The Prisoner's Dilemma

Click here to read about The Prisoner's Dilemma.

In my micro classes we recently played a Prisoner's Dilemma game. It relates to what might happen in an oligopoly (an industry with just a few firms). If two firms, like Ford and GM, both charge a high price, their profits will be high. But they each have a temptation to charge a lower price to make more profit (if they other firm does not lower their price).

Say they each charge $20,000 for a car. Then they each make $3 billion in profit.

But if one of them drops the price to $10,000 per car while the other stays at $20,000, that firm makes $5 billion in profit (very tempting) and the other makes zero.

What if they both charge $10,000? (we can expect the other firm to lower their price, since they do not want to make zero profit). Then they each make only $1 billion in profit.

If they could cooperate with each other, they would each charge $20,000 and make more profit than if they compete with each other on price.

Of course, cooperating on price is against the law (anti-trust laws, that is). So both Ford and GM can never really know if the other will keep charging $20,000. Then they both end up with less profit than if they charge $20,000. When they both charge $10,000, it is a "dominant strategy Nash equilibrium." (named after John Nash, the mathematician who won a Nobel Prize in economics and was portrayed by Russell Crowe in the movie "A Beautiful Mind")Click here to read how the movie presented some misleading views on Adam Smith and economics.

When Ford charges $20,000, GM's best move will be to charge $10,000 (see above discussion). When Ford charges $10,000, GM's best move will be to charge $10,000 (see above discussion). The same goes for Ford. So they both end up with lower profit. They can't really talk to each other. Not in a legal sense. Ford can't sue GM for violating a contract to raise prices since Ford knows the government will charge them with breaking ant-trust laws.

The same thing happens in the prisoner's dilemma in the link above. Two criminals are being questioned about a crime in separate rooms and they can't talk to each other. If they both deny doing the crime, they will get some jail time. But they each have a temptation to confess to get less time no matter what the other guy does. But, if they both deny they did it, they would each get less time than if they both confess.

If they could each think of the well being of their two person group (like Ford and GM), they would do better. But that is hard if you don't know for sure what the other person will do.