Intermediate Microeconomics Instructor: Selcuk Ozyurt Short Notes on Game Theory Pure Strategy Nash Equilibrium Finding a Nash

Equilibrium (NE) is, most of the time, nothing but employing the Guess and Verify method. So, how does this method really work? Lets assume that we consider a game G =< N, Si , ui >iN where #N 2. You rst choose a strategy prole s = (s1 , ...sN ); one strategy for each player. The strategy prole s is NE if, and only if it passes the following test: (1) Start from player 1. Fix the strategy of all other players (player 2,3,...N). Consider the player 1s payo function u1 (.). If there is another strategy s1 of player 1 where u1 (s1 , s2 , ..sN ) > u1 (s1 , s2 , ..sN ) = u1 (s) ((1)) then, this means that strategy prole s is not NE because player 1 will nd optimal to deviate to another strategy s1 as long as others play their strategies s2 , ..sN as suggested by the strategy prole s. If so, s is not NE. You should choose another strategy prole and start the procedure again. On the other hand, if there is no strategy of player 1 that satises inequality (1), then s passes the rst test. But we are not done yet, you should go to the second test. (2) Fix the strategy of all other players 1,3,...N and consider this time player 2s payo function u2 (.). If there is another strategy s2 of player 2 where u2 (s1 , s2 , s3 , ..sN ) > u2 (s1 , s2 , ..sN ) = u1 (s) ((2))

then, this means strategy prole s is not NE, because player 2 will nd optimal to deviate to the strategy s2 as long as her opponents play their strategies s1 , s3 , ..., sN as suggested in strategy prole s. If so, s is not NE. You should choose another strategy prole and start the procedure from test (1) again. If there is no strategy of player 2 that satises inequality (2), then s passes the second test. If we have only two players, and the strategy prole s passes test 1 and 2, then we call s Nash Equilibrium strategy prole. If, however, there are more than two players, we should repeat this test for the rest of the N 2 players as well.

Mixed Strategy Nash Equilibrium: 1

Suppose that we want to nd the mixed strategy Nash Equilibrium of the following game: L R U 3,2 1,1 D 1,1 2,3 First note that this game has two pure strategy Nash equilibria: (U, L) and (D, R) with the corresponding payo vectors (3, 2) and (2, 3). There is also one mixed strategy NE, and we nd it as follows: First assume that player 2 plays L with probability p and plays R with probability 1 p. L(p) 3,2 1,1 R(1 p) 1,1 2,3

U D

Then, we nd player 1s expected utility by playing U and playing D. So, EUU = 3p + 1(1 p)

EUD = 1p + 2(1 p) Then, we nd the value of p that makes player 1 indierent between playing U and D, i.e., we nd p that solves EUU = EUD which implies that 3p + 1(1 p) = 1p + 2(1 p) and so p = 1/3 Therefore, if player 2 plays L with probability 1/3 and plays R with probability 2/3, then player 1 is just indierent between playing U and D. We, now, do the same for player 1. That is, assume that player 1 plays U with probability q and plays D with probability 1 q; L 3,2 1,1 R 1,1 2,3

U (q) D(1 q)

and we nd 2nd players expected value of playing L and R; EUL = 2q + 1(1 q) EUR = 1q + 3(1 q) We then nd the value of q that makes player 2 indierent between playing L and R, i.e., we nd q that solves EUL = EUR which implies that 2q + 1(1 q) = 1p + 3(1 q) and so q = 2/3 Therefore, if player 1 plays U with probability 2/3 and plays D with probability 1/3, then player 2 is just indierent between playing L and R. Well, its time to combine our ndings: We know that if player 1 randomize between U and D with probabilities 2/3 and 1/3 respectively, then player 2 is indierent between playing L and R (that is whatever action player 2 takes, his expected payo will not change), similarly if player 2 randomize between L and R with probabilities 1/3 and 2/3 respectively, then player 1 is indierent between playing U and D (that is whatever action player 1 takes, his expected payo will not change). Therefore the following strategy prole (( 2/3 , 1/3), ( 1/3 , 2/3)) is a Nash
player 1 plays U player 2 plays L

Equilibrium.

Cournot Competition: Suppose there are two rms, rm 1 and rm 2, facing with the same inverse demand function p = a bQ where Q is the total quantity produced by rm 1 and rm 2 and p is the market price (so both rms produce exactly the same output and they have to sell it exactly the same price). Also assume that the marginal cost of rm 1 is c1 and marginal cost of rm 2 is c2 . Then what is the NE output level that each rm will choose? In this game, there are two rms, each rms strategy consist of choosing a positive quantity q 1 , q2 [0, ), and the payos of the rms are the prot functions 1 (q1 , q2 ) and 2 (q1 , q2 ). So, to nd the NE output, we rst need to nd the reaction functions (or best response functions) of each rm: 3

Firm 1s problem is maximize 1 (q1 , q2 ) by choosing q1 : We know that 1 (q1 , q2 ) = (a b(q1 + q2 ))q1 q1 c1 to nd the value of q1 that maximize this function we need to solve 1 =0 q1 or equivalently, a 2bq1 bq2 c1 = 0 implies that q1 = a bq2 c1 2b

(1)

we call the last equation as best reply function of rm 1: It gives the prot maximizing output level that rm 1 must choose for any given level of quantity rm 2 produces. Similarly, Firm 2s problem is maximize 2 (q1 , q2 ) by choosing q2 : We know that 2 (q1 , q2 ) = (a b(q1 + q2 ))q2 q2 c2 to nd the value of q2 that maximize this function we need to solve 2 =0 q2 or equivalently, a bq1 2bq2 c2 = 0 implies that q2 = a bq1 c2 2b

(2)

To nd the NE q1 and q2 we solve these two equations simultaneously, i.e., plug equation 1 into equation 2 or vice versa: q2 = = implies that 4bq2 = 2a a + bq2 + c1 2c2 a bq1 c2 2b a b abq2 c1 c2 2b 2b

Therefore, q2 =

a + c1 2c2 3b

If you plug back this value into equation 1 then you get q1 = a + c2 2c1 3b

Hence, the quantities (q1 , q2 ) = ( a+c2 2c1 , a+c1 2c2 ) is the Nash equilibrium of 3b 3b the Cournot game.