Nash Equilibrium:

Illustrations
Cournots Model of Oligopoly
Single good produced by n firms
Cost to firm i of producing q
i
units: C
i
(q
i
), where
C
i
is nonnegative and increasing
If firms total output is Q then market price is
P(Q), where P is nonincreasing
Profit of firm i, as a function of all the firms
outputs:

( ) ( )
q
C
q
P
q q q q
i
i
n
j
j i n
i

|
|
.
|

\
|
=

=1
2 1
..., , ,
t
Cournots Model of Oligopoly
Strategic game:
players: firms
each firms set of actions: set of all possible
outputs
each firms preferences are represented by its
profit

Example: Duopoly
two firms
Inverse demand:

constant unit cost: C
i
(q
i
) = cq
i
, where c < o
Example: Duopoly
Example: Duopoly
Recall for a perfectly competitive firm, P=MC, so
o Q = c, or Q = o c.

Recall for a monopolist, MR=MC, so
o 2Q = c, or Q = (o c)/2.

Example: Duopoly
Example: Duopoly
Best response function is:

Same for firm 2: b
2
(q) = b
1
(q) for all q.
Example: Duopoly
Example: Duopoly
Nash equilibrium:
Pair (q*
1
, q*
2
) of outputs such that each firms action
is a best response to the other firms action
or
q*
1
= b
1
(q*
2
) and q*
2
= b
2
(q*
1
)

Solution:
q
1
= ( o - c - q
2
)/2 and q
2
= (o - c - q
1
)/2

q*
1
= q*
2
= (o - c)/3
Example: Duopoly
Example: Duopoly
Conclusion:
Game has unique Nash equilibrium:
(q*
1
, q*
2
) = (( o - c)/3, (o - c)/3)

At equilibrium, each firms profit is
t = ((o - c)
2
)/9

Total output 2/3(o- c) lies between monopoly
output (o - c)/2 and competitive output o - c.

Cournots Model of Oligopoly
Comparison of Nash equilibrium with collusive
outcomes. Can both firms do better than the
Cournot Nash? Yes! (if they can collude)
Exercise 60.2 in Osborne

Dependence of Nash equilibrium on number of
firms. What happens to the Nash quantity and
price as the number of firms grows?
Exercise 61.1 in Osborne
Bertrands Model of Oligopoly
Strategic variable price rather than output.
Single good produced by n firms
Cost to firm i of producing q
i
units: C
i
(q
i
), where
C
i
is nonnegative and increasing
If price is p, demand is D(p)
Consumers buy from firm with lowest price
Firms produce what is demanded

Bertrands Model of Oligopoly
Strategic game:
players: firms
each firms set of actions: set of all possible prices
each firms preferences are represented by its profit
Example: Duopoly
2 firms
C
i
(q
i
) = cq
i
for i = 1, 2
D(p) = o - p



Example: Duopoly
Nash Equilibrium (p
1
, p
2
) = (c, c)

If each firm charges a price of c then the other firm
can do no better than charge a price of c also (if
it raises its price it sells no output, while if it
lowers its price it makes a loss), so (c, c) is a
Nash equilibrium.

Example: Duopoly
No other pair (p
1
, p
2
) is a Nash equilibrium since
If p
i
< c then the firm whose price is lowest (or
either firm, if the prices are the same) can
increase its profit (to zero) by raising its price to c
If p
i
= c and p
j
> c then firm i is better off
increasing its price slightly
if p
i
p
j
> c then firm i can increase its profit by
lowering p
i
to some price between c and p
j
(e.g. to
slightly below p
j
if D(p
j
) > 0 or to p
m
if D(p
j
) = 0).

Example: Duopoly
45
p
1
p
2
c
c
p
m
p
m
P
2
= BR
2
(p
1
)
P
1
= BR
1
(p
2
)
Hotellings Model of Electoral
Competition
Several candidates run for political office
Each candidate chooses a policy position
Each citizen, who has preferences over policy
positions, votes for one of the candidates
Candidate who obtains the most votes wins.

Hotellings Model of Electoral
Competition
Strategic game:
Players: candidates
Set of actions of each candidate: set of possible
positions
Each candidate gets the votes of all citizens who
prefer her position to the other candidates
positions; each candidate prefers to win than to
tie than to lose.

Note: Citizens are not players in this game.


Example
Two candidates
Set of possible positions is a (one-dimensional)
interval.
Each voter has a single favorite position, on
each side of which her distaste for other
positions increases equally.
Unique median favorite position m among the
voters: the favorite positions of half of the voters
are at most m, and the favorite positions of the
other half of the voters are at least m.

Example
Direct argument for Nash equilibrium
(m, m) is an equilibrium: if either candidate chooses
a different position she loses.
No other pair of positions is a Nash equilibrium:
If one candidate loses then she can do better by
moving to m (where she either wins or ties for first
place)
If the candidates tie (because their positions are
either the same or symmetric about m), then
either candidate can do better by moving to m,
where she wins.

The War of Attrition
Two parties involved in a costly dispute
E.g. two animals fighting over prey
Each animal chooses time at which it intends to
give up
Once an animal has given up, the other obtains
all the prey
If both animals give up at the same time then
they split the prey equally.
Fighting is costly: each animal prefers as short a
fight as possible.
Also a model of bargaining between humans.

The War of Attrition
Strategic game
players: the two parties
each players set of actions is [0,) (set of possible
concession times)
player is preferences are represented by payoff
function

The War of Attrition
If t
1
= t
2
then either player can increase her
payoff by conceding slightly later (in which case
she obtains the object for sure, rather than
getting it with probability 1/2 ).
If 0 < t
i
< t
j
then player i can increase her payoff
by conceding at 0.
If 0 = t
i
< t
j
< v
i
then player i can increase her
payoff (from 0 to almost v
i
- t
j
> 0) by conceding
slightly after t
j
.
The War of Attrition
Thus there is no Nash equilibrium in which
t
1
= t
2
, 0 < t
i
< t
j
, or 0 = t
i
< t
j
< v
i
(for i = 1
and j = 2, or i = 2 and j = 1).

The remaining possibility is that 0 = t
i
< t
j

and t
j
v
i
for i = 1 and j = 2, or i = 2 and j =
1. In this case player is payoff is 0, while if
she concedes later her payoff is negative;
player js payoff is v
j
, her highest possible
payoff in the game.
The War of Attrition
In no equilibrium is there any fight
There is an equilibrium in which either
player concedes first, regardless of the
sizes of the valuations.
Equilibria are asymmetric, even when v
1
=
v
2
, in which case the game is symmetric.

Auctions
Second-Price Sealed-Bid Auction
Assume every bidder knows her own valuation and
every other bidders valuation for the good being
sold

Model
each person decides, before auction begins,
maximum amount she is willing to bid
person who bids most wins
person who wins pays the second highest bid.

Second-Price Sealed-Bid Auction
Strategic game:
players: bidders
set of actions of each player: set of possible bids
(nonnegative numbers)
preferences of player i: represented by a payoff
function that gives player i v
i
- p if she wins
(where v
i
is her valuation and p is the second-
highest bid) and 0 otherwise.
Second-Price Sealed-Bid Auction

Simple (but arbitrary) tie-breaking rule: number
players 1, . . . , n and make the winner the player
with the lowest number among those that submit
the highest bid.
Assume that v
1
> v
2
> > v
n
.

Nash equilibria of second-price sealed-
bid auction
One Nash equilibrium
(b
1
, . . . , b
n
) = (v
1
, . . . , v
n
)

Outcome: player 1 obtains the object at price v
2
;
her payoff is v
1
- v
2
and every other players
payoff is zero.
Nash equilibria of second-price sealed-
bid auction
Reason:
Player 1:
If she changes her bid to some x b
2
the
outcome does not change (remember she pays
the second highest bid)

If she lowers her bid below b
2
she loses and
gets a payoff of 0 (instead of v
1
- b
2
> 0).

Nash equilibria of second-price sealed-
bid auction
Players 2, . . . , n:
If she lowers her bid she still loses

If she raises her bid to x b
1
she still loses

If she raises her bid above b
1
she wins, but
gets a payoff v
i
- v
1
< 0.

Nash equilibria of second-price sealed-
bid auction
Another Nash equilibrium
(v
1
, 0, . . . , 0) is also a Nash equilibrium

Outcome: player 1 obtains the object at price 0;
her payoff is v
1
and every other players payoff is
zero.
Nash equilibria of second-price sealed-
bid auction
Reason:
Player 1:
any change in her bid has no effect on the
outcome

Players 2, . . . , n:
if she raises her bid to x s v
1
she still loses
if she raises her bid above v
1
she wins, but
gets a negative payoff v
i
- v
1
.
Nash equilibria of second-price sealed-
bid auction

For each player i the action v
i
weakly
dominates all her other actions

That is: player i can do no better than bid
v
i
no matter what the other players bid.

Nash equilibria of second-price sealed-
bid auction
b

i
< v
i
b

i
= v
i
b

i
> v
i

I Payoff if
b
^
-i
s b

i
v
i
-

b
^
-i
+
v
i
-

b
^
-i
+
v
i
-

b
^
-i
+
II Payoff if
b

i
< b
^
-i
s v
i
0 v
i
-

b
^
-i
+
v
i
-

b
^
-i
+
III Payoff if
v
i
< b
^
-i
s b

i
0 0 v
i
-

b
^
-i
-
IV Payoff if
b

i
<

b
^
-i
0 0 0
First-Price Sealed-Bid Auction
Strategic game:
players: bidders
actions of each player: set of possible bids
(nonnegative numbers)
preferences of player i: represented by a payoff
function that gives player i v
i
- p if she wins
(where v
i
is her valuation and p is her bid) and 0
otherwise.
Nash Equilibria of First-Price Sealed-Bid
Auction
(b
1
, . . . , b
n
) = (v
2
, v
2
, v
3
, . . . , v
n
) is a Nash
equilibrium
Reason:
If player 1 raises her bid she still wins, but pays a
higher price and hence obtains a lower payoff. If
player 1 lowers her bid then she loses, and
obtains the payoff of 0.
If any other player changes her bid to any price at
most equal to v
2
the outcome does not change. If
she raises her bid above v
2
she wins, but obtains
a negative payoff.
Nash Equilibria of First-Price Sealed-
Bid Auction
Property of all equilibria
In all equilibria the object is obtained by the player
who values it most highly (player 1)
Argument:
If player i 1 obtains the object then we must
have b
i
> b
1
.
But there is no equilibrium in which b
i
> b
1
:
If b
i
> v
2
then is payoff is negative, so she can do
better by reducing her bid to 0
If b
i
v
2
then player 1 can increase her payoff
from 0 to v
1
- b
i
by bidding b
i
.
First-Price Sealed-Bid Auction
As in a second-price auction, any player is
action of bidding b
i
> v
i
is weakly dominated by
the action of bidding v
i
:
If the other players bids are such that player i
loses when she bids b
i
, then it makes no
difference to her whether she bids b
i
or v
i

If the other players bids are such that player i
wins when she bids b
i
, then she gets a
negative payoff bidding b
i
and a payoff of 0
when she bids v
i
First-Price Sealed-Bid Auction
Unlike a second-price auction, a bid b
i
< v
i
of
player i is NOT weakly dominated by any bid.

It is not weakly dominated by a bid b
i
< b
i

Neither by a bid b
i
> b
i
Revenue Equivalence
The price at which the object is sold, and
hence the auctioneers revenue, is the same
in the equilibrium (v
1
, v
2
, . . . , v
n
) of the
second-price auction as it is in the equilibrium
(v
2
, v
2
, v
3
, . . . , v
n
) of the first-price auction.