Nash equilibrium

If you haven't watched the movie "A Beautiful Mind", you should. It is about John Nash (played by
Russell Crowe) who won the Nobel Prize in economics for his foundational contributions to game
theory. This is what this tutorial is about. Nash put some structure around how players in a "game"
can optimize their outcomes (if the movie is to be fully believed, this insight struck him when he
realized that if all his friends hit on the most pretty girl, he should hit on the second-most pretty one).
In this tutorial, we use the classic "prisoner's dilemma" to highlight this concept.

Why parties in a cartel will cheat

You know what Nash equilibrium is (from the other tutorial). Now we apply it to a scenario that is
fairly realistic--parties to a cartel cheating. A cartel is a group of actors that agree (sometimes
illegally) to coordinate their production/pricing to maximize their collective economic profit. What we
will see, however, is that this is not a "Pareto optimal" state and they will soon start producing more
than agreed on.
What economists call game theory psychologists call the theory of social situations,
which is an accurate description of what game theory is about. Although game theory is
relevant to parlor games such as poker or bridge, most research in game theory
focuses on how groups of people interact. There are two main branches of game
theory: cooperative and noncooperative game theory. Noncooperative game theory
deals largely with how intelligent individuals interact with one another in an effort to
achieve their own goals. That is the branch of game theory I will discuss here.
In addition to game theory, economic theory has three other main branches:decision
theory, general equilibrium theory and mechanism design theory. All are closely
connected to game theory.
Decision theory can be viewed as a theory of one person games, or a game of a single
player against nature. The focus is on preferences and the formation of beliefs. The
most widely used form of decision theory argues that preferences among risky
alternatives can be described by the maximization of the expected value of a numerical
utility function, where utility may depend on a number of things, but in situations of
interest to economists often depends on money income. Probability theory is heavily
used in order to represent the uncertainty of outcomes, and Bayes Law is frequently
used to model the way in which new information is used to revise beliefs. Decision
theory is often used in the form of decision analysis, which shows how best to acquire
information before making a decision.
General equilibrium theory can be viewed as a specialized branch of game theory that
deals with trade and production, and typically with a relatively large number of
individual consumers and producers. It is widely used in the macroeconomic analysis of
broad based economic policies such as monetary or tax policy, in finance to analyze
stock markets, to study interest and exchange rates and other prices. In recent years,
political economy has emerged as a combination of general equilibrium theory and
game theory in which the private sector of the economy is modeled by general

equilibrium theory, while voting behavior and the incentive of governments is analyzed
using game theory. Issues studied include tax policy, trade policy, and the role of
international trade agreements such as the European Union.
Mechanism design theory differs from game theory in that game theory takes the rules
of the game as given, while mechanism design theory asks about the consequences of
different types of rules. Naturally this relies heavily on game theory. Questions
addressed by mechanism design theory include the design of compensation and wage
agreements that effectively spread risk while maintaining incentives, and the design of
auctions to maximize revenue, or achieve other goals.

An Instructive Example
One way to describe a game is by listing the players (or individuals) participating in the
game, and for each player, listing the alternative choices (called actions or strategies)
available to that player. In the case of a two-player game, the actions of the first player
form the rows, and the actions of the second player the columns, of a matrix. The
entries in the matrix are two numbers representing the utility or payoff to the first and
second player respectively. A very famous game is the Prisoner's Dilemma game. In this
game the two players are partners in a crime who have been captured by the police.
Each suspect is placed in a separate cell, and offered the opportunity to confess to the
crime. The game can be represented by the following matrix of payoffs

not confess confess

not confess 5,5

-4,10

confess

1,1

10,-4

Note that higher numbers are better (more utility). If neither suspect confesses, they
go free, and split the proceeds of their crime which we represent by 5 units of utility for
each suspect. However, if one prisoner confesses and the other does not, the prisoner
who confesses testifies against the other in exchange for going free and gets the entire
10 units of utility, while the prisoner who did not confess goes to prison and which
results in the low utility of -4. If both prisoners confess, then both are given a reduced
term, but both are convicted, which we represent by giving each 1 unit of utility: better
than having the other prisoner confess, but not so good as going free.
This game has fascinated game theorists for a variety of reasons. First, it is a simple
representation of a variety of important situations. For example, instead of confess/not
confess we could label the strategies "contribute to the common good" or "behave
selfishly." This captures a variety of situations economists describe as public goods

problems. An example is the construction of a bridge. It is best for everyone if the

bridge is built, but best for each individual if someone else builds the bridge. This is
sometimes refered to in economics as an externality. Similarly this game could describe
the alternative of two firms competing in the same market, and instead of confess/not
confess we could label the strategies "set a high price" and "set a low price." Naturally
it is best for both firms if they both set high prices, but best for each individual firm to
set a low price while the opposition sets a high price.
A second feature of this game, is that it is self-evident how an intelligent individual
should behave. No matter what a suspect believes his partner is going to do, it is
always best to confess. If the partner in the other cell is not confessing, it is possible to
get 10 instead of 5. If the partner in the other cell is confessing, it is possible to get 1
instead of -4. Yet the pursuit of individually sensible behavior results in each player
getting only 1 unit of utility, much less than the 5 units each that they would get if
neither confessed. This conflict between the pursuit of individual goals and the common
good is at the heart of many game theoretic problems.
A third feature of this game is that it changes in a very significant way if the game is
repeated, or if the players will interact with each other again in the future. Suppose for
example that after this game is over, and the suspects either are freed or are released
from jail they will commit another crime and the game will be played again. In this case
in the first period the suspects may reason that they should not confess because if they
do not their partner will not confess in the second game. Strictly speaking, this
conclusion is not valid, since in the second game both suspects will confess no matter
what happened in the first game. However, repetition opens up the possibility of being
rewarded or punished in the future for current behavior, and game theorists have
provided a number of theories to explain the obvious intuition that if the game is
repeated often enough, the suspects ought to cooperate.

If We Were All Better People The World Would Be A Better

Place
Some of the power and meaning of game theory can be illustrated by assessing the
statement "If we were all better people the world would be a better place." This may
seem to you to be self-evidentally true. Or you may recognize that as a matter of
logic this involves the fallacy of composition: just because a statement applies to each
individual person it need not apply to the group. Game theory can give precise meaning
to the statement of both what it means to be better people and what it means for the
world to be a better place, and so makes it possible to prove or disprove the statement.
In fact the statement is false, and this can be shown by a variation of the Prisoner's
Dilemma.
Let us start with a variation on the Prisoner's Dilemma game we may call the Pride
Game.

proud

not confess

confess

proud

4.0, 4.0

5.4, 3.6

1.2, 0.0

not confess

3.6, 5.4

5.0, 5.0

-4.0, 10.0

confess

0.0, 1.2

10.0, -4.0

1.0, 1.0

The Pride Game is like the Prisoner's Dilemma game with the addition of the new
strategy of being proud. A proud individual is one who will not confess except in
retaliation against a rat-like opponent who confesses. In other words, if I stand proud
and you confess, I get 1.2, because we have both confessed and I can stand proud
before your humiliation, but you get 0, because you stand humiliated before my pride.
On the other hand, if we are both proud, then neither of us will confess, however, our
pride comes at a cost, as we both try to humiliate the other, so we each get 4, rather
than the higher value of 5 we would get if we simply chose not to confess. It would be
worse, of course, for me to lose face before your pride by choosing not to confess. In
this case, I would get 3.6 instead of 4, and you, proud in the face of my humiliation
would get 5.4.
The Pride Game is very different than the Prisoner's Dilemma game. Suppose that we
are both proud. In the face of your pride, if I simply chose not to confess I would
lose face, and my utility would decline from 4 to 3.6. To confess would be even worse
as you would retaliate by confessing, and I would be humiliated as well, winding up
with 0. In other words, if we are both proud, and we each believe the other is proud,
then we are each making the correct choice. Morever, as we are both correct, anything
either of us learns will simply confirm our already correct beliefs. This type of situation where players play the best they can given their beliefs, and they have learned all there
is to learn about their opponents' play is called by game theorists a Nash Equilibrium.
Notice that the original equilibrium of the Prisoner's Dilemma confess-confess is not an
equilibrium of the Pride game: if I think you are going to confess, I would prefer to
stand proud and humiliate you rather than simply confessing myself.
Now suppose that we become "better people." To give this precise meaning take this to
mean that we care more about each other, that is, we are more altruistic, more
generous. Specifically, let us imagine that because I am more generous and care more
about you, I place a value both on the utility I receive in the "selfish" game described
above and on the utility received by you. Not being completely altruistic, I place twice
as much weight on my own utility as I do on yours. So, for example, if in the original

game I get 3 units of utility, and you get 6 units of utility, then in the new game in
which I am an altruist, I get a weighted average of my utility and your utility. I get 2/3
of the 3 units of utility that belonged to me in the original "selfish" game, and 1/3 of
the 6 units of utility that belonged to you in the "selfish" game. Overall I get 4 units of
utility instead of 3. Because I have become a better more generous person, I am happy
that you are getting 6 units of utility, and so this raises my own utility from the selfish
level of 3 to the higher level of 4. The new game with altruistic players is described by
taking a weighted average of each player's utility with that of his opponent, placing 2/3
weight on his own utility and 1/3 weight on his opponent's. This gives the payoff matrix
of the Altruistic Pride Game

proud

not confess

confess

proud

4.00, 4.00

4.8, 4.20*

0.80, 0.40

not confess

4.20*, 4.80

5.00, 5.00

0.67, 5.33*

confess

0.40, 0.80

5.33*, 0.67

1.00*, 1.00*

What happens? If you are proud, I should choose not to confess: if I were to be proud I
get a utility of 4, while if I choose not to confess I get 4.2, and of course if I do confess
I get only 0.4. Looking at the original game, it would be better for society at large if
when you are proud I were to choose not to confess. This avoids the confrontation of
two proud people, although of course, at my expense. However, as an altruist,
I recognize that the cost to me is small (I lose only 0.4 units of utility) while the benefit
to you is great (you gain 1.4 units of utility), and so I prefer to "not confess." This is
shown in the payoff matrix by placing an asterisk next to the payoff 4.2 in the proud
column.
What should I do if you choose not to confess? If I am proud, I get 4.8, if I choose not
to confess I get 5, but if I confess, I get 5.33. So I should confess. Again, this is
marked with an asterisk. Finally, if you confess, then I no longer wish to stand proud,
recognizing that gaining 0.2 by humiliating you comes at a cost of 1 to you. If I choose
not to confess I get only 0.67. So it is best for me to confess as well.
What do we conclude? It is no longer an equilibrium for us both to be proud. Each of us
in the face of the other's pride would wish to switch to not confessing. Of course it is
also not an equilibrium for us both to choose not to confess: each of us would wish to
switch to confessing. The only equilibrium is the box marked with two asterisks where
we are both playing the best we can given the other player's play: it is where we both
choose to confess. So far from making us better off, when we both become more
altruist and more caring about one another, instead of both getting a relatively high
utility of 4, the equilibrium is disrupted, and we wind up in a situation in which we both

get a utility of only 1. Notice how we can give a precise meaning to the "world being a
better place." If we both receive a utility of 1 rather than both receiving a utility of 4,
the world is clearly a worse place.
The key to game theory and to understanding why better people may make the world a
worse place is to understand the delicate balance of equilibrium. It is true that if we
simply become more caring and nothing else happens the world will at least be no
worse. However: if we become more caring we will wish to change how we behave. As
this example shows, when we both try to do this at the same time, the end result may
make us all worse off.
To put this in the context of day-to-day life: if we were all more altruistic we would
choose to forgive and forget more criminal behavior. The behavior of criminals has a
complication. More altruistic criminals would choose to commit fewer crimes. However,
as crime is not punished so severely, they would be inclined to commit more crimes. If
in the balance more crimes are committed, the world could certainly be a worse place.
The example shows how this might work.
For those of you who are interested in or already know more advanced game theory,
the Pride Game has only the one Nash equilibrium shown - it is solvable by iterated
strict dominance. The Atruistic Pride Game, however, has several mixed strategy
equilibria. You can compute them using the fine open source software
program Gambit written by Richard McKelvey, Andrew McLennan and Theodore Turocy.
One equilibrium involves randomizing between proud and confess, so is worse than the
proud-proud equilibrium of the Pride game. The other is strictly mixed in that it
randomizes between all three strategies. The payoffs to that equilibrium gives each
player 2.31 - so while it is better than both players confessing for certain, it is still less
good than the unique equilibrium of the Pride Game.