Picture this: you and your friends are in a bar, and in front of you is a group of ladies of which there was one who caught everyone’s eye. All of you want to go after the same girl. The question here, is what is the socially optimal outcome? By intuition, you and your friends could all behave according to your own interest and go for that one girl. This is essentially what Adam Smith proposed in the Wealth of Nations in that market competition maximises welfare, and that individual ambition serves the common good. But rethinking this scenario leaves an unequivocally lonely outcome: that you and all your friends would get into each others’ way, and when you turn to the other ladies you receive the same rejection because no one wants to be treated as a second choice. Therefore, a more romantic choice would be for you and all your friends to each go for all the other ‘less desirable’ ladies in the group, a choice which leaves everyone with a date. Believe it or not, this was the initial conceptualisation of Game Theory by John Nash.
For all the criticisms of economics for its failure to model human behaviour quite adequately, Game Theory is a branch that preserved the integrity of this social science. Essentially, it is a study of perfectly logical players locked in a situation who are interested only in winning. With both rationality and a desire to win, the players will behave in a manner that encourages the most optimal outcome for themselves. This, opens the game to the analysis of Game Theory.
Game theory analysis is applied in reality through the complexities of a situation known as the prisoner’s dilemma. Imagine a situation where two prisoners are involved, and with three possible outcomes: if both prisoners do not testify against each other, there’s little evidence of a crime and their sentence gets reduced to the minimum; if only one of the prisoners testify, he’s freed while the other prisoner gets full sentence. But if both of the prisoners testify, both get a lower sentence for admitting to their crimes. In this case, what should a prisoner do in order to behave in his own interest?
This is a dilemma because the prisoner is forced to make a rational choice under uncertainty, such that it is impossible to weigh the options in both logical and illogical manners. Is it even possible to make a rational decision in games of such dilemma? Both fear being the only one who doesn’t co-operate, because that leaves one with the worse punishment. By rational logic, this implies that one should always co-orperate. YET, applying this same rational framework to the mind of your opponent, it shows that he can attain an even better payoff by defecting. Therefore, when you think strategically in the shoes of your opponent, it suddenly becomes rational not to co-operate instead. You thus find yourself trapped in a mental dilemma, because it is as hard to justify cooperation as it is to accept mutual defection as the logical outcome. In this sense, the prisoner’s dilemma falls into a grey area of logic – neither cooperation not defection is purely right, and this is a problem where we may truly not have a genuine solution for. Therein, lies the beautiful paradox of Game Theory.
Prisoner’s dilemma was ground-breaking in the field of economics precisely because it proved that it may be impossible to act rationally according to one’s own private interests. It essentially causes players indifferent towards either strategies… a situation where their entire rationalising, decision-making framework simply breaks down. Game Theorists R. Duncan Luce and Howard Raiffa wrote in great detail in their 1957 book Games and Decisions about the [sense] of hopelessness that one feels in such a game, as both ‘rationality’ and ‘irrationality’ are simultaneously inherent in the situation. The complexity here could be applied to the analysis of various market developments as well. For instance, while it could be said that the trigger of the largest oil-price slide this year was attributed to the huge increases in oil supply due to years of investments reaching fruition in the U.S Shale industry, another main culminating force that sustained the price drop was due to Saudi Arabia and OPEC nations matching their oil-production to that of U.S’s. Given that these Middle-Eastern countries usually require at least USD$90 per barrel in order to avoid public fiscal deficits, it makes sense to wonder what self-interests are they protecting when they increase oil-production even at an unsustainable price of USD$47.50 per barrel. This makes me believe that Middle-Eastern countries, like the prisoner, decided to cooperate and play the same strategy as that of the U.S’s because they don’t want to be left with the worst consequence of losing market share in the global oil market. By increasing oil supply and depressing prices even further, they reduce the profit margins of U.S Shale producers and ensure that they don’t obtain the best outcome. While this is not the perfect case of prisoner’s dilemma because either parties are not playing in total uncertainty, it shows that in a competitive market acting irrationally could be a way of protecting one’s self-interests, and hence, a rational behaviour.
A more salient illustration of the kinds of complexity brought out by prisoner’s dilemma is the dollar auction. This is a game played by two players who both simultaneously bid for a dollar. The dollar goes to the highest bidder while the second-highest bidder pays the full price of his bid and gets nothing in return. Evidently, topping a bid is defective in nature because it increases the player’s short term position while hurting the common good by chipping away the potential profit gain. Rationality causes the player to always be defective, and this ends up blurring the lines of rationality even more when the next bid exceeds the value of a dollar, in which both players compete for minimising losses. Prisoner’s dilemma, as it is, shows then that it is possible to sell a dollar for more than a dollar in such an auction. But when thoughtful players try to cooperate for the collective good, their kind intentions gets exploited. They then end up in an endless cycle of peer competition until they completely lose sense of rational discretion.
This is why I feel that the implication of prisoner’s dilemma is strongest when it is greatly personal. It undermines our values because we are forced to deviate from our true inner compass, which happens when we second-guess others and their goodwill. When two players who genuinely wanted to cooperate ends up defecting because they misread each other’s intentions, what we have is a moral tragedy. The puzzle of the prisoner’s dilemma, therefore, is how such good intentions pave the road to hell.
4th November, 2015
SITONG
Rethinking utopian economics. 
“co-orperate”
spelling mistake in paragraph 4
Thanks Gabriel. Like old times (: