03.

Strategic Games - Applications

Ryan Fang1
1 ryf1@psu.edu

Decision Making and Strategy in Economics

Econ 402 (Spring 2015)

Reading

Osborne: Chapter 3

1 Review the Key Concepts

2 Cournot Oligopolistic Competition

3 Bertrand Oligopolistic Competition

4 Hotellings Model of Electoral Competition

5 Auctions

A strategic Game

a set of players
for each player, a set of actions
potentially different across players
action profile: a list of actions, exactly one action from each

player.
for each player, a payoff function defined over the set of all

possible action profiles

Nash Equilibrium

A steady state action profile

no player has an alternative action that can yield her a

strictly higher payoff, given the actions of her opponents.

thus, no player has an incentive to deviate from a Nash

equilibrium.
An action profile in which each players action is her best

response to the actions of her opponents.

if every player is already best responding, no one can

profitably deviate.

Dominance

An action of a player strictly dominates another action of

the same player if, regardless of her opponents choices of

actions, the dominant action always yields her a strictly
higher payoff than the dominated action.
An action of a player weakly dominates another action of

the same player if:

i) regardless of her opponents choices of actions, the

dominant action always yields her a payoff that is no less

than that yielded by the dominated action; and,
ii) given some action profiles of her opponents, the dominant
action is strictly better than the dominant action.

Dominance and Nash Equilibria

A strictly dominated action of a player is never a best

response to any profiles of her opponents actions.

Thus, a strictly dominated action can never be played in any

Nash equilibrium.
When looking for Nash equilibria, we can simply eliminate

the strictly dominated actions of every player.

1 Review the Key Concepts

2 Cournot Oligopolistic Competition

3 Bertrand Oligopolistic Competition

4 Hotellings Model of Electoral Competition

5 Auctions

The Cournot Model

Two firms produce a homogeneous good.

The cost to firm i = 1, 2 of producing qi units of the good is

Ci (qi ) = c qi .
The output by the two firms are sold at a single price,

determined by the inverse demand function. Specifically, we

have:
(

P (Q) =

Q
0

if Q
if Q >

where Q = q1 + q2 is the total output of the firms. Assume

that > c.

The Cournot Model

The profit of firm 1 given its choice of q1 and firm 2s choice

q2 is thus:
1 (q1 , q2 ) = q1 (P (q1 + q2 ) c)
Similarly, the profit of firm 2 is:

2 (q1 , q2 ) = q2 (P (q1 + q2 ) c)

The Cournot Game

We model the competition between the duopolists by the

following strategic game:

players: firm 1 and firm 2
Actions: each firm chooses a non-negative quantity
Payoffs: each firms payoff is given by its profit given the

outputs of both firms

Best Responses

We would like to find the Nash equilibria of this game. To do

so, we first solve for the firms best response functions.

For firm 1, we solve the following problem:

max q1 (P (q1 + q2 ) c)
q1

For every q2 c, firm 1s profit is maximized by setting

q1 =

1
2

( c q2 ).

For q2 > c, firm 1s profit maximizing output is zero.

Best Responses

Summarizing, we have:
(

B1 (q2 ) =

1
2

( c q2 )

if q2 c
if q2 > c

Similarly, firm 2s best response function is given by:

(

B2 (q1 ) =

1
2

( c q1 )

if q1 c
if q1 > c

Nash Equilibrium

A Nash equilibrium of this game is a pair (q1 , q2 ) satisfying

the set of equations:

(

q1 =
q2 =

1
2
1
2

( c q2 )
( c q1 )

The unique pair of (q1 , q2 ) satisfying the two equations is

where q1 = q2 =

1
3

( c).

Comparison with Collusive Outcome

How does the total output in the Nash equilibrium compare

with the output produced by the two firms if they were to

collude and maximize the sum of their profits?
The sum of their profits is maximized by setting their total

output equal to the monopoly output.

What is the monopoly output level? Simply go back to either

firms best response function, and set their opponents

output level to zero.
B1 (0) =

1
( c 0)
2

Comparison with Collusive Outcome

How does the total output in the Nash equilibrium compare

with the output produced by the two firms if they were to

collude and maximize the sum of their profits?
The sum of their profits is maximized by setting their total

output equal to the monopoly output.

What is the monopoly output level? Simply go back to either

firms best response function, and set their opponents

output level to zero.
B1 (0) =

1
( c 0)
2

Comparison with Collusive Outcome

How does the total output in the Nash equilibrium compare

with the output produced by the two firms if they were to

collude and maximize the sum of their profits?
The sum of their profits is maximized by setting their total

output equal to the monopoly output.

What is the monopoly output level? Simply go back to either

firms best response function, and set their opponents

output level to zero.
B1 (0) =

1
( c 0)
2

Comparison with Collusive Outcome

Thus, the monopoly output level is 12 ( c). The total

output in the Nash equilibrium is

2
3

( c), which is higher.

The firms can increase their profits ifthey were to agree on



the following collusive output levels:

Do you expect this to happen? Why?

1
4

( c) , 41 ( c) .

n firms

Now suppose there are n firms, each with the same cost

function Ci (qi ) = cqi .

The inverse demand function remains P (Q) = Q.
The n firms simultaneously choose their output levels.
What are the Nash equilibria of the game?

n firms

As before, we can solve for each firms best response

function.
For example, in the case of firm 1, we solve:

max q1 (P (q1 + q2 + . . . + qn ) c)
q1

and find the unique maximizer for any (q2 , q3 , . . . , qn ) to be:

(

B1 (q1 ) =

1
2

( c

Pn

i=2 qi )

if ni=2 qi c
P
if ni=2 qi > c
P

Nash Equilibrium

A Nash equilibrium of the game is a profile (q1 , q2 , . . . , qn )

that satisfies:



= 1 c P

q
q

i6=1 i 
1
2

q = 1 c P
i6=1 qi
2
2




P

1

qn =

i6=n

qi

The unique Nash equilibrium of this game is where

q1 = q2 = . . . = qn = ( c) / (n + 1).

Increasing n

n
The total output of the n firms is n+1
( c), and the

market price is

n
n+1

( c).

As n increases, the total output increases and the price

decreases.
As n approaches , the total output approaches ( c)

and the market price approaches c.

Thus, as n increases, the Nash equilibrium price and supply

approach those in a perfectly competitive market.

1 Review the Key Concepts

2 Cournot Oligopolistic Competition

3 Bertrand Oligopolistic Competition

4 Hotellings Model of Electoral Competition

5 Auctions

The Bertrand Model

In the Cournot model, firms choose their output levels.

What if, instead of quantity competition, we have price

competition?
Suppose that the n = 2 firms each choose a price and are

prepared to supply any quantity demanded from them at

their nominated prices.
Assume that the firms cost functions remain the same, that

is, Ci (qi ) = cqi for i = 1, 2.

Assume also that the demand function is given by:
(

D (p) =

p
0

if p
.
if p >

The Bertrand Model

The consumers always choose to purchase from the firm that

offers the lowest price.

If the two firms offer the same price, then they each serve

half of the total demand for their goods.

Thus, firm i s profit is given by:

(pi c) ( pi )

i (p1 , p2 ) =

1
2

where j is i s competitor.

(pi c) ( pi )

if pi < pj
if pi = pj
if pi > pj

The Bertrand Game

We now model the competition between the duopolists by

the following strategic game:

Players: firm 1 and firm 2.
Actions: each firm can choose any non-negative price (i.e.,

Ai = R+ ).
Payoff: each players payoff is its profit given its own price

and that of its competitors.

What are the Nash equilibria of this game?

Finding Nash Equilibria

Claim: the unique Nash equilibrium of this game is where

p1 = p2 = c.
Proof:
First we need to show that (c, c) is indeed a Nash equilibrium.
Given that its opponent chooses price c, a firm can receive a

profit equal to 0.
Deviating to any price higher than c will yield a firm zero

profits, while deviating to any price lower than c will yield

negative profits.
Thus, there are no profitable deviations and (c, c) is a NE.

Finding Nash Equilibria

Proof (continued):
There cannot be any Nash equilibria where at least one firm

chooses a price lower than c. (why?)

There cannot be any Nash equilibria where at least one firm

chooses a price higher than c. (why?)

What if the two firms prices are different?
What if the two firms prices are equal?

Different Marginal Costs

Now suppose that firm 1s cost function is C1 (q1 ) = c1 q1 ,

while that of firm 2 is C2 (q2 ) = c2 q2 .

Without loss of generality, let c1 < c2 .
What are the Nash equilibria of the Bertrand game with this

modification?

Cournot or Bertrand?

The Nash equilibrium of the Cournot game and the Nash

equilibrium of the Bertrand game are very different.

Which do you think is the better model? Why?

1 Review the Key Concepts

2 Cournot Oligopolistic Competition

3 Bertrand Oligopolistic Competition

4 Hotellings Model of Electoral Competition

5 Auctions

Electoral Competition

What determines the number of candidates competing in

elections?
What determines the candidates policy platforms?
Why are there often no substantive differences between the

positions of political parties? (Not necessarily an accurate

description of todays political landscape in the U.S.)

The Model

Assume that the policy space one-dimensional. Specifically,

let it be the real line, R.

left wing vs. right wing

There are two political parties, A and B, each choose a

policy position, xA , xB R.
There are a continuum of voters, each has an ideal policy

position, xi R.
The ideal positions of the voters are continuously distributed

on R, and has a unique median point xm .

That is, exactly half the population has ideal points xm and

half the population has ideal points xm .

The Model

We assume sincere voting. That is, the voters always vote

for their most preferred policy platform.

Each voters preference over the policy positions, y R, is

given by |y xi |.
Thus, a voter always votes for the party whose policy

position is closest to her own ideal point.

If both parties positions are equally distant from a voters

ideal position, she votes for either of them with equal

probability.

The Model

The two parties simultaneously choose their policy position.

They care only about winning the election (i.e., they are
office-seeking). So their payoff is assumed to be the
probability of winning.
The election is plurality rule: the party with the most votes

win.
Thus, a partys payoff is 1 (0) if strictly more (less) voters

prefer their platform than that of their opponents. If equal

number of voters strictly prefer either party, then each wins
the election with probability 12 .
What are the Nash equilibria of this game?

Finding Nash Equilibria

Claim: the unique Nash equilibrium of this game is where

both parties choose the median voters ideal position, xm .

Proof:
First, we check that (xm , xm ) is a Nash equilibrium:
When both party choose xm , they split the votes in half, and

each obtains a payoff equal to 21 .

Given that its opponent chooses xm , any party deviating from

xm to some x < xm will only get the votes of those voters

whose ideal points fall in (, 21 (x + xm )] and hence lose the
election.
Similarly, deviating from xm to some x > xm will also lose a

party the election.

Therefore, (xm , xm ) is a Nash equilibrium.

Finding Nash Equilibria

Claim: the unique Nash equilibrium of this game is where

both parties choose the median voters ideal position, xm .

Proof:
First, we check that (xm , xm ) is a Nash equilibrium:
When both party choose xm , they split the votes in half, and

each obtains a payoff equal to 21 .

Given that its opponent chooses xm , any party deviating from

xm to some x < xm will only get the votes of those voters

whose ideal points fall in (, 21 (x + xm )] and hence lose the
election.
Similarly, deviating from xm to some x > xm will also lose a

party the election.

Therefore, (xm , xm ) is a Nash equilibrium.

Finding Nash Equilibria

Claim: the unique Nash equilibrium of this game is where

both parties choose the median voters ideal position, xm .

Proof:
First, we check that (xm , xm ) is a Nash equilibrium:
When both party choose xm , they split the votes in half, and

each obtains a payoff equal to 21 .

Given that its opponent chooses xm , any party deviating from

xm to some x < xm will only get the votes of those voters

whose ideal points fall in (, 21 (x + xm )] and hence lose the
election.
Similarly, deviating from xm to some x > xm will also lose a

party the election.

Therefore, (xm , xm ) is a Nash equilibrium.

Finding Nash Equilibria

Claim: the unique Nash equilibrium of this game is where

both parties choose the median voters ideal position, xm .

Proof:
First, we check that (xm , xm ) is a Nash equilibrium:
When both party choose xm , they split the votes in half, and

each obtains a payoff equal to 21 .

Given that its opponent chooses xm , any party deviating from

xm to some x < xm will only get the votes of those voters

whose ideal points fall in (, 21 (x + xm )] and hence lose the
election.
Similarly, deviating from xm to some x > xm will also lose a

party the election.

Therefore, (xm , xm ) is a Nash equilibrium.

Finding Nash Equilibria

Claim: the unique Nash equilibrium of this game is where

both parties choose the median voters ideal position, xm .

Proof:
First, we check that (xm , xm ) is a Nash equilibrium:
When both party choose xm , they split the votes in half, and

each obtains a payoff equal to 21 .

Given that its opponent chooses xm , any party deviating from

xm to some x < xm will only get the votes of those voters

whose ideal points fall in (, 21 (x + xm )] and hence lose the
election.
Similarly, deviating from xm to some x > xm will also lose a

party the election.

Therefore, (xm , xm ) is a Nash equilibrium.

Finding Nash Equilibria

Proof (continued):
Now consider any strategy profile where exactly one party

chooses xm .
Then that party will win the election with certainty. The
other party can increase their payoff from 0 to 21 by deviating
to xm .

Finding Nash Equilibria

Proof (continued):
Now consider any strategy profile where exactly one party

chooses xm .
Then that party will win the election with certainty. The
other party can increase their payoff from 0 to 21 by deviating
to xm .

Finding Nash Equilibria

Proof (continued):
Now suppose neither party chooses xm . Then either their

positions are equally distant from xm or not.

In the first case, either party can increase their payoff from
to 1 by moving slightly closer to xm .
In the second case, the party whose position is further from
xm can increase its payoff from 0 to 1 by deviating to a
position that is slightly closer to xm than its opponents
position.
Therefore, there are no other Nash equilibria.

1
2

Finding Nash Equilibria

Proof (continued):
Now suppose neither party chooses xm . Then either their

positions are equally distant from xm or not.

In the first case, either party can increase their payoff from
to 1 by moving slightly closer to xm .
In the second case, the party whose position is further from
xm can increase its payoff from 0 to 1 by deviating to a
position that is slightly closer to xm than its opponents
position.
Therefore, there are no other Nash equilibria.

1
2

Finding Nash Equilibria

Proof (continued):
Now suppose neither party chooses xm . Then either their

positions are equally distant from xm or not.

In the first case, either party can increase their payoff from
to 1 by moving slightly closer to xm .
In the second case, the party whose position is further from
xm can increase its payoff from 0 to 1 by deviating to a
position that is slightly closer to xm than its opponents
position.
Therefore, there are no other Nash equilibria.

1
2

Finding Nash Equilibria

Proof (continued):
Now suppose neither party chooses xm . Then either their

positions are equally distant from xm or not.

In the first case, either party can increase their payoff from
to 1 by moving slightly closer to xm .
In the second case, the party whose position is further from
xm can increase its payoff from 0 to 1 by deviating to a
position that is slightly closer to xm than its opponents
position.
Therefore, there are no other Nash equilibria.

1
2

Discussion

Thus, the logic of political competition forces both party to

adopt the same position, xm . Only then is neither party able

to increase its chances of winning.
Another way to look at this is that by adopting the position

xm , each party can guarantee that it does not lose the

election. That is, the parties are "maxminimizing."
If the opponent does the same thing, the "best" a player can

hope for is also just "not losing".

This is what we call a zero-sum game. And in such games,

the players always play maxminimizing strategies in any Nash

equilibrium.

1 Review the Key Concepts

2 Cournot Oligopolistic Competition

3 Bertrand Oligopolistic Competition

4 Hotellings Model of Electoral Competition

5 Auctions

Auctions

An auction is a mechanism for selling goods.

Most commonly, potential buyers submit bids and the goods

are sold to the highest bidder.

However, the details of the rules involved can vary from

auctions to auctions. Different rules often result in very

different consequences in terms of revenue raised and
allocation efficiency.
We are going to look at two types of auctions: second price

(sealed bid) auctions and first price (sealed bid) auctions.

Second Price Auctions

In a second price (sealed bid) auction, also known as a

Vickrey auction, prospective buyers each submit a bid for a

single good.
The highest bidder obtains the good and pays the highest

among her opponents bids (hence the term "second price").

The Game

Let there be n 2 players. Player i values the good at vi .

Assume that all players valuations are different and are

ordered such that v1 > v2 > . . . > vn .

Each player i chooses a bid, bi R+ (i.e., any non-negative

real number).
The payoffs to player i is vi max{bj }j6=i if her bid is among

the highest and she obtains the good and 0 otherwise.

When there are multiple bidders offering the highest bid, the

good is given to the player among these bidders who has the
highest valuation.

Nash Equilibria

There are many Nash equilibria of this game.

First, consider the action profile where bi = vi for all i .
This is a Nash equilibrium. Why?
In this equilibrium, player 1 gets the good and pays v2 .

Nash Equilibria

Another equilibrium is where b1 = v1 and bi = 0 for all i 6= 1.

Why?
Here player 1 also gets the good, but pays 0.

Nash Equilibria

There are also Nash equilibria in which player 1 (who values

the good most) doesnt get the good.

Can you think of one?

Nash Equilibria

There are also Nash equilibria in which player 1 (who values

the good most) doesnt get the good.

Can you think of one?
What about (0, v1 , 0, . . . , 0)?

Nash Equilibria

There are also Nash equilibria in which player 1 (who values

the good most) doesnt get the good.

Can you think of one?
What about (0, v1 , 0, . . . , 0)? And (0, 0, . . . , 0, v1 )?

Nash Equilibria

There are also Nash equilibria in which player 1 (who values

the good most) doesnt get the good.

Can you think of one?
What about (0, v1 , 0, . . . , 0)? And (0, 0, . . . , 0, v1 )?
Do you find such Nash equilibria reasonable?

Nash Equilibria

The issue here is that Nash equilibrium permits weakly

dominated actions.
recall that strictly dominated actions can never be a part of

any Nash equilibrium.

For example, in (0, v1 , 0, . . . , 0), some players are playing

weakly dominated strategies. Who?

Nash Equilibria

The issue here is that Nash equilibrium permits players play

weakly dominated actions.

recall that strictly dominated actions can never be a part of

any Nash equilibrium.

For example, in (0, v1 , 0, . . . , 0), some players are playing

weakly dominated strategies. Who?

Everyone! Why?

Nash Equilibria

The unique weakly undominated action for player i is bi = vi .

Any bi lower than vi is (weakly) dominated, since there are

action profiles of i s opponents where the highest bid

amongst them is strictly lower than vi but strictly higher
than bi .
Any bi higher than vi is dominated, since there are action

profiles of i s opponents where the highest bed amongst

them is strictly higher than vi but strictly lower than bi .
bi = vi for all i is the unique Nash equilibrium where all

players play weakly undominated actions.

First Price Auctions

In a first price (sealed bid) auction, the players each submit a

bid.
The winner is still the one with the highest bid.
However, the winner now has to pay her own bid.
When there are ties, the good goes to the player amongst the

highest bidders who has the highest valuation for the good.

Nash Equilibria

There are again many Nash equilibria of this game.

For example, (v2 , v2 , v3 , . . . , vn ) is a Nash equilibrium.
Why?

Nash Equilibria

Claim: In any Nash equilibria, the good goes to player 1

(who, recall, has the highest valuation of the good).

Proof:

Nash Equilibria

Claim: In any Nash equilibria, the good goes to player 1

(who, recall, has the highest valuation of the good).

Proof: Suppose there is an equilibrium in which the winner is

some other bidder i 6= 1.

It must be the case that the winners bid is no higher than v2 .
But then player 1 can deviate to bidding bi and get a payoff

v1 bi , which is strictly higher than 0, the payoff she gets

should she lose the bid.

Nash Equilibria

Claim: In any Nash equilibria, the good goes to player 1

(who, recall, has the highest valuation of the good).

Proof: Suppose there is an equilibrium in which the winner is

some other bidder i 6= 1.

It must be the case that the winners bid is no higher than v2 .
But then player 1 can deviate to bidding bi and get a payoff

v1 bi , which is strictly higher than 0, the payoff she gets

should she lose the bid.

Nash Equilibria

Claim: In any Nash equilibria, the good goes to player 1

(who, recall, has the highest valuation of the good).

Proof: Suppose there is an equilibrium in which the winner is

some other bidder i 6= 1.

It must be the case that the winners bid is no higher than v2 .
But then player 1 can deviate to bidding bi and get a payoff

v1 bi , which is strictly higher than 0, the payoff she gets

should she lose the bid.

Nash Equilibria

Claim: In any Nash equilibrium, the highest two bids must be

equal and must be between v1 and v2 .

Proof:

Nash Equilibria

Claim: In any Nash equilibrium, the two highest bids must be

equal and must be between v1 and v2 .

Proof:
If the two highest bids are not equal, then the winning player

can strictly increase her payoff by lowering her bid slightly.

We already proved that player 1 must be the winner. So

player 1 must be one of the highest bidders. But player one

cannot bid anything higher than v1 in equilibrium, for he
would be receiving a negative payoff.
Also, the highest bid cannot be lower than v2 , because, if it

were the case, player 2 can bid slightly higher than the
highest bids and receive a positive payoff.

Nash Equilibria

Claim: In any Nash equilibrium, the two highest bids must be

equal and must be between v1 and v2 .

Proof:
If the two highest bids are not equal, then the winning player

can strictly increase her payoff by lowering her bid slightly.

We already proved that player 1 must be the winner. So

player 1 must be one of the highest bidders. But player one

cannot bid anything higher than v1 in equilibrium, for he
would be receiving a negative payoff.
Also, the highest bid cannot be lower than v2 , because, if it

were the case, player 2 can bid slightly higher than the
highest bids and receive a positive payoff.

Nash Equilibria

Claim: In any Nash equilibrium, the two highest bids must be

equal and must be between v1 and v2 .

Proof:
If the two highest bids are not equal, then the winning player

can strictly increase her payoff by lowering her bid slightly.

We already proved that player 1 must be the winner. So

player 1 must be one of the highest bidders. But player one

cannot bid anything higher than v1 in equilibrium, for he
would be receiving a negative payoff.
Also, the highest bid cannot be lower than v2 , because, if it

were the case, player 2 can bid slightly higher than the
highest bids and receive a positive payoff.