GEORGIA STATE UNIVERSITY

ANDREW YOUNG SCHOOL OF POLICY STUDIES

ECONOMICS DEPARTMENT



EC 8500 History of Economic Thought
Prof. Bruce Kaufman


John Forbes. Nash Jr.
Rationality of Interaction: The Beauty of
Reasoning





Prithvijit Mukherjee







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Adam Smith needs revision! he declares triumphantly. To his baffled
classmates, he explains: "Adam Smith said the best result comes from
everyone in the group doing what's best for himself, right? Adam Smith was
wrong!" The message: Sometimes it's better to cooperate!
- A quote from Beautiful Mind

I . I ntroduction
The quote from Beautiful Mind is probably the best summary of Nashs contribution to
economics, non-cooperative games (a modified Invisible Hand taking into account other
peoples action at work), bargaining games (or cooperative games) and Nash Program (non-
cooperative reduction of cooperative games). Nashs mathematical analysis of game theory
widened the horizon of research in economics. The rational (homoeconomicus) agent could
now be studied in various settings; economics was no longer contained in the realm of
production and allocation of material goods.
Game theory started more formally with mathematicians attempting to find scientific solution
to human conflicts in a simple setting or games. Christian Huygens and Gottfried Leibniz
were the first to understand the importance of this approach. A pivotal development in game
theory was proven by Ernst Zermelo in 1912 that finite games such as tic-tac-toe, chckers,
and chess have an optimal solution, or strategy. His theorem was although not very universal
since the proof required perfect information about past movies and all possible future
moves.

(Karier 2010). Followed by the research by Emile Borel publishing four notes in
Game Theory between 1921-1927, he was the first to define the mixed strategy and
demonstrated the existence of a minimax solution to a two-player zero-sum game. But the
biggest breakthrough came in 1928 with the von Neumann publication On the Theory of
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Social Games in Mathematische Annalen and later refined along with an expected utility
theory in von Neumann and Oscar Morgenstern book Theory of Economic Games and
Behavior.
In 1944, with the publication of von Neumanns and Oskar Morgensterns
Theory of Games and Economic Behavior, the scattered contributions to game
theory were synthesised and extended. It also set an agenda that took
considerable hold of the discipline for years to come.
There are two feature of this book are noteworthy. First, it contains essentially
no new important game-theoretic results. Its theoretical centrepiece remains
the Minimax Theorem. In particular, the authors analysis of non-zero-sum
games, and games with more than two players, produced a lot of interesting
ideas, but no firm conclusion. Second, Morgenstern an economist at Princeton,
had perceived the potential value of game theory to economics. (Ryan 2002)
There was stream of change in the nature of research tools which were evolving in economic
analysis. Cournot, Walras ,Pareto, Jevon, Edgeworth, Marshall among other infused the use
of mathematics in economics which got formalized with the with culminating in the
publication of Paul Samuelsons Foundation of Economic Analysis in 1947, along with the
development of game theory as a field of mathematical study. The two fields of study
converged with The Theory of Games and Economic Behavior along Nashs seminal work on
existence of equilibrium in non-cooperative games only expanded the scope of applicability
of game theory to economics and other social sciences.
The popularisation of game theory as a tool is attributed to Albert Tucker a mathematician
from Princeton and Nashs supervisor while giving a presentation to an audience of
psychologist on game theory invented the example of Prisoners Dilemma showing for a
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rational person the dominant strategy was to betray his partner. Prisoners Dilemma
illustrates the basic and very intuitively the process of reach a (Nash) equilibrium in the
game. This simple example of prisoners dilemma without the oodles of math caught the
attention of academics and soon game theory started being applied to various disciplines.
I I . Short Biography
There are probably only a handful of mathematicians in the world to become famous for their
contribution to economics and even less who became famous for their life stories (Karier
2010) Nashs story comes around a full circle, from a genius mathematician, working in
military intelligence, devastating mental illness and redemption winning the Nobel Prize in
1994.
John Forbes Nash Jr. was born or as he writes in his biography beginning of a legally
recognized individual occurred on June 13, 1928. His father John Forbes Nash was WWI
veteran was an electrical engineer from Texas who came to work for Appalachian Electric
Power Company in Bluefield Virginia. His mother Margaret Virginia Martin, was school
teacher but her life was considerably affected by a partial loss of hearing due to scarlet fever
infection as a student.
Nash writes in his biography writes that Bluefield was a small city which was a centre of
trade hardly had any scholars so from the intellectual viewpoint Nash relied on extra-
curriculum reading like Men of Mathematics, by E.T. Bell In high school he Nash displayed
his talent in mathematics by proving one of Fermats Theorem. In his last year of high school
his parents arranged for classes in mathematics at the Bluefield college which gave him a
head start, as he writes he did not learn much from the first maths courses at Carnegie Tech.
He joined Carnegie Tech. to study chemical engineering switched his major and he graduated
with an M.S .in mathematics in addition to his B.S. For his graduate studies Nash got through
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both Harvard and Princeton with his more than celebrated one line recommendation letter by
R.L. Duffin, This man is a genius. Soon after he graduated he started working at MIT in
1951 but his academic career came to a standstill in 1959, his classes became completely
chaotic and start his tragic mental illness. It is only 1980s that Nash began to recover; today
he continues to explore mathematics at Princeton University.
I I I . Contribution
Non Cooperative Games
When young John Nash came into Princeton he studied mathematics and was influenced by
von Neumanns research on economic application of game theory.
Von Neumann and Morgenstern have developed a very fruitful theory of
two-person zero-sum games in their book Theory of Games and Economic
Behavior. This book also contains a theory of n-person games of a type which
we would call cooperative. This theory is based on an analysis of the
interrelationship of various coalitions which can be formed by the players of
the game. (Pg 5 Nash 1950a)
In essence his dissertation is an extension of von Neumann idea of a zero-sum cooperative
game but with the following important changes:
a) Nash extended the analysis to non-cooperative games, it is assumed that each
participants acts independently, without collaboration or communication with any of
the others (Nash 1950a).
b) The most important contribution of Nash which he called the basic ingredient in our
theory was the idea of a general proof of the existence of equilibrium in n-player
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case ( which is now called Nash Equilibrium) which von Neumann provided a proof
with certain rules.
Nash in his dissertation used the Brouwer fixed-point theorem to prove the existence of the
equilibrium. Ever since then many others inspired from Nash used the Brouwer and Kakutani
fixed point theory, for example the early proofs of the existence of Walrasian Equilibrium
was based on Nashs idea. (Myerson 1999)
Nash in his dissertation gives the following interpretation of his work;
We proceed by investigation the question: what would be rational
prediction of the behaviour to be expected of rational playing the game in
question? By using the principles of rational prediction should be unique, that
the players should be able to deduce and make use of it, and that such
knowledge on the part of each player of what to expect the other to do should
not lead him to act out of conformity with the prediction, one is led to the
concept of a solution. In his interpretation we need to assume that players
know the full structure of the game in order to able to deduce the prediction
for themselves. It is quite strongly a rationalistic and idealizing interpretation
(pg 23, Nash 1950a.)
The notion of the rational individual plays a key role in Nashs equilibrium and in current
research in economics. Nash seminal work broadly expanded the horizon of applicability of
game theory to economics. Situations analyzed in economics are usually non-zero sum
games, this extended the applicability of von-Neumann and Morgenstern work in Theory of
Games and Economic Behavior. The notion of a Nash Equilibrium has been the mainstay in
analysis of conflicts of interests and social outcomes. This has become the testing ground for
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the validity of the theorys prediction via a huge body of growing literature in experimental
economics.

Bargaining
John Nash took only one course in Economics at Carnegie Tech is that of International
Economics that made analyse the possibility of modelling bargaining. Nash followed an
axiomatic approach toward the solution to the bargaining problem which it does not assume
transferable utility in a two person cause. In his paper The Bargaining Problem he develops
an axiomatic approach to solving the bargaining problem, extending the analysing of von
Neumann The Theory of Economic Games and Behaviour.
Nashs Bargaining theory builds on the insight that individuals utility scales
can be defined up to spate increasing linear transformations, but this result
follows only from von Neumann and Morgensterns 1947 derivation of utility.
Thus, Nashs bargaining solution could not have been appreciated before
1947 (Myerson, 1999)
Nash Bargaining solution satisfies the following axioms:
1) Invariant to affine transformation or scale invariance
2) Pareto optimality
3) Independence of irrelevant alternatives
4) Symmetry
The only function which satisfies if the players choose the maximize (u
i
- d)(u
j
d) in a two
player scenario where U is the utility function and d is the disagreement point (this is referred
to as Nash Bargaining Solution). Although in this approach the axiom abstracts away from
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reality, like the symmetry axiom equal bargaining power, in real world hardly this is the case.
But the model provides a benchmark to be considered in an ideal world.
The modern theory of bargaining, which is based on Nashs formulation of the bargaining
problem and incorporates the specific solution that he proposed, lies at the heart of studies of
many real-life negotiations. In particular, Ariel Rubinstiens celebrated model of bargaining
provides a firm foundation for Nashs bargaining solution. As such, Nashs bargaining
solution is the concept often used in applications of bargaining theory, such as in studies
involving firm-union wage negotiations and international negotiations
Nash Program
In 1950 and 1953 paper, Nash offered an application of his program for reducing cooperative
game theory to non-cooperative equilibrium analysis.
This meaning of this term (Nash Program) can be understood by studying the
two papers together: The bargaining problem is a description of the utilities
that can be achieved. Nash in the first paper considers an abstract rule that
picks a solution from any possible bargaining problem. His simple and
reasonable axioms yield an unique solution now called the Nash bargaining
solution. The second paper takes as its starting point a normal form game,
views the set of possible outcomes of this cgame as the attainable payoffs of a
bargaining problem, describes a new noncooperative game to model the
negotiation procedures, computes a Nash equilibrium of the negotiation game
and observes that his Nash equilibrium results in the payoffs associated with
the bargaining solution. Thus, the axiomatic solution is justified showing that
it is the Nash equilibrium outcome of some noncooperative game. (Gul 1997)
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The Nash program draws an important equivalence between cooperative and non-cooperative
games which highlight the role of a rational human reasoning.
IV. Discussion of Nashs contribution and Conclusion
It is merely not enough to laud the wide array of application and further research in game
theory and bargaining theory which was inspired by Nashs work. But in essence understand
the inter-twining of Nashs work and economic theory.
Rubinstein (1995) points an interesting aspect of Nashs 1950 paper, he discusses if the paper
evaluated by current standards, the referee would make the following complaints:
1) The paper lack economic example which demonstrate the usefulness of the model.
The paper provides only one example namely a Three-man Poker Game which is
unrealistic
2) The model is unrealistic: it is difficult to think of any strategic interaction in which
each player chooses a single action and all players move simultaneously. Exceptions
are mostly from zero sum games which have already analyzed by von Neumann and
Morgenstern. Thus difficult to see the value addition to zero-sum games
3) The concept of equilibrium is too weak to be interesting. In economics we need
powerful tools and this equilibrium is usually uninformative
4) The notion of mixed strategy which has some appeal in the context of zero-sum
games is not realistic in the context of non zero sum games.
These are all valid complaints but still do not undermine the importance of Nashs
contribution to economics. The beauty of Nashs work is the simple structure to represent the
process of reason about a situation. What Nash achieved in his work a model of interactive
rationality which is key to economics, at the end of the day through various models, schools
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of thought what we are trying to understand and synthesize is how economic agents interact
given priors. Even the simplest model of perfect competition taught in Econ 101 models the
interactive rationality of individual firms vis--vis the market structure. What Nashs
contribution expanded our horizon beyond market structure to every aspect of human
interaction which involves a pay-off to an individual. It is the generality of definition of
equilibrium which has aided future research is applying game theory to social sciences.
Nashs in his interpretations of his dissertation and even his bargaining paper (Nash 1950b)
highlights the most critical aspect on his theory hinges on notion of rationality. Nash writes
we idealize the bargaining problem by assuming that the two individuals are highly
rational, that each can accurately compare his desires for various things, that they are equal in
bargaining skill Nash made no tall claims of the practical applicability of his theory, then
the question arises what makes Nashs work so pivotal to the progress of economic theory.
The common denominator which binds the current exposition in research in economics and
Nashs contribution is the notion of a rational agent or the homoeconomicus. The notion of
perfectly rational although far from the reality has yield tractable results in economic analysis
than any other theory of human behaviour.
the functional goal of social science is not just to predict human behavior
in the abstract, but analyze social institutions and evaluated proposals for
institutional reforms (Myerson 1999)
One of the most important research questions have been studying the social structure and
institutions in which human behaviour is nested. The assumption of perfect rationality allows
us to clearly distinguish the effects which are due to irrational behaviour and that from flaws
in the institutional structure. Economic theory in essence will collapse if we dont endorse to
the notion that individuals are self utility maximizers, after all economics as a social science
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is trying to measure and improve a notion of welfare, as understood and analysed by the
father of modern economics, Adam Smith in The Wealth of Nation. When analysing
economic problems related to welfare or social outcomes if analysis reveals the deviations
from optimal solution is due to flaws in the design or some agents donot completely
understand their scenario gives us direct policy prescription one can work on. This notion of
rationality although vague and abstracted from reality is the key to economic analysis and
Nashs solutions.
The Nash equilibrium is useful not just when it is itself an accurate predictor
of how people will behave in a game but also when it is not, because then it
identifies situations in which there is a tension between individual incentives
and other motivations. A class of problems that have received a good deal of
study from this point of view is the family of social dilemmas, in which
there is a socially desirable action that is not a Nash Equilibrium. (Holt and
Roth 2004)
One of the more recent and robust strand of economics taking shape today is experimental
economics which was started as field of enquiry more formally by Nobel Laureate Vernon
Smith. It is worth mentioning that Nash both commented on and participated in early
experiments in economics (Holt and Roth 2004), it was a natural development from terse
mathematical structures and assumption to apply testing these notions in the laboratory on
people actually making these decisions. Game theory moved to the frontier of economic
research due to it is strongly testable prediction, which laid the foundation for experimental
economics. This extension is possibly more exciting avenues of developing tractable theories
of irrational behaviour to make theories in economics more real. Before Smiths
experiments it was widely believe that the competitive predictions of supply/demand
intersections required very large numbers of well-informed traders. Smith showed that
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competitive efficient outcomes could be observed with surprisingly small number of traders,
each with no direct knowledge of others costs or value. An important developing area of
game theory is to explain these and other experimental results in the context of well specified
dynamic models of interactions. (Holt and Roth 2004). Also experimental studies have
shown abstract models have predictive power which only reinforces the idea of the rational
agent might not although unreal can predict with some degree of accuracy the outcomes in
the economy. One of the most important aspect which has been highlighted by experimental
economics in the dynamic evolution of interaction which eventually converge towards
learning and better understanding of the situation, even papers written about use of heuristics
in analysing economic scenarios converge on average to a Nash Equilibrium on average.
In conclusion it is hard to refute the importance of Nashs theory to economics as a field of
study, probably he is the most celebrated Mathematician in economics and his ideas are so
integrated with the study of economics, today hardly it is required to quote Nashs paper
when talking about Nash equilibrium. Also, Nashs work has not only inspired work in
further in game theory and bargaining theory but also in various other application and newer
avenues of research like experimental economics. It often takes a lot of words to express
something very simple, a model of interactive rationality fundamentally shifted the frontier of
research in economics.





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Reference:
1) Damme, E and Weibull, J (1995), Equilibrium in Strategic Interaction: The
Contributions of John C. Harsanyi, John F. Nash and Reinhard Selten Scandinavian
Journal of Economics, 97 15-40
Ryan, Matthew J. (2002) "Mathematicians as Great Economists: John Forbes Nash,
Jr." Agenda 9, no. 2: 121-134.
2) Holt, C. A. and Roth, A. E., (2004) The Nash equilibrium: A perspective, in
Proceedings of the National Academy of Sciences, vol. 101, no. 12,.
3) Karier, T. (2010) Intellectual Capital: Forty Years of the Nobel Prize in Economics,
Cambridge University Press
4) Muthoo, A, (2002) On John Nash's Scientific Contributions, in Game Theory: A
Festschrift in honor of John Nash, edited by C. Kottaridi and G. Siourounis, Eurasia
Publications, Athens, Greece, 2002, 134-137.
5) Myerson, R.B. (1999) "NASH Equilibrium and The History of Economic Theory",
Journal of Economic Literature 36:1067-1082.
6) Nash, Jr., John F. 1950a. Noncooperative Games Dissertation, Princeton University
7) Nash, Jr., John F. 1950b. "The bargaining problem." Econometrica 18:155-162.
8) Nash, Jr., John F. 1951. "Noncooperative games." Annals of Mathematics 54:289-
295.
9) Nash, Jr., John F. 1953. "Two-person cooperative games." Econometrica 21:128-140.
10) Nash, Jr., John F.. - Biographical". Nobelprize.org. Nobel Media AB 2013. Web. 17
Apr 2014. <http://www.nobelprize.org/nobel_prizes/economic-
sciences/laureates/1994/nash-bio.html>
11) Rubinstein, Ariel. 1995. "John Nash: the master of economic modeling."
Scandinavian Journal of Economics 97:9-13.