Game Theory

For Topics in Microeconomics Course


Game theory models strategic behavior by
agents who understand that their actions affect
the actions of other agents.
This is called Strategic Interdependence.

In a game theoretic model there must be at least

two agents who are Strategically Interdependent
 
A game consists of
a set of players
a set of strategies for each player
the payoffs to each player for every possible
list of strategy choices by the players.
Examples
 The study of oligopolies (industries containing only a few
firms)
 The study of cartels; e.g. OPEC
 The study of externalities; e.g. using a common resource
such as a fishery; Problems of Commons
 The study of military strategies. Choice of Defense
Strategies by Nations
Types of Games
 Static Games of Complete Information
 Dynamic Games of Complete Information
 Static Games of incomplete Information (Bayesian games)
 Dynamic Games of Incomplete Information
 The static games usually implies Simultaneous move
games:
 Game in which each player makes decisions without
knowledge of the other players’ decisions (ex. Cournot
or Bertrand Oligopoly).

Alternatively, Dynamic Games implies:Sequential Move

Game – Game in which one player makes a move after
observing the other player’s move (ex. Stackelberg
Oligopoly).
Static games of Complete Information
 It is also called one shot games where a set of players
independently choose once and for all actions which in
turn will cause the realisation of an outcome. One player
does not know what others have chosen while taking his
action: That is why it is simultaneous move game.
 Conditional upon players choice of action, payoff are
distributed to each players.
 These two elements define the Static part.
 What is complete Information?
Complete Information
 Following four components must be common knowledge
 1. All the Possible actions of all Players
 2. all possible outcomes
 3. How each combinations of action of all players affects
which outcome will materialise
 4. The preference of each and every players over
outcomes

But what is Common Knowledge?

Common Knowledge
 An Event E is common knowledge if
 1 Everyone knows E
 2. Everyone knows that everyone knows E and so on.
 Example: today weather is cloudy: it is knows by me as well
as by all of you. I know that you also know this.
 But consider the case:
 I introduce game theory in this class. I know that I have done
this, but I do not know whether you have followed me or
not. X may have followed but Y may not.
 So to me it is not a common knowledge.
Normal Form Games with pure Strategies
 Normal Form Game – A representation of a game indicating
the number of players, their possible strategies ( Action set),
and the payoffs resulting from alternative strategies.

 Strategy – In game theory, a decision rule that describes the

actions a player will take at each decision point. It is basically
a Plan of action, intended to accomplish a specific goal.
 Suppose, Mr X is interviewing a Politician. The politician
must have a plan of action like if X asks me Q1, I will Answer
A1.
 If asks Q2 I will answer A2 and so on
What is pure strategy
 A pure strategy for player I is a deterministic plan of
action. The set of all pure strategies for player i is
denoted by 𝑆𝑖 . A profile of pure stategies 𝑠 = (𝑠1 ,
𝑠2 , … … … … 𝑠𝑁 ), 𝑠𝑖 ∈ 𝑆𝑖 for all i= 1,2, N describes a
particular set of pure strategies.

 Why “pure”
 It is deterministic set. No probabilities are attached or
randomisation is done.
The normal form
 1. The finite set of players, N={ 1,2, ,n}
 2. A collection of set of pure strategies, (𝑆1 ,
𝑆2 , … … … … 𝑆𝑛 )
 3. A set of payoff function
{𝑢1 , 𝑢2 , … … … … 𝑢𝑁 )
 each assuming a payoff value to each combination of
chosen strategies.
 Examples

 Prisoner's dilemma
 Two prisoners. They are being question by the police in
different rooms. Each can confess or not
Prisoner B

Prisoner A Not Confess
Confess
Not -1,-1 -9,0
Confess
Confess 0,-9 -6,-6
 Rock-Paper- scissor

Children Play with Three Strategies:

Player B
Rock Paper Scissor

Player A Rock 0,0 -1,1 1,-1

Paper 1,-1 0,0 -1,1
Scissor -1,1 1,-1 0,0
 Classical Games: Matching Pennies
 2 Head Tail
1
1, -1 -1, 1
H
Head

T -1, 1 1, -1
TailT

Zero-sum game: sum of payoffs in each cell is zero

 Classic Game: Coordination: Stag Hunt game
Player B

 2
Stag Hare
1
2, 2 0, 1
A
Stag
Player A
B 1, 0 0, 0
Hare

Coordination: want to use the same strategy, (A, A) or (B, B)

Example: traffic rules
Car Game
 Two cars are meeting at an
intersection and want to proceed
as indicated by the arrows in .
 Each player can proceed or move.
If both proceed, there is an
accident. A would have a payoff of
-100 in this case, and B a payoff of
-1000 (since B would be made B
Proceed Move
responsible for the accident, since
A has the right of way).
Proceed -100,-1000 5, -5
 If one yields and the other A
proceeds, the one yielding has a Move -5, 5 -10, -10
payoff of -5, and the other one of
5. If both yield, it takes a little
longer until they can proceed, so
both have a payoff of -10.
 Classic Game: Pareto Coordination
2 A A B B
1
 2, 2 0, 0
A

0, 0 1, 1
B

Coordination: want to select the same strategy;

Prefer to coordinate on A rather than on B.
 Classic Game: Battle of the Sexes
2 OperaPlayer B Movie
1
 Opera Movie
Player A

ovie Opera 2, 1 0, 0

Movie 0, 0 1, 2

Coordination game: want to go to an event together,

with slightly different preferences
 Classic Game: Hawk-Dove/Chicken
2 D
1 H
 0, 0 3, 1
HH

D 1, 3 2, 2
D

Coordination game: want to take different strategies

 Classic Game: Pigs
A pair of pigs, one dominant and one submissive, are in a box and have a chance to be rewarded

with food.
At one end of the box is a lever which releases food when pressed.
The twist is the food is released at the other end of the box. The pig that presses the lever is at a
disadvantage as the other pig can get to the food first.
If the dominant pig presses the lever, the submissive pig can eat 80 percent of the food before the
dominant pig can arrive and take the rest. If the submissive pig presses the lever, then the dominant
pig can take all the food as the submissive pig races across the box. If neither pig presses the lever,
then neither pig gets any food. And if both are adjacent when the lever is pressed, the dominant pig
can eat 70 percent of the food.
Suppose the food is worth 10 units, it takes 1 unit of energy to press the lever and rush to the
other side of the box to fight for the food. The game then has the following payouts.
 Classic
S
Game: Pigs
D
D
Press Wait
PPress

S 2, 6 -1, 10
D
Wait
8,1 0, 0

D: dominant pig
S: submissive pig
Big John and Little John
 Big John and Little John eat coconuts, which dangle from a
lofty branch of a palm tree. Their favourite coconut palm
produces only one fruit per tree.
 To get the coconut, at least one of them must climb the tree
and knock the coconut loose so that it falls to the ground.
 Energy measurements show that a coconut is worth 10 Kc
(kilocalories) of energy, the cost of running up the tree,
shaking the coconut loose, and running back down to the
ground costs 2 Kc for Big John, but is negligible for Little
John, who is much smaller.
 Moreover, if both individuals climb the tree, shake the
coconut loose, then climb down the tree and eat the
coconut, Big John gets 7 Kc and Little John gets only 3 Kc,
because Big John hogs most of it; if only Big John climbs the
tree, while Little John waits on the ground for the coconut
to fall, Big John gets 6 Kc and Little John gets 4 Kc (Little
John eats some before Big John gets back down from the
tree); if only Little John climbs the tree, Big John gets 9 Kc
and Little John gets 1 Kc (most of the food is gone by the
time Little John gets there).
 Three person Games
 Suppose each person chooses a number between 1. 2, 3. The payoff
is 4 times minimum number announced minus his own number.
 B B B
A 1
1
3,3,3
2
3,2,3
3
3,1,3 1
1
3,3,2
2
3,2,2
3
3,1,2 1
1
3,3,1
2
3,2,1
3
3,1,1

A A
2 2,3,3 2,2,3 2,1,3 2 2,3,2 6,6,6 6,5,6 2 2,3,1 6,6,5 6,5,5
3 1,3,3 1,2,3 1,1,3 3 1,3,2 5, 6,6 5,5,6 3 1,3,1 5, 6,5 9,9,9

C chooses 1 C chooses 2 C chooses 3

 Three cars are meeting at an intersection
and want to proceed as indicated by the  Car Game
arrows. Green and blue colors for cars
/arrows indicate "right of way", red
indicates "no right of way".
 Each player can proceed or move.
 If two with intersecting paths proceed,
there is an accident. The one having the
right of way has a payoff -100 in this case,
the other one a payoff of-1000.
 If a car proceeds without causing an
accident, the payoff for that car is 5.
 If a car yields and all the others
intersecting its path proceed, the yielding
car has a payoff of -5.
 If a car yields and a conflicting path
car as well, it takes a little longer until they
can proceed, so both have a payoff of -10.
Car Game
 B B
P Y P Y

A P -100, -1000,
-100
5, -5, 5 P -100, -1000, -5 5, -10,
-10

Y -5, -1000, -10, -10, Y -5, 5, -10. -10. -

-100 5
A -5 10

C chooses P C chooses Y
Solution Concepts
 Assumptions and set up”
 1. Players are rational: A rational player is one who chooses
his action 𝑠𝑖 ∈ 𝑆𝑖 to maximise his payoff consistent with his
belief about what is going on in the game.
 2. Players are intelligent: Knows every thing about the game:
the actions, outcomes,
 3. Common knowledge
 4. Self-enforcement:
 In non-cooperative game theory a solution must be self
enforcing. The player should not have any incentive for
unilateral deviation.
Dominance in Pure Strategy
 What is a dominated strategies:
◦ Let 𝑠 = (𝑠1 , 𝑠2 , … … … … 𝑠𝑁 )be a strategy profile
◦ s-i := (s1, …, si-1, si+1, … sn)
◦ s’=(s-i,s’i) := (s1, …, si-1 ,s’i, si+1, … sn)
 Strictly dominated strategy:
◦ An strategy sj*  Sj is strictly dominated if there exists any other strategy sj’
such that for all strategy profiles s  S:
uj(s-j, sj’) > uj(s-j, sj*) for all s-j  S-j
 Of course, it is not rational to play strictly dominated strategies
 Examples

 Prisoner's dilemma Dominated Strategy

Prisoner B

Not Confess
Confess
Prisoner A
Not -1,-1 -9,0
Confess
Confess 0,-9 -6,-6
Iterated Elimination of
Strictly Dominated pure Strategies
 Since strictly dominated strategies will never be played,
one can eliminate them from the game
 This can be done iteratively
 If this converges to a single strategy profile, the result is
unique
 This can be regarded as the result of the game, because it
is the only rational outcome
 In any case, if by iterated elimination of dominated
strategies there is only one strategy left for each
player, the game is called a dominance-solvable game.
 Player B

L C R
U 4,3 5,1 6,2
Player A
M 2,1 8,4 3,6
D 3,0 9,6 2,8
Does Player 1 have a dominated strategy?
Hint: Compare b and d.
Iterated Elimination of Dominated Strategies-Stage 1

Does Player 2 have a dominated

strategy?
Hint: Compare y and z.
The game After first round of Eliminaton

If each knows the other won’t

play a dominated strategy,
we have a smaller game.
 Reduced Game after one iteration.

This is the game if each knows that the other is rational

and each knows that the other knows that the other is rational.

Are there any dominated strategies?

Reduced Game after 2 rounds of iterated
elimination of strictly dominated strategies. (Note
that x couldn’t have been eliminated in the first
round.)
Reduced Game after 3 rounds of iterated elimination.
a is eliminated. This couldn’t have been done in earlier rounds.

Are there any strictly dominated strategies in this game? NO

Now find PSNE : But No PSNE exists.
 For Player 2, w is strictly dominated by y. So we eliminate w.
 Next, for Player 1 we can eliminate c by a.

Player 2
x y z

Player1 a 1,1 4,3 3,5

b 3,0 2,4 1,5
d 2,0 2,1 4,2

 Now x and y are dominated and eliminated. Next for player 1 ‘d’is the strategy he will
choose when Player 2 plays z.
Weakly Dominated Strategies
 Instead of strict domination, we can also go for weak
domination:
◦ An strategy sj*  Sj is weakly dominated if there exists a strategy
sj’ such that for all strategy profiles s  S:
uj(s-j, sj’) ≥ uj(s-j, sj*)
and for at least one profile a  A:
uj(s-j, sj’) > uj(s-j, sj*).
 When there is a weakly dominant strategy, if the
player is rational and cautious, then he will play the
dominant strategy
 In this game, player 1 (firm) has a strictly dominant
strategy: “hire.” Player 2 has only a weakly
dominated strategy. If players are rational, and in
addition Player 2 is cautious, then Player 1 hires
and Player 2 shirks.
 Each one of two tea shops charges its own price for
a cup, either Rs2, Rs4, or Rs.5. The cost of
obtaining and serving the tea can be neglected. It is
expected that 6000 cups per month are drunk in a
shop by tourists, who choose one of the two shops
randomly, and 4000 cups per month are drunk by
natives who go to the bar with the lowest price, and
split evenly in case both shops offer the same price.
What prices would the shops select?
 The game, as all games considered so far, is
symmetric. Let me illustrate in one instance how to
 compute the payoffs. If shop A charges Rs. 2 and
shop B charges Rs4, then all natives will choose A.
 Therefore tea shop A will serve 4000 cups to the
natives, and 3000 cups to tourists, serving 7000
cups in total, making 7000 *Rs. 2 = Rs.14000.
Teashop B will only serve 3000 cups to tourists,
making 3000 *Rs. 4 =Rs.12000
 The payoff matrix, with values in thousands of Rs, is

For each tea shop, move “4” strictly dominates move “2”, therefore we could eliminate
both moves “2” to

Move “4” strictly dominates move “5”. Therefore

we eliminate these moves for both players as well
and arrive at a game with only one option, “4”, for
each player, and
a payoff of Rs. 20000 for each. Therefore both
players will choose Rs. 4 as the price for per cup
of tea.
Second Price Sealed bid Auction with complete
information
 In second price auction, the winner, who is the highest bidder makes
the payment equal to the second highest bid to obtain an object
 An object is to be assigned to players {1,2, N}
 Each payer has his own valuation 𝑣𝑖 . We assume 𝑣1 >𝑣2 >………. 𝑣𝑛
 Each payers simultaneously submit the bids. (𝑏𝑖 )
 The payoff function is
 𝑈𝑖 = 𝑣𝑖 − max 𝑏𝑗 for the winner where 𝑏𝑗 is the second highest bid
𝑖≠𝑗
 =0 otherwise
 Proposition: Strategy of bidding true valuation is the weakly
dominant strategy
Proof
 Let 𝑟𝑖 = 𝑚𝑎𝑥𝑖≠𝑗 𝑏𝑗 , the amount to be paid by the winner.
 Case 1: 𝑏𝑖 > 𝑣𝑖 , that is ith player is overbidding or bidding
over her valuation.
 If 𝑟𝑖 >𝑏𝑖 , the ith bidder does not get the product. Hence , her
net utility is zero, same as her utility if her bid is equal to 𝑣𝑖 .
 If 𝑟𝑖 ≤ 𝑣𝑖 < 𝑏𝑖 , the ith bidder gets the product and pays 𝑟𝑖 .
Her net utility is 𝑣𝑖 -𝑟𝑖 same if her bid is equal to 𝑣𝑖 .
 Alternatively, if 𝑣𝑖 < 𝑟𝑖 < 𝑏𝑖 , then for overbidding the bidder
gets the product. However her utility is 𝑣𝑖 -𝑟𝑖 <0. She can
improve her condition by bidding her true valuation as that
will provide her with zero utility. Thus, overbidding is weakly
dominated by bidding of true valuation.
Case 2:
 Let us assume that the bidder is underbidding and 𝑏𝑖 < 𝑣𝑖 .
 If 𝑟𝑖 < 𝑏𝑖 , then the ith bidder gets the product , gains 𝑣𝑖 -𝑟𝑖
same if her bid is equal to 𝑣𝑖 .
 Alternatively for 𝑟𝑖 ≥ 𝑣𝑖 > 𝑏𝑖 , the bidder gets zero utility
same as if her bid is equal to 𝑣𝑖 .
 Finally, suppose, 𝑏𝑖 <𝑟𝑖 <𝑣𝑖 . Then for underbidding she is
loosing the product. But if her bid was 𝑣𝑖 , then she would
get the product and gain 𝑣𝑖 -𝑟𝑖 >0. Thus, underbidding is also
weakly dominated by bidding true valuation.
 Combining Case 1 and Case 2 , we prove our proposition.
Guess the 2/3 of an average
 Suppose everyone in your town selects a real number
between 1 and 100, inclusive (i.e. 1 and 100 are both
possible choices, as is any other number between). The
winner is the individual (or individuals) who selects the
number closest to 2/3 of the average of numbers chosen.
What number do you choose? Why?

Proposition:
After iterated elimination of dominated strategies, players
will select 1.
Solution
2
 Suppose all players choose, the maximum number 100. Then ∗ 100 =
3
66.66667 ≈ 67.
Round 1: All numbers in the interval [68 ,100] are weakly dominated by 67.
Firstly, the numbers in this interval cannot be two third of average of numbers
chosen between 68 and 100. Thus, if any play wins by choosing a number in the
interval [68 ,100], then he will do so, by choosing 67 itself. Thus all numbers in
this interval are weakly dominated by 67, and eliminated.
 Round 2: Using the above logic we can eliminate the numbers above
2 2 2 2
( ∗ 100) = ( )2 ∗ 100 = ∗ 67 = 44.444 ≈ 45
3 3 3 3
 Thus, after two rounds of elimination, we are left with numbers in the
interval [1, 45]
 Round 3: again by same logic we can eliminate all the numbers
2 3 2
above ( ) ∗ 100 ≈ ∗ 45 = 30.
3 3
 Thus after round 3, we are left with integers in the interval [1,
30]
2 4 2
 Round 4: We can eliminate numbers above ( ) ∗ 100 ≈ ∗
3 3
30 = 20.
 Following this logic, all players will ultimately choose 1.
 Advertising game
Suppose two competing brands can choose one of the three marketing
campaigns Low(L), Medium (M) and High (H),

Player B
L M H
L 6,6 2,8 0,4
Player A
M 8,2 4,4 1,3
H 4,0 3, 1 2,2
Nash equilibrium
A Nash Equilibrium occurs when each player chooses a
strategy that gives him/her the highest payoff, given the
strategy chosen by the other player(s) in the game.
("rational self-interest")
Alternatively, a Nash Equilibrium occurs when each player
chooses his best responses.
 More generally, at Nash equilibrium if no player wants to
unilaterally deviate to an alternative strategy
 A Nash equilibrium corresponds to a steady state.
 Definition:
 The pure strategy profile 𝑠 ∗ = (𝑠1∗ ,𝑠2∗ , … … … … … … 𝑠𝑛∗ ) ∈ 𝑆 is a strict Nash
equilibrium if 𝑠𝑖∗ is a best response to 𝑠−𝑖∗
for all i ∈ N, that is ui(𝑠𝑖∗ , 𝑠−𝑖
∗
) > ui(𝑠𝑖′ 𝑠−𝑖
∗
) for
all 𝑠𝑖′  𝑆𝑖 and all i ∈ N.
 What is a best response?
 The strategy 𝑠𝑖  𝑆𝑖 is player i’s best response to his opponent’s
strategies 𝑠−𝑖 𝑆−𝑖 if
 ui(𝑠𝑖 , 𝑠−𝑖 ) > ui(𝑠𝑖′ 𝑠−𝑖 ) for all 𝑠𝑖′  𝑆𝑖
 If 𝑠𝑖  𝑆𝑖 is a strictly dominated strategy for player i, then it cannot be a
best response to any 𝑠−𝑖 𝑆−𝑖 .
 Corollary
 A strictly Dominant strategy, that survives IESDS must be included in the
set of best response strategies
Best Response Function of a Player
 we define the function B byi

 Bi(s−i) = {si in Si : u (si , s−i) ≥ u (s’ i , s−i) for all s i in Si} :

i i

 any action in Bi(s− ) is at least as good for player i as every other action of
i

player i
 when the other players’ actions are given by s−i. We call B the best
i

response
 function of player i.
 The function B is set-valued: it associates a set of actions with any list of the
i

 other players’ actions. Every member of the set B (s−i) is a best response of
i

 player i to s−i:
 if each of the other players adheres to s i then player i can do
−

 no better than choose a member of Bi(a−i).

 Player B
L C R
U 7,7 4,2 1,8
Player A
M 2,4 5,5 2,3
D 8,1 3,2 0,0

 Step 1: For every strategy of player 2( for each column) find the statefy of player 1 that gives him the
highest payoff( Best response)
 Strategies of Player 2 Best response of player 1
 L D
 C M
 R M
 Step 2:
 Strategies of Player 1 Best response of player 2
 U R
 M C
 D C
 The Nash equilibrium is found where the best response correspondence of each player will intersect. In
this case (M,C) is Pure Strategy Nash Equilibrium of this game.
Strict and Non strict PSNE

This game has a unique Nash equilibrium,

namely (T, L). (For every other pair of actions, one of the players is better off changing
her action.) When player 2 chooses L, as she does in this equilibrium, player 1 is
equally happy choosing T or B; if she deviates to B then she is no worse
off than she is in the equilibrium. We say that the Nash equilibrium (T, L) is not a strict
equilibrium.
For a general game, an equilibrium is strict if each player’s equilibrium action
is better than all her other actions, given the other players’ actions.
Precisely, an
action profile s∗ is a strict Nash equilibrium if for every player i we have ui(s∗) >
ui(si, s∗−i) for every action si of player i.
 Three person Games: Solutions
 Suppose each person chooses a number between 1. 2, 3. The payoff
is 4 times minimum number announced minus his own number.
 B B B
A 1
1
3,3,3
2
3,2,3
3
3,1,3 1
1
3,3,2
2
3,2,2
3
3,1,2 1
1
3,3,1
2
3,2,1
3
3,1,1

A A
2 2,3,3 2,2,3 2,1,3 2 2,3,2 6,6,6 6,5,6 2 2,3,1 6,6,5 6,5,5
3 1,3,3 1,2,3 1,1,3 3 1,3,2 5, 6,6 5,5,6 3 1,3,1 5, 6,5 9,9,9

C chooses 1 C chooses 2 C chooses 3

Car Game: Solution
 B B
P Y P Y

A P -100, -1000,
-100
5, -5, 5 P -100, -1000, -5 5, -10,
-10

Y -5, -1000, -10, -10, Y -5, 5, -10. -10. -

-100 5
A -5 10

C chooses P C chooses Y
Synergistic Relationship Game

 Two people are involved in a. If both devote more effort

to the relationship, they are both better off. For any
given effort of individual j, the return to individual i’s
effort first increases, then decreases.
 Specifically, an effort level is a nonnegative number,
and each individual i’s preferences are represented by
the payoff function
 𝑢𝑖 = 𝑒𝑖 (𝑐 + 𝑒𝑗 − 𝑒𝑖 )
 where ei is i’s effort level, ej is the other individual’s
effort level, and c > 0 is a constant.
Continued….
 ui = 0 if ei = 0 or if ei = c + ej, so anything in between
willn give i a positive payoff

Best response function of ith individual.

Best response function of j th individual.

Best Response Functions
 𝑒2
Best response for Player 1

Best response for Player 2

e∗2

𝑒1
e1∗

e1∗ = e∗2 = c
First Price sealed bid Auction
 A first-price auction differs from a second-price auction only in that
the winner
 pays the price she bids, not the second highest bid. Precisely, a first-
price sealed bid auction (with perfect information) is defined as
follows.
 Players The n bidders, where n ≥ 2.
 Actions The set of actions of each player is the set of possible bids
(nonnegative numbers).
 Preferences The payoff of any player i is vi − bi if either bi is higher
than every
other bid, or bi is at least as high as every other bid and the number
of every other player who bids bi is greater than i. Otherwise player i’s
payoff is 0.
Proposition
 One Nash equilibrium of a first-price sealed-bid auction is (b1, . . . ,
bn) = (v2, v2, v3, . . . , vn), in which player 1’s bid is player 2’s valuation
v2 and every other player’s bid is her own valuation.The outcome
of this equilibrium is that player 1 obtains the object at the price
v2.
 Proof: If player 1 raises her bid above v2, she still wins, but pays a higher
price and hence obtains a lower payoff. (𝑣1 − 𝑣2 − 𝜖). If player 1 lowers her
bid then she loses, and obtains the payoff of 0. Player 1 has no incentive for
unilateral deviation.
 If any other player changes her bid to any price at most equal to 𝑣2 the
outcome does not change. If she raises her bid above v2 she wins, but
obtains a negative payoff. Has no incentive for unilateral deviation.
Contributing to a public good
 Each of n people chooses whether or not to contribute a fixed amount toward the
provision of a public good.
 The good is provided if and only if at least k people contribute, where 2 ≤ k ≤ n;
If it is not provided, contributions are not refunded.
Each person ranks outcomes from best to worst as follows:
(i) any outcome in which the good is provided and she does not contribute,
(ii) any outcome in which the good is provided and she contributes,
(iii) any outcome in which the good is not provided and she does not contribute,
(iv) any outcome in which the good is not provided and she contributes.
 Formulate this situation as a strategic game and find its Nash equilibria.
 Is there a Nash equilibrium in which more than k people contribute?
 One in which k people contribute?
 One in which fewer than k people contribute?
 There are n players, each of which has two strategies: Contribute (C) or
don't contribute (D). The payoffs for player i are as follows, given that 𝛼
other players contribute.
 if n≥ 𝛼 ≥ k, player i is better off not contributing (the good will be provided
without her contribution).
 If 𝛼= k − 1 people contribute, player i is better off contributing (the
good will only be provided with her contribution which she values
higher than the good not being provided).
 If 0 ≤ 𝛼 ≤ 𝑘 − 2 people contribute, player i is better off not contributing
(the good won't be provided anyway).
 Clearly, player i best response/optimal strategy does depend what the other
players are doing, so there is no dominant strategy/dominated strategy.
 Nash Equilibrium Solution:
 First, is there a NE where more than k people contribute?
Answer: no, since this means that from the point of view of
some player i, k others already contribute, so the best
response for this player is to play D.
 Second, is there a NE where exactly k people contribute?
Yes: from a contributing player i's point of view 𝛼 = 𝑘 − 1
people play C so he should play C as well. This is true for all
players who play C. For all players who play D, 𝛼 = 𝑘 so
playing D is optimal as well. Note that we cannot say who
contributes. Each possible combination of contributing
players/defecting players is a NE.
 Finally, are there NE were strictly less than k people
contribute?
Yes, there is one NE where no one contributes: if nobody else
contributes 𝛼 = 0 and it doesn't pay to contribute for player i
either. So D for all players is a NE.

 Are there any NE where a positive number of people, say

𝛽> 0 contribute but 𝛽 < k?
No. If 𝛽 = k-1, then each non-contributing player would have
an incentive to deviate and contribute instead. If 𝛽 < k-1, then
each contributing player would want to deviate and play D.
Choosing a route

Four people must drive from A to B at the same time. Two routes are available, one via X and
one via Y. (The roads from A to X, and from Y to B are both short and narrow;
in each case, one car takes 6 minutes, and each additional car increases the travel
time per car by 3 minutes. (If two cars drive from A to X, for example, each car takes
9 minutes.) The roads from A to Y, and from X to B are long and wide;
on A to Y one car takes 20 minutes, and each additional car increases the travel time per car
by 1 minute;
on X to B one car takes 20 minutes, and each additional car increases the travel time per car
by 0.9 minutes.
Formulate this situation as a strategic game and find the Nash equilibria. (If all four people take
one of the routes, can any of them do better by taking the other route? What if three take one
route and one takes the other route, or if two take each route?)
Solution
 A strategic game that models this situation is:
 Players The four people.
 Actions The set of actions of each person is {X,Y} (the
route via X and the route
 via Y).
 Preferences Each player’s payoff is the negative of her
travel time.
Nash equilibrium
In a Nash equilibrium two people take each route. (In any other case, a person taking
the more popular route is better off switching to the other route.
For any such action profile, each person’s travel time is either 29.9 or 30 minutes
.(depending on the route they take).
If a person taking the route via X switches to the route via Y her travel time becomes
12 + 21.8 = 33.8 minutes; if a person
taking the route via Y switches to the route via X her travel time becomes 22+12 =
34 minutes. For any other allocation of people to routes, at least one person can
decrease her travel time by switching routes. Thus the set of Nash equilibria is the
set of action profiles in which two people take the route via X and two people take
the route via Y.
A new road is built
 Now suppose that a relatively short, wide road is built from X to Y, giving each
 person four options for travel from A to B: A–X–B, A–Y–B, A–X–Y–B, and A–Y–
 X–B.
 Assume that a person who takes A–X–Y–B travels the A–X portion at the same time as someone
who takes A–X–B, and the Y–B portion at the same time as someone who takes A–Y–B. (Think of
there being constant flows of traffic.)
 On the road between X and Y, one car takes 7 minutes and each additional car increases
 the travel time per car by 1 minute. Find the Nash equilibria in this new situation.
 Compare each person’s travel time with her travel time in the equilibrium before the road from X to
Y was built.
Solution

 1. Before new road is built, two are taking A-X-B, and

other two are taking A-Y-B. Suppose one person taking
A-X-B deviates and takes A-X-Y-B. His travel time
becomes 9+12+7=28<29.9. Thus, he has incentive to
deviate.
 2. Consider the players taking A-Y-B route. If one deviates
to A-X-Y-B his travel time 12+8+12=32. Alternatively, by
sticking to A-Y-B will lead to a travel time : 21+12=33>32.
Thus, one player will deviate to A-X-Y-B route.
Solution
 What happens to the remaining two?
 One following A-X-B, his travel time is now: 12+20=32
 One following A-Y-B, his travel time: 20+ 12=32
 Thus no body has any incentive to deviate. Hence it is a
Nash equilibrium.
Extended Stag Hunt game
 Extend the n-hunter Stag Hunt by giving each hunter K (a positive integer) units of effort, which she
can allocate between pursuing the stag and catching hares. Denote the effort hunter i devotes to
pursuing the stag by ei, a nonnegative integer equal to at most K. The chance that the stag is caught
depends on the smallest of all the hunters’ efforts, denoted minjej. Hunter i’s payoff to the action
profile (e1,…., en) is 2minjej – ei. (She is better off the more likely the stag is caught, and worse off the
more effort she devotes to pursuing the stag, which means she catches fewer hares.) Is the action
profile (e,…., e), in which every hunter devotes the same effort to pursuing the stag, a Nash
equilibrium for any value of e? (What is a player’s payoff to this profile? What is her payoff if she
deviates to a lower or higher effort level?) Is any action profile in which not all the players’ effort
levels are the same a Nash equilibrium? (Consider a player whose effort exceeds the minimum effort
level of all players. What happens to her payoff if she reduces her effort level to the minimum?)
 No of Players n
 Utility of each player: 2minjej – ei
 Where each player chooses effort level 𝑒𝑖 ≤ 𝐾
 Preference: She is better off the more likely the stag is caught,
and worse off the more effort she devotes to pursuing the stag,
which means she catches fewer hares
 Q1: Is the action profile (e,…., e), in which every hunter devotes
the same effort to pursuing the stag, a Nash equilibrium for any
value of e? (What is a player’s payoff to this profile? What is her
payoff if she deviates to a lower or higher effort level?)
Solution
 Consider the action profile (e,…., e), in which every hunter devotes the
same effort to pursuing the stag.
 The payoff under this strategy u=2e-e=e
 For this profile to be a Nash equilibrium no agents will have any
incentive to deviate.
 Consider upward deviation: 𝑒𝑖 = 𝑒 ∗ > e
 Payoff of ith player 𝑢𝑖 = 2𝑒 − 𝑒 ∗ < e.
 Thus upward deviation is not profitable.
 Consider downward deviation:𝑒𝑖 = 𝑒 ∗ < e.
 Thus his effort level is minimum among all.
 Payoff of ith player 𝑢𝑖 = 2𝑒 ∗ − 𝑒 ∗ = 𝑒 ∗ < e.
 Thus upward and downward deviations are not profitable. So the
profile (e,…., e) is a Nash Equilibrium.
• Q2: Is any action profile in which not all the players’ effort levels are the same a Nash equilibrium? (Consider a player
whose effort exceeds the minimum effort level of all players. What happens to her payoff if she reduces her effort level to
the minimum?)

 Suppose minjej =𝑒
 Let player 𝑖 chooses 𝑒𝑖 = 𝑒 ∗ > 𝑒
 The payoff 𝑢𝑖 = 2𝑒 − 𝑒 ∗
 The player 𝑖 can improve his payoff if he moves towards
𝑒 and he will have incentive to deviate 𝑒.
 So any player with effort level 𝑒 ∗ > 𝑒, will have
incentive to deviate to 𝑒.
A model of electoral competition.
First proposed by Hotelling (1929) and popularized by Downs (1957).

 Setup:
 ◃ Parties/candidates compete by choosing a policy on the line
 segment [0, 1]. The party with most votes wins; if there is a
 draw, each party has a 50% chance of winning.
 ◃ Parties only care about winning, and will commit to the
 platforms they have chosen.
 ◃ Each voter has a favorite policy on [0, 1]; her utility decreases
 as the winner’s position is further away from her favourite policy
Voter’s Preference regarding one dimensional
Policy variable:
 Single peaked preferences: Single-peaked – each voter has an ideal point and
the further away from the ideal point the lower their utility. Each voter’s
distaste for any position is given by the distance between that position and
her favorite position. In particular, for any value of k, a voter whose favorite
position is x∗ is indifferent between the positions x∗ − k and x∗ + k.

 The payoff of a voter whose favorite position is x∗, as a function of the winning position, x.
Single Peaked preference: examples

Non single peaked voter

Single peaked “moderate” voter
Single peaked “left” voter
Single peaked “right” voter

Left (x=0) Right (x=1)

Suppose there are three candidates, with positions 𝑥1 , 𝑥2 and 𝑥3 , preassigned.
Candidate 1 attracts the votes of every citizen whose favorite position is in the interval,
labeled “votes for 1”, up to the midpoint (𝑥1 +𝑥2 )/2 of the line segment from 𝑥1 to 𝑥2 ;
candidate 2 attracts the votes of every
citizen whose favorite position is in the interval from (𝑥1 +𝑥2 )/2 to (𝑥3 +𝑥2 )/2 and
candidate 3 attracts the remaining votes.
Assume that citizens whose favorite
position is (𝑥1 +𝑥2 )/2 divide their votes equally between candidates 1 and 2, and those
whose favorite position is (𝑥3 +𝑥2 )/2 divide their votes equally between candidates 2
and 3. If two or more candidates take the same position then they share
equally the votes that the position attracts.

The allocation of votes between three candidates, with positions x1, x2, and x3.
Consider: Two Party case
 Action: A party will choose a value for policy variable x.
 Best response for a party:
 Fix the position 𝑥2 of candidate 2 and consider the best position for candidate 1. First
suppose that 𝑥2 < m, the median value of policy variable based on voter’s preferences.
 candidate 1 takes a position to the left of 𝑥2 then candidate 2 attracts the votes of
 all citizens whose favourite positions are to the right of (𝑥1 +𝑥2 )/2 , a set that includes the
50% of citizens whose favorite positions are to the right of m, and more.
 Thus candidate 2 wins, and candidate 1 loses.
 If candidate 1 takes a position to the right of 𝑥2 then she wins so long as the dividing line
between her supporters and those of candidate 2 is less than m. If she is so far to the right
that this dividing line lies to the right of m then she loses.
 Player 1 prefers to win than to lose, and is indifferent between all the
outcomes in which she wins, so her set of best responses to 𝑥2 is the
set of positions that causes the midpoint (𝑥1 +𝑥2 )/2 of the line segment
from 𝑥2 to 𝑥1 to be less than m. (If this midpoint is equal to m then the
 candidates tie.) The condition (𝑥1 +𝑥2 )/2 < m is equivalent to 𝑥1 < 2𝑚 −
𝑥2.

 Candidate two has the same incentive as Candidate 1.

Best Response Functions
𝑥1 = 𝑥2

𝑥1 + 𝑥2 = 2𝑚
 If we superimpose the two best response functions, we
see that the game has a unique Nash equilibrium, in
which both candidates choose the position m, the voters’
median favorite position.
 The edges of the shaded area, which correspond to pairs
of positions that result in ties, are excluded from the best
response functions. The outcome is that the election is a
tie.
 This is the so-called ”median voter theorem
 The Median Voter Theorem only strictly holds if there is a single issue.
 If there are two or more issues that parties take stands on, but only one
election, there is no guarantee that the median voter's preference will win
on any issue.
 Moreover, even with single-peaked preferences, multiple voting
dimensions make it possible for voting cycles to arise. Chaos
 Suppose there is a continuum of voters, with favorite
policies uniformly distributed on [0, 1], and the number
of parties is 3 (L, C, R). Do we still have the equilibrium
that all parties choose m?
 No. One of the parties can move slightly to the left or the
right of the median voter position, and win the election.
 Would the three parties positioning at 0.45, 0.55, 0.6 be a
 NE?
 Yes. L wins already; C and R cannot win by moving
anywhere.
Voting Game
 Two candidates, A and B, compete in an election where there are n number
of voters and n is even. Of the n voters, n/2 support candidate A and n/2
support candidate B. Each citizen decides whether to vote, at a cost, for the
candidate she supports, or to abstain. A citizen who abstains receives the
payoff of 2 if the candidate she supports wins, 1 if this candidate ties for first
place, and 0 if this candidate loses. A citizen who votes receives the payoffs
2−c, 1−c, and−c in these three cases, respectively, where 0< c <1. Find the
set of all pure-strategy Nash equilibria.
Solution
 There are four possible cases:
 Case 1: All voters vote. In this case both candidates will be
tied. Payment for those who has voted is 1-c.
 Possibility of deviation. If one voter does not vote, he gets
zero as his candidate will loose. Thus it is best for him to
vote.
 Case 2: Not every one votes and candidates are tied.
 In this case the person who has not given his vote gets 1.
However if he is casting his vote his payoff will go up to 2-
c>1 as his candidate will win. Thus this is not a Nash
equilibrium as the player has incentive to deviate.
Voting game continued
 Case 3: Not everyone votes and one candidate wins by one
vote: The voter who does not cast his vote and supports
the loser will get zero. However he can improve his
condition deviating; if he gives his vote so that the result is a
tie and the voter gets 1-c >0. Thus, it is not a Nash
equilibrium.
 Case 4: Not everyone votes and one candidate wins by
more than one vote: In this case, a voter who votes
 for the wining candidate would probably deviate to not
voting, since 2-c < 2.
 Thus, the only Nash equilibrium is the one where everyone
votes.
Oligopoly models and Game Theory
 The word Oligopoly is derived from two Greek words –
‘Oligi’ meaning ‘few’ and ‘Polein’ meaning ‘to sell’.
 The Oligopoly is a market structure with finite number of
sellers, where each seller’s decision will affect the profitability
of others.
 A duopoly is a special form of oligopoly with two firms
operating in a market.
 In game theoretic terminology, duopoly or Oligopoly can be
defined as the market structure where firms are strategically
interdependent.
 In this case we will consider the situations where firms
simultaneously choose there decision variables.
Case1: Firms simultaneously choosing Quantity
levels( Cournot Model)
 Two firms
• Maximising profit and Producing homogenous product.( We can also have models with
heterogeneous product)
• Neither firm knows the other’s output decision when making its production choice as
they move simultaneously
 Each firm makes an assumption about the other’s decision
• firm 1 assumes firm 2’s output to be given number
• likewise for firm 2
• Each is fully described by its cost function.
 Two firms labelled f = 1,2
 Firm f produces output qf
 So total output is:
• q = q1 + q2
 Market price is given by:
• p = p (q)
 Firm f has cost function Cf(·)
 So profit for firm f is:
• p(q) qf –Cf(qf )
 Each firm’s profit depends on the other firm’s output
• (because p depends on total q)
 Firm 1’s problem is to choose q1 so as to maximise
1(q1; q2) := p (q1 + q2) q1 – C1 (q1)
 Differentiate P1 to find FOC:
  1(q1; q2)
————— = p q(q 1 + q2) q1 + p(q1 + q2) – C 1(q1)=0
q
 q1
  1(q1; q2)
————— =0
 q 1
𝜕2 𝜋1 1 𝜕2 𝜋1 2 =0
• 12 d𝑞 + 2 1 𝑑𝑞
𝜕𝑞 𝜕𝑞 𝜕𝑞

• for an interior solution this is zero

 Solving, we find q1 as a function of q2
 This gives us 1’s reaction function, R1 :
q1 = R1 (q2)
 Cournot – the reaction function for Firm 1
q2
Firm 1’s Iso-profit curves
Assuming 2’s output constant at q0
firm 1 maximises profit
R1(·)
If 2’s output were constant at a higher level
 2’s output at a yet higher level
The reaction function


1(q1; q2) = const Slope of Iso-profit curve of firm 1
 𝑑𝑞 2 pq(q1 + q2) q1 + p(q1 + q2) – Cq1(q1)
=−
q0  1(q1; q2) = const 𝑑𝑞1 𝑝𝑞

1(q1given
Firm 1’s choice ; q2) =that
const
2 chooses output q0
q1

April 2018 99
 R1(·) is the reaction function observed from profit-maximisation by firm 1
 Gives firm’s reaction 1 to fixed output level of competitor:
• q1 = R1 (q2)
• Slope of reaction function of Firm 1:
2 2
𝑑𝑞2 𝜕2 𝜋1 Τ𝜕𝑞1 𝜕2 𝜋1 Τ𝜕𝑞1
• ቚ = − 2 Τ 2 1 = − <0 ( unambiguously for linear dd function)
𝑑𝑞1 𝑅1 𝜕 𝜋1 𝜕𝑞 𝜕𝑞 𝑝𝑞𝑞 𝑞1 +𝑝𝑞
 Firm 2’s problem is also solved in the same way
 We get q2 as a function of q1 :
• q2 = R2 (q1)
• Slope of reaction function of firm 2
𝑑𝑞2 𝜕2 𝜋2 Τ𝜕𝑞2 𝜕𝑞1
• ቚ =− 2 <0
𝑑𝑞1 𝑅2 𝜕2 𝜋2 Τ𝜕𝑞2
 Treat the above as a pair of simultaneous equations
 Solution is a pair of numbers (qC1 , qC2)
• So we have qC1 = R1(R2(qC1)) for firm 1
• and qC2 = R2(R1(qC2)) for firm 2
 This gives the Cournot-Nash equilibrium outputs
Second order condition of Profit Maximization
and Stability of Reaction function diagram :
2 12
𝜕 𝜋1 Τ𝜕𝑞 <0
2 Τ 22
𝜕 𝜋2 𝜕𝑞 <0
2 Τ 12
𝜕 𝜋1 𝜕𝑞 𝜕 2 𝜋2 Τ𝜕𝑞1 𝜕𝑞 2
2 >0
𝜕 2 𝜋1 Τ𝜕𝑞 2 𝜕𝑞1 𝜕 2 𝜋2 Τ𝜕𝑞 2
From this we get

2
𝜕2 𝜋1 Τ𝜕𝑞1 𝜕2 𝜋2 Τ𝜕𝑞2 𝜕𝑞1
>
𝜕2 𝜋1 Τ𝜕𝑞2 𝜕𝑞1 𝜕2 𝜋2 Τ𝜕𝑞 22
𝑑𝑞2 𝑑𝑞2
ቚ > ቚ
𝑑𝑞1 𝑅1 𝑑𝑞1 𝑅2

Thus the reaction function of Firm 1 must be steeper than the reaction function of Firm 2.
Cournot-Nash equilibrium :
𝑞01

q2

R1(·)

b
qC2

R2(·)
𝑞02
a

q1
qC1
 It also is the Nash equilibrium of a simple quantity game:
• players are the two firms
• moves are simultaneous
• strategies are actions – the choice of output levels
• functions give the best-response of each firm to the
other’s strategy (action)
A numerical Example
 Take the case where the inverse demand function is:
p = b0 – bq
 And the cost function for f is given by:
Cf(qf ) = C0f + cf qf
 So profits for firm f are:
[b0 – bq ] qf – [C0f + cf qf ]
 Suppose firm 1’s profits are 
 Then, rearranging, the iso-profit curve for firm 1 is:
b0 – c1 C01 + 
q2 = ——— – q1 – ————
b b q1
 Firm 1’s profits are given by
1(q1; q2) = [b0 – bq] q1 – [C01 + c1q1]
 So, choose q1 so as to maximise this
 Differentiating we get:
1(q1; q2)
————— = – 2bq1 + b0 – bq2 – c1
q 1

 𝑀𝑅1 = 𝑀𝐶 1
 FOC for an interior solution (q1 > 0) sets this equal to zero
 Doing this and rearranging, we get the reaction function:

b0 – c1 𝑞2 ( Assuming an interior solution exists)

𝑞1 = −
2b 2
 Firm 2’s profits are given by
2(q1; q2) = [b0 – bq] q2 – [C02 + c2q2]
 So, choose q2 so as to maximise this
 Differentiating we get:
2(q1; q2)
————— = – 2bq2 + b0 – bq1 – c2 =0
 q2
 𝑀𝑅 2 = 𝑀𝐶 2

 Doing this and rearranging, we get the reaction function:

b0 – 𝑐 2 𝑞 1 (
𝑞2 = − Assuming an interior solution exists)
2b 2
Nash Equilibrium Solution
 Solving the reaction functions we get
a + c2 – 2c1 a + 𝑐 1 – 2𝑐 2
 𝑞𝑐1 = 𝑞𝑐2 =
3𝑏 3𝑏
 Firms with homogenous marginal cost:

 Put c1 = c2 = c. Then we find qC1 = qC2 = qC where

 a–c
◦
◦
qC = ––––––
3b
 From the demand curve the price in this case is ⅓[a+2c]
 Profits are
 [a – c]2
◦
◦
C = ––––––
9b – C0
Example
1.Two sellers
2.MC = 40 for both firms
3.Homogeneous product
4.Quantity is the “decision variable”
 Let the inverse demand function be given by:
 P = 100 – (𝒒𝟏 + 𝒒𝟐 )

 The profit () functions of sellers 1 and 2 are given by:

1 = (100 – q1 – q2)q1 – 40q1 .
 2 = (100 – q1 – q2)q2 – 40q2
The reaction function or Best Response Function of firm 1:q1 = 30 - .5q2

60

30 - .5q2
30

10

0 15 25 30
Output of seller 1
In similar fashion, we derive a best reply function for seller 2. It is given by
q2 = 30 - .5q1

q2

30 q2 = 30 - .5q1

0 60 q1
So we have a system with 2 equations and 2 unknowns (q1 and q2) :
q1 = 30 – .5q2 q2 = 30 – .5q1

The solutions are:

q1 = 20 units
q2 = 20 units
q2
Equilibrium is established
60 when both sellers are on
Seller 1’s BRF
their best reply function

30
Equilibrium
20 Seller 2’s BRF

0 20 30 60 q1
Bertrand Model
• Bertrand model
– Oligopolistic competition
– Firms compete - setting prices
• Demand function
 D( pi ) if pi  p j

Di ( pi , p j )  (1 / 2)[ D( pi )] if pi  p j

0 if pi  p j

• Payoff to each firm

i  pi [ Di ( pi , p j )]  c[ Di ( pi , p j )]
• The Nash equilibrium: P1=P2=MC
• Proof: At each of the following an individual firm has an
incentive to deviate
– P1=P2>MC
– P1>P2>MC
• The equilibrium is socially optimal
• This is called Bertrand Paradox
Model with different Marginal Cost
• Now take the same example, but suppose that the two firms have different marginal costs.
• Suppose D(P) = α – P
• But now: C1(q1) = c1q1, but C2(q2) = c2q2. Assume c1 > c2.

• Now, no Nash equilibrium exists with two firms operating in the market.

• Clearly, any outcome where p1 < c1 or where p2 < c2 is not an equilibrium (at least one firm
will earn negative profits and can profitably deviate).
• Any outcome where min[p1,p2] > c1 is not an equilibrium; at least one firm could increase
their profit by lowering their price.
• p1 = p2 = c1 is not an equilibrium; firm 2 could profitably lower their price.
• p1 ≥ c1, p2 < c1 is not an equilibrium; firm 2 could increase their price and increase its profit.
• Thus, no equilibrium exists.
Bertrand Model with Heterogeneous Firms
Suppose Cost functions C(q) = cq for both firms.
Let demand function is qi = α – pi + bpj, where α > c, 0 < b < 2.
Firm 1 and 2 choose prices simultaneously.
So, now we have a well-behaved problem with continuous profit functions, and well-defined best response
functions.
Firm 1 solves: maxp1 (α – p1 + bp2)(p1 – c)
This gives FOC: α – 2p1 + bp2 + c = 0
So BR1: p1 = (α + bp2 + c)/2

By symmetry, BR2: p2 = (α + bp1 + c)/2

Solve these simultaneously to find NE.
p1 = [α + b((α + bp1 + c)/2 + c]/2
By some algebra, this gives the NE:
p1* = (α + c)/(2-b) = p2* (by symmetry).
 Notice that , given our assumptions on α and b, this
price is very clearly > c.
 So, moving to a differentiated product environment,
we have got away from the result that we can get
competitive prices with only 2 firms from a Bertrand
competition model.
 In the real world, virtually all products are
differentiated to some extent.
Bertrand (Price) Competition: Differentiated Products examples

Example: q1=90-2p1+p2, q2=90-2p2+p1,

No variable costs

1= p1q1 = p1(90-2p1+p2) =90p1 – 2p12 + p2p1

d1/dp1=90-4p1+p2 =0 or

p1=(90+p2)/4 (Reaction function of firm 1)

Similarly, p2=(90+p1)/4 (Reaction function of firm 2)

 Reaction function of firm 1
p2

 Reaction function of firm 2

p1

Equilibrium p1*=p2*=30
1= p1q1 = p1(90-2p1+p2)= 30(60)=1800
2= p2q2 = p2(90-2p2+p1)= 30(60)=1800
No Bertand Paradox with Differentiated Products
Tragedy of commons

 Suppose there are n players say firms in the world each choosing how much
to produce. The production activity consumes some of the clean air that
surrounds our planets. There is a total amount of clean air equal to K and
any consumption of clean air comes out of this common resource. Each
player i chooses his own consumption of clean air for production, 𝑘𝑖 ≥ 0
and the amount of clean air left is therefore
 𝐾 − σ𝑛𝑖=1 𝑘𝑖
 The benefit of consuming an amount 𝑘𝑖 ≥ 0 gives player i a payoff equal to
ln(𝑘𝑖 ), and no other player benefits from i’s choice. The utility of player i is
 𝑣𝑖 (𝑘𝑖 , 𝑘−𝑖 ) = ln 𝑘𝑖 + ln(𝐾 − σ𝑛𝑗=1 𝑘𝑗 )
 Let the Nash equilibrium solution be (𝑘1∗ , 𝑘2∗ ………….. 𝑘𝑛∗ ) where 𝑘𝑖∗ =
∗
𝐵𝑅𝑖 (𝑘−𝑖 ) for all 𝑖 ∈ 𝑁
 Maximising the objective function of each n players we
get their best response functions( aka reaction function)
𝜕𝑣𝑖(𝑘𝑖 ,𝑘−𝑖 ) 1 1
 = − σ𝑛 =0
𝜕𝑘𝑖 𝑘𝑖 (𝐾− 𝑗=1 𝑘𝑗 )
(𝐾−σ𝑛
𝑖≠𝑗 𝑘𝑗 )
 thus 𝑘𝑖∗ = 𝐵𝑅𝑖 𝑘−𝑖
∗
= for all n agents.
2
Under symmetry condition
 𝑘1∗ = 𝑘2∗ …………..= 𝑘𝑛 ∗
= 𝑘∗
 Thus 𝑘 ∗ = 𝐾/(𝑛 + 1)
 This is the PSNE of the game
Social Planner
 Suppose a social planner is maximising the joint profit to
determine the air consumption of all n agents.
 V= σ𝑛𝑗=1(𝑙𝑛𝑘𝑗 ) + n ∗ ln(𝐾 − σ𝑛𝑗=1 𝑘𝑗 )
𝜕𝑉 1 𝑛
 = − 𝑛 =0 for all i
𝜕𝑘𝑖 𝑘𝑖 (𝐾−σ𝑗=1 𝑘𝑗 )
Again using the symmetry condition we have
1 𝑛
 ′− ′ = 0
𝑘 𝐾−𝑛𝑘
 Or
′ 𝐾
 𝑘 = < 𝐾/(𝑛 + 1)
2𝑛
Final Offer Arbitration
 Arbitration is a procedure in which a dispute is submitted,
by agreement of the parties, to one or more arbitrators
who make a binding decision on the dispute.
 In Final-offer arbitration, in which the two parties make
offers to the arbitrator, and then the arbitrator picks one
of the offers to be the wage settlement.
 How the arbitrator makes her decision?
Final Offer arbitration Continued.

 Firstly, the game starts with the Firm and the union making
simultaneous offers, which will we denote respectively by wf and
wu. The arbitrator has a settlement in mind which we will call x,
and we assume that she simply chooses whichever offer is closer
to x, provided that wf < wu. If x < (wf + wu)/2 then she chooses
wf , and if x > (wf + wu)/2, then she chooses wu. This is expressed
in the figure below, where we consider x to be any value on a
real line, with wf and wu fixed.
The Model
 Considering the terminology we just introduced, the arbiter knows her ideal
settlement, x, but the other parties do not . They assume that x is randomly
distributed by a cumulative probability distribution F(x), with corresponding
probability density function f(x).
𝑑𝐹(𝑥)
 Note that =f x
𝑑𝑥
This is a property of cumulative distribution functions.
 With these assumptions kept in mind, the parties want to know the
probability that their offer is chosen; these probabilities can be expressed as
 These probabilities tell the firm and the union what chances they have of
their offer getting chosen. We can use these probabilities to determine
the expected wage settlement, denoted by E[settlement]. Thus we have
that

 This equation is very important to both the firm and the union; the Firm
wants to minimize this value, but the union wants to maximize it. If the
offer(𝑤𝑓∗ ; 𝑤𝑢∗ ) is to be a Nash equilibrium of this game, then the following
must be
 true:
 max

 This means that the pair (𝑤𝑓∗ ; 𝑤𝑢∗ ) ) must solve the first
order conditions for both of the optimization problems
above. These first order conditions:
 The left hand sides are equal implies

 Thus, the average of the offers is the median of the arbiter's

preferred settlement. From first order condition of the firm

 Or
 This means that the difference between the offers must equal the
value of the density function at the median of the arbitrator's
preferred settlement (x).
 Now suppose that the arbiter's preferred settlement is normally
distributed with mean 𝜇 and variance 𝜎 2 . This means that we
have the density function

Since we're looking at a normal distribution, the mean is equal to

𝑤𝑓∗ +𝑤𝑢
∗
median implies 𝜇 = .
2
 Thus
 The Nash equilibrium Solutions are

 When faced with this distribution, the offers are

centered around the mean, and as the uncertainty over
the arbitrator's preferred settlement increases, so does
the gap between the offers.