Nash equilibrium question

CFA Level I Economics
#1

There is a question in Reading 13:

SigmaSoft and ThetaTech are the dominant makers of computer system software. The market has two components: a large mass-market component in which demand is price sensitive, and a smaller performance-oriented component in which demand is much less price sensitive. SigmaSoft’s product is considered to be technically superior. Each company can choose one of two strategies:

● Open architecture (Open): Mass market focus allowing other software venders to develop products for its platform.

● Proprietary (Prop): Allow only its own software applications to run on its platform.

Depending upon the strategy each company selects, their profits would be:

SigmaSoft – Open: 400

ThetaTech – Open:600

SigmaSoft – Prop: 650

ThetaTech – Open:700

SigmaSoft – Open: 800

ThetaTech – Prop:300

SigmaSoft – Prop: 600

ThetaTech – Prop:400

The Nash equilibrium for these companies is:

A proprietary for SigmaSoft and proprietary for ThetaTech.

B open architecture for SigmaSoft and proprietary for ThetaTech.

C proprietary for SigmaSoft and open architecture for ThetaTech

The correct answer is C. I’m confused. As according to Nash Equilibrium, both companies are supposed to choose the strategy that most benefits themsevles, without knowing what the other one will choose. In this case, SigmaSoft shall choose open (800 profits) and ThetaTech shall choose open too (700 profit). So in the end they shall both choose open. But this is not even an option in the answers? Can anyone please help me explain?

Thank you very much!

#2

For Nash equilibrium, you have to assume you are the competitor and guess what move will benefit them the most, then from there decide the best move for yourself. Then do the same for the other company.

So let’s say you are now SigmaSoft. You will try to anticipate what ThetaTech would do. In this case, the best move for ThetaTech is to choose Open architecture (600 or 700). So, for SigmaSoft, the best option is to go for Prop, so you will have a 650 profit. The combination here is SigmaSoft - Prop (650) and ThetaTech - Open (700). If SigmaSoft goes for Open, they will only get 400, which is inferior to 650.

Now let’s say you are ThetaTech. What do you think SigmaSoft would do? The best move for SigmaSoft would be Open, which gives a 800 profit, but there is a risk that their profit will be 400 if ThetaTech goes for Open too. So, this is an inferior outcome for SigmaSoft, so the Open architecture is not a viable option. What if SigmaSoft went for the Prop architecture? Then the profit could be 600 or 650. Given that SigmaSoft went for the Prop architecture, ThetaTech will go for the Open Architecture, and SigmaSoft will get a profit of 650 (which is higher than the outcome under the Open architecture (400).

#3

Thank you very much for your detailed explanation Fino! I’m all clear now! Can’t imagine where else I can get help without you!
Much appreciate it!

1 Like
#4

No problem :sunglasses: