Question: Using an example, explain what is meant by the term Prisoner’s Dilemma.
The Prisoner’s Dilemma is a situation in which two rational decision makers pursue actions which benefit their own self-interest but the end-result is not Pareto efficient.
Let’s assume there is a duopoly in the soft drinks market with Coca-Cola and Pepsi the only two firms. Coca-Cola and Pepsi must decide whether to spend $100 million on a TV advertisement or not.
If both Coca-Cola and Pepsi do not advertise then they make $100 million more profit because they save $100 million if they do not pay for TV adverts. If Coca-Cola believes that Pepsi will not advertise then Coca-Cola will advertise, make its brand stronger, steal some of Pepsi’s consumers and make $1 billion more profit, Pepsi’s profits fall by $500 million because Pepsi lose some consumers and vice versa. If both Coca-Cola and Pepsi advertise then they make their brands equally as strong and receive $100 million less profit because they receive no extra sales and yet must spend $100 million on advertising.
Now, if Coca-Cola believes Pepsi will not advertise then Coca-Cola will want to advertise to steal some of Pepsi’s consumers and receive $1 billion extra profit rather than make $100 million less profit. Pepsi will reason the same way. So both Coca-Cola and Pepsi will play their dominant strategy and advertise. In this case, both Coca-Cola and Pepsi will each make $100 million less profit because they spend money on advertising but attract no extra consumers from each other. So the Nash equilibrium (Advertise, Advertise) makes Coca-Cola and Pepsi worse off than if they both do not advertise.
As long as Coca-Cola and Pepsi do not trust each other to not advertise, they will both advertise. If Coca-Cola and Pepsi could collude and make an agreement or if they trust each other then they could both not advertise and save $100 million.