Interpretation and Real-Life Applications of The Famous Economic Theory
The Article below was assigned to one of this year’s summer Interns, Ioanna Ioannou, and was written with the help and close supervision of our Team. Ioanna is currently a final year student at De Montford University, Leicester, UK. Ultimately, it has provided an opportunity for both the intern to enhance her knowledge through research, as well as writing skills, while our Company gained insight from a piece of writing which assesses real-life applications of an all-famous economic theory. The Article concentrates on the meaning and common sense included in the mind game between the two parties. It emphasises on demonstrating and evaluating real-life incidents and circumstances where the Prisoner’s Dilemma (part of the famous Game Theory) actually applies. It forms a short, simple, yet effective piece of writing, which allows for a pleasant academic read.
Prisoner’s Dilemma was first illustrated by the mathematicians M. Flood and M. Dresher in 1950 and then it was conceptualized by the Canadian mathematician A.W. Tucker. This theory is based on decision-making and follows from the well-known Game Theory paradox. It illustrates two individuals making decisions that result in an initially undesirable solution. Prisoner’s dilemma describes a situation where these two individual parties seek their welfare by acting selfishly to the disadvantage of the other party. In general, mis-cooperation in real life often leads to much worse condition of both participants. In this theory, it is the responsibility of the two parties, to choose whether to collaborate or not. The literature and real-life practice demonstrate that good level of cooperation often leads to greater economic choices, and ultimately better outcomes for everyone.
The Prisoner’s Dilemma scenario was initially described based on two arrested suspects of a crime. These two suspects were locked separately in different cells, and they could not communicate with each other. The two suspects were given the chance either to blame the other suspect or to remain silent. The outcome of being silent was a one-year punishment in prison. On the other hand, if they decided to speak out and blame each other then they would each get a three-year sentence in prison. However, if one suspect chose to blame the other and the other party remained silent, then the suspect who remained silent would serve a five-year period in prison, whilst the other would be set free. Table A shown below demonstrates the possible outcomes (years in prison) from any possible strategy:
Table A
In such a situation, both parties do not have the chance to know the decision made by the other suspect. However, acting selfishly and blaming the other suspect can be considered as a method of self-interest. If suspect A remains silent, they will receive five years in prison if suspect B blames them. On the other hand, if suspect A chooses to blame suspect B, then they are not going to serve any years in prison. However, that is not very common, as suspect B will follow the same path as A, that is blaming suspect A. In such case, they will both end up with 3 years of imprisonment.
Reviewing the theory from a distance, the decision of remaining silent by both suspects provides the ideal solution for them. However, this is not the rational option at the moment as both parties believe that they will end up with less privileges, even though in reality this would be the strategy serving their own self-interest. Therefore, they will each blame the other person in an effort to be better off.
Application to a real-life scenario:
Table B
Considering a real-life application of the Prisoners’ Dilemma (following from the example demonstrated by Investopedia), Coca-Cola and Pepsi are selling similar products and they are called to decide on a pricing strategy that will help in making profit in a competitive market. Through maintaining a high price, both companies are taking advantage of their joint market share, and each gain a profit of $500m per month. High prices are the respective result of keeping silent. Assuming that there is perfect competition between the two firms, in the case of Coca-Cola decreasing its prices, then lots of Pepsi’s customers will start buying the most affordable product, that being Coca-Cola (other things being equal, i.e., taste, customer loyalty, etc). As a result, Coca-Cola’s profits will increase to $750m, while Pepsi’s profit will decrease to $100m. Similarly, if Pepsi decreases its prices, then it will enjoy higher profits than Coca-Cola. However, Prisoner’s Dilemma states that both companies will behave irrationally in the essence that they will both lower their prices to achieve higher market share (similar to a prisoner’s confession) and they will end up with a decreased equal profit of $350m each. All in all, if any company decides to ‘cheat’, it will find itself in a position to suffer from the consequences of seeing the competitor copying this strategy by doing the same. Inevitably, the outcome of this, is worse for both companies than that of cooperating in the first place. Consequently, they will both have a lower profit, as an ‘’arms race’’ will not constitute an advantage for them (Dixit and Nalebuff, 1991).
However, evaluating the above scenario from the perspective of the average consumer, it is clear that such strategies do benefit the people buying these products, as the prices of the products fall (other things being equal). As a result, oligopolies in industries of products like the one above often have the incentive to form cartels and fix prices in order to avoid the inevitable “lose-lose” situation (e.g., OPEC (Organisation of the Petroleum Exporting Countries)). On the other hand, governments and regulatory bodies are usually assigned with the task of intervening to maintain healthy levels of competition amongst the different sectors of the economy, therefore allowing the market forces to work properly when necessary and restricting Price Fixing.
It is evident from above that human nature (be it a prisoner, or a multinational company, or even a State) will always try to win the extra bit for themselves in the game of life. As everyone will think and behave the same way, they will all end up (in most cases) in a worse position than the initial.
It takes greatness and thinking ahead rationally, from both sides, and an effort to step in each other’s shoes in order to understand and act towards their mutual benefit. That is not so much in trade, in ways such as illegal Price Fixing, but rather in Politics, where there is much at stake and negative results for one or both parties could be disastrous. An example of such behaviour where the Game Theory analysis was applied, producing the optimal result for both parties and (more broadly) for the whole world, was the avoidance of nuclear conflict in the Cuban Missile Crisis of 1962 between the U.S.A. and the Soviet Union, where common logic was applied for the benefit of humankind.
BIBLIOGRAPHY:
• Dixit Avinash and Barry Nalebuff. Thinking Strategically: A Competitive Edge in Business, Politics, and Everyday Life. New York: W. W. Norton, 1991.
• Corporate Finance Institute Website Link: https://corporatefinanceinstitute.com/resources/knowledge/other/prisoners-dilemma/ (Table A).
• Investopedia Website Link: The Prisoner’s Dilemma in Business and the Economy (investopedia.com)v (Table B).
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