EC5501: Thinking Strategically Essay Student Matriculation Number: 110018073

Prisoners Dilemma
Prisoners Dilemma (PD) game has two players and each one usually has two strategies that are identical with the opponents. As any other games in Game Theory, PD assumes that both players are rational and will play out their best strategy in order to gain the maximum benefit. It is a simultaneous game with players having no complete information of what their opponents will do, except assuming that their opponents will also play for their own personal gain (Poundstone, 1993). A distinctive characteristic of PD is that players choose to play their dominant strategy, which will result in a worse payoff than the payoff they will yield, if they cooperate by playing the dominated strategy instead. Cooperating to play the dominated strategy that will give the best outcome is called the cooperative strategy and playing the other strategy is called the cheating or defecting strategy. (Dixit, Skeath & Reiley, 2009) When a player cooperates and the other defects, the co-operator will receive the lowest payoff and the defector will receive the highest payoff. We can see an example of the play of cooperating strategy in one of Christopher Nolans movies, Inception. The main character, played by Leonardo di Caprio, strikes a deal with a character, played by Ken Watanabe, where di Caprio must alter the mind of Watanabes rival by entering his rivals dream. The payment for di Caprio is that his name will be cleared of any crime and he can come back to his home in the States. If both defect from the deal, both will not get anything from the deal. If Watanabe defects but di Caprio cooperates, Watanabe will get his benefit but di Caprio will not be able to get home at all even after all the trouble. On the other hand, Watanabe will still have its rival but di Caprio can come home. The real story is that both cooperate and get what they want in the end. The payoff matrix can be seen as follow:
Watanabe Defect Cooperate 0, 0 20, -5 -15, 20 10, 15

di Caprio

Defect Cooperate

According to Dixit, Skeath & Reiley (2009), there are 4 solutions to the Prisoners Dilemma. All solutions follow the first theorem of welfare economics, the invisible hand hypothesis, except Penalties and Rewards solutions where interventions are possible. By looking at these solutions closely, we see distinct properties in each solution. 1. Repetition:

In repeated PD, the players will not try to defect in order to keep the cooperation from breaking down. Players will keep cooperating if the present value of benefits when keeping the cooperation exceeds the present value of cost when cooperating. Alternatively, players will defect when the present value of benefits when defecting exceeds the present value of cost when defecting. The collective gain for both players will be much higher than it will be if both players defect. 2. Penalties and Rewards: In one-shot PD game, the Kaldor-Hicks efficiency can be seen, in which penalties for defecting and rewards for cooperating are incorporated in the payoffs. The original payoffs are made more efficient by reaching the Pareto optimal payoffs with allocating compensation from those who defect and made better off (as penalties) to those who cooperate and made worse off (as rewards). The effect of the outcome to a third party outside the game can also add positive externality and negative externality to cooperating and defecting players, respectively. It may be possible that when players have the bad outcome, it is beneficial for the rest of society (Dixit, Skeath & Reiley, 2009). However, it may be difficult to apply penalties in larger games, due to the possibility of misperceptions. 3. Leadership: In this solution, one player is a bigger player or relatively has a bigger stake in the outcome of the game, which makes that one player as the leader. The payoffs are designed using the Economic Impact Analysis. This type of solution more frequently comes in games at macroeconomic level, with countries or nations being the players. An example can be seen on Dixit, Skeath & Reiley (2009) about two countries plagued by a disease and to determine its cure. The example also follows the Bagnoli-Lipman mechanism where each player offers a voluntary contribution (Varian, 1994). 4. Asymmetric information: In a finitely repeated PD game, each player reaps benefits from the misperception against their opponents motives, especially when the opponents appear to be cooperating. Rosenthal (2001, p.423) argues that the equilibrium resulting from this solution is beneficial for overall welfare, as being a more steady equilibrium than the symmetric equilibrium. PD should be resolved in the interest of the players, as it gives them the best outcome. The payoffs exceed the Pareto optimal reached by the Nash equilibrium in the game. However, for the interest of other parties outside the game, it might be the case that PD should not be resolved. A real-world example of price war in telecommunication providers can be used. Assume that there are only two providers in this PD game and all

services cost both providers the same amount. Each provider promises their customers the lowest price. If left unresolved, the price war continues until each provider offers the price that will cover the cost of their services, however, customers benefit from cheap telecommunication services. In the case of one-shot game, PD should be resolved when the objective of the game is to minimize cost or loss (for example, jail time). On the other hand, it should remain unsolved when the objective of the game is to maximize profit or loss (for example, revenue per month). It is also because, the defectors cannot be inflicted with the penalties after a one-shot game (Dixit, Skeath & Reiley, 2009, pp.410-411).
Word Count: 956 words

References DIXIT A., S. SKEATH, and D. REILEY (2009) Games of Strategy. W.W. Norton & Compay, 3rd edition. POUNDSTONE, W. (1993) Prisoners Dilemma: John Von Neumann, Game Theory and the Puzzle of the Bomb. Anchor Books, 1st edition. ROSENTAHL, R.W. (2001) Trust and Social Efficiencies, Review of Economic Design, Vol. 6 Issue 3/4, 413-428. VARIAN, H.R. (2001) A Solution to the Problem of Externalities When Agents Are WellInformed, The American Economic Review, Vol. 84 No. 5, December 1994, 1278-1293. Additional Bibliography DIXIT, A.K. and B.J. NALEBUFF (1993) Thinking Strategically: The Competitive Edge in Business, Politics, and Everyday Life. W.W. Norton & Company, New edition.