can work together to gain a profit of maximal 1. Now the firms are
going to bargain about the part of the profit each receives. But it needs to be
mentioned that when we take x1 as the profit which firm A receives and x2 as
the profit which firm B receives, the rule x1+x2<=1 needs to be obtained.
Therefore all other shares of the profit where x1+x2 < 1 is pareto inefficient,
because all players could increase their share the profit until the sum gives one
without harming each other.

To solve such problems the Nash-Axiome are applied. These are the set of
conditions, which the outcome needs to meet.

The Nash-Axiome:

1. There is only one optimal outcome.
2. The outcome needs to be pareto efficient. every firm is aiming for the highest
outcome for itself until 1.
3. The outcome should not be changed, if possibilities become skipped which no
one would have chosen anyway. This could be for instance if although the firms
agree at a outcome of 0.4 and 0.6, a new government law says that one firm is not
allowed to more than 0.55, so 0.6 would be wrong. This axiome says that it does
not have an effect on the original behaviour of the firms.



Applying these rules, helps us to solve the bargain issue. First we create a graph
which illustrates the distribution of the profit each firm gets.

As we can see it is possible that every point, which lies in area between the x1
axis, x2 axis and the linear graph, gives us a distribution of profit which is
possible as a outcome. However the existence of Nash-Axiome results in a strong
limitation of possible outcomes. The Axiom states that the outcome needs to be
pareto-efficient, thus only distributions of profit are possible which lie on the
linear graph.

As it is assumed that the players act rational in an economic way (maximise their
profits), the product out of x1 and x2 should be maximised axiome 1. Graphical,
this can be seen as a rectangle, that has a corner on the x2 axis and another one
on the linear graph.



The area of such a rectangle, dependent on x1, can be illustrated in the following
way.

f(x1) = (1-x1) * x1 = -x12 + x1

The graph of this function is an inverse parabola. To find the highest point (max)
of this graph we need to find the vertex. This can be done by transform the
function of the graph using binomial formula:

-x12 + x1 = -(x12-x1) = -(x12-2*0.5x1+0.52 0.52) = -(x12-2*0.5x1+0.52) + 0.25 =
-(x1-0.5)2 +0.25

Therefore the highest area is achieved when x1 = 0.5 and the area of the
rectangle 0.25 is. Moreover, as x2 = 1 x1 and x1 = 0.5 is, x2 is 0.5 as well. This
this the Nash Bargaining result of the problem.

However, in economics there is often a term used opportunity cost, which plays
an important role in the decision making of firms. So lets assume firm A has
another (opportuntity-)offer with which it can gain profit of 0.2 and firm B a
offer with which it can gain a profit of 0.3. The question arises if this has any
effect on the bargaining outcome/distribution of profit.

Obviously now, firm A would not accept any agreement with firm B, where it gets
less profit than 0.2 and firm B would no accept any agreement with firm A,
where it gets less profit than 0.3.

X1 >= 0.2 and
X2 >= 0.3



In this case the result/outcome can only in the coloured area. But same to the
first instance applying the second axiom restricts the possible outcomes to
points which lie on the linear graph, therefore the middle of the red line covered
by the vertical and horizontal green lines. In addition, the outcome must have the
characteristic that the product out of (x1-0.2)*(x2-0.3) is maximised.
The maximised area is gained again by setting x2 = 1-x1.

(x1 - 0,2) * (x2 - 0,3) = (x1 - 0,2) * (1 - x1 - 0,3) = (x1 - 0,2) * (- x1 + 0,7) =
-x12 + 0,7x1 + 0,2x1 -0,14 = -x12 + 0,9x1 - 0,14 = -(x12 - 0,9x1) - 0,14 =
-(x12 - 2*0,45x1 + 0,45 2) + 0,45 2 - 0,14 = - (x1-0,45)2 + 0,0625

Thus, x1 is 0.45 and x2 is then 0.55. Therefore at the end Firm B ends up with a
higher amount of profit received making the agreement as it had a better
bargaining position at the start.



Bibliography:

Maley and Welker

Hargreaves, Shaun: Game Theory - A Critical Introduction, Routledge, 2005