If in the future we develop the ability to make accurate simulations of other humans, a lot of things will change for the weirder. In many situations where agents with access to simulations of each other interact, a strange type of apparent backward causality will arise. For instance…

When you have two agents that both have access to simulations of the other, things get weird. In such situations, there’s no clear notion of whose decision is a response to the other (as both are responding to each other’s future decision), and so there’s no clear notion of whose decision is causally first. But the question of “who comes first” (in this strange non-temporal sense) turns out to be very important to what strategy the various agents should take!

Let’s consider some examples.

# Chicken

Two agents are driving head-on towards each other. Each has a choice to swerve or to stay driving straight ahead. If they both stay, then they crash and die, the worst outcome for all. If one stays and the other swerves, then the one that swerves pays a reputational cost and the one that stays gains some reputation. And if both swerve, then neither gains or loses any reputation. To throw some numerical values on these outcomes, here’s a payoff matrix:

This is the game of chicken. It is an anti-cooperation game, in that if one side knows what the other is going to do, then they want to do the opposite. The (swerve, swerve) outcome is unstable, as both players are incentivized to stay if they know that their opponent will swerve. But so is the (stay, stay) outcome, as this is the worst possible outcome for both players and they both stand to gain by switching to swerve. There are two pure strategy Nash equilibria (swerve, stay) and (stay, swerve), and one mixed strategy equilibria (with the payoff matrix above, it corresponds to swerving with probability 90% and staying with probability 10%).

That’s all standard game theory, in a setting where you don’t have access to your opponent’s algorithm. But now let’s take this thought experiment to the future, where each player is able to simulate the other. Imagine that you’re one of the agents. What should you do?

The first thought might be the following: you have access to a simulation of your opponent. So you can just observe what the simulation of your opponent does, and do the opposite. If you observe the simulation swerving you stay, and if you observe the simulation staying you swerve. This has the benefit of avoiding the really bad (stay, stay) outcomes, while also exploiting opponents that decide to swerve.

The issue is that this strategy is exploitable. While you’re making use of your ability to simulate your opponent, you are neglecting the fact that your opponent is also simulating you. Your opponent can see that this is your strategy, so they know that whatever they decide to play, you’ll play the opposite. So if they decide to tear off their steering wheel to ensure that they will not swerve no matter what, they know that you’ll fall in line and swerve, thus winning them +1 utility and losing you -1 utility. This is a precommitment: a strategy that an agent uses that restricts the number of future choices available to them. It’s quite unintuitive and cool that this sort of tying-your-hands ends up being an enormously powerful weapon for those that have access to it.

In other words, if Agent 1 sees that Agent 2 is treating their decision as a fixed fact and responding to it accordingly, then Agent 1 gets an advantage, as they can precommit to staying and force Agent 2 to yield to them. But if Agent 2 now sees Agent 1 as responding to their algorithm rather than the other way around, then Agent 2 benefits by precommitting to stay. If there’s a fact about which agent precommits “first”, then we can conclusively say that this agent does better, as they can force the outcome they want. But again, this is not a temporal first. Suppose that Agent 2 is asleep at the wheel, about to wake up, and Agent 1 is trying to decide what to do. Agent 1 simulates them and sees that once they wake up they will tear out their steering wheel without even considering what Agent 2 does. Now Agent 1’s hand is forced; he will swerve in response to Agent 2’s precommitment, even though it hasn’t yet been made. It appears that for two agents in a chicken-like scenario, with access to simulations of one another, the best action is to precommit as quickly and firmly as possible, with as little regard for their opponents’ precommitments as they can manage (the best-performing agent is the one that tears off their steering wheel without even simulating their opponent and seeing their precommitments, as this agent puts themselves fully causally behind anybody that simulates them). But this obviously just leads straight to the (stay, stay) outcome!

This pattern of precommitting, then precommitting to not respond to precommitments, then precommiting to not respond to precommitments to not respond to precommitments, and so on, shows up all over the place. Let’s have another example, from the realm of economics.

# Company Coordination and Boycotts

In my last post, I talked about the Cournot model of firms competing to produce a homogenous good. We saw that competing firms face a coordination problem with respect to the prices they set: every firm sees it in their rational self-interest to undercut other firms to take their customers, but then other firms follow suit, ending up with the price dropping for everybody. That’s good for consumers, but bad for producers! The process of undercutting and then re-equilibrating continues until the price is at the bare minimum that it takes for a producer to be willing to make the good – essentially just minutely above the cost of production. At this point, producers are making virtually no profit and consumer surplus is maximized.

This coordination problem, like all coordination problems, could be solved if only the firms had the ability to precommit. Imagine that the heads of all the companies meet up at some point. They all see the problem that they’re facing, and recognize that if they can stop the undercutting, they’ll all be much richer. So they sign on to a vow to never undercut each other. Of course, signing a piece of paper doesn’t actually restrict your future options. Every company is still just as incentivized as before to break the agreement and undercut their competitors. It helps if they have plausible deniability; the ability to say that their price drop was actually not intended to undercut, but a response to some unrelated change in the market. All that the meeting does is introduce some social cost to undercutting and breaking the vow that wasn’t there before.

To actually permanently fix the coordination problem, the companies need to be able to sign on to something that truly and irrevocably ties their hands, giving them no ability to back out later on (equivalent to the tearing-off-the-steering-wheel as a credible precommitment). Maybe they all decide to put some money towards the creation of a final-check mechanism that looks over all price changes and intervenes to stop any changes that it detects to be intended to undercut opponents. This is precommitment in the purer sense of literally removing an option that the firms previously had. And if this type of tying-of-hands was actually possible, then each company would be rationally incentivized to sign on! (Of course, they’d all be looking for ways to cheat the system and break the mechanism at every step, which would make its actual creation a tad bit difficult.)

So, if you give all companies the ability to jointly sign on to a credible precommitment to not undercut their opponents, then they will take that opportunity. This will keep prices high and keep profits flowing in to the companies. Producer surplus will be maximized, and consumers will get the short end of the stick. Is there any way for the consumers to fight back?

Sure there is! All they need is the ability to precommit as well. Suppose that all consumers are now given the opportunity to come together and boycott any and all companies that precommit to not undercutting each other. If every consumer signs on, and if producers know this, then it’s no longer worth it for them to put in place the price-monitoring mechanism, as they’d just lose all their customers! Of course, the consumers now face their own coordination problem; many of them will still value the product at a price higher than that which is being offered by the companies, even if they’re colluding. And each individual reasons that as long as everybody else is still boycotting the companies, it makes little difference if just one mutually beneficial trade is made with them. So the consumers will themselves face the problem of how to enforce the boycott. But let’s assume that the consumers work this out so that they credibly precommit to never buying from a company that credibly precommits to not undercutting its competitors. Now the market price swings back in their favor, dropping to the cost of production! The consumers win! Whoohoo!

But we’re not done yet. It was only worth it for the consumers to sign on to this precommitment because they predicted that the companies would respond to their precommitment. But what if the companies, seeing the boycott-tactic coming, credibly precommit to never yielding to boycotters? Then the consumers, responding to this precommitment, will realize that boycotting will have no effect on prices, and will just cause them all to lose out on mutually beneficial trades! So they won’t boycott, and therefore the producers get the surplus once more. And just like before, this swings back and forth, with the outcome at each stage depending on which agent treats the other agent’s precommitment as being more primal. But if they each run their apparently-best strategy (that is, making their precommitments with no regard to the precommitments of the other party so as to force their hand and place their own precommitments at the beginning of the causal chain), then we end up with the worst possible outcome for all: producers don’t produce anything and consumers don’t consume, and everybody loses out.

This question of how agents that can simulate one another AND precommit to courses of action should ultimately behave is something that I find quite puzzling and am not sure how to resolve.

# Solving the Linear Cournot Model

The Cournot model is a simple economic model used to describe what happens when multiple companies compete with one another to produce some homogenous product. I’ve been playing with it a bit and ended up solving the general linear case. I assume that this solution is already known by somebody, but couldn’t find it anywhere. So I will post it here! It gives some interesting insight into the way that less-than-perfectly-competitive markets operate. First let’s talk about the general structure of the Cournot model.

Suppose we have n firms. Each produces some quantity of the product, which we’ll label as $q_1, q_2, ..., q_n$. The total amount of product on the market will be given the label $Q = q_1 + q_2 + ... + q_n$. Since the firms are all selling identical products, it makes sense to assume that the consumer demand function $P(q_1, q_2, ..., q_n)$ will just be a function of the total quantity of the product that is on the market: $P(q_1, q_2, ..., q_n) = P(q_1 + q_2 + ... + q_n) = P(Q)$. (This means that we’re also disregarding effects like customer loyalty to a particular company or geographic closeness to one company location over another. Essentially, the only factor in a consumer’s choice of which company to go to is the price at which that company is selling the product.)

For each firm, there is some cost to producing the good. We capture this by giving each firm a cost function $C_1(q_1), C_2(q_2), ..., C_n(q_n)$. Now we can figure out the profit of each firm for a given set of output values $q_1, q_2, ..., q_n$. We’ll label the profit of the kth firm as $\Pi_k$. This profit is just the amount of money they get by selling the product minus the cost of producing the product: $\Pi_k = q_k P(Q) - C_k(q_k)$.

If we now assume that all firms are maximizing profit, we can find the outputs of each firm by taking the derivative of the profit and setting it to zero. $\frac{d\Pi_k}{dq_k} = P(Q) + q_k \frac{dP}{dQ} - \frac{dC_k}{dq_k} = 0$. This is a set of n equations with n unknown, so solving this will fully specify the behavior of all firms!

Of course, without any more assumptions about the functions $P$ and $C_k$, we can’t go too much further with solving this equation in general. To get some interesting general results, we’ll consider a very simple set of assumptions. Our assumptions will be that both consumer demand and producer costs are linear. This is the linear Cournot model, as opposed to the more general Cournot model.

In the linear Cournot model, we write that $P(Q) = a - bQ$ (for some a and b) and $C_k(q_k) = c_k q_k$. As an example, we might have that P(Q) = $100 –$2 × Q, which would mean that at a price of \$40, 30 units of the good will be bought total.

The constants $c_k$ represent the marginal cost of production for each firm, and the linearity of the cost function means that the cost of producing the next unit is always the same, regardless of how many have been produced before. (This is unrealistic, as generally it’s cheaper per unit to produce large quantities of a good than to produce small quantities.)

Now we can write out the profit-maximization equations for the linear Cournot model. $\frac{d\Pi_k}{dq_k} = P(Q) + q_k \frac{dP}{dQ} - \frac{dC_k}{dq_k} = a - bQ - b q_k - c_k = 0$. Rewriting, we get $q_k + Q = \frac{a - c_k}{b}$. We can’t immediately solve this for $q_k$, because remember that Q is the sum of all the quantities produced. All n of the quantities we’re trying to solve are in each equation, so to solve the system of equations we have to do some linear algebra!

$2q_1 + q_2 + q_3 + ... + q_n = \frac{a - c_1}{b} \\ q_1 + 2q_2 + q_3 + ... + q_n = \frac{a - c_2}{b} \\ q_1 + q_2 + 2q_3 + ... + q_n = \frac{a - c_2}{b} \\ \ldots \\ q_1 + q_2 + q_3 +... + 2q_n = \frac{a - c_n}{b}$

Translating this to a matrix equation…

$\begin{bmatrix} 2 & 1 & 1 & 1 & 1 & \ldots \\ 1 & 2 & 1 & 1 \\ 1 & 1 & 2 & & \ddots \\ 1 & 1 & & \ddots \\ 1 & & \ddots \\ \vdots \end{bmatrix} \begin{bmatrix} q_1 \\ q_2 \\ q_3 \\ \vdots \\ q_{n-2} \\ q_{n-1} \\ q_n \end{bmatrix} = \frac{1}{b} \begin{bmatrix} a - c_1 \\ a - c_2 \\ a - c_3 \\ \vdots \\ a - c_{n-2} \\ a - c_{n-1} \\ a - c_n \end{bmatrix}$

Now if we could only find the inverse of the first matrix, we’d have our solution!

$\begin{bmatrix} q_1 \\ q_2 \\ q_3 \\ \vdots \\ q_{n-2} \\ q_{n-1} \\ q_n \end{bmatrix} = \begin{bmatrix} 2 & 1 & 1 & 1 & 1 & \ldots \\ 1 & 2 & 1 & 1 \\ 1 & 1 & 2 & & \ddots \\ 1 & 1 & & \ddots \\ 1 & & \ddots \\ \vdots \end{bmatrix} ^{-1} \frac{1}{b} \begin{bmatrix} a - c_1 \\ a - c_2 \\ a - c_3 \\ \vdots \\ a - c_{n-2} \\ a - c_{n-1} \\ a - c_n \end{bmatrix}$

I found the inverse of this matrix by using the symmetry in the matrix to decompose it into two matrices that were each easier to work with:

$\mathcal{I} = \begin{bmatrix} 1 & 0 & 0 & 0 \ldots \\ 0 & 1 & 0 \\ 0 & 0 & \ddots \\ 0 \\ \vdots \end{bmatrix}$

$\mathcal{J} = \begin{bmatrix} 1 & 1 & 1 & 1 \ldots \\ 1 & 1 & 1 \\ 1 & 1 & \ddots \\ 1 \\ \vdots \end{bmatrix}$

$\begin{bmatrix} 2 & 1 & 1 & 1 & 1 & \ldots \\ 1 & 2 & 1 & 1 \\ 1 & 1 & 2 & & \ddots \\ 1 & 1 & & \ddots \\ 1 & & \ddots \\ \vdots \end{bmatrix} = \mathcal{I} + \mathcal{J}$

As a hypothesis, suppose that the inverse matrix has a similar form (one value for the diagonal elements, and another value for all off-diagonal elements). This allows us to write an equation for the inverse matrix:

$(\mathcal{I} + \mathcal{J}) (A \mathcal{I} + B \mathcal{J}) = \mathcal{I}$

To solve this, we’ll use the following easily proven identities.

$\mathcal{I} \cdot \mathcal{I} = \mathcal{I} \\ \mathcal{I} \cdot \mathcal{J} = \mathcal{J} \\ \mathcal{J} \cdot \mathcal{I} = \mathcal{J} \\ \mathcal{J} \cdot \mathcal{J} = n \mathcal{J} \\$

$(\mathcal{I} + \mathcal{J}) (A \mathcal{I} + B \mathcal{J}) \\ = A \mathcal{I} + A \mathcal{J} + B \mathcal{J} + nB \mathcal{J} \\ = A \mathcal{I} + \left( A + B(n+1) \right) \mathcal{J} \\ = \mathcal{I}$

$A = 1 \\ A + B(n+1) = 0$

$A = 1 \\ B = - \frac{1}{n+1}$

$(\mathcal{I} + \mathcal{J})^{-1} = \mathcal{I} - \frac{1}{n+1} \mathcal{J} = \frac{1}{n+1} \begin{bmatrix} n & -1 & -1 & -1 & -1 & \ldots \\ -1 & n & -1 & -1 \\ -1 & -1 & n & & \ddots \\ -1 & -1 & & \ddots \\ -1 & & \ddots \\ \vdots \end{bmatrix}$

Alright awesome! Our hypothesis turned out to be true! (And it would have even if the entries in our matrix hadn’t been 1s and 2s. This is a really cool general method to find inverses of this family of matrices.) Now we just use this inverse matrix to solve for the output from each firm!

$\begin{bmatrix} q_1 \\ q_2 \\ q_3 \\ \vdots \\ q_{n-2} \\ q_{n-1} \\ q_n \end{bmatrix} = (\mathcal{I} - \frac{1}{n+1} \mathcal{J}) \ \frac{1}{b} \begin{bmatrix} a - c_1 \\ a - c_2 \\ a - c_3 \\ \vdots \\ a - c_{n-2} \\ a - c_{n-1} \\ a - c_n \end{bmatrix}$

Define: $\mathcal{C} = \sum_{i=1}^{n}{c_i}$

$q_k = \frac{1}{b} (a - c_k - \frac{1}{n+1} \sum_{i=1}^{n}{(a - c_i)}) \\ ~~~~ = \frac{1}{b} (a - c_k - \frac{1}{n+1} (an - \mathcal{C})) \\ ~~~~ = \frac{1}{b} (\frac{a + \mathcal{C}}{n+1} - c_k)$

$Q^* = \sum_{k=1}^n {q_k} \\ ~~~~~ = \frac{1}{b} \sum_{k=1}^n ( \frac{a + \mathcal{C}}{n+1} - c_k ) \\ ~~~~~ = \frac{1}{b} \left( \frac{n}{n+1} (a + \mathcal{C}) - \mathcal{C} \right) \\ ~~~~~ = \frac{1}{b} \left( \frac{n}{n+1} a - \frac{\mathcal{C}}{n+1} \right) \\ ~~~~~ = \frac {an - \mathcal{C}} {b(n+1)}$

$P^* = a - bQ^* \\ ~~~~~ = a - \frac{an - \mathcal{C}}{n+1} \\ ~~~~~ = \frac{a + \mathcal{C}}{n+1}$

$\Pi_k^* = q_k^* P^* - c_k q_k^* \\ ~~~~~ = \frac{1}{b} (\frac{a+\mathcal{C}}{n+1} - c_k) \frac{a + \mathcal{C}}{n+1} - \frac{c_k}{b} (\frac{a + \mathcal{C}}{n+1} - c_k) \\ ~~~~~ = \frac{1}{b} \left( \left( \frac{a + \mathcal{C}}{n+1} \right)^2 - 2c_k\left( \frac{a + \mathcal{C}}{n+1} \right) + c_k^2 \right) \\ ~~~~~ = \frac{1}{b} \left( \frac{a + \mathcal{C}}{n+1} - c_k \right)^2$

And there we have it, the full solution to the general linear Cournot model! Let’s discuss some implications of these results. First of all, let’s look at the two extreme cases: monopoly and perfect competition.

Monopoly: n = 1
$Q^* = \frac{1}{2b} (a - c) \\ P^* = \frac{1}{2} (a + c) \\ \Pi^* = \frac{1}{b} \left( \frac{a - c}{2} \right)^2$

Perfect Competition: n → ∞
$q_k^* \rightarrow \frac{1}{b} (\bar c - c_k) \\ Q^* \rightarrow \frac{1}{b} (a - \bar c) \\ P^* \rightarrow \bar c \\ \Pi^* \rightarrow \frac{1}{b} (\bar c - c_k)^2$

The first observation is that the behavior of the market under monopoly looks very different from the case of perfect competition. For one thing, notice that the price under perfect competition is always going to be lower than the price under monopoly. This is a nice demonstration of the so-called monopoly markup. The quantity $a$ intuitively corresponds to the highest possible price you could get for the product (the most that the highest bidder would pay). And the quantity $c$, the production cost, is the lowest possible price at which the product would be sold. So the monopoly price is the average of the highest price you could get for the good and the lowest price at which it could be sold.

The flip side of the monopoly markup is that less of the good is produced and sold under a monopoly than under perfect competition. There are trades that could be happening (trades which would be mutually beneficial!) which do not occur. Think about it: the monopoly price is halfway between the cost of production and the highest bidder’s price. This means that there are a bunch of people that would buy the product at above the cost of production but below the monopoly price. And since the price they would buy it for is above the cost of production, this would be a profitable exchange for both sides! But alas, the monopoly doesn’t allow these trades to occur, as it would involve lowering the price for everybody, including those who are willing to pay a higher price, and thus decreasing net profit.

Things change as soon as another firm joins the market. This firm can profitably sell the good at a lower price than the monopoly price and snatch up all of their business. This introduces a downward pressure on the price. Here’s the exact solution for the case of duopoly.

Duopoly: n = 2
$q_1 = \frac{1}{3b} (a - 2c_1 + c_2) \\ q_2 = \frac{1}{3b} (a + c_1 - 2c_2) \\ Q^* = \frac{1}{3b} (2a - c_1 - c_2) \\ P^* = \frac{1}{3} (a + c_1 + c_2) \\ \Pi_1^* = \frac{1}{3b} (a - 2c_1 + c_2)^2 \\ \Pi_2^* = \frac{1}{3b} (a + c_1 - 2c_2)^2 \\$

Interestingly, in the duopoly case the market price still rests at a value above the marginal cost of production for either firm. As more and more firms enter the market, competition pushes the price down further and further until, in the limit of perfect competition, it converges to the cost of production.

The implication of this is that in the limit of perfect competition, firms do not make any profit! This may sound a little unintuitive, but it’s the inevitable consequence of the line of argument above. If a bunch of companies were all making some profit, then their price is somewhere above the cost of production. But this means that one company could slightly lower its price, thus snatching up all the customers and making massively more money than its competitors. So its competitors will all follow suit, pushing down their prices to get back their customers. And in the end, all the firms will have just decreased their prices and their profits, even though every step in the sequence appeared to be the rational and profitable action by each firm! This is just an example of a coordination problem. If the companies could all just agree to hold their price fixed at, say, the monopoly price, then they’d all be better off. But each individual has a strong monetary incentive to lower their price and gather all the customers. So the price will drop and drop until it can drop no more (that is, until it has reached the cost of production, at which point it is no longer profitable for a company to lower their price).

This implies that in some sense, the limit of perfect competition is the best possible outcome for consumers and the worst outcome for producers. Every consumer that values the product above the cost of its production will get it, and they will all get it at the lowest possible price. So the consumer surplus will be enormous. And companies producing the product make no net profit; any attempt to do so immediately loses them their entire customer base. (In which case, what is the motivation for the companies to produce the product in the first place? This is known as the Bertrand paradox.)

We can also get the easier-to-solve special case where all firms have the same cost of production.

Equal Production Costs
$\forall k (c_k = c)$
$q_k^* = \frac{1}{n+1} \frac{a - c}{b} \\ Q^* = \frac{n}{n+1} \frac{a - c}{b} \\ P^* = \frac{a + nc}{n + 1} \\ \Pi^* = \frac{1}{b} \left( \frac{a - c}{n+1} \right)^2$

It’s curious that in the Cournot model, prices don’t immediately drop to production levels as soon you go from a monopoly to a duopoly. After all, the intuitive argument I presented before works for two firms: if both firms are pricing the goods at any value above zero, then each stands to gain by lowering the price a slight bit and getting all the customers. And this continues until the price settles at the cost of production. We didn’t build in any ability of the firms to collude to the model, so what gives? What the Cournot model tells us is certainly more realistic (we don’t expect a duopoly to behave like a perfectly competitive market), but where does this realism come from?

The answer is that in a certain sense we did build in collusion between firms from the start, in the form of agreement on what price to sell at. Notice that our model did not allow different firms to set different prices. In this model, firms compete only on quantity of goods sold, not prices. The price is set automatically by the consumer demand function, and no single individual can unilaterally change their price. This constraint is what gives us the more realistic-in-character results that we see, and also what invalidates the intuitive argument I’ve made here.

One final observation. Consider the following procedure. You line up a representative from each of the n firms, as well as the highest bidder for the product (representing the highest price at which the product could be sold). Each of the firms states their cost of production (the lowest they could profitably bring the price to), and the highest bidder states the amount that he values the product (the highest price at which he would still buy it). Now all of the stated costs are averaged, and the result is set as the market price of the good. Turns out that this procedure gives exactly the market price that the linear Cournot model predicts! This might be meaningful or just a curious coincidence. But it’s quite surprising to me that the slope of the demand curve ($b$) doesn’t show up at all in the ultimate market price, only the value that the highest bidder puts on the product!