The best thing about economics is that there’s no end to topics that sound absolutely riveting.
I mean (forgive me for being a bit opinionated), “Prisoners’ dilemma”, who wouldn’t be interested to at least have a look?
Prisoners’ dilemma is a part of game theory, which basically is a study of how people behave in strategic situations. Strategic in the sense that decisions are made after considering how other people might respond to it.
Let’s get to it with a very cool visual.
The prisoners’ dilemma is a story about 2 criminals captured by the police. We’ll call them A and B. The police have enough evidence to convict A and B of the minor crime of petty thievery which will put them behind bars for 1 year. The police also suspect their involvement in an arson case but they lack hard evidence to convict them of this major crime.
So here’s what they do. They question A and B in separate rooms and offer a deal:
“Hey, right now we can lock you up for 1 year. If you confess to the arson crime and implicate your partner, you go free and the partner will get 20 years in jail. But if you both confess, you both will get an immediate sentence of 5 years since we’ll be able to avoid the complications of a trial.”
A and B, ruthless criminals as they are, obviously only care about themselves. What will they do? Each prisoner has two strategies (see figure 1) : confess or remain silent.
Consider A’s decision. He thinks, “I have no clue what B will do. If he remains silent, my best strategy is to confess because I’ll go free rather than spending a year in jail. If he confesses, my best strategy is still to confess, because then I’ll spend 5 years instead of 20. So, whatever he does, I’m better off confessing.”
In game theory, this is called a dominant strategy, it is the best strategy for a player to follow regardless of the strategies other players would be pursuing. So A’s dominant strategy is to confess. Similarly, B faces exactly the same situation and thus B’s dominant strategy is also to confess.
In the end, both A and B end up confessing and spend 5 years in jail. This outcome is the Nash equilibrium.(named after Nobel Prize winning mathematician and economic theorist John Nash) It is a situation in which players choose their dominant strategies.
However from their standpoint, this outcome is terrible. If they had both remained silent, both of them would’ve been better off, spending only 1 year in jail.
You might as well have thought that they could’ve planned in advance not to confess. But what is the guarantee each of them will live up to the agreement? Once they are separated, self-interest dominates and leads them to confess.
Now let’s put this into perspective.
To see how prisoners’ dilemma applies in imperfect markets, we need to first understand a little bit about how oligopolies work.
An oligopoly is a market with only a few sellers so there’s a huge tension between cooperation and self-interest. Oligopolists may come to an agreement to produce less and keep profits high (because lesser supply increases the price) or they may choose to produce more because that gives them a higher share of the market and thus higher profits.
(Please note that there is much more to how this market works, but here we have kept it brief for understanding how prisoners’ dilemma works in markets)
We’ll take an example to understand this more fully. OPEC, the Organisation of the Petroleum Exporting Countries, is a cartel (group of firms acting in unison) formed by the countries that produce most of the world’s oil. It includes nations like Iran, Iraq, Saudi Arabia, Kuwait, etc. What they essentially try to do is to raise the price of its product through a coordinated reduction in quantity produced. It tries to set production levels for each of the member countries.
But it’s not so easy. Why?
Consider there are only 2 countries, Iran and Iraq, for simplification (refer to figure 2)
Here’s what Iran thinks: “I don’t know what Iraq will do. If it produces less, that is, lives up to its agreement, my best strategy is to produce more because though the overall supply will increase, I will get more profits because of higher market share. If Iraq produces more, my best strategy still is to produce more because I’d rather have $40 billion than 30. So regardless of what Iraq does, I’m better off with higher production.”
So both produce more which leads to an inferior outcome for them with low profits for the producers (see the figure). Producing less was jointly rational for them, but each oligopolist has an incentive to cheat.
The OPEC was successful at maintaining coordination initially and enjoyed higher profits. But in recent years, it has been failing at reaching and enforcing agreements, thus the prices are driven by natural forces of demand and supply than by the cartel’s artificial restrictions on production. So while it has led to lower profits for oil-producing nations, it has benefited consumers around the world.
Cooperation is difficult to maintain, because cooperation is individually irrational.
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