Extensive form representation of a two proposal ultimatum game. Player 1 can offer a fair (F) or unfair (U) proposal; player 2 can accept (A) or reject (R).
For ease of exposition, the simple example illustrated above can be considered, where the proposer has two options: a fair split, or an unfair split. The argument given in this section can be extended to the more general case where the proposer can choose from many different splits.
A Nash equilibrium is a set of strategies (one for the proposer and one for the responder in this case), where no individual party can improve their reward by changing strategy. If the proposer always makes an unfair offer, the responder will do best by always accepting the offer, and the proposer will maximize their reward. Although it always benefits the responder to accept even unfair offers, the responder can adopt a strategy that rejects unfair splits often enough to induce the proposer to always make a fair offer. Any change in strategy by the proposer will lower their reward. Any change in strategy by the responder will result in the same reward or less. Thus, there are two sets of Nash equilibria for this game:
- The proposer always makes an unfair offer, and the responder always accepts an unfair offer. (The proposer never gives a fair offer so the responder can accept fair offers with any frequency without affecting the average reward.)
- The proposer always makes a fair offer. The responder rejects unfair offers often enough to make fair offers at least as profitable as unfair offers, and always accepts fair offers.
However, only the first set of Nash equilibria satisfies a more restrictive equilibrium concept, subgame perfection. The game can be viewed as having two subgames: the subgame where the proposer makes a fair offer, and the subgame where the proposer makes an unfair offer. A perfect-subgame equilibrium occurs when there are Nash Equilibria in every subgame, that players have no incentive to deviate from.[2] In both subgames, it benefits the responder to accept the offer. So, the second set of Nash equilibria above is not subgame perfect: the responder can choose a better strategy for one of the subgames.