Economics

for Managers

GAME
THEORY:
NASH
EQUILIBRIUM

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 Topics

• solution
concept #2:
Nash
equilibrium

"John F. Nash, Jr. - Photo Gallery". Nobelprize.org.

http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1994/nash-photo.html
Picture dated 2/23/2001

Recall the game that we developed for

advertising dishwasher detergent
Solution concept #1 is to predict a STRICTLY DOMINANT strategy….if
one exists. The basis for selecting a strictly dominant strategy for a
player is that it offers a strictly better payoff for that player than any
other choice they have, regardless of what other players do.
Strictly
dominant
Firm B strategy
no ads ads for B

no ads 50, 50 20, 60

Firm A prediction

Strictly
dominant
ads 60, 20 30, 30
strategy
for A

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 Not all Games have Strictly Dominant
Strategies for All Players
A & B are competitors. Each chooses their price to be LO, MED, or HI,
and profits (payoffs in the table) are based on the pair of prices chosen.
B’s Pricing Strategies

LO MED HI

LO 6, 6 8, 5 10, 4
A’s Pricing
Strategies
MED 5, 8 9, 9 11, 7

HI 4, 10 7, 11 10, 10

A’s optimal price varies based on B’s pricing choice. Same for B. So, neither
has a strictly dominant pricing strategy. Instead, the choice for each will be
influenced by their “beliefs” about what the other will do. Is there a solution
concept that we can use to predict outcome of these kinds of games??

Nash Equilibrium
A Nash equilibrium is a set of strategies, one for each player, with the property that
each player’s strategy is a best response to what is proposed for the other players.

Firm B
B’s Pricing Strategies
No
Ads
Ads LO MED HI
A’s Pricing Strategies

No
50,50 20,60
Firm A

Ads LO 6,6 9,5 10,4

Ads 60,20 30,30
MED 5,9 8,8 11,7

If B does NO ADS HI 4,10 7,11 10,10

If B does ADS
If A does NO ADS
If A does ADS
Neither A nor B has a strictly
Two checks  (Ads, Ads) is NE
dominant strategy.
In this example, strictly dominant strategies (SDS)
and the NE identify the same strategies. In
general, if each player has a SDS, then it is a NE But there is a Nash Equilibrium:
for each player to play their SDS. But what if one
or more players do not have SDS? Nash proved
that there still exists a NE.

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 Nash Equilibrium
The Nash equilibrium is a set of strategies, one for each
player, with the property that each player’s strategy is a
best response to what is proposed for the other players.

B’s Pricing Strategies B’s Pricing Strategies

LO MED HI LO MED HI

A’s Pricing Strategies

A’s Pricing Strategies

LO 6,6 9,5 10,4 LO 6,6 9,5 10,4

MED 5,9 8,8 11,7 MED 5,9 8,8 11,7

HI 4,10 7,11 10,10 HI 4,10 7,11 12,12

Nash Equilibrium Nash Equilibria

- (LO,LO) for (6,6) payoff - (LO,LO) for (6,6) payoff
- (HI,HI) for (12,12) payoff

Example 6: Location Game

(Pindyck and Rubinfeld, 2009) 100 sunbathers at the beach. Vendors A and B sell the same
soda at same price. Sunbathers choose the closer vendor. Where will the vendors locate?
Let’s consider the following locations for the vendors.

20 20 20 40

These locations mean 40 sales for A and 60 for B. Is this pair of locations a NE?
No, consider A. Given B’s location, A prefers to relocate just to the left of B, which
means 60 sales for A and 40 for B.
60 40

Is this a NE? No, B would relocate just to the left of A for a payoff of 60, leaving 40 for A.
60 40

Is this a NE? No, A prefers to relocate just to left of B for a payoff of 59, leaving 41 for B.
SO, WHAT IS THE NASH EQUILIBRIUM TO THE LOCATION GAME?

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 Example 6: Location Game
The NE has A positioned at customer 50 and B positioned at customer 51, so that A sells to
the 50 customers numbered 1 to 50 and B sells to the 50 customers numbered 51 to 100.
This is a NE because, from this position, neither vendor has an incentive to relocate.

50 50

The NE of this game provides insights into why gas stations are often positioned next to each
other. It also offer an explanation for why political candidates move to the political center.

Finally, notice that the average sunbather is not well served by this NE. Think about
customers #1, #2, …., #50 who buy from vendor A. Customer #1 travels a distance of 49 to
get to A, customer #2 travels a distance of 48, and customer #N travels a distance of 50-N. It
is the same for vendor B’s customers. The average distance travelled by the 100 sunbathers
is about 25.

Suppose instead that A was positioned at 25 and B was positioned at 75. Then A would still
have sunbathers 1-50 and B would have 51-100. But the average distance travelled by the
100 sunbathers would be only 12½. This pair of locations is not a NE, though.

Summary
• NE is a pair of strategies with the property that the
strategy for each player is a best response to what is
proposed for the other player, i.e., the strategies are
mutual best responses.
• Sometimes the NE is viewed positively by all, but not
always. For example, the NE of a Prisoner’s Dilemma
game is strictly worse for both parties than a feasible
alternative.
• And in our Location Game, customers were not well
served by the NE
• Despite these issues, we should be cautious
predicting an outcome that is not a NE, because then
we’re predicting one or both parties to do something
that is not actually in their best interest.

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Resolving the Prisoners’ Dilemma
1) Repeated Interaction

Retailer B
high price low

high price 5, 5 -2, 7

Retailer A
low 7, -2 0, 0

Resolving the Prisoners’ Dilemma

2) Change the Game
Suppose Retailer A makes the following promise: “If, after your
purchase, you find the same model available for sale for less, we
will refund the difference.” Suppose that Retailer B makes a similar
promise. (This is a meet-the-competition clause.)

Retailer B
high price low

high price 5, 5 -2, 7

Retailer A
low 7, -2 0, 0

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 Meet-the-Competition Clause
EXAMPLES:

OfficeMax: “Find a lower price at another online

retailer? We'll match it”

“VillageHatShop.com WILL NOT BE UNDERSOLD.

When comparing the same hat or cap by the same
manufacturer or the same quality, we will match
any advertised on-line price.”

Used for computers, automobile service, interest

rates for loans, etc.

Meet-the-Competition Clause

Justifications for their use

Firm can deter price cutting by competitors,

because cutting one’s price only lowers the
price offered by others

Firm can price discriminate by charging a

high price to uninformed buyers and a low
price to informed buyers

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Resolving the Prisoner’s Dilemma: Tying One’s Hands
Recall advertising game with NE of (ads, ads) and NE payoff of (30,30)
What happens with an industry ban on advertising?
This happened with cigarette advertising in the 1960s, and there is
some evidence that it improved industry profits….at least for awhile.
So everyone “tying one’s hands” sometimes helps!

Firm B
no ads ads

no ads 50, 50 20, 60

Firm A NE outcome

ads 60, 20 30, 30

Example 7: Matching Fingers

(see Gibbons, 1997)

Player 2
1 finger 2 fingers

1 finger -1, 1 1, -1
Player 1
2 fingers 1, -1 -1, 1

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 GAME
THEORY:
Sequential
Games

Topics
• solution concept #3:
Subgame Perfect Nash
equilibrium, a
refinement of the Nash
equilibrium for
sequential games,
developed by Reinhard
Selten, co-winner of
1994 Nobel Prize in
By Tohma (talk) - Own work, GFDL,
Economics.
https://commons.wikimedia.org/w/index.php?curid=1277868

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 SEQUENTIAL GAME of MARKET ENTRY
POTENTIAL ENTRANT Incumbent, Entrant
Don’t Enter Stay out
prepare & 100,20
share if
100,20 200,0
there’s entry Incumbent
INCUMBENT
Invest in
70,-10 130,0
capacity &
start a price
70,-10
war in there’s Potential
200,0
entry Entrant
Strategic Form Game with NE
of (share, enter) for (100,20) Incumbent
130,0
The Sequential Game is explicit
about the sequence of Incumbent, Entrant
decisions, which leads to two 100,20
versions of the Sequential Game Potential
Entrant
Our approach to solving
sequential games is Backward 200,0
Induction: start at the end of the 70,-10
game and work to the front
solving for rational choices Incumbent
(based on an assumption of Potential
subsequent rational choices). Entrant 130,0

SEQUENTIAL GAME of MARKET ENTRY

“Solution” or “Prediction” in Incumbent, Entrant
Version 1 of the game is:
PE enters and I shares, for a 100,20
payoff of (100,20).
Incumbent
“Solution” or “Prediction” in
Version 2 is:
I chooses invest & price war if 70,-10
PE enters and PE chooses stay Potential 200,0
out,
for a payoff of (130,0). Entrant

In Version 1, I moves 2nd, so when Incumbent

PE is deciding what to do, I can only
threaten to invest in capacity &
130,0
engage in a price war if PE enters.
Incumbent, Entrant
Notice, however, that once PE’s
decision has been made, I does not 100,20
want to carry out this threat. This
makes the threat “not credible.” Potential Entrant
Version 2, however, lets I credibly
commit to invest in capacity to
prepare for a price war if PE enters 200,0
by having I actually add capacity 70,-10
ahead of PE’s decision and because, Incumbent
once I has that capacity and if PE
enters, I is more profitable with a
price war than accommodating. This Potential
is what deters PE from entering in Entrant 130,0
Version 2.

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 Entry-Deterrence Strategies
“Excess”: extra level chosen because of the threat of entry.

Survey of almost 300 firms on their entry-deterrence

strategies:

- Excess capacity “frequently” used by 22% of firms for

new products and 21% of firms for existing products.

- Excess advertising “frequently” used by 62% for new

products and 52% for existing products

- Limit pricing “frequently” used by 8% for new products

and 21% for existing products. (see Southwest Airline
example in text)

Backward Induction Solution is SUBGAME PERFECT NASH EQUILIBRIUM

A, B
10, 12
A
5, 18
B
5, 13
A
7, 14

There are 3 ways to 7, 14

ask and answer
about the A
A
equilibrium of this 15, 2
B
game.
6, 5
Version 1 A

Q: What is the 5, 6
equilibrium payoff? 20, 2
A: A

18, 20

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Backward Induction Solution is SUBGAME PERFECT NASH EQUILIBRIUM
A, B
A chooses IN, for a 10, 12
payoff of 10
B chooses RIGHT, A
for a payoff of 14

10,12 5, 18
B
5, 13
A chooses UP, for a
7,14
payoff of 7 A
A chooses OUT, for a
payoff of 7 7,14 7, 14
There are 3 ways to 7, 14
A chooses OUT, for a
ask & answer about payoff of 15
the equilibrium of A
A
this game. 7,14 15, 2
B 15,2
Version 2 6, 5
6,5
B chooses MIDDLE, A
Q: What is the for a payoff of 5
equilibrium path? 6,5 5, 6
A chooses IN, for a
payoff of 6
20, 2
A: A goes UP, B A
goes RIGHT, and A
goes OUT A chooses IN, for a
payoff of 20
20,2 18, 20

Backward Induction Solution is SUBGAME PERFECT NASH EQUILIBRIUM

A, B
A chooses IN, for a 10, 12
payoff of 10
B chooses RIGHT, A
for a payoff of 14

10,12 5, 18
A chooses UP, for a
B
payoff of 7
5, 13
Version 3 7,14
A

Q: What is the
A chooses OUT, for a
7,14
7, 14
payoff of 7
SPNE?
A chooses OUT, for a
7, 14
A: - A chooses UP payoff of 15
A
- B chooses RIGHT A 7,14
if A chose UP and 15, 2
B 15,2
MIDDLE if A chose 6, 5
DOWN. 6,5
- A chooses IN if A & B for
chooses MIDDLE, A
a payoff of 5
B chose UP & LEFT, 5, 6
6,5
OUT if A & B chose
A chooses IN, for a
UP & RIGHT, OUT if payoff of 6
20, 2
A & B chose DOWN A
& LEFT, and IN A chooses IN, for a
otherwise. payoff of 20
20,2 18, 20

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 SEQUENTIAL GAME of MARKET ENTRY
AMAZON, APPLE
-0.5, 0.8

APPLE

0.5, 0.6
AMAZON

0, 1.2
APPLE

-0.5, 0.8
APPLE

0.5, 1.0

AMAZON
0, 2

Source: Goolsbee, Levitt, Syverson, 2013

What you should be able to do after this section

on Game Theory and Sequential Games

- Set up a sequential game to capture

the sequencing of decisions in a game

- Apply backward induction to solve for

the subgame perfect Nash equilibrium
of a sequential game

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