The Prisoner's Dilemma

The best way to understand the Prisoner's Dilemma is to set 2 examples.

A classic example of the Prisoner's Dilemma

Two suspects are arrested by the police. The police have insufficient evidence for a conviction, and, having separated both prisoners, visit each of them to offer the same deal.
If one testifies ("defects") for the prosecution against the other and the other remains silent, the betrayer goes free and the silent accomplice receives the full 10-year sentence.
If both remain silent, both prisoners are sentenced to only six months in jail for a minor charge.
If each betrays the other, each receives a five-year sentence. Each prisoner must choose to betray the other or to remain silent. Each one is assured that the other would not know about the betrayal before the end of the investigation. How should the prisoners act?




Economics application of the Prisoner's Dilemma.

Consider two firms, say Coca-Cola and Pepsi, selling similar products. Each must decide on a pricing strategy.
They best exploit their joint market power when both charge a high price; each makes a profit of ten million dollars per month. If one sets a competitive low price, it wins a lot of customers away from the rival.

Suppose its profit rises to twelve million dollars, and that of the rival falls to seven million. If both set low prices, the profit of each is nine million dollars.
Here, the low-price strategy is akin to the prisoner’s confession, and the high-price akin to keeping silent. Call the former cheating, and the latter cooperation. Then cheating is each firm’s dominant strategy, but the result when both “cheat” is worse for each than that of both cooperating.


sources:
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multiple choice questions

Market Failure and Government Failure.

1. A farmer tips chemical waste into a river because he can do so at no cost to itself is an example of a positive externality.

a) True
b) False


2. People may not know what is in their own best interests and thus may under-consume certain goods or services such as education or health care.

a) True
b) False


3. Government failure cannot happen if the government has the support of consumers and producers when it decides on it's policies.

a) True
b) False


4. The list below shows the estimated costs and benefits of building a new factory

Private costs 90,000 pounds
External costs 30,000 pounds
Private benefits 75,000 pounds
External benefits 25,000 pounds

From the data it can be concluded that

a) Social costs exceed social benefits
b) Social benefits exceed social costs
c) The factory should be built
d) The social costs equal 30,000 pounds


5. Which one of the following is a characteristic of a merit good?

a) Once the good has been supplied to one consumer, there is no extra cost in supplying it to others
b) It is always provided free of charge to low-income consumers
c) It may not be provided by the market in sufficient quantities
d) It tends to be provided by the government because of the problem of non-excludability


6. A free good

a) Is available free of charge to consumers
b) Has no opportunity cost of production
c) Is not taxed by the government
d) Creates no externalities


7. Which of the following can be efficiently allocated between competing uses by the price mechanism?

a) Private goods
b) Public goods
c) Free goods
d) Negative and positive externalities


8. Which of the following is least likely to be a feature of a monopoly?

a) In the long run, no profits will be earned
b) Choice for the consumer will be restricted
c) It will be protected by barriers to entry
d) Price may be higher than in a more competitive market


9. What is implied by the existence of a negative externality?

a) Individuals are not the best judges of their own well-being
b) Output is below its socially optimum level
c) Producers are not always seeking to maximise profits
d) There is a divergence between private and social costs

10. Which of the following is not a cause of market failure?

a) The existence of commonly-owned property resources such as the oceans
b) The existence of public goods
c) The existence of externalities
d) The existence of perfect knowledge of prices among consumer and producer


Answers:
1)b
2)a
3)b
4)a
5)c
6)b
7)a
8)a
9)d
10)d