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Nash Equilibrium

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
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?

Lets solve one by one:

Consider the first situation. The whole deal can be represented by the
following matrix, known as the Pay-off Matrix.

The dilemma here is that, either of Ricks or Johns fate is wholly

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?

The following is how a Game Theorist, would analyse the situation:

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
If John Confess Rick is better-off confessing than remaining
silent (the first column of the Matrix, 3 years is better than 4 years
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
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.

This gives a vague idea of the Nash Equilibrium.

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:

It is a stable state of a system that involves several interacting

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