The prisoner’s dilemma

Optimal outcome ... Setting a lower price benefits consumers and both companies.

BY definition, the prisoner’s dilemma is a contradictory situation in which two parties acting in their own self-interests do not produce an optimal outcome.

This concept was originally developed in 1950 by Merrill Flood and Melvin Dresher. Some have speculated to say this concept was established to inspire enhanced thinking during the cold war.

The prisoners dilemma presents a situation where two parties or individuals in different locations and unable to communicate are made to make choices that entail cooperation.

The highest reward from this matrix always emanates from both parties cooperating but because these parties cannot communicate and reach a consensus, it becomes a dilemma, hence the term as derived by Alvin Tucker. Strategic thinking between two individuals can lead to outcomes that are suboptimal for both players.

The classic prisoner’s dilemma

Two bank robbers would have been arrested and placed in separate rooms. The interrogators and authorities will seek to convince the two criminals that they will have to testify to the crime and betray their accomplice in order to get the best deal.

If both remain silent, then they will both get one year each in prison and two years in total. On the other hand, if one testifies and the other does not, then the one that testifies will go free, while the one that does not will get five years in prison.

However, if they both testify that they committed the crime, then they will get three years each in prison. This scenario can actually be presented in a matrix to indicate the outcome of their separate choices.

The predicament faced by the two robbers is not knowing what the other is thinking and may often lead to one party betraying the other and barely cooperating.

Unfortunately this can be precarious as opposed to cooperation. If both parties cooperate and remain silent you will realise they will attain the most optimal result which is a one-year prison term as opposed to other scenarios as presented above.

The incentives faced by each prisoner separately will ultimately drive them to defect and face more jail time of three years each, which is suboptimal.

The economic implications

The most common concept is the tragedy of commons. Let us assume that there is a natural resource in the form of gold. It may be to everyone’s advantage to conserve and to re-invest in the propagation of the natural resource and continue consumption although each individual always has an incentive to consume as much as possible and as quickly as possible which then depletes the resource. Finding some way to cooperate will always make everyone better off.

On the other hand, the behaviour of suppliers in a market can be linked to the prisoner’s dilemma. Considering two firms say Coca Cola and Pepsi sell similar products. Each must ascertain a pricing strategy. They best exploit the market when they both charge a high price and each makes a profit of say US$5 million a month.

If one sets a relatively lower price than the other, it wins away a lot of customers from the other and let us assume that from this move, its profit rises to seven million a month and the rival falls to three million a month.

However, if both set low prices you will realise that maybe the profit may be US$4 million a month. However, the more optimal condition is both companies charging a higher price and getting US$7 million a month or a low price strategy to attain the next best optimal.

One firm co-operating with the other defecting will lead a point where one party is worse off.

Combating the prisoner’s dilemma

As discussed above, there is always a more optimum outcome when both players and parties cooperate. When one party defects while the other cooperates, there is a suboptimal outcome. The ultimate solution to this conundrum would be to focus on overcoming individual incentives in favour of the common goal.

Parties trading in markets or otherwise must choose strategies that reward co-operation and punish defection over time. In the example of Coca Cola and Pepsi, setting a lower price benefits the consumers and both companies also achieve an optimal condition without any party being made worse off as far as profits are concerned.

In a nutshell, following individual interests can lead to the worst possible outcome. Firms and companies in markets can always benefit more if they devised ways that benefit them in terms of optimal profits, while benefiting consumers in terms of lower prices.

  • Nyatanga holds a Bachelor’s degree in Banking and Investment Management. — 0784 909 184/[email protected]


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