Consider this scenario: -
Two Prisoners, A and B, are suspects for a crime and are put behind bars. The cops have no evidences against either of them. So the cops offer the following to each of the prisoners. "If you deny your crime and the other accepts, you get a term of 10 years and the other goes free. If you both accept, each one gets 5 years and if you both deny you both get 6 months each." The offer is summarized below
| Prisoner B Rejects his crime | Prisoner B Accepts his crime | |
| Prisoner A Rejects his crime | A gets 6 months B gets 6 months | A gets 10 years B goes free |
| Prisoner A Accepts his crime | A goes free B gets 10 years | A gets 5 years B gets 5 years |
Given the above scenario, how do you expect each of the Prisoner's to react considering the fact that neither of the prisoners knows what the other is going to do.
Consider Prisoner A. What would be the best course of action for Prisoner A given the actions of Prisoner B.
- If B rejects his crime, the best course of action for A would be to accept his crime.
- If B accepts his crime, the best course of action for A would be to accept his crime.
Consider Prisoner B. What would be the best course of action for Prisoner B given the actions of Prisoner A.
- If A rejects his crime, the best course of action for B would be to accept his crime.
- If A accepts his crime, the best course of action for B would be to accept his crime.
Since neither A nor B are aware of the actions of the other, they both end up accepting their Crimes thereby getting terms of 5 years each.
The above scenario is what is referred to as the Prisoner's Dilemma and is a classic example of Game Theory. It explains why, even though by co-operating each player can benefit more, each player tries to maximize his/her payoff at the cost of the other player's payoff.
One application of the above theory is to explain how firms in an Oligopoly work together. Oligopoly refers to a market where there are a few firms competing with each other. If all firms in an oligopoly collude together, they can artificially jack up the prices and earn extra ordinary profits. However, each firm has an incentive to reduce prices in order to increase sales so that they can increase their profits even more as compared to their competitors. Because of this suspicion that the other firms might reduce prices, every firm reduces it prices and the collusion fails. Because of this none of the firms in an Oligopoly earn extraordinary profits.
However, there are Oligopolies that collude and work successfully by raising prices artificially. One example which I can cite is 'OPEC'.
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