Required D

Explain how the prisoner’s dilemma game is relevant with regard to the behaviour of firms.

Required (A)

Explain under which market structure game theory may be used to analyse the behaviour of firms and why.

Game theory analyses situations involving the strategic behaviour of two or more decision makers who have conflicting objectives.

Game theory is used to analyse the behaviour of firms in an oligopoly market structure.

Oligopoly is characterised by a few (two or more) large firms which dominate the market.

The unique feature of this market is that the actions of one firm affects the behaviour of other firms and vice versa. Each firm has to consider the possible response of the other firm/s when embarking on a course of action.

For example mobile phone service providers or coffee beans producers. In this market structure game theory is useful to analyse the way in which two or more players choose actions or strategies which jointly affect each participant.

Required (B)

Explain the outcome of the above game using a payoff table.

		Subway
		Advertise	Do Not Advertise
Red rooster	Advertise	A (20,20)	B (50,10)
	Do Not Advertise	C (10,50)	D (30,30)

Explanation of the Outcome

In the above game in the first column if Subway advertises, then Red rooster will get a profit of 20 if it advertises and will have 10 if it does not. Therefore Red rooster will choose to advertise.

On the other hand (2^nd column) if Subway does not advertise, Red rooster will earn 50 if it advertises but will earn 30 if it does not. Therefore Red rooster will advertise.

The same reasoning holds for Subway. If Red rooster advertises (1^st row), then Subway will get a profit of 20 if it advertises and will have 10 if it does not. Therefore Subway will choose to advertise.

If Red rooster does not advertise (2^nd row), then Subway will get a profit of 50 if it advertises and will have 30 if it does not. Therefore Subway will choose to advertise.

Therefore no matter what strategy one firm follows, the other firm’s best strategy is to advertise. This is the outcome of the Game (cell A) where each firm earns 20.

However if the firms co-operate with each other they can earn 30 each by not advertising which is the pareto optimal outcome.

Required (C)

Explain the prisoner’s dilemma game using a payoff table and identify the nash equilibrium.

		Prisoner B
		Confess	No Confess
Prisoner A	Confess	C (5years, 5years)	D (3months, 10years)
	No Confess	E (10years, 3 months)	F (1year, 1year)

Description of the Game

Prisoner A and B are partners in crime. They are caught by the police and are interviewed in separate rooms by the district attorney. They are not allowed to see each other. The district attorney says “ I have enough on both of you to send you to jail for a year. But I will make a deal with you: If you alone confess, you will get off with a 3 month sentence, while your partner will serve 10 years. If you both confess, you will both get 5 years”.

The outcome of the Game

What should prisoner A do? Should she confess and get a shorter sentence? She will look at prisoner B’s strategies. If Prisoner B confesses then its better for B to confess and get 5 years rather than 10 years (column 1). If Prisoner B does not confess its still better for B to confess and get 3 months rather than 1 year (column 2).

Prisoner B is in the same dilemma: if only he knew what prisoner A was thinking. Since he is unable to contact prisoner A, prisoner B will decide that it is better to confess using the same reasoning that prisoner A used above.

Therefore both prisoners will confess and the outcome of the Game is shown in cell C where each prisoner gets 5 years. The significant result here is that when both prisoners act selfishly by confessing, they both end up with long prison terms of 5 years. Only when they act co-operatively or collusively will they end up with short prison terms of 1 year.

Required (D)

Explain how the prisoner’s dilemma game is relevant with regard to the behaviour of firms.

The prisoner’s dilemma is an example of non cooperative game where each party acts selfishly in their own interest and end up with long prison terms. However if the parties collude they will be better off.

This analysis can be applied to the behaviour of two rival firms. If the two firms collude they may be better off.

An example is price collusion under oligopolistic market conditions. However since this type of behaviour is anti competitive, there may be regulations restricting such behaviour.

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