NASH EQUILIBRIUM

Nash Equilibrium is a game theory concept that determines the optimal solution in a non-cooperative
game in which each player lacks any incentive to change his/her initial strategy. Under the Nash
equilibrium, a player does not gain anything from deviating from their initially chosen strategy, assuming
the other players also keep their strategies unchanged. A game may include multiple Nash equilibria or
none of them.

Nash equilibrium is one of the fundamental concepts in game theory. It conceptualizes the behavior and
interactions between game participants to determine the best outcomes. It also allows predicting the
decisions of the players if they are making decisions at the same time and the decision of one player
takes into account the decisions of other players.

Nash equilibrium was discovered by American mathematician, John Nash. He was awarded the Nobel
Prize in Economics in 1994 for his contributions to the development of game theory.

Example

Imagine two competing companies: Company A and Company B. Both companies want to determine
whether they should launch a new advertising campaign for their products.

If both companies start advertising, each company will attract 100 new customers. If only one company
decides to advertise, it will attract 200 new customers, while the other company will not attract any new
customers. If both companies decide not to advertise, neither company will engage new customers. The
payoff table is below:

Company A should advertise its products because the strategy provides a better payoff than the option
of not advertising. The same situation exists for Company B. Thus, the scenario when both companies
advertise their products is a Nash equilibrium.

Example of Multiple Nash Equilibria

Under some circumstances, a game may feature multiple Nash equilibria.

John and Sam are registering for the new semester. They both have the option to choose either a
finance course or a psychology course. They only have 30 seconds before the registration deadline, so
they do not have time to communicate with each other.

If John and Sam register for the same class, they will benefit from the opportunity to study for the
exams together. However, if they choose different classes, neither of them will get any benefit.
In the example, there are multiple Nash equilibria. If John and Sam both register for the same course,
they will benefit from studying together for the exams. Thus, the outcomes finance/finance and
psychology/psychology are Nash equilibria in this scenario.

What is Game Theory?

Game theory is a mathematical framework developed to address problems with conflicting or

cooperating parties who are able to make rational decisions. The theory primarily deals with finding the
optimal rational decision in various scenarios.

Game theory is a relatively new discipline. Modern game theory was introduced in the works of John
von Neumann in the 1920s. Von Neumann, Oskar Morgenstern, and John Nash were the main
contributors to the development of game theory. The theory offers a wide number of applications in
different fields, including economics, political science, finance, psychology, and biology, among others.

Game Theory Applications in Finance

A game theory framework can be applied in different areas of finance, including corporate finance,
portfolio management, and investment banking. Some of the most popular areas of game theory
application are the following:

Asset pricing

Mergers and acquisitions (M&A)

Capital structure

Corporate governance
Classifications in Game Theory

Game theory classifications are related to several settings. The scenarios examined include the
following:

1. Cooperative/Non-cooperative

This is probably the most common type of game discussed in game theory. In cooperative game settings,
the participating players can form binding agreements with each other, and decisions are made by a
coalition (a group of players). The decision made by a coalition leads to the payoff that should be
distributed among the players.

On the other hand, a non-cooperative game considers situations where players cannot form binding
agreements. The non-cooperative game theory analyzes possible strategies and payoffs of individual
players to determine a Nash equilibrium.

2. Symmetric/Asymmetric

A symmetric game deals with a game setting in which the payoffs primarily depend on the strategy
chosen by each player, not on other players’ choices. In an asymmetric game, the payoffs vary among
the players. Thus, even if the players employ the same strategy, their payoff will be different.

3. Zero-sum/Non-zero-sum

In a zero-sum game, the gains/losses of one player are balanced with the losses/gains of other players.
In non-zero-sum games, the gains/losses of one player do not result in the losses/gains of other players.
In other words, a non-zero-sum game may result in a win-win situation.

4. Simultaneous/Sequential

In a simultaneous game, all the participating players make their decisions simultaneously, or they make
their decisions without the knowledge of the decisions of other players. In a sequential game, the
players take turns to make decisions or have information about the decisions of other players.

Learn more with the Behavioral Finance Fundamentals Course.

5. Perfect information/Imperfect information

The perfect information game considers the situation when all the players are able to access the same
information with which to make their decisions. In contrast, in an imperfect information game, the
information that is available to one player is inaccessible to the other players.
POSSIBLE QUESTIONS

What are the types of Nash equilibrium?

There are two pure-strategy Nash equilibria, (yes, yes) and (no, no), and no mixed strategy equilibria,
because the strategy "yes" weakly dominates "no". "Yes" is as good as "no" regardless of the other
player's action, but if there is any chance the other player chooses "yes" then "yes" is the best reply.

What are the general properties of Nash equilibrium?

For strategic games, the Nash equilibrium concept is axiomatized using three properties: (i) if the
difference between two games is 'strategically irrelevant', then their solutions are the same; (ii) if a
player has a strategy with a constant payoff, this player need not settle for less in any solution of the
game.

What is meant by the concept of a Nash equilibrium?

Nash Equilibrium represents an action profile for all players in a game and is used to predict the
outcome of their decision-making interaction. It models a steady state (i.e., a combination of strategies
of all players) in which no player can benefit by unilaterally changing its strategy.

Is Nash equilibrium always a dominant strategy?

A Nash equilibrium is always a dominant strategy equilibrium. If a player's optimal strategy depends on
the behavior of rival players, then that player must have a dominant strategy. The prisoners' dilemma
provides an explanation for price wars among oligopolists.

What is an example social dilemma in economics?

A well-known example of a real-world social dilemma is the problem of over-fishing, whereas individual
fishermen may be tempted to fish as much as they can, if they all do so the fish population might
become depleted, which it detrimental to all fishermen.

What is a real-life example of Nash equilibrium?

Another example where there is a Nash equilibrium in an everyday decision is one that Cornell students
often face. There are two friends, each with two strategies, stay up late and work or go to sleep. In this
case there is only one Nash equilibrium because of the payoff structure.

How does Nash equilibrium apply to economics?

In economic theory, the Nash equilibrium is used to illustrate that decision-making is a system of
strategic interactions based on the actions of other players. It can be used to model economic behavior
to predict the best response to any given situation.

How does game theory apply to economics?

While used in several disciplines, game theory is most notably used as a tool within the study of business
and economics. The "games" may involve how two competitor firms will react to price cuts by the other,
whether a firm should acquire another, or how traders in a stock market may react to price changes.

How do you find Nash equilibrium without dominant strategies?

Finding Nash Equilibrium

If no firm has any dominant strategy, identify any dominated strategies and cross those cells out.
Identify the maximum payoffs for each player in each row and column and place check marks against
them. Cells in which both payoffs are checked show the potential Nash equilibria.

Who created Nash equilibrium?

John Nash

n 1950, John Nash contributed a remarkable one-page PNAS article that defined and characterized a
notion of equilibrium for n- person games. This notion, now called the “Nash equilibrium,” has been
widely applied and adapted in economics and other behavioral sciences.

What is the difference between Nash equilibrium and dominant strategy?

Nash equilibrium takes place when players don't change their positions, knowing that a change in
positions would create a worse outcome. Dominant strategy occurs when each player chooses the best
strategy, independent of the opponent's move.

Can a game have more than one dominant strategy equilibrium?

Dominance and Nash equilibria

If a strictly dominant strategy exists for one player in a game, that player will play that strategy in each
of the game's Nash equilibria. If both players have a strictly dominant strategy, the game has only one
unique Nash equilibrium.

Is Nash Equilibrium the best outcome?

Unlike dominant strategy, the Nash equilibrium doesn't always lead to the most optimal outcome, it just
means that an individual chooses the best strategy based on the information they have.

What is the Nash equilibrium for trade policy?

In the trade policy game, the Nash equilibrium, A game equilibrium in which every player is
simultaneously maximizing his own profit given the choices being made by the other players. or
noncooperative solution is the set of strategies (optimal tariffs, optimal tariffs).

What is a mixed strategy Nash equilibrium?

A mixed strategy Nash equilibrium involves at least one player playing a randomized strategy and no
player being able to increase his or her expected payoff by playing an alternate strategy. A Nash
equilibrium without randomization is called a pure strategy Nash equilibrium.
How do you find the Nash equilibrium of a game?

To find the Nash equilibria, we examine each action profile in turn. Neither player can increase her
payoff by choosing an action different from her current one. Thus, this action profile is a Nash
equilibrium. By choosing A rather than I, player 1 obtains a payoff of 1 rather than 0, given player 2's
action.

Is Nash equilibrium Pareto optimal?

It is found that Pareto optimal strategies are a subset of Nash Equilibrium strategies, and the former give
the maximum payoff to all agents. Calculation of Pareto Optimal solutions incurs a lesser computational
cost than that for Nash Equilibrium solutions.

What is the difference between pure and mixed strategy?

A pure strategy involves all players making their moves simultaneously, while a mixed strategy
minimizes the losses of players.

What is pure strategy in game theory?

In a pure strategy, players adopt a strategy that provides the best payoffs. In other words, a pure
strategy is the one that provides maximum profit or the best outcome to players. Therefore, it is
regarded as the best strategy for every player of the game.

The analysis of anti-dumping actions based on the game theory

As a frequent use of trade protection means in today's international trade, the anti-dumping affects the
development of the world economy and trade cooperation to some extent. Basing on the theory of
static and dynamic game model, the article analyzes the traders' motivation of anti-dumping actions and
the product pricing strategies in consideration of anti-dumping duties. It suggests that a trust and
cooperation mechanism is good for the world trade liberalization and global economic development.

What is the connection between Nash equilibrium and dumping

In this case, (Dump, No countermeasure) is the Nash equilibrium. In other words, when the importing
nation takes counter measures against the potential dumping of the exporting nation, the importing
nation has to spend more than its loss in terms of revenue.