Question

3a. Describe and explain the prisoners’ dilemma. Discuss its implications for firms’ pricing in an oligopolistic market.

3b. Explain the Dominant Firm Model and apply it to the OPEC cartel to explain why they have been successful in maintaining world oil prices above competitive levels. Use a diagram to illustrate your answer.

Answer 1

The Prisoners Dilemma.

Two prisoners are held in a separate room and cannot communicate They are both suspected of a crime They can either confess or they can deny the crime Payoffs shown in the matrix are years in prison from their chosen course of action		Prisoner A
		Confess	Deny
Prisoner B	Confess	(3 years, 3 years)	(1 year, 10 years)
	Deny	(10 years, 1 year)	(2 years, 2 years)

• What is the best strategy for each prisoner?

• Equilibrium happens when each player takes decisions which maximise the outcome for them given the actions of the other player in the game.

• In our example of the Prisoners' Dilemma, the dominant strategy for each player is to confess since this is a course of action likely to minimise the average number of years they might expect to remain in prison.

• But if both prisoners choose to confess, their "pay-off" i.e. 3 years each in prison is higher than if they both choose to deny any involvement in the crime.

• In following narrowly defined self-interest, both prisoners make themselves worse off

• That said, even if both prisoners chose to deny the crime (and indeed could communicate to agree this course of action), then each prisoner has an incentive to cheat on any agreement and confess, thereby reducing their own spell in custody.

The equilibrium in the Prisoners' Dilemma occurs when each player takes the best possible action for themselves given the action of the other player. The dominant strategy is each prisoners' unique best strategy regardless of the other players' action Best strategy? Confess? A bad outcome! – Both prisoners could do better by both denying – but once collusion sets in, each prisoner has an incentive to cheat!		Prisoner A
		Confess	Deny
Prisoner B	Confess	(3 years, 3 years)	(1 year, 10 years)
	Deny	(10 years, 1 year)	(2 years, 2 years)