If you’ve taken a course in game theory or economics, you may already be familiar with the Prisoner’s Dilemma. Here at the Johnson Graduate School of Management at Cornell, we just went over it today in class. My professor is the esteemed Robert Frank – I find him to be quite likable and his course to be quite intriguing. For those of you who aren’t familiar with him or his work, he has co-authored a textbook with Ben Bernanke (presiding Federal Reserve Chairman), among other things.
At any rate, today he brought up the famed Prisoner’s Dilemma, which I vaguely remember seeing during some game theory class during my undergraduate computer science days. In economics, there is a beautiful thing Robert Frank calls the “Invisible Hand”, which guides prices to their correct equilibrium points. Before today, the equilibrium points were illustrated as being good achievements for the most part, other than certain social surplus implications, which is another whole topic in itself. But today we were shown the case where the “Invisible Hand” actually guides those partaking in a particular market to a less desirable option. This was illustrated with the Prisoner’s Dilemma.
The image to the left from Investopedia.com shows a visual representation of the dilemma. The problem starts like this: there are two prisoners being held for crimes the district attorney knows they committed together. They are given the following plea deals: if one of them confesses and the other does not, the one who confesses gets no time in jail where as the other one gets 20 years in jail. If both of them confess they both get five years in jail. Finally, if both of them keep quiet, they both get three months in jail. The criminals are not allowed to talk to each other before making their decisions.
So, how do they decide? First, you might think that they would both keep quiet and thus get the lightest average sentence. However, the two haven’t been able to talk to each other, and even if they were able to talk and reach some sort of agreement, what would keep one of them from backing out and screwing the other one over? These are criminals by the way.
So what gives? Well, if the criminals behaved economically in their own self interests, they would have to confess. The worst case scenario for either of the criminals is 20 years in jail, and this can be avoided for sure by confessing. Neither criminal can trust the other criminal to keep quiet, and even if they thought they could the temptation to break the agreement and get out of jail immediately as well as the constant thought of getting screwed over by the other criminal would most likely dissuade them both. From the standpoint of either criminal, confessing leads to surefire avoidance of the worst option, 20 years in jail. Furthermore, confessing leads to the possibility of achieving the best option, no time in jail, should the other criminal elect not to confess. Thus, by confessing both criminals are eliminating the worst option and keeping the best option on the table as far as either of them know.
The end result is that the “Invisible Hand” guides the prisoners to an equilibrium point that is not as desirable as one that could have been achieved if they somehow could have reached and maintained a compromise. The best result possible collectively for both of them would have obviously been three months in jail each, but in this case we have economics gone wrong, and they end up both spending five years in jail.
It is cases such as this that fuel the need for regulation in certain industries in order to achieve the best collective results. This is why completely unregulated free market capitalism actually isn’t always the best answer. And this is why I’m growing to love economics, it really does hold a lot of interesting insights to the way society functions in the world around us.