Two men are in custody for a crime they may or may not have committed: armed robbery. The police have the men in separate cells and have told them the following:
Confess to the crime of armed robbery and we will let you off with a light term of three years in jail with parole after one year.
Remain silent and we will throw everything we have at you, you will get 10 years in jail, because we promise you, your accomplice will talk.
However, if you both remain silent, we have to let you go with a slap on the wrist, just six months in jail for trespassing.
With this information in mind, the men, who are unable to communicate with one another both confess and get three years in jail. Why didn’t they both remain silent, though, and get just six months in jail?
This story is what’s known as the Prisoner’s Dilemma. It is a popular story used by economists to illustrate the challenges faced by non-collusive oligopolistic firms in deciding how to determine what prices to set for their products, whether to advertise or not to advertise, and many other strategic decisions that will affect the level of profits being earned.
The oligopoly market structure, more than any other, requires that firms act strategically, taking into account the decisions of their competitors, on whom they are highly inter-dependent. This lesson will apply the Prisoner’s Dilemma game to two firms deciding whether to charge a high price or a low price for their output, and analyze the most likely outcome in such a game. As we will see, without the ability to collude with one another, the strategic behavior of oligopolistic firms tends to result in an outcome that is not optimal for the sellers, but may benefit consumers.