An introductory article to Nash Equilibrium

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An introductory article to Nash Equilibrium

© All Rights Reserved

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ECONOMISTS can usually explain the past and predict the future but not

without any help. One of the effective tools, they use is Nash Equilibrium.

Named after the celebrated mathematician John Nash, who received the Nobel

Prize in Economics in 1994, for this discovery. This simple concept helps the

economists to work out how competing companies set their prices, foreign

policies adopted by the Govt. of a country and how to explain the sometimes

self-defeating decisions that groups make.

Before stating, what Nash Equilibrium actually is, let me put

forward in front of you, two situations where it becomes hard to take any

decisions.

Situation I: The following illustration is known as Prisoners Dilemma.

Two suspects, say, Rick and John, were arrested separately for selling drugs.

They were selling drugs completely independent of each other, neither of them

having any clue of the other one. This is an open and shut case, since they were

caught red-handed and will have to serve a term of 1 year in Jail. But then the

inspector had a hunch that they might be involved in a major crime that happened

a week ago. But, he has no evidence to convict them of the crime unless either of

them speaks out. So what he does is put forward a deal in front of each of them

separately. The deal goes like this:

(i) If neither of you confess, then you both will serve a jail

term of 1 year each.

(ii) If you confess but the other doesnt, then you will be freed

and used as an evidence and the other guy will serve a jail

term of 4 years.

(iii) If the other guy confesses, but you dont, then you will get

a jail term of 4 years and the other one will be freed.

(iv) If both of you confess then both of you will serve a term of

3 years each.

Now, here lies the problem. What will be the most rational decision taken by

Rick and John?

Situation II: The second situation is on what will be the price fixed by a

company, for a particular commodity. Suppose, we consider that there

exists only two companies in the whole market, say, ASUS and hp, for a

particular commodity, say, Laptops, where the commodities are identical in

all respects. Let there be 100 customers in the market who will buy the

laptops and each one of them will not buy more than one laptop. Now, there

are two options for each company. Either they will keep the price to Rs.45K

for each laptop or Rs.50K for each laptop. So, what will be the most

profitable price set by each of the companies?

Consider the first situation. The whole deal can be represented by the

following matrix, known as the Pay-off Matrix.

dependent on the behaviour of the other. To avoid the cruel sentence of 4

years, what would be ones safest decision, to confess and hope to go free

or remain silent with the hope that the other person doesnt snitch on him?

o From Ricks perspective:

Rick has two options, a) Confess or b) Remain Silent.

Lets see how these two decisions impact Ricks sentence based on Johns

decision.

If John Confess Rick is better-off confessing than remaining

silent (the first column of the Matrix, 3 years is better than 4 years

sentencing).

If John Remains Silent Rick is better-off confessing than

remaining silent (the second column of the Matrix, going free/0 years is

better than 1 year sentencing).

As a result, Rick will always confess, since in both the cases the pay-off

from confessing is higher than remaining silent.

o From Johns perspective:

Similarly, by the same logic. John has two options, a)

Confess or b) Remain Silent and his sentencing is dependent upon Ricks

decision.

If Rick Confess John is better off confessing than

remaining silent (the first row, 3 years is better than 4 years sentencing).

If Rick Remains Silent John is better off confessing again,

than remaining silent (the second row, going free/0 years is better than 1

year sentencing).

As a result, John will always confess, since in both the cases the pay-off

from confessing is higher than remaining silent.

Thus both Rick and John will always confess and accept a jail sentence

of 3 years each.

When both of them pursues their self-interest, they both end up worse off

than they would have been had they acted otherwise or co-operated with

each other. This is called Nash Equilibrium.

Adam Smith said: Best result comes when everyone in the group is doing what

is best for himself.

But this is incomplete, because the best result comes from everyone in the group

doing whats best for himself and for the group.

~From the film A Beautiful Mind, biopic of John Nash.

Let us consider this Prisoners Dilemma. Had they followed Adam Smiths

theory that is they took the decision on the basis of their self-interest, then

obviously either of them would have preferred to remain silent, and if by the

chance the other guy confessed then he would have to serve a Jail term of 4

years, which was the worst case. So, instead they followed what Nash said and

did what was best for themselves and for the group, i.e. to confess.

Now lets state the Nash Equilibrium more formally:

participants, in which no participant can gain by a change of strategy

as long as all other participants remain unchanged.

Now let us again go back to the Prisoners Dilemma and examine whether it

reached a Nash Equilibrium or not.

Consider the pay-off matrix. The top left box denoted the rational decision taken

by the prisoners.

Now, is it a Nash Equilibrium point?

Let us examine:

Nash Equilibrium states that, at that equilibrium point none of the participants

will be able to gain if they change their strategy if the other participants keep

their strategy unchanged. This is the exactly the case here. Suppose Rick wants to

change his strategy from confessing to keeping quiet, while Johns strategy of

confessing remains unchanged. Then the outcome point shifts down to the bottom

left box, where Rick will have to serve 4 years of jail and John gets freed. So

Rick didnt gain anything by changing his strategy, (4 years sentence is far worse

than 3 years jail). Similarly, if John changes his strategy the outcome point shifts

to the top right corner, where John serves a term of 4 years and Rick gets freed.

So John gain anything too, by changing his strategy. So both of them confessing

is a Nash Equilibrium point.

But does there exists any more Nash Equilibrium points?

Lets see:

Let us consider the bottom right box where both of them keeps quiet. Now this be

the outcome point. But is this a Nash Equilibrium point?

If John wants to change his strategy from keeping quiet to confess, while Ricks

strategy of keeping quiet remains unchanged, then the outcome point moves to

bottom left corner where he (John), gets freed but Rick serves a term of 4 years.

Hence, John gains (from one year jail to getting freed) by changing his strategy,

hence violating the condition for Nash Equilibrium. Hence it is not a Nash

Equilibrium point. Similar is the case for Rick.

So we discussed whatever was possible to discuss about the first situation.

Now its time for the 2nd situation.

The 2nd situation can be framed as follows:

(i) If both ASUS and hp fix the price of laptops at Rs.45k, then they will

equally share the customers, 50 each. So each of them will make an

income of Rs.2,250k each.

(ii) If ASUS keeps the price at 45k but hp increases the price to 50k, then

no one will buy laptops from hp (who will pay Rs.5k extra for the same

commodity!). So ASUS will have all the 100 customers, making an

income of Rs.4,500k.

(iii) If the opposite happens, hp keeps the price at Rs.45k but ASUS

increases it to Rs.50k, then, by the similar argument hp will have all the

100 customers making an income of Rs.4,500k.

(iv) If both of them fix the price at Rs.50k, then they will again share the

whole market equally, getting 50 customers each. Hence making an

income of Rs.2,500k each.

The 1st outcome gives the Nash Equilibrium point. The explanation is left as an

exercise to the readers. Draw the necessary pay-off matrix and proceed as before.

*****************

Promit Kanti Chaudhuri

MTMA, 2nd Year

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